Jeffrey A. Miller

Does Gold Beat the DJIA? It Depends

DJIA vs. Gold Gold as a store of value March 19, 2009

I appreciate all the comments on my article. Those who think me an “idiot” will not be surprised to learn that my wife agrees with them at least once a week. In an effort to diminish that view I have done a bit more research to compare gold with the CPI (consumer price index) as published by the Bureau of Labor Statistics. The CPI is available from 1913 to the present. I selected, again, the annual values to compare with the annual spot price of gold. Several comments suggested gold is an insurance policy against inflation I presume. Others suggested gold is a “store of value” (SOV) not an investment, again I presume against the loss of value due to inflation. At least one excoriated me for ignoring the fact that ownership of gold was prohibited until 1974.

The comment about gold ownership being prohibited until 1974 ignored the main thrust of the article. Gold completely failed as an investment over the twenty year period from 1980 through 2000. Yet gold was freely traded during this time. I examined the longest possible historical record to obtain as much information as possible about the relative value of gold versus the DJIA. Yes, gold was prohibited until 1974. But ownership of stocks was relegated to a small minority of the population as well. Neither fact changes the conclusion of the article that whether gold outperforms the DJIA depends on the current economic circumstances. Neither is “best” at all times.

As insurance against inflation I believe gold also fails since insurance is designed to replace value dollar for dollar. If 10% of a portfolio is in gold then a doubling of the value of gold is required to increase the portfolio by 10%. Stated differently, to protect against a 10% inflation rate requires that gold (at 10% of the portfolio) double in price. Gold certainly can double in a year (or less) but it has never done so over any extended period of time and never done so during periods of low to moderate inflation. Gold only jumps in value during periods of extreme financial stress. Of course, today we are in fact experiencing extreme financial stress so gold is doing well. For now.

As a store of value (SOV) gold, or any asset for that matter, must also perform well as an investment. I am clearly not the brightest bulb in the chandelier but I cannot understand how a poorly performing investment can succeed as a store of value. But set that argument aside. Given a historical record of the CPI how does gold stack up as a store of value? The BLS statistics set 1982-1984 as 100 and then adjust the CPI up or down accordingly. Thus if inflation at some future time is double what it was in 1982-1984 the CPI goes to 200. If it were half the CPI drops to 50.

Since the 1983 CPI is set at 99.6 I arbitrarily used that as my base level for inflation. Also, since gold had been trading freely at that time I set the yearend spot price of gold, 415.00 as my base level for the price of gold. Using the base level of gold I then adjusted the price using the annual CPI figures for each year. By coincidence the CPI adjusted price of gold in 1974 was 203.78 versus the actual spot price of 195.20 which is extremely close.

There were several interesting results from this exercise. First, the CPI adjusted price of gold was well above the government set levels from 1913 through 1973, sometimes by 2 or 3 times. This suggests the government was arbitrarily devaluing the dollar, in gold terms during this period. No big surprise there. What was a surprise is that from 1974 through 1978 spot gold was still below the CPI adjusted level. However, even more stunning is that the only times spot gold exceeded the CPI adjusted level was from 1979-1983 plus 1987 and 2008. If we only look at the period from 1974 through 2008, when gold was freely traded its SOV function was only reliable for a single 5 year period plus two additional separate years of extreme financial stress. Obviously 2009 and beyond may add to gold’s SOV utility.

My conclusion is that gold as a store of value, as a hedge against inflation and as an investment is only valuable during periods of extreme financial stress. We are in such a period at the present. Gold is doing well, at the present. Stay alert for improvements in the underlying economic circumstances and protect yourself. The gold versus CPI table is available at redst8r.wordpress.com

A Five Year Investment Plan

GRAR: Thank you for your comment. You had good points on all counts. Your points in order:
1) It does take a considerable amount of time to oversee the investment. I do question whether our stock investments shouldn't also be monitored closely. But I appreciate the distinction. To some degree this is a matter of preference - oversee a major stock investment or a small business.
2) Here I do disagree. Yes, it is unlikely GE will go to zero. But it seems quite possible that Citi or BofA or GM etc. may in fact go to zero. My small business also has the risk of going to zero although it is not "the most likely outcome". In fact the worst outcome (which you also mentioned) is not going to zero but slowly bleeding to death. Again, I have cutoff points (e.g., stop-loss) established for just that reason.
3) My requirement all along was to be the majority owner for exactly the reasons you state. I do not participate in the daily operations but by retaining majority ownership I can pull the plug - and will - when and if it becomes necessary. Managing this risk is very similar to managing my risk in a major stock investment where timely information is often difficult to obtain and may only be unearthed after the fact.

I'm sure we all agree there is no risk free investment so it does become a personal choice. The liquidity argument is the strongest against a small business. Being in that position now brings that fact home. But it is not necessarily a sufficient reason to avoid investing in a small business. Thanks again, I appreciate all the thoughtful comments.




On Feb 19 02:52 PM GRAR wrote:

> Investing in small business is a fine idea. I see only three problems.
>
>
> First, investing in small businesses requires a serious investment
> of time, both in finding the most promising among the thousands of
> opportunities, and keeping close tabs on the progress. This sounds
> more like a second job than an investment.
>
> The second problem is risk. It is true GE stock could go down 30%
> from here. But it is very unlikely to go to zero, which is the most
> likely outcome for the majority of small businesses.
>
> The third problem is liquidity. If GE goes down 10% you can always
> just sell the stock. With a small business, you are pretty much locked
> into the investment. The only way out is to liquidate or sell the
> entire business. And even with your increased "say", unless you own
> a controlling majority, you don't get to decide when to pull the
> plug. You could be treated to watching your equity slowly bleed away.
>
>
> To summarize: I agree that the stock market probably will not appreciate
> in the forseeable future, and that small business is potentially
> more profitable. However, direct investment in small ventures ("angel
> investing") entails more downside than was described.

A Five Year Investment Plan

Thanks for your comment. I agree that a strong currency will offset global inflation pressures. I believe currency values are relative such that even if our domestic economy is in the tank, our currency can be strong if we are the best economy of a bunch of bad economy. The best of the worst so to speak.


On Feb 19 10:18 AM kelm wrote:

> This is a great article because you analyze the problem, draw your
> conclusions and then state exactly what you plan to do to implement
> those conclusions - bravo!
>
> I completely agree with your conclusion that the US equity markets
> are impaired and will be for some time to come. Te day traders I
> talk to are having fits with this market as well so I don't even
> think it is a good traders market.
>
> Keep in mind that for much of the 1990s and 2000s the US imported
> deflation and were happy to do so due to our strong currency. The
> dollar, despite recent strength, is well below the levels it was
> at previously. The next big round of inflation will be partially
> imported and partially home grown, and the currency may be a lot
> lower.
>
>

A Five Year Investment Plan

Thanks for your comment. I too looked at dividend stocks but was dismayed that those paying higher amounts (4%+) were either cutting or likely to cut their dividends. Those paying a reasonable amount (2% - 3%) sadly just didn't provide enough income to justify the risk. I am open to quality recommendations though. Dividend stocks will be one of the best equity investments for the next 5 years.


On Feb 18 05:38 PM Larry House wrote:

> I think your note of caution is well taken. I see nothing wrong with
> bonds for the next few years. I am not opposed to holding a few good
> dividend-paying stocks, but my expectations for them are quite modest.

Fair Value for the S&P: It's Not 440

I'm not the brightest bulb in the chandelier so please explain what exactly, constitutes "normalized earnings"? (And why should I care?)Such a phrase suggests excluding events that are supposedly one off events. As is usual in such an circumstance that may make some sense such as a one time write down of the value of an investment. One concern is how often can we exclude such one time events that seem, curiously, to occur fairly often?

In the past I have used the reported operating earnings number to calculate a "fair value" for the S&P 500 using 10 year Tbill rates. That and $4 will get me a Starbucks latte. It is an interesting exercise but after a bit the thrill was gone. The market doesn't give two hoots about some academic assertion of "fair value". It does care about future earnings if investors have a long enough time horizon. Those with short time horizons are basically momemtum traders.

I have read that 2009 S&P 500 operating earnings (which excludes those 'one time events') may be in the $60 range. If I assign a 15 PE to that then fair value may be 900. If I assign a 10 PE then fair value is 600. It is not clear to me why a higher PE is reasonable for a seriously reduced earnings stream especially in an environment of extremely low interest rates. Yes, I understand the inverse might be more normal (low rates = higher PE) but those low rates are indicative of probable weak earnings not an harbinger of future gains.

