Tuesday, June 8, 2010

Why we need to protect ourselves with gold (and silver)

This post is for those who think that talk about holding gold and silver is alarmist rubbish.

One of the issues favored by the liberty movement is "Honest Money" -- that is, returning to the use of gold and silver as currency, because they are a store of value, and the paper Federal Reserve Note is not. One problem with that discussion is most of its proponents are biased either for political (yours truly, Ron Paul) or business reasons (Goldline, Monex).

This is not true, however, of The Joseph Group. The Joseph Group, based in Columbus, is an investment advisory firm that provides personalized service to select clients (It's a great firm -- I know the managing partners personally -- but is a little rich for my blood). As part of their service, they have in-house analysts who manage according to a long-term strategy, which works to strike a balance between stocks, bonds, and other investments that will be profitable to their clients. In general, I have seen them recommend that precious metals be included as a small part of a sound portfolio.

With this in mind, you will understand why the following segment from their Wealth Notes e-newsletter dated May 24 (no link available) made me sit up and take notice (While not indented, the following text is directly quoted from Wealth Notes with their permission. Emphasis and the comment in brackets are mine).

To inform… The Perfect Bubble: Fiat money chasing a “Store of Value” (Gold)

The most important thing about money is to maintain its stability…You have to chose between trusting the natural stability of gold and the honesty and intelligence of members of the government. With due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold.

-- George Bernard Shaw

The financial markets have always run to gold in times of great uncertainty. As we wrote a few weeks back, the price of gold is often sought of as a barometer of fear. The recent push higher in gold may not just be concern over the European Union (EU) crises but the sobering reality that there is seemingly an endless supply of paper money being created by debt laden governments. [Including ours].

The recent response by the European Central Bank (ECB) of purchasing government bonds to thwart the debt crisis in the EU, is yet another example of how central banks are used to create fiat money. What is fiat money? Fiat money is “currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith” (Investopedia). With the recent decline in the Euro, investors apparently have little faith in the EU government and the value of that currency.

Currency is supposed to be a constant unit of account, a “Store of Value”. Historically, paper money has been a very poor store of value. The chart below shows the decline in the purchasing power of the dollar since 1940. (Similar path for all fiat currencies.)

Purchasing power drops when prices rise. Prices rise from too much money chasing the same amount of goods. Thus, the more supply of money, the less it is worth.

Financial bubbles occur when assets are not priced according to cash flow, but according to what another investor is willing to pay. (Recall tech stocks in 1999, subprime loans and real estate in 2007.) Gold cannot be valued on any basis of cash flows and thus perfectly satisfies bubble conditions. However, the bubble is not in gold but rather in the rapid creation of fiat money.

The growth in the global money supply is vastly exceeding central bank gold holdings. The chart below shows the growth in the monetary base has more than tripled compared to the gold holdings by central banks. Thus the value of fiat currency has become (and will continue to be) relatively less and less compared to gold.

Investors will continue to seek a store of value away from fiat currency. And, without any restraint by governments to create currency, global demand for gold will overwhelm supply, causing gold prices to skyrocket.

The last chart below shows how gold has outperformed all major asset classes on many time horizons. This was during a period of relatively slow money growth. With the recent acceleration in money growth, future returns of gold should be even better.

No comments: