Better Late Than Never?!?

"No one ever went broke underestimating the intelligence of the American Public" - H. L. Mencken

"Few people have lost money underestimating the competence of the modern Federal Reserve" - Whitmore's Corollary to Mencken

Back in the Saddle

Apologies to those of you who have been left hanging for twenty-three months since my last blog post.  Two years ago, I felt very good about the direction I had been heading with my latest (using that word very liberally) missives.  While spending time reviewing all of the posts, I believe the analysis and advice contained therein are still sound and applicable.  So, time to take up the cause again for the handful of you out there who may be interested in more thoughts on successful investing.

The goal of this blog has never been to engage in specific  recommendations for personal finance;  although as you will see, I will violate that precept below.  Rather, my hope has always been to encourage and equip people to think in a manner befitting a successful investor.  I will continue to press ahead with that vision.

What has been happening over the last two years?  Quite a bit as it turns out.  Most importantly, I have become a new father!!  Kai Yoo Whitmore entered our lives almost eleven months ago.  I cannot express how transforming he has been for both Mina and me.  We are so blessed to have such a precious and wonderful soul for whom to care and to love.  To give the little fellow a bit more room to roam, we have also moved into a larger home that was in foreclosure last January.  Finally, I am in the process of moving into money management after doing full-time investing for the last nine years.  That should serve as a brief, if exceptionally truncated, personal recap.  On to the world of investing.

Proud Papa

So What is So Precious About Some Metals?

Recently, I was on a plane returning from a conference in LA.  While I consider myself a reasonably affable person, my strategy concerning plane travel is to, while not being impolite, generally avoid conversations extending beyond brief pleasantries.  Call it a form of PTSD perhaps, stemming from a few too many cross-country flights seated next to overly loquacious individuals sans reading materials or entertainment devices.  I had just cracked open my book when I could not help but eavesdrop upon the conversation between two professionals seated next to me.

"Sure, it is pretty to look at, but for what is it really useful?"

"Well, it does have some inherent value, right?  I mean, doesn't it have some dental applications?"

"Nah, gold is not worth crap.  Even its dental uses have become obsolete.  What is possibly the point of owning it?  I mean look at your ring.  It probably cost a lot.  But do you know tungsten carbide costs a tiny fraction of gold, yet is more resilient, and even more reflective?"

"Interesting point.  So you think that gold is overvalued?"

"Absolutely!  I mean it is only worth anything because people have always said it was 'valuable.'  Remove people's perceptions and it is a worthless metal.  Trust me, gold is a bubble that will burst."

Given my conversations with friends and acquaintances, my opinionated fellow traveler embodies the perceptions of many, many individuals.  Particularly in light of the fact that gold is now trading at the upper end of it historic valuation levels, this seems to be a particularly good time to address what role, if any, owning gold and other precious metals should occupy in one's portfolio.

By way of full disclosure, I am not a disinterested individual when it comes to precious metals.  I began accumulating gold around $300/oz., silver at about $8/oz. and platinum at approximately $800 oz.  Over the years, I have gradually added to my positions, particularly when there have been significant pull-backs in price.  I have never sold an ounce of any of the metals in my possession, regardless of market gyrations.  When I first recommended gold as an attractive asset class here, it was almost three years and $900/oz. ago.  Clearly, I find value where my travel companion did not.

In Defense of Gold

The first issue implicitly raised by the gentlemen discussing gold is something called the paradox of value.  Indeed, tungsten carbide probably is a material that has infinitely greater utility than gold.  However, it is even more obvious that water is of far greater practical use than diamonds.  Yet I would scarcely expect the price of the latter to collapse (although I would not be surprised to see an escalation in the price of the former, a discussion for another time).  In essence, the conceptualization of my skeptical friend concerning gold's value was completely divorced from scarcity.  While water and tungsten carbide may both have huge practical use advantages, they are both relatively common.  While diamonds and gold may both suffer from being of limited use industrially, their scarcity helps makes them extremely valuable. 

When gold was trading in the $300-800 range, I used to call it an insurance policy that paid you a premium to hold it in the form of significant expected capital appreciation.  And while it can no longer be called historically "cheap" (although this is not to say that gold does not have room to appreciate further), I would argue that it merits a place in every investor's portfolio. 

What I mean by an insurance policy is that precious metals, and gold in particular, are the ultimate anti-crash assets.  I am not talking about any type of crash here.  Precious metals went down with virtually all other assets back in the '08-'09 financial implosion (although gold went down very little by way of comparison to the vast majority of assets). No, the kind of crash I am talking about is the sort when currencies collapse. 

Now I know that most people tend to view the integrity of the US dollar as sacrosanct.  It has been the reserve currency for three generations now.  If you talk to most traditional money managers, they will tell you the "safest" asset is US government bonds.  After all, they have the "full faith and credit" of the federal government backing them and are denominated in the almighty dollar.

I see such faith as deeply misplaced.  Without going into too much detail at this point, the US can be characterized as "Greece Lite."  For years now, our public finances have been deteriorating quite dramatically.  The most recent skirmish between Republicans and Democrats over raising the debt ceiling is just the beginning of a what will be a protracted process in an effort by policy-makers to make Uncle Sam's balance sheet remotely solvent, one which I think will most likely lead to stalemates and "kicking the can down the road."  Or simply put, politics as usual.

We as a nation are having the ignominious distinction of seeing our Debt-to-GDP ratio surpass 1.00.  What does that mean, and why does it matter?  Well, in order to clear our federal balance sheet, we would collectively have to cough up a cool $15 trillion, or basically an entire year's worth of total economic production!  That prognosis is actually rosy if one considers the level of unfunded liabilities (in the form of Medicare, prescription drug and Social Security obligations).  Depending upon the accounting methods employed, the federal government is in the hole between $60-115 trillion!  Considering that the total non-government national assets equal about $80 trillion, these are problematic obligations.

All Roads Lead to Inflation

So what is a bloated, decrepit and hoary super-power to do?  What the US should do is dramatically slash spending it cannot afford, as well as non-regressively tax consumption so as to broaden and deepen the tax base.  Since this has no chance of being politically viable with either party, what the government will do is provide more bread and circus to the masses. 

The Federal Reserve has already begun to do something that will effectively lighten the debt load.  It sounds innocuous enough.  Whether gussied up as QE1, QE2 or QEad infinitum, it is also known as "monetizing the debt." In plain English, it amounts to the same noxious thing: printing money.  Now do not get me wrong.  The effect of printing money for the debtor/counterfeiter is great.  That much cannot be denied.  Who would not like a massive cash infusion that requires no more effort or cost than Bernanke making a few keystrokes on the Fed's computer system?

The problem is that there is no such thing as a long-term free lunch in the world of finance and economics.  Whether it was Nero debasing the silver content of the denarius almost two-thousand years ago or Mugabe debasing the Zimbabwe dollar to the point of literal worthlessness in 2008, students of economic history know that the results of money printing are eventually ruinous.

This leads us to the two main reasons why people should consider holding metals like gold, silver and platinum.  First, precious metals are a storehouse of value.  I am old enough to remember with some vividity the stagflation of the 70's.  Most non-tangible assets did not keep up with the level of inflation.  Hence stocks and bonds underperformed.  People's standard of living declined as the dollar bought less and less over time.  Inflation typically is characterized by confiscation of wealth through the decline of real purchasing power by most citizens.

One of the few assets to perform spectacularly well during the 70's and into the very early 80's was gold, literally increasing in price more than twenty-two fold from trough to peak.  When dollars are being created willy-nilly, the amount of available gold barely budges every year.  I noted in a past post that the world's supply of gold would fit into a cube slightly larger than sixty-feet on each side; pretty rare stuff indeed.  When thinking about the price of gold, both today and in the future, it would behoove investors to consider the denominator - the US dollar.  It is simple economics that as the supply of something goes up, the clearing price of that item should decline.  Logically, if the amount of dollars created is dramatically increasing (which it is), yet the amount of gold is remaining relatively fixed (which is also true), the value of the latter in terms of the former should increase.

Second, gold is worthy of occupying a place in portfolios because it constitutes holding real currency.  I once had a prolonged discussion with a financial services professional who had substantial assets under his management.  He expressed incredulity at my assertion that gold represented an attractive asset class (this was even before gold breached $1000/oz.).  When I pressed him for his assessment of desirable investments, he identified short-term treasuries and cash as the best places to be in uncertain, volatile times.  I was taken aback by what I saw as a glaring contradiction in his analysis.  On one hand, he rejected gold as it was a "barbarous relic" that had no intrinsic value and generated no income.  On the other hand, he placed a large portion of his clients' funds in US dollars, which as a fiat currency has no intrinsic value and, in a zero-percent interest rate environment, generated essentially no income.  Furthermore, whereas gold is an element whose supply could not be increased at the discretion of desperate central bankers, the same most certainly cannot be said of US dollars.  So which would you rather hold over time?  Which would you be more confident will get you a decent amount of goods and services in the future?  Which asset will not be debased in the future? 

I find it noteworthy that, controlling for quality of inputs, gold will buy roughly the same amount of food, clothing and shelter today as it did centuries ago.  Indeed, most people forget that for years the only paper money that held value over long periods of time were those backed by a gold standard, and that as recently as 1971, the US backed its currency with gold.  The history of fiat currencies does not bode well for the future of the US dollar untethered to a gold standard.

Bubble Babble

One of the most common arguments I hear from traditional money managers, pundits and analysts is that at nearly $1800/oz., gold is clearly in a bubble, having increased in price seven times from its lows about a decade ago.  I think this is nonsense.  This is not to say that gold cannot experience a dramatic pullback from here.  I could easily see it declining by as much as 30%, depending upon macroeconomic events going forward.  But having shorted tech stocks in 2000, and mortgage lenders several years after that, I feel as if asset bubble analysis is a personal forte.  And I see none of the traditional signs of a bubble when it comes to the prices of precious metals.

For instance, I actually know very few individuals that own gold, much less any other precious metal.  I can literally count on one hand the number of people of whom I am aware whose portfolio comprises more than 10% gold or other precious metals.  Amongst money managers, exposure to gold is even rarer.  My favorite investment guru, Marc Faber, describes speaking before hundreds of money management professionals and asking everyone in the crowd who owns gold to raise their hands; nary an arm moves.  Ownership of silver or platinum (which is interestingly trading at less than the price of gold - a relative historical anomaly) is far rarer.

As far as I am concerned, the ultimate litmus test for an asset bubble is my not-exactly-patented "cocktail chatter index."  So far, it is two for two.  In the late 90's and into 2000, I could barely pick up a martini (or more truthfully a Midori sour) without hearing someone rave about their returns in Xyz.com.  Fast-forward seven years and I was unable to quaff a glass of syrah without being assaulted with tales of zero-down mortgages, condo-flipping and acquisition of "investment properties."  To date I have yet to be verbally accosted by anyone claiming to have doubled their money by owning gold bullion or to have financed a vacation by owning silver futures.  When that happens, I will have to reconsider my analysis.

Tread Cautiously

Importantly, I am not predicting an imminent rise in the price of precious metals.  As I mentioned, I think there is a very good chance that we could see price declines from these levels.  But from a long-term perspective, I think precious metals represent a very good risk-reward profile.  This is particularly true when considering what I believe to be relatively unattractive prospects in more traditional assets such as equities and (especially) government bonds.

What would change my analysis or cause me to be wrong in my expectations for precious metals?  Quite simply, a debt-deflation trap should the Fed and/or other key central bankers be unsuccessful in their efforts to reflate the world economy through massive monetary stimulus.  Personally, I think it is more likely than not that Bernanke and his ilk will be successful in their efforts to de facto destroy the credibility of the US dollar.  But nothing in investing is a sure thing.

Accordingly, I think if investors presently have no exposure to gold and other precious metals, it would be worthwhile to consider purchasing small quantities at regular intervals (monthly or quarterly perhaps).  To have less than 5% of one's portfolio in precious metals is, in my opinion, a serious oversight.  A higher weighting would be even more desirable.

I promise it will be earlier than the Fall of 2013 before another post!