Bottom line: while GAAP earnings include supposed one time events as if they were routine the 15 PE is overstating the future value of whatever the earnings will be.

How to Fix America's Housing

The article was about how to fix America's housing [crisis]. 'Tradememe' says stop the vicious cirlce while 'The hand' says get the housing market [prices] to the bottom fast. It seems to me that if we do the latter the former will occur also.

So far every effort by public and private officials alike is oriented towards "solving" the housing cum financial crisis but only if they can minimize the losses to the banks and investors. When banks are on the hook for multiple trillions (especially if we include CDS's) there is no way to minimize their losses without bankrupting the country.

Ed Glaeser's review of the book by Robert Ellickson adds little to the debate. Basically Ellickson [apparrently] again tries to diminish the losses to banks and homeowners by crafting a whole new set of rules. If this market circumstance teaches nothing it should teach that "rules" create a system that the 'financial geniuses' can circumvent to their profit.

I'm more in tune with 'The hand' and 'MrMillergd' in that the housing prices need to be allowed to bottom, banks need to fail, investors need to take serious losses and then government can provide some assistance to individuals. Shoveling money into banks only props up their balance sheets, it does nothing to solve the housing crisis.

Deflation Risk Dipping As Stagflation Risk Rises

Credit contraction is creating in asset devaluation. This combination in turn results in a contraction in net demand and employment not deflation. I don't buy the deflation scenario. Deflation, like its sibling inflation, is a monetary phenomenon. Technically we can't have inflation and deflation at the same time. What we might actually have at the moment is more consistent with a stable price system than either of the "...flation" siblings. That is, in a stable pricing environment some prices may rise but others will fall.

I also don't buy into gold as a useful investment but if the crowd wants gold (or tulips or oil or houses) the price will rise. Just please go to goldprice.org and check the 30 year history of gold prices. It will streak higher in financial panices (early 80's and today) but otherwise is in a trading range. And if the world's central banks decided to unload their hoards? What then?

I am concerned at the future prospect for inflation as the Fed monetizes the bailout(s). But since the Obama administration, like the last days of the Bush administraion, is following the Japanese economic program we can expect multiple failed bailouts and a long, long time before inflation rears its very ugly head. I'll be watching the markets, considering TBT at some point, and who knows, maybe a bit o' the gold. (Actually diamonds are better. Smaller, lighter, easier to carry and also valuable. Plus the diamond hoards are held by private companies.)

Deflation Risk Dipping As Stagflation Risk Rises

I agree with jkca1. Our markets in NC are quite full thanks. Prices aren't rising nor falling much but there are more sales (2 for 1 for instance).


On Jan 26 05:43 PM jkca1 wrote:

> I don't know where CAFK lives but our supermarkets in CA are well
> stocked and full. You name it, it's available and plentiful.

Measure, Don't Model: The Forest and the Trees

Don - Thanks for the article, it confirms what I recently read in a book by Madelbrot last summer. I was, well, staggered by watching the markets this fall. Especially since I have been all in cash for some time and happy for it. Now to review the prior article and see what all the fuss is about.

Hope you and CM settle down. You're both smart and interesting but the thread was getting boring.

Housing: Where Is the Bottom?

Excellent article, thanks for all the hard work. I got foggy brain syndrome (possible side effect from age) from all the data and information that will take some time to clear but I will reread the article and then, ... try to figure out what to do. For the vast majority of comments, thanks also. Great stuff.

Housing: Where Is the Bottom?

Yes, this would work, except for the furniture makers, applicance builders, decorators, etc. My wife had the same inspiration this weekend while walking the neighborhood but without your numbers. For analytical support just consider what happens on the good old family farm where the agriculture department pays farmers NOT to grow crops. Why not do the same for builders et.al.?


