When Do You Skip Gold?

Time to Follow the Yellow Brick Road?

"You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the Government. And, with due respect for these gentlemen, I advise you, as long as the Capitalist system lasts, to vote for gold."  -George Bernard Shaw

"With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people."  -Fredrich August von Hayek

“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.” – Ernest Hemingway 

As we continue to deal with the fallout from the Great Recession (and with the help of primary campaign of Ron Paul), more and more people are rightfully questioning the status quo and asking themselves important questions. "What is money and how does our monetary system work?"  "What is fractional reserve lending?"  "What does the Federal Reserve do?"  "Should money be made available in unlimited quantities by the Fed, and who most benefits from its policies (hint: not you)?"  "Do deficits matter?"

More and more talk lately has been centered on the idea of a return to the gold standard, which many believe is clearly laid out in the Constitution.  Yes, the Founding Fathers knew the dangers of "fiat" -- money that has no intrinsic value but only has value via government regulation or law.  What we view as money is so because the government will accept only it for payment of debts.

All those and more are great questions, and Skipgold plans to address many of them in future posts.  But for now, we will stick with something a little simpler.  Mainly, why has gold been used as "money" so much in human history?  What makes gold so special compared to all the other elements on earth?

First, check out this great, short video that for some God-forsaken reason was not embeddable (at least not with my feeble computer skills).  Go ahead.  Click on that hyperlink.  I'll wait.

Okay, hopefully you found that interesting.  But even before the invention of the internet, many centuries ago Aristotle observed the basics of what good money should be.  Money should be:

• Durable: Money must stand the test of time and the elements. It must not fade, corrode, or change through time;
• Portable: Good money needs to hold a high amount of 'worth' relative to its weight and size;
• Divisible: Money should be relatively easy to separate and re-combine without affecting its fundamental characteristics. An extension of this idea is that the item should be "fungible", defined as "being freely exchangeable or replaceable, in whole or in part, for another of like nature or kind."
• Intrinsically Valuable: This value of money should be independent of any other object and contained in the money itself, starting with rarity.

There are so few materials that employ all those characteristics.  Agriculture products, diamonds, oil, artwork, etc. all come up short in one or more categories.  Unbacked paper money comes nowhere close to qualifying.  Gold does and that is why whenever it has been available it has become money.  In the same way steel, concrete and wood have been used for construction and oil has been used for energy, gold is most perfectly suited as money.  Get in a time machine with a pocket full of gold coins, and regardless of time or place in history you end up, you would be able to survive and transact.  A pocket full of Benjamin's would yield you some nice fire tinder or emergency toilet paper, and little else.

Skipgold has written much on gold since the start of the blog in 2005.  I suspect there will be much more written on this topic in the months and years ahead.  Since the fundamental problem of our economy is far too many debts and liabilities compared to the income that has to pay that back, I believe our monetary system will have to be remade at some point in our lifetimes.

Apple of My Eye

“The average man doesn’t wish to be told that it
is a bull or a bear market. What he desires is to be told specifically which
particular stock to buy or sell. He wants to get something for nothing. He does
not wish to work. He doesn’t even wish to have to think.”  ~ Jesse Livermore

Johnny Appleseed, William Tell, Snow White -- these are all tales involving apples in some way.  And of course the most infamous apple of all might be the one that fell on the head of Sir Isaac Newton that led to his "discovering" of gravity (Ironically enough, though, he was a rather poor investor, losing millions in The South Sea Company mania.  "I can calculate the motions of the heavenly bodies, but not the madness of people.")

But today the only apple people care about is the company itself.  Apple Computer has almost single-handedly moved the stock market higher.  Consider that earnings for the S&P 500 in Q4 2011 grew 6.4% year-over-year.  However, if you exclude Apple, the other 499 companies combined grew just 2.2%.  Personally, I am indifferent to the stock, but I do own two Apple computers, two iPhones, and one iPad.  But great products and a great company do not necessarily make a great stock (I love my Nissan Pathfinder. Brand new fully loaded is a solid value at $37k, a steal below that, and I wouldn't touch it over $40k.  Same car, but it all depends on the value).  A short list for the...

Bull Case: given current earnings and growth estimates, the stock may be cheap.  Cash on hand is $98 billion, larger than the GDP of most countries on planet Earth.  It is one of the most innovative companies in the world, and there is probably not a company that has a more loyal customer base.

