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Gold & precious metals, macro, research analyst, deep value
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Introduction

This is the first article of two on buying and owning gold. In writing these articles I hope to help my audience understand gold ownership on three levels: the theoretical - the reasons for gold ownership, the quantitative - the portion of one's portfolio that is to be allocated to gold, and the qualitative - the specific ways to own gold and the corresponding risk/reward paradigms for each.

In part 1 I explain my philosophy of gold ownership and my reasons for owning gold. I go on to apply this philosophy to the current asset price environment and argue that now is a good time to own a significant amount of gold in lieu of stocks and bonds.

In part 2 I provide specifics regarding how to own gold. No form of gold ownership is without risk, and different risk parameters will appeal to different kinds of people. Owning GLD shares is not the same thing as owning American Gold Eagles, which is not the same as owning gold mining shares…and so on. The distinction is not simply one between high risk versus low risk, but of different kinds of risk such as counter-party risk and (geo)political risk.

The Reasons for Gold Ownership

1. Asset Price Relativity

When we speak of asset prices we speak of them as if they are expressed in a fixed unit: the fiat currency we are used to dealing in. But fiat currencies are not fixed units. As an American I buy assets using dollars, and so it is easy for me to mistake the dollar for a fixed unit. However this is a mistake, and one that can end up being very costly.

Consider the following analogy. Einstein, in his Special Theory of Relativity, suggested that the velocity of an object can only be measured relative to another object. So, for example, if I am driving 60 MPH down the highway I assume that the road, or the Earth, is fixed in space. But this is merely a practical assumption. We know that the Earth rotates, that it revolves around the Sun, that the Sun revolves around the center of the Milky Way, and so on. From these other points of reference my assumption that I am traveling at 60 MPH is incorrect, but factoring these facts into my assumption will not help me get to where I am going, and so I disregard them.

Similarly, because I make my purchases using dollars it is easy to mistake the dollar for a fixed unit. But there is no such thing as a fixed unit. The values of all assets, including dollars, are constantly changing relative to one another. If I see an item at a store and it is $100, and then next week I see the same item selling for $75, then my conventional thought is that the price has gone down 25%. But it is equally valid to state that the value of my dollars have gone up 33.3% relative to the item in question.

Since I cannot measure my purchases or my wealth in terms of a fixed asset, the next best thing is to measure them in terms of a stable asset.

2. Gold is a Stable Asset

Historically gold is a stable asset. While stock and commodity prices seem to climb ever higher in terms of dollars, this ascent is illusory because the dollar is losing value, even if there are periods when the dollar gains value. If stock and commodity prices are measured in terms of gold, however, they are range-bound over long periods of time.

But this value-stability in itself is not sufficient to claim that gold is the best practical measure of value. Why not for instance, oil, the price of which figures significantly into the prices of numerous assets?

The value of oil is very specific to the world we live in and its industries. If humanity is able to harness energy from the sun or invents cold fusion oil will not only have little to no use value, but it will have little to no exchange value as well . In such a scenario, given how burdensome it is to store oil, we could conceive of oil as being nearly worthless, or even as being a liability.

This argument can be applied to all commodities with the exception of precious metals (gold, silver, platinum and palladium), precious stones, and rare collectibles. While precious stones and rare collectibles can have stable values, no two are alike, and consequently appraising them requires incredible expertise. Silver, platinum and palladium are the next best alternatives to gold. However they each have industrial use values far outweighing that of gold, and they consequently have exchange values that are tied to specific segments of the economy. Their values are consequently inseparable from the vicissitudes of specific industries.

The key to choosing gold is its seemingly paradoxical exchange value given its apparent lack of use value. But there is no paradox insofar as the use value of gold is its value as a medium of exchange. Thus while gold is not an ideal medium of exchange, for all practical purposes it is the best available given its: (1) relative ease of storage, (2) uniformity (each ounce of gold is identical to every other), (3) stable supply and (4) its lack of connection to specific industries, the specificity of which makes them necessarily volatile relative to the general economy.

While these are the reasons that I chose gold as the "cash" in my portfolio it is conceivable that 3 and 4 could change. As a holder of gold I would gladly welcome new industrial uses for it, and I only fear a supply increase.

Why Buy Gold Now (or Soon)?

While the above arguments sufficiently explain that gold should be held as "cash" in all portfolios, they do not and cannot pinpoint how much gold should be in a given portfolio. This is to be determined by an analysis of the specific economic environment as well as the relative valuation of other asset classes.

I maintain that now is a good time to hold a substantial portion of one's wealth in gold. I cannot say what percentage this is given since every portfolio is geared towards the specifics of its owner's risk tolerance, but for the sake of "specificity" I will set a floor at 15% and a ceiling of 70%. These numbers should be taken with a grain of salt.

