Why China Is Right About Gold

Includes: ABX, AG, ASA, GG, NG, TAHO
by: Dr. Stephen Leeb

China is arguably the oldest civilization on the face of the earth. A civilization, in the words of a famous historian, that has been astonishingly stable over time compared with others, such as European ones.

When the modern incarnation of that civilization starts buying hand over fist one of the world’s oldest currencies, you have to take notice.

Readers know that we are fixated on how long things have been around; one can make the case that there’s no better predictor of how long things will stay around than how long they’ve been around.

The former Soviet Union was around less than a century when it fell. The euro currency, much less than the Soviet Union -- which doesn’t say much for its long-term prospects.

But when China meets gold, you’re talking millennia.

Now we want to make clear, if we haven’t already (at least for our newer readers), that we haven’t been a gold bug forever. In fact, we spent most of the 1980s and ‘90s extolling the virtues of the stock market. Our first book, Getting in on the Ground Floor (1986), was in fact a forecast of a long-running bull market in equites.

But the conditions for a market in financial assets have changed dramatically in the last 10-12 years.

The biggest change is one of resource scarcity. Throughout the ‘80s and ‘90s all resource prices bounced around midpoints; they were cyclical. But as we know, that cyclicality vanished at the beginning of the present century.

Even the very best sometimes miss such critical points of inflection. For example, Warren Buffett, arguably the greatest investor in the history of capitalism, made his case against gold in 2010 by stating:

You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all – not some – all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils (NYSE:XOM), plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?

Clearly, Buffett meant this as a rhetorical question. But unfortunately, it’s not so simple. Let’s say instead of talking about Exxon Mobil (XOM), we talk about the products that company produces – oil and oil-related products; instead of talking about farmland qua farmland, let’s talk about the products farmland produces. After all, that’s why you’re buying farmland or Exxon Mobil; the value is contained in the products these entities produce.

So now let’s ask what makes more sense, to purchase those products (current and future) by using that hypothetical stash of gold, or to buy them with a currency such as the dollar?

The critical point here is that the products they produce – foodstuffs, oil, etc. – are all becoming scarcer relative to demand, or at least you can make a compelling case that they are.

When it comes to Exxon you just need to look at its production figures: They’re not going up. And while U.S. farmland may still be becoming more productive, that added production pales in comparison to the increased demand, and ultimately is capped by the amount of fresh water available.

So let’s say this scarcity is widely accepted – which not only applies to oil and food, but to other critical metals and materials ranging from silver (which is used in a wide variety of electronic products as well as being an essential element in the solar energy industry), to heavy rare earths, which are indispensable in a number of industries, including wind energy (via wind turbines.)

In other words, there is only so much of these materials being produced, and this "so much" is becoming ever less sufficient to support a world where population continues to grow and the members of that population continue to demand more of the materials.

This brings us back to why you might want to choose gold.

What would be your alternative if you wanted to own Exxon Mobil or farmland as the embodiment of ever scarcer materials?

The alternative course would be to buy them in dollars. But every other country in the world also wants a stake in these materials. So that, for example, if Germany starts printing a lot of Deutsche marks or a lot of euros, and other countries start printing more currency to get their hands on these same scarcer materials, the U.S. will start printing more dollars to compete – they will have no choice. Then the value of all these currencies becomes essentially a joke, as the lower and lower they go, it’s a race to the bottom with no one really gaining an edge on the other. You in effect wind up with a whole mess – with inflationary consequences, the impossibility of planning for the future, of creating new industries, etc.

Clearly there has to be a system for rationing the scarce materials. There has to be a currency which cannot be created at will.

Gold is plainly such a currency. It’s been around for several millennia, there’s only so much of it, and it’s not changing.

Keep in mind that silver also could fill that role, but does it so much less effectively than gold because we are consuming some of the silver, and to that extent to use it as a vehicle for rationing becomes much more difficult.

Of course, there are other ways of rationing. During the Second World War we simply put a limit on how much one could buy of certain materials and goods; no matter how much money you had, you could not buy more than your designated allowance for milk, butter, etc.

That kind of system of rationing doesn’t appeal to me; it smacks of totalitarianism. But it can work. Indeed, hopefully never. But we may have to resort to it.

We in this country don’t seem to understand that we need a way of rationing scarce resources, not to mention a full-scale effort to figure out ways of substituting different resources.

And this brings us right back to the civilization which has stood the test of time: China.

They get it, and they get it in spades. And they almost surely see the inevitability of a world currency system which permits effective rationing without destroying the ability to plan and grow.

We wish we could return to the ‘80s and ‘90s when all these critical commodities remained cyclical, and financial assets were the greatest thing in the world. But unfortunately we can’t.

The Chinese this year will likely buy 1,000 tons of gold. And sometime before 2015 they will likely be purchasing in a single year as much gold as the world produces.

We’re not bold enough or smart enough to say a society or civilization that’s been around as long as they have been is wrong. We continue to exhort you to follow their lead, and continue to overweight gold and other precious metals.

As a sidebar, including this year, compared to the stock market, gold has outperformed the S&P 500 (with dividends invested) over the past 40 years. If this doesn’t make it as asset class in itself, in addition to being a currency, we don’t know what can or will.

Our chief recommendations remain a diversified portfolio of gold stocks and other precious metals. We continue to favor Goldcorp (NYSE:GG), Barrick Gold (NYSE:ABX), ASA Ltd. (NYSE:ASA), NovaGold Resources (NYSEMKT:NG), First Majestic Silver (NYSE:AG),and Tahoe Resources (THOEF.PK).

And I’m sure you may have your own favorites. If it’s a mine that’s producing or increasing production of gold or silver, in a place that is relatively safe politically, you’re not going to find an argument from us.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.