Bear Case: the chart is exhibiting the typical parabolic blow-off; the hype and mania are in overdrive and seemingly everyone loves the stock (once everyone is "in" there are no more buyers); I find it difficult to believe that Apple will be on the cutting edge of the fickle consumer electronics market for decades to come.  People will be drinking Pepsi and washing their clothes with Tide in 10 years.  Will Apple still be relevant?

Also consider this: Apple has become the largest company in the world by market capitalization, and last week Apple became larger than GE, Google, and Intel...combined.  Apple, with its handful of products, is also worth nearly 3x the value of product-deep Proctor & Gamble with sales of just 20% more.

Sorry, no prediction on the stock here.  Gun to head I'd lean a little more bearish.  With a stock price of $602.50 and a market cap of roughly $600 billion, I'm just putting up this post for posterity to see what happens with the most interesting stock in the world.

The "Real" World

"From a time long ago when we sold our vote to no man, we have abdicated our responsibilities. The People who, once upon a time, handed out military command, high civil office, legions — everything, now sits in craven silence, and anxiously hopes for just two things: bread and circuses."

Juvenal, Satire X

Or in today's parlance, reality TV and smart phones.

One convenience for our policy-makers is that most American's do not differentiate between nominal and real returns and income.  Real is what matters.  Nominal is the focus Washington and Wall Street want you to have.  Like skilled magicians diverting your attention from the reality that their (Fed and Congress) massive monetary policies have wrought on your real world, they compel you not to look what the other hand is doing under the table. That way Dow 13,000 means a lot, when in fact in real, inflation-adjusted terms, stocks are down 20%+ over the past decade.  And you are maybe making more money, but real incomes have been stagnant for a few decades now while the cost of living (energy, gasoline, education, food, healthcare, etc.) is up materially over that same time period.  Dow 13,000 today is nothing like it would have been a decade ago, yet here we are celebrating it nonetheless.

To see what I mean of how this monetary expansion (i.e. inflation) can impact stock prices, here's a look at the Dow in terms of a currency that cannot be printed at will by those interested first and foremost in expediency.  This chart ought to calm down (though it will not) the nominal euphoria as Dow 13,000 screams across the screens. Since May 2008, the Dow is unchanged in price and down 50% in 'real' gold terms.

 

That's just something to keep in mind as the financial talking heads get euphoric.  I want to be clear that this is not necessarily an endorsement for gold in your portfolio, but saw this comment from John Mauldin, and I thought it summed up my thoughts well, too:

"I buy a little physical gold every month [SG: I don't monthly, but I do every so often]. I don't even look at the price [SG: I do]. The check is written the same day each month, for the same amount. I take delivery. I hope the price of gold goes down so I can get more gold per dollar. I also hope it ends up being worthless, as that will mean everything else has worked out just fine. But my gold is there just in case my crazy gold bug friends are right and we can't actually trust the government to find a reasonable solution to our dilemma. And maybe because deep down I really don't trust the (insert your favorite expletive). Just a little insurance, you understand."

I do, John, but unfortunately most are trusting in the powers that be to do the right thing.  Good luck to them.

The Big Bank Bailout Bluff

“Banks have done more injury to the religion, morality, tranquility, prosperity, and even wealth of the nation than they can have done or ever will do good.”

-John Adams

Because I think it is reasonably likely in the intermediate future, this needs to remembered when the time comes for potentially more bank bailouts -- any talk of the necessity of using taxpayer funds to "rescue" the big banks is a complete, fabricated lie.  It was true in 2008 during TARP, and it remains true to this day.  Any attempt at causing economic hysteria is meant solely to threaten economic armageddon in order to keep the status quo when the expiration date on that is long past due.

In this week's commentary John Hussman gives a little more detail:

Over the past three years, Wall Street and the banking system have enjoyed enormous fiscal and monetary concessions on the self-serving assertion that the global financial system will "implode" if anyone who made a bad loan might actually experience a loss. Because reversing this mantra is so difficult, policy makers are likely to continue fitful efforts to "rescue" this debt for the sake of bondholders, through mechanisms that are increasingly distasteful to the broader population. The justification for those policies will therefore have to be coupled with rhetoric that institutions holding these securities are too "systemically important" to suffer losses.