There are two primary reasons for holding a large gold position in the current economic environment: high stock and bond valuations, and a mass psychology that is favorable to gold: particularly pessimism in the gold market and optimism in the stock market.

1. Stocks and Bonds are Fundamentally Overvalued

Stock and bond valuations are high, and in most cases these assets should be sold at current prices.

Bond valuations are high given that interest rates are at record lows. Even in cases where bond yields are not so low, I would argue that yields should be even higher given that there is heightened uncertainty in the value of fiat currencies in today's economy. If Venezuela can devalue its currency by over 40% by government fiat other nations can do this as well, including the United States (recall that the U.S. dollar was devalued by a similar amount during the Great Depression, again by government fiat). While I cannot give a definite interest rate that would pique my interest in bonds, it is certainly much higher than the current level.

Stocks are overvalued as well. The iShares S&P 500 ETF, (NYSEARCA:IVV), trades at roughly 20X trailing earnings in an environment where earnings growth is, in many cases, (1) minimal or negative, (2) due to cost cutting, or (3) a result of share repurchases. Historically the S&P 500 is a good buy at less than 10X earnings, and it averages roughly 14X earning.

The S&P 500 trades at roughly 4X its stated book value according to the iShares data for IVV. Historically, when stocks are inexpensive they trade at just above book value, or in many cases, below book value. Even an aggressive target of 2X book value as a buying point for stocks would mean that the S&P 500 would have to fall by 50%.

Dividend yields are extremely low with the S&P 500 yielding just 2%. The historical average is over 4%, which means that the S&P 500 would have to decline more than 50% in order for its yield to be "average." Historically the S&P 500 has been a good buy when it yields 6% - 8% which would suggest that the S&P 500 offers good value at 400-500.

Some maintain that today's low dividend yield on stocks is justified due to low interest rates on bonds, particularly U.S. Treasury Bonds. But such an argument presupposes an "either stocks or bonds" scenario that does not allow for a third choice of assets that don't produce income (namely, commodities). Low stock yields and low bond yields do not make the asset with greater yields more appealing, but lead me to the conclusion that the risk of buying an income producing asset is simply not worthwhile in most cases.

I should note that another justification for a low dividend yield on stocks is that dividends are being eschewed in favor of stock buybacks. Exxon Mobil Corporation, (NYSE:XOM), for example, pays a 2.5% dividend, yet they buy back an enormous amount of stock, making the yield as a percentage of total capital returned to share holders greater than 7%. But this is an exception to the norm.

While broad indexes of bonds and stocks are overvalued, there are individual exceptions. For investors interested in bonds consider the Pertius High Yield ETF (NYSEARCA:HYLD), which has a yield to maturity of more than 9.7% and a duration of only 3.25 years. I will not name any individual stocks here, but one broad stock market that I believe represents good value is the Russian stock market, which trades at just over 7X earnings and at slightly over its stated book value. Those interested should consider purchasing shares in RSX.

2. Mass Psychology and Sentiment Favor Gold over Stocks and Bonds

Record high prices in American stock indexes and promises of unabated quantitative easing have created euphoria in stock and bond markets (especially the stock market as of late), while the lack of direction in the price of gold over the past couple of years, and its recent decline from $1,800 to $1,600, has driven public sentiment to extreme pessimism.

In fact, very recently gold bulls have been bombarded by negative price projections from investment analysts and broadcasts in the media. Here are links to a few examples:

The Credit Suisse call for the end of the gold bull market is of particular interest, given that CS has an abysmal track record in their gold price predictions. I view their schizophrenic attitude toward gold prices as a microcosm of how short-term price momentum guides sentiment regardless of long term price momentum (which gold certainly has) and fundamentals. In the following Business Insider article from the beginning of 2011, a CS analyst calls for $2,000 gold.

In the following Zero Hedge article we see that CS (and Goldman Sachs) were openly long gold calls at the end of 2011.

The icing on the cake is the fact that the reason given for CS's bullish bet on gold is low interest rates. Since the publication of this article interest rates have gone essentially nowhere while gold prices are down, making the argument given by CS for their bullish gold bets equally as valid as they were at the end of 2011, if not more so.

Conclusion

If one accepts that (1) gold is a stable asset that retains its value over long periods of time, (2) that stock and bond prices with very few exceptions are incredibly overvalued, and (3) that sentiment is negative for gold prices, then one comes to the conclusion that (s)he should sell stocks and bonds and purchase gold. In my next article I will discuss how to buy gold, and the risks and rewards entailed by each of these methods.

Source: Buying And Owning Gold Part 1: Arguments For Gold Ownership