by Darren C. Pollock
March 15, 2011
More than five years ago our analysis of the housing and mortgage markets indicated the eventual bursting of the housing and credit bubbles would lead to a weakened economy, and the Government would seek to combat this economic malaise with massive monetary and fiscal stimuli that would decrease the value of the U.S. dollar (USD) and increase the value of precious metals relative to the USD.
The price of gold has appreciated significantly in relation to the USD in recent years. Some even wonder if gold is in a price bubble and if so it is a reasonable question whether we should make sales and take profits. We think not. Our view is that gold is in a long-term bull market, not a bubble. While the price of gold could decline in the near term, and we certainly expect volatility, we foresee higher prices over time.
Ideally, money is a medium of exchange, a unit of account, a store of value and may be readily exchanged for other assets without losing value. For thousands of years gold has been accepted as money. This is no quirk: it is portable, divisible, durable, and – other than through a process requiring both a supply of platinum and a controlled nuclear reaction – inimitable. It is widely accepted, noncorrosive and indestructible. Due to the aforementioned, plus its scarcity, gold retains its value over time, though its price fluctuates. Humans are eminently attracted to the yellow metal as if pre-programmed at birth, yet gold is weighty not just in the mind of man: one cubic foot of gold weighs close to 1,000 pounds (worth nearly $22,000,000 today). Small quantities – such as one ounce – can be stretched into a wire 60 miles long. Is it any wonder that gold is the traditional gift for the rare accomplishment of a couple's 50th wedding anniversary? On the other hand, the couple that reaches the easily attainable one year anniversary gets to celebrate with the gift of, you guessed it, paper.
And paper is the very material against which gold is most commonly measured. While gold might not be the perfect currency, those of "fiat" origin – that which is printed on paper and is backed by nothing more than faith in those doing the printing – are riddled with imperfections. Their lack of sustainability is just one example. In this country alone, currency arrangements have taken many forms in more than 200 years. Each form and the value thereof has evolved more or less based on the underlying health of the economy and the degree to which its value was either protected or debased by the U.S. dollar's governing body, the Federal Reserve.
Paper money is far easier to use than gold in personal and commercial transactions. However, compared to gold fiat money has not been a reliable store of value. For example, in 1932 an ounce of gold was worth about $20, while early this year an ounce of gold was worth nearly $1,400. In this measure of relative value, since 1932 the U.S. dollar (USD) has lost almost 99% of its value in relation to an ounce of gold.
Gold epitomizes faithfully, as it always has, the key monetary characteristic of being a reliable store of value. And unlike fiat paper money, gold cannot be created by printing or its electronic equivalent. There is no "central bank" for gold, and none is needed.
Our Federal Reserve is the steward of the USD, our nation's currency which has been the world's key currency for nearly 100 years. The current Chairman of the Fed, Ben Bernanke (as well as his predecessor, Alan Greenspan), displayed a lack of understanding of the troubles they were instrumental in creating for our economy that led to the great crash and financial crisis that erupted in 2008. We have little faith that the same central bankers at the Fed who did not see the financial crisis coming will be able to extricate us safely from the destructive aftermath of the crisis. This is among the reasons we believe gold will continue to rise vis-à-vis the USD.
An economic recession began in March 2001 and ended in November 2001. At the onset of the 2001 recession, the Federal Reserve immediately began lowering short-term interest rates, eventually taking rates down from 5% to 1%. The economic downturn of 2001 was considered the shallowest recession in nearly a century. Yet the stimulative response of the Fed was extraordinary: the Fed held rates as low as 1% until June 2004—two and a half years past the point the recession ended.
Rates held this low for this long motivated people to seek a better return anywhere they thought they could find it. This boosted asset prices in the stock market, but especially in the housing market which escalated into the biggest house price bubble in U.S. history. That should have ended confidence in the Federal Reserve.
Unconcerned about causing the previous bubbles in the stock market and real estate the Bernanke Fed met the onset of an "unprecedented" (to Bernanke) collapse in housing and financial markets with a truly unprecedented monetary stimulus. Within two years of the crisis erupting in September of 2008, Bernanke increased the monetary base by more than 10% of the size of the U.S. economy. This was over 3x as much monetary stimulus as the Fed provided during the Great Depression, and more than 10x as much monetary stimulus as in the average recession since World War II.
In the second half of 2007, when growing losses in the subprime mortgage market became apparent to Bernanke, the Fed began to lower interest rates. The Fed quickly pushed its short-term interest rates down to a range of 0.0% to 0.25% where they remain today.
With no more ability to cut short-term interest rates the Bernanke Fed turned to "quantitative easing" ("QE"), the euphemism given by the Fed for its creation of money out of thin air to purchase financial assets such as Treasury bonds and mortgage-backed securities. The dollar amount of money newly created by QE is staggering—roughly $1.7 trillion to date. Rather than stimulating the economy the new money stimulated stock markets across the globe and pushed up the price of nearly all other investment classes, too.
Knowing that this type of money creation was potentially dangerous in the long run, Bernanke reassured the markets by vowing to end his campaign of quantitative easing by April 2010. As with other stimulus measures such as cash for clunkers and tax credits doled out to first-time homebuyers, the withdrawal of the stimulus would likely cause a decline in the very markets it served temporarily to support. The Fed spoke strongly of an "exit strategy" from its initial QE program (QE 1), but we expected it to renew QE once the markets responded poorly to the end of QE 1.
When the QE crutch was pulled away in April, the S&P 500 fell 17% into July and fear gripped the financial markets. The Bernanke Fed was forced to pick its poison: either withdraw liquidity, reducing the monetary base causing the markets and economy to dive immediately, or resume QE and run the risk of devaluing the dollar and fostering future inflation. So, beginning in August, Bernanke hinted at what would become explicit policy in November: committing another $600 billion of money not yet in existence to what is dubbed "QE 2."
In an Op-Ed essay Mr. Bernanke said it was the aim of QE 2 to stimulate the stock market in the expectation that would encourage consumers to resume borrowing and buying as they had before the recession. However, that is what got so many people into financial trouble in the first place. Mr. Bernanke ought to be aware that such tactics failed to help the Japanese economy emerge from what has become over 20 years of economic stagnation.
In a recent "60 Minutes" TV interview, when asked for the level of his confidence about avoiding the high inflation that is considered a natural byproduct of such an immense increase in the monetary base through QE 1 and QE 2, Bernanke said that he was "100%" confident the Fed could avert high inflation. Bernanke must know that the only way to stop inflation from getting out of hand after too much money creation is to do what the Paul Volcker Fed did in 1979: raise interest rates to high levels and actually decrease the monetary base, thereby causing a sharp downturn in the economy. That was painful but it paved the way for an economic recovery coupled with lower inflation.
From Bernanke we expected nothing less than 100% confidence; catering to the financial markets while boasting of the ability to walk a monetary tightrope is a top priority for the Bernanke Fed. Yet given the Fed's unwillingness to raise interest rates and tighten monetary policy in a timely manner in the wake of the shallowest recession on record just ten years ago, is it realistic for investors to be 100% confident that during this Great Recession the Bernanke Fed will turn off the monetary spigot in time to avoid significant inflation? We think not. Bernanke believes that one of the worst policy missteps in handling the Great Depression was ending monetary stimulus too soon. By his previous actions and in currently stating a desire to increase the rate of inflation, he has made clear his intent to not repeat this supposed mistake. We believe precious metals offer protection against the continued dollar debasement that could come from this Fed's policies.
Increasing demand for gold is global due in part to the Fed's dollar devaluation policies as foreign governments and citizens move reserves out of the USD and into gold to protect their wealth from loss of value in the USD. Central banks of China, India, Russia and others have purchased large quantities of gold and other resources to diversify out of the Bernanke-backed dollar. In 2009, Chinese officials announced that China had increased its gold reserves by 76% since 2003. In 2010 through the end of October, China imported more than 200 additional tons of gold. Furthermore, China is keeping 100% of the gold produced within its borders while encouraging its citizenry to purchase gold as a means of protecting itself from worldwide currency debasement. Yet the central banks of most emerging nations maintain a very small – almost insignificant – amount of gold relative to their overall foreign exchange reserves.
Foreign governments have been quick to criticize Bernanke's plan for seemingly endless quantitative easing. Representatives from China, our largest trading partner, have been vociferous. Brazil was not to be outdone: "It's no use throwing dollars out a helicopter," said that country's finance minister, invoking the image painted by Bernanke himself in 2003 when discussing how a country could easily whip deflation and spur economic activity by overprinting its own currency.
While much of Asia pegs its currency to the U.S. dollar (buying or selling foreign currencies to dampen exchange rate fluctuation and keeping prices low for Asian goods), in recent months more than two dozen countries have intervened in the foreign exchange market to help ward off what they perceive as a currency attack by our Federal Reserve.
Other countries are devaluing their fiat money to protect their export industries from the disadvantage of a relatively over-valued domestic currency. Due to concern about an escalating "currency war" Robert Zoellick, President of the World Bank, recently suggested that leading economies should consider readopting a modified global gold standard. Critics denounce the gold standard as an ancient idea unsuitable for modern times. To be clear, the classical gold standard took place from 1880 through 1914. Until 1971, the U.S. would pay gold for foreign USD holdings. Compared to the act of debasing one's currency – monetary sleight of hand spanning millennia – the gold standard is a spring chicken. History proves, over time, that gold is stable while fiat currencies are volatile, illusory, and ultimately transitory.
Even with the nascent suggestion of returning to some form of gold standard, the market for gold has not yet entered bubble status. What we see eventually bursting is not a bubble in gold but rather the bubble in confidence that the markets have placed in the Bernanke Fed's ability to end safely its quantitative easing money creation.
If we are in a bubble for gold, it is a strange mania given the low prices of leading gold mining companies in relation to current and likely future earnings, cash flow, gold in reserves, production capacity, ability to increase dividends, etc.
This supposed gold bubble—a 400% rise over the past ten years—is unexceptional in comparison to the upward spikes of 1,324% in the Nasdaq stock market of the late 1990s, the 954% rise in housing stocks in the last decade and the 882% rise in the price of oil. Furthermore, it appears that many of the "experts" who now assert that gold is in a bubble failed to recognize the development of the stock market and housing bubbles. In fact, many well-known investors who like gold now are the ones who saw the stock and housing bubbles for what they were. We know of no financial mania that did not include both the general public and its financial advisors pouring money into an already over-priced market. That is not yet the case with precious metals.