On this note, it is critical to remember that nearly all financial institutions have enough capital and obligations to their own bondholders to completely absorb restructuring losses without customers or counterparties bearing any loss at all. So keep in mind that the debate here is not about protecting customers or counterparties - it is really about whether the stockholders and bondholders of banks and other financial institutions should bear a loss. The "failure" of a bank only means that existing stockholders and bondholders are disenfranchised - the company simply takes on a new life under new ownership. Existing stockholders lose everything, unsecured bondholders typically lose something, and senior bondholders get any residual obtained as a result of the sale or transfer of the company. If the global economy is fortunate, the financial system two or three years from now will look much the same as it does today, but the ownership and capital structure will have changed almost entirely. A major restructuring of debt is the clearest path to long-term economic recovery, and the accompanying losses to those who recklessly made bad loans would be the highest realization of Schumpeter's idea of "creative destruction."

From that perspective, Warren Buffett's $5 billion investment in Bank of America preferred stock last week was essentially a defense of the old guard. Buffet observed, "It's a vote of confidence, not only in Bank of America, but also in the country."

Yes - to be specific, it's a vote of confidence that the country will bail out Bank of America in any future crisis. We should all hope that Buffett's investment is successful - provided there is no future crisis - and we should equally hope that Buffett loses the entire investment otherwise.

We'll see what happens.  I suspect Uncle Warren's investment in BofA will be tested in the next 18 months.

Stocks? Still Overvalued.

"He's mad, that trusts in the tameness of a wolf, a horse's health, a boy's love, or a whor's oath."

-The Fool, King Lear 

Or the charlatans on CNBC.  As the chart shows, we've been living in a period of stock overvaluation for so long that no one recognizes real value anymore.  This is also the reason why equity returns for the past decade plus have been so dismal, and why they will likely continue to be dismal until valuations get back to reasonable levels.

Mike "Mish" Shedlock also has some excellent commentary on why stock returns will likely continue to disappoint.  The main reason?  Demographics.  The biggest holders of equities are baby boomers, and they are likely to generally be sellers of stocks to fund their retirements.  That factor is likely to be a major headwind (in addition to the current overvaluation) for stock returns in the coming decade.

The "Success" of Bernanke's Quantitative Easing

"When God desires to destroy a thing, he entrusts its destruction to the thing itself.  Every bad institution of this world ends by suicide."  -Victor Hugo

I don't know about you, but I am fired up about the Fed's next round of money-printing, also known as "Quantitative Easing", or QE-3 for short.  Investors are already anticipating it:

U.S. Index Futures Climb on Speculation Bernanke to Signal Third QE Round

Aug. 22 (Bloomberg) -- U.S. stock futures rose, signaling the Standard & Poor’s 500 Index will rebound from its biggest four-week drop since 2009, amid speculation the Federal Reserve will unveil further measures to support the economy…

“The market is expecting another round of asset purchases and it will come,” said Matthias Jasper, head of equities at WGZ Bank AG in Dusseldorf.

But I jest.  We are coming up on the one year anniversary of "QE-2".  Ben Bernanke is scheduled to speak Friday at the annual Jackson Hole event, and mention of another round of quantitative easing is being hoped for by the Fed's Wall Street allies.  For those promoting QE-3 -- you must assume that interest rates being too high are the key impediment to economic growth?  That's the story you are going with?  That interest rates are too high?  Okee-dokee.  The 10-year Treasury is very close to 2.0% and mortgage rates are dropping to fresh all-time lows.  And the Fed's answer is to implement a policy designed to further lower interest rates?  That's quite the theory.

John Hussman did a nice job last week of summarizing just how "successful" QE-2 has been, and maybe provide a glimpse of what's to come with the next round (and the next, and the next...):

Without question, one of the notions buoying Wall Street optimism here is the hope that the Fed will pull another rabbit out of its hat by initiating QE3. That's a nice sentiment, but it does overlook one minor detail. QE2 didn't work.

Actually, that's not quite fair.

-The Federal Reserve was indeed successful at provoking a speculative frenzy in the financial markets, which has now been completely wiped out.

-The Fed was also successful in leveraging its balance sheet by more than 55-to-1 (more than Bear Stearns, Lehman, Fannie Mae, Freddie Mac, or even Long-Term Capital Management ever achieved), and driving the monetary base to more than 18 cents for every dollar of GDP - a level that requires short-term interest rates to remain below about 3 basis points in order to maintain price stability ( see Charles Plosser and the 50% Contraction in the Fed's Balance Sheet ).

-The Fed was indeed successful in provoking a wave of commodity hoarding that affected global supplies and injured the poorest of the poor - particularly in developing countries.

-The Fed was successful in setting off a very predictable decline in the value of the U.S. dollar.

-The Fed was successful in punishing savers and the risk averse, and driving investors to reach for yield in risky investments that they would normally avoid were it not for the absence of yield.

