As we embark on 2011, gold continues to climb and investors are questioning its future price direction. Is gold in a bubble? Have the price gains of the last decade-which beat out stocks, bonds and several other favored asset classes- peaked? Did today's investors miss the opportunity to buy?
Since 2002, we have responded to these questions daily, as gold climbed from $275 an ounce to over $1,400. Unfortunately, most people see gold as just another dollar-based asset class to be evaluated using the same metrics as stocks and bonds, and commodities like corn and coffee. But in order to understand the benefits of buying and holding physical gold, investors must go beyond conventional economic wisdom and understand causes rather than symptoms. They need to be able to interpret the message gold is sending.
Gold has its own rules, which explain its price performance and form the foundation of what we call "the gold mindset." This is completely different from the debt-based mindset that has prevailed since 1971, when President Nixon removed the U.S. dollar-the world's reserve currency-from its international peg with gold. Eliminating the gold standard has resulted in anywhere from $14 trillion to $200 trillion of debt for the U.S., which now relies on a phenomenon called "Quantitative Easing" (QE) for economic survival. QE, or money printing, has triggered global currency devaluations and protectionism worries.
In this piece, we will examine four of gold's most important rules; the irreversible trends affecting the gold price; and how the consequences of these trends will push gold higher in 2011 and beyond.
The Golden Rules
Rule 1: Gold is money, not a commodity. Gold trades on the currency desks of the major banks and brokerage houses, not the commodity desks. Central banks have always regarded gold as money, yet many investors today view it as an ordinary commodity, like pork bellies. Because none of the world's currencies are backed by gold, it has become the anti-currency-the money of last resort impervious to Wall Street games, Main Street's over-consumption or QE-happy Keynesians. In 2009, gold officially became money once again when central banks around the world, including those of China, India and Russia, became net buyers for the first time in nearly 20 years. We believe that central banks are preparing for a return to some form of the gold standard.
Rule 2: Gold does not rise: currencies lose purchasing power against gold. Milton Friedman-the renowned American economist-stated: "Nations are not ruined by one act of violence, but gradually and in an almost imperceptible manner, by the depreciating of their circulating currency, through excessive quantity." That is bad news for the U.S., Canada, Britain, the Eurozone and Japan. Their currencies have lost more than 70% of their purchasing power against gold during the past 10 years. When we begin asking: "How many ounces of gold will this cost?" rather than, "How many dollars will this cost?" The shift in perspective is eye-opening.
Gold is a stable economic measure and a reliable standard by which to measure real inflation. Governments manipulate inflation figures to keep the official Consumer Price Index (CPI) artificially low, since the slightest rise can translate into billions of dollars in government-indexed pension payments to the growing number of baby boomer retirees. Today, instead of using a fixed basket of goods that represents a certain standard of living, methods such as substitution, hedonic adjustments (for estimating demand or value) and geometric weighting, are used to understate the CPI.
For instance, John Williams of www.shadowstats.com, calculates the CPI using the original methodology. His figures show that real inflation is already at 8.5% and climbing. Since the CPI has an inverse relationship with Gross Domestic Product (GDP), understating the CPI automatically overstates GDP.
Rule 3: Gold has intrinsic value. Gold has intrinsic value because it is difficult to find, to mine and to refine. In Roman times, an ounce of gold would buy a good suit of clothes; today, the same applies. In his book, "The Golden Constant," Prof. Roy Jastram demonstrated that gold's purchasing power remained remarkably stable between the years of 1560 and 2007.
Rule 4: Gold is a wealth-preserving asset, not a wealth-accumulating asset. We buy and hold gold bullion to preserve wealth. We may speculate in gold stocks, exchange-traded funds, futures and options to increase wealth, but gold bullion ownership best serves the purpose of wealth preservation. This has been the case for thousands of years and will continue to be so unless governments discover a way to produce gold out of thin air, as they do fiat currencies.
Three Irreversible Trends
Since gold appears to be rising because of currency debasement (a term derived from the Roman Empire's practice of hollowing out gold coins and filling them with base metals), we need to consider whether governments will continue to spend and whether inflation will continue to rise. Three irreversible trends indicate that this pattern will persist for years to come. They are the aging population, outsourcing and peak oil.
The world's population is getting older, and most countries offer government-funded social programs designed to help retirees enjoy their golden years. However, an aging population means rising health care costs along with declining tax revenues. This is an unsustainable situation. In Europe, there has been rioting in the streets, as people protest retirement age hikes and cuts to benefits and services.
North American companies now outsource whatever they can with no regard for employees or communities; only the bottom line matters. It is far cheaper to hire someone in China-at 80 cents per hour with no benefits-than it is to hire someone in America-at $20 per hour, plus benefits. Without government protectionism, shareholder pressure ensures that this trend is irreversible. Without jobs, people cannot pay taxes or buy goods.
Finally, we have the serious issue of peak oil, which threatens to destroy the global economy, heavily dependent on cheap fossil fuel. Peak discovery has already occurred and we are fast approaching peak production of reasonably priced oil. Switching over to more expensive oil or to alternative fuels will have a negative impact on global GDP. This irreversible trend will fuel inflation for years to come.
These macro trends will result in:
- lower GDP
- systemic unemployment
- lower tax revenues
- increased money supply
- more government debt
- rising inflation
- declining currency value
- and higher gold prices.
Increased government debt and money printing to service the interest on this debt are direct consequences of these three trends. Since 1971, U.S. debt has soared to $13.96 trillion from $776 billion. Boston University economist Laurence Kotlikoff disagrees with that number; he believes true U.S. debt is $200 trillion, or a staggering 840% of GDP.
As investors lose confidence in currencies, the world's appetite for the relatively small amount of available gold will increase. There is an estimated $200 trillion in financial assets worldwide, not including real estate and derivatives. When demand for gold as a safe haven increases, there will be a transition from the $200 trillion financial assets market, to the $3 trillion gold market-much of which is owned by central banks and the world's wealthiest families, and not for sale at any price.
Future: Too Much Money Chasing Too Little Gold
The Chinese government is encouraging its citizens to invest 5% of their savings in bullion. Central banks in China, India and Russia are scrambling to increase reserves. Investment funds and banking institutions globally are turning to gold for insurance. Meanwhile, gold discoveries are down and production costs are rising. Clearly, competition for available gold will become fierce.
Where will the price of gold go?
In 2011, if gold repeats its average five-year increase of 19%, it will climb to $1,785 per ounce. If gold repeats 2010's projected performance in 2011, it could reach $2,010 per ounce. If the U.S. Federal Reserve unleashes more QE, gold's price will be much higher.
Today, gold is telling us that it can protect our wealth as it has successfully done for thousands of years. In such uncertain times, it is comforting to know that bullion ownership allows for sovereignty over personal economic destiny, and can change the way we view and experience economic reality.