On Jan 10 08:46 PM floridauser wrote:

> This is a comment from Oct.1, 2008. Seemed easy enough to implement:
>
>
> There's Still a Better Bailout Available Since all the trouble rests
> with tumbling home prices, resulting in massive CDO losses, why not
> act at the source? Stop issuing new residential building permits
> until unsold housing inventory is absorbed. Since new house sales
> are only a small fraction of all sales, this would take some time.
> Certainly, such a plan would be an unamerican, anti-capitalist program,
> just like the one being proposed by Paulson to rescue nearly bankrupt
> financial institutions. However, it would likely be much cheaper
> to temporarily compensate the new home builders and their suppliers
> for lost income than to rescue these behemoth banks. About 500,000
> new homes are sold yearly at an average price of just over $200,000
> resulting in an approx $100 billion/year subsidy. This should have
> the desired effect of stabilizing the housing price freefall and
> the value of CDO's. A gradual return to normal permitting could be
> allowed in several years. The US is simply overbuilt and this can
> be remedied in time by a growing population if no more inventory
> is added.
> Oct 01 23:22 pm |Rating: 0 0 |Link to Comment |View article
> Your Comments Stream Stats
>
> 1 Comments, 0 , 0
> Total Comment Stream rating - = 0

Want to Reform Wall St.? Bring Back Partnership Investment Banks

I wholeheartedly endorse this concept.

To Ricard: it was NOT naive for the companies to go public it was smart! Look at the outcome. The managers sold their ownership for tremendous profits and then proceeded to use the public money (e.g., stockholders) to earn huge bonuses and salaries. What's not to like - if you were an insider. To the public that bought those shares? Caveat Emptor.

To savagecapital: there is a distinction between "Wall Street" (e.g., investment banks) and the large commercial banks (e.g., Citi, BofA etc.)

To CautiousInvestor: anytime a rules based situation is created (as opposed to an outcomes based situation) the big money will hire the smart poeple to game the rules. That's just reality.

As for commercial banks that are "too big to fail" I believe that if any private institution (or semi-private as in Fannie / Freddie) is deemed "too big to fail" then they are "too big" period and need to be split up. It should be obvious that under any so-called free market system if there are no regulations or limitations then the ulitmate outcome is a series of sector monopolies. That is, the strongest will prevail and ultimately own it all.

The key for a responsible capitalist is where to draw the lines?

How Investors Can Profit from the Coming Bear Market in Bonds

Thanks to all for the intelligent discussion; especially Doubelguns who asked my exact question and Simit for his answer. I have been struggling to understand how to connect asset deflation with trillion dollar bailouts that should be highly inflationary.

Clearly a short term deflation is ongoing and while problematic it is necessary in order to complete the deleveraging of financial and hard assets. And it is that same deleveraging process that is the link between current deflation and future inflation.

Once the deleveraging is complete and asset valuations are trusted then lending will gradually resume and inflation will rear its ugly head.

Simit: It may be too early to take the TBT trade. IF the current deflationary, deleveraging is derived from the housing bubble then perhaps the bottoming of the housing market (e.g., builders) is the fundamental indicator to establish a time to initiate inflationary trades.

Where We Go from Here: Best and Worst Cases

Wait a minute, the overall problem is "solvency" not "liquidity" but the solution proposed is more liquidity? I generally agree that solvency is the bottom line issue but all the liquidity in the world won't resolve that key issue. Sellers must find buyers. Finding buyers in a deleveraging process is easy - but only at a price. And thus we find ourselves back at the solvency issue.

For a company to deleverage in the midst of a group deleverage is vastly more difficult than otherwise. If there is a group of companies trying to deleverage simultaneously and most have similar assets then prices for those assets must drop well below what any individual company wants to accept or would have to accept if it was the only company involved. Hence solvency is the issue not liquidity - or buyers.

Frankly, I believe that the price for the assets that will clear the markets is a value that leads to insolvency for many financial instituitions and not a few industrial cum financial (think GE and GMAC) companies. And the government cannot fund all the companies seeking to deleverage (and now states as well) but it doesn't want the political hit from having dozens of firms going belly up scant weeks before a major election. So we have bailouts that won't work, rescues of favored firms, bankruptcy for the few and a depressing sense of capitalism being sold out for a selectively socialized economy.

Signed Rescue Bill Hasn't Stopped the Market's Downward Trend

Anarchist: Geez, I hope so. If the Blue Dogs really did represent their constituents they would have frozen this bill and examined any of a variety of other plans that might have actually done some good for us out here in the hinterland.

As to whether this is a routine credit contraction or some extreme abnormality I believe it is more routine than abnormal. The US housing market was severely over extended, credit default swaps were traded like candy back and forth without even owning the underlying security.

With so much leverage to be unwound the contraction is painful but to those of us who lived through the early 1980's this is modest. The Ben and Hank panic is a far more severe issue than the credit contraction they're worried about. What will they do with a real crisis?