-The Fed was successful in provoking those with strong balance sheets to pay down existing higher interest-rate debt, and in creating an incentive for those with weak balance sheets to issue more of it at low rates, resulting in a simultaneous deterioration of credit quality and compensation for risk in the financial system.

-The Fed was successful at boosting the trading profits of the banks that serve as primary dealers, by announcing precisely which securities it would be buying prior to Treasury auctions, and buying them on the open market a few days later from the dealers that acquired them. -

-The Fed was successful in creating a portfolio of low yielding securities that will be almost impossible to disgorge without capital losses unless the Fed holds them to maturity.

On proper reflection, the list of the Fed's successes from QE2 is nothing short of stunning.

It is beyond comprehension why anyone would wish for more of this recklessness.

Since the Fed enacted QE-2, GDP growth has been less than 1.5% annually, and the official unemployment rate has risen.  Quantitative easing is economically baseless, but in reading the bullet points above one can see why Wall Street and their media allies are such big fans.  It also exposes the rank hypocrisy of many of those who espouse "free markets" and "capitalism".  Many of them are nothing but welfare queens themselves.

 

A Different Perspective on the Rally

"Money, when considered as the fruit of many years' industry, as the reward of labor, sweat and toil, as the widow's dowry and children's portion, and as the means of procuring the necessaries and alleviating the afflictions of life, and making old age a scene of rest, has something in it sacred that is not to be sported with, or trusted to the airy bubble of paper currency."  -Thomas Paine

It's amazing how much the people can be fooled if you only make them think they are wealthier than they really are.  The same policies that have driven up stocks are also stagnating home prices and have driven up the prices of food, gas, insurance, healthcare, etc.  Given the state of the economy, the need for illusion is deep.  Here is the Dow Jones Industrial Average priced in a currency that can't be printed:

The Other Side of the Equity Coin

"People can foresee the future only when it coincides with their own wishes, and the most grossly obvious facts can be ignored when they are unwelcome."  -George Orwell

I try my very best not to get locked into an overly biased viewpoint.  Too many people stubbornly stick to a particular viewpoint and refuse to see the other side or even hear reasonable arguments that contradict their own beliefs (political affiliation, gold bugs, etc.).  So while I have been very cautious on the stock market for some time (most recently HERE) due to what I see is poor valuation, I took note when Martin Armstrong noted the following last week:

JUST when you thought it couldn’t get worse, surprise – THE BEST IS YET TO COME! Yes, the sentiment is going to change. But the change on the horizon for the next 4.3 years is going to be very different. We are entering a phase of the Private Wave where confidence in government sinks lower still. The irony of these types of moves is that the economic decline continues, but the financial markets recover with a twist. Capital becomes leery of government debt and thus the private sector rebounds in the face of rising unemployment and worsening economic statistics. 

It is absolutely critical to understand International Capital Flows. The Dow rose between 1932 and 1937 and unemployment exploded to 25% going into 1935, the Dust Bowl tore the economy apart, and the economy was far from booming. There was a lift due to the devaluation of the dollar. This is also the famous bank holiday. Much of the news between 1932 and 1937 was BEARISH. Yet the stock market rallied as a HEDGE AGAINST untrustworthy public debt. Even the city of Detroit suspended all payment on its debt. It made good in 1963 with the help of inflation. We face similar crisis in the state and local governments. Unemployment will rise as the local governments (WHO CANNOT PRINT MONEY LIKE THE FEDS NOR BORROW FROM THEM) are forced into reality.

Now, it's important to remember that future stock market returns are a direct function of how cheap stocks are today.  While I respect Armstrong and his unique point of view, in my opinion it's vital to realize that valuations in 1932 based on the Shiller P/E were in the 5-7 range vs. the over 20 now.  So even though the economy was terrible throughout the 1930's, stocks were very cheap in 1932, forecasting solid long-term returns even in a poor economy.  That is not all all the case today.  Still, it's an interesting concept and might be a tailwind for stocks (or at least to help with a floor).

There and Back Again -- A Story of Market Valuation

"It's a dangerous business, going out your door. You step onto the road, and if you don't keep your feet, there's no telling where you might be swept off to."  -Bilbo Baggins, The Lord of the Rings

There was a very nice piece by John Hussman this week.  His commentary dealt largely with stock market valuations and historical bull and bear markets.

In short, peak-to-peak earnings growth throughout all cycles for decades has been about 6%.  Powerful secular bull and bear markets are not necessarily driven by earnings growth as is widely believed, but instead by expansion (bull) or contraction (bear) of market valuations.  That is, what multiple investors are willing to pay for earnings.  The most accurate measure of stock market valuation over the decades has been the Shiller P/E ratio (price to earnings).

As Hussman notes, at the start of secular bull markets, the Shiller P/E has historically been around 7.  This was the case in the late 1940's and in the early 1980's.  These secular rallies have averaged about 18 years in duration and end with a Shiller P/E over 24.  Think about that for a second -- that means in secular bull markets the stock market more than triples due to valuation expansion alone!  Investors get more and more confident about the economy and markets and are willing to pay more and more for every dollar of earnings.  That is what drives the stock market.

Long, secular bear markets, on the other hand, start with high valuations -- generally with the Shiller P/E over 24 -- and inevitably conclude on average 18 years later with sub-10 Shiller P/E's.  Wash, rinse, and repeat.  Earnings have been in a growing trend over this whole time, so each stock market peak and valley is generally higher than the last, which accounts for a generally rising stock market in the U.S. over the long haul.

While this is all interesting and important from an investment perspective, my greater point is that market valuation is the key to future performance.  Buy when valuations are low (1950's and 1980's) and solid, long-term future returns are almost guaranteed.  Buy when valuations are high (late 1990's and early 2000's and 2007), and you are bound to be disappointed by future returns.  And that valuation range has spent well over 90% of the time with a Shiller P/E between 7 and 24.

But here's the key.  The Shiller P/E, as we sit here and now, is about 24.  Yes, the level from which prior secular bear markets have historically started.

So the idea of the here and now being the start of a long-term secular bull market is HIGHLY unlikely.  This is certainly no guarantee going forward, but there is a lot of history behind that.

Also, perhaps you should ask yourself whether the economic outlook for the U.S. today is far better than it was in decades past that might render history moot.  I hardly think so, but you can formulate your own opinion on that.  But even when we had the type of growth in the U.S. like we've had for the past 70 years, when the Shiller P/E reached current levels stocks stagnated for a decade or more.

Something to think about.  We'll see if this time is different.

Hussman also had this to say:

The importance of aligning investment strategy with prevailing conditions was nicely summarized by Howard Marks in a letter to investors last week (I've repeatedly quoted Marks in recent weeks, as something of an endorsement of his recent book The Most Important Thing, which is well worth reading):

"One of the things that makes investing interesting is the ever-changing nature of the route to profit, the pitfalls that are present, and the tools and approaches that should be employed. Conscious decisions regarding these things should underlie all efforts to manage capital, and they must be revisited constantly as circumstances and asset prices change. What's right today?

"First, should you prepare for prosperity or not? By prosperity I mean a return to the happy days of the 1980s and '90s, when reported economic growth was strong and consumers were eager to spend. My answer is that we're not likely to see anything like that, in large part because in those decades the gap between stagnant incomes and vigorous consumption growth was bridged through buying on credit. Instead, in the years ahead I think (a) growth in employment and incomes will be sluggish, (b) consumers should be restrained in their borrowing as a result of having experienced the crisis, (c) consumer credit shouldn't be available as readily, and (d) borrowing against home equity will be much less of a factor, especially because home equity is so scarce.

"Second, should you worry more about losing money or about missing opportunities? This one's easy for me. First, the macro uncertainties tell me we won't be seeing a highly effervescent economy or market environment. Second, other people's increasingly aggressive behavior tells me to seek cover. And third, since I don't see many compellingly cheap assets, I doubt there will be gains big enough to make us kick ourselves for having invested too cautiously.

"And that brings me to my third question: what tools should you employ? I think we're back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding... with all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right. (Of course that's not an unfamiliar refrain from me.)

"We can never be sure what will happen – and certainly not when – but it's important to be prepared for what's likely to lie ahead. And understanding the inevitable pendulum swing in the way investments are viewed – from weeds to flowers and back – is an essential ingredient in being able to do so."

Sage advice, if you ask me.  Keep your feet, and don't get swept away.

Sign of the Times

"A nickel isn't worth a dime these days."  -Yogi Berra

While the entire piece is a must-read, I thought this comment at the end of John Hussman's weekly commentary was particularly interesting.  Woe be the fool who saves and invests.

As a side note, in the U.S., 3-month Treasury bill yields are now down to 2 basis points.  This means that $1,000 investment in 3-month bills now gets you a nickel of interest over the life of the investment.

$1 million will get you $50, and $10 million will land you $500.  Considering that savings and investment are the backbone of a productive economy, what a twisted web of perverted policies we weave.