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Jeffrey Dow Jones
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Jeffrey Dow Jones is the managing editor for Alpine Advisor. He has previously worked for PaineWebber/UBS and Ford Motor Credit Company, and he spent the last decade co-managing a group of hedge funds. He holds a degree in Business Economics with a specialization in Computer Programming from The... More
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The Trade of the Decade: A Guide to Investing in the 2010s
  • Six Things Most People Don't Know About Gold (Part 3) 0 comments
    Jul 13, 2010 3:00 PM | about stocks: GLD, GOLD, NEM, ABX, CDE, AU, AEM, GG, KGC
    Click to read parts one and two.
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    5) Sorry, Tea Party.  We’re not going back to a gold standard.

    And take away Obama, Bernanke, Geithner & Co.’s ability to keep printing more dollars on demand?  puh-lease!

    They might be fighting a noble fight, attempting to combat the effects of a nasty recession, but know that each dollar that gets printed or pumped into the system via quantitative easing runs the risk of decreasing the relative value of all the other dollars in the system.  It’s simple supply and demand.

    There’s been substantial easing already, but we haven’t seen many signs of price inflation.  One of the big reasons why is frequently overlooked: there has been a total collapse in monetary velocity.

    The velocity of money is just the average frequency with which a dollar is spent within an economy.  For example, if I have $1 and use it to buy a cup of coffee from you, and you then take that $1 and use it to buy a donut from me, we’ve created $2 of Gross Domestic Product for the little economy that exists between you and me.  Our $1 of total money supply has turned over twice. With this, we can actually rewrite GDP another way:

    GDP = M (the money supply) * V (the velocity of money)

    So when the velocity of money in a big economy like the US drops because people slow down their spending, The Fed needs to increase the money supply to prevent a subsequent drop in GDP.  It typically does this by purchasing government bonds out in the market which increases the reserves at banks which means they can turn around and loan more money to people.

    Here’s a monetary velocity chart for M2, which consists of things like paper currency, bank checking deposits, traveler’s checks, savings & time deposits, and money market funds:

    image

    The big reason for that sharp drop in velocity has been banks’ unwillingness to lend out money because of shakier capital foundations and stricter lending standards.  There’s a reason the banking system in particular has been so aggressively targeted with stimulative efforts.  Imagine a giant network of gears – the banking system is the big gear in the middle that turns a whole bunch of smaller gears around it and so The Fed has spent the majority of its efforts getting that central gear turning again.

    This is all relevant for gold because, as you can see, we’ve needed to aggressively grow the money supply lest that collapse in velocity seriously impact GDP.  But the great economist Milton Friedman warned we shouldn’t ever increase it by too much.   Increase the money supply by too much and you do get inflation.  It’s a tight rope act.  And like any tight rope act, it’s incredibly captivating because so much is at stake – the life of the rope walker or the fate of our currency.

    There’s a very common false argument out there that simply “printing money” (via quantitative easing) will destroy the dollar, create inflation, and therefore drive the price of gold sky high.   This isn’t always the case.  Thereare times when good old fashioned money printing is what’s called for, especially when we want to make a nasty recession a little less nasty.  A gold standard would throw a monkey wrench in The Fed’s ability to do that.  It also would make it much more difficult for the US to pay back its creditors, but that’s a whole ‘nother can of worms.  We’ll explore that rabbit hole in another letter.

    The US paper dollar has value because we can always use these dollars to settle our debt with the government (aka income taxes).  So long as everybody needs to pay taxes then paper dollars will have some sort of value.  I know that if I offer my services in exchange for your dollars, I will accept your dollars because I can use those to settle my tax bill next April.

    That being said, the track record of fiat currencies throughout history is very poor.  Many have involved spectacular collapses from the late Romans to John Law’s 18th Century France to Weimar Germany to more recent collapses in the Mexican Peso, Thai Baht, and Russian Ruble.  There has never been a major fiat currency that has lasted very long.  I’d like to think our track record will be better here, but really bad things have happened in the US before and really bad things will happen again.

    A currency crisis could be one.

    Which brings me to…

    6) Every investor needs to own gold.

    If you have an investment portfolio of significant size, some of that portfolio needs to be allocated to gold.

    If you've ever met with a financial advisor, you've surely heard something about building a “balanced portfolio”, something like 60/40 or 70/30 stocks and bonds depending on your age.  Target Date funds are very popular now with mutual fund companies; these are funds that start out aggressively with allocations to riskier equities and then slowly get more conservative and add more fixed income as they move towards a “target date” at which one will presumably retire.  They’d be a neat idea if that was the way investors actually invested.

    But how many financial advisors have seriously urged you to add gold to your portfolio?  Where's the 40/40/20 portfolio? Or where’s the “six dimensional portfolio” that allocates across cash, equities, bonds, gold, real estate, and alternative funds?  That’s real diversification for you.

    Anyway, let me be clear: own gold.

    The reasons for owning gold are numerous, but only one reason matters.  The only reason that should ever matter when adding any new investment to your portfolio.  Gold is different and it moves in totally different ways.

    And I've got good news.  It's a lot easier to add gold to your portfolio than you might think.

    The easiest way to get it is through a gold ETF.  There are several gold ETF's (exchange traded funds), but GLD is what I use.  You can learn about The SPDR Gold Trust here, but the key thing to know is that it holds physical bullion.  A lot of commodity ETFs – you might be familiar with UNG (natural gas) or USO (crude oil) – just hold or trade the futures contracts which is problematic because futures contracts expire and before they do, new ones need to be purchased.

    Without getting too technical and dropping crazy terms like "backwardation" and "contango" (two of my all time favorite words) you simply need to be aware that the values of these ETFs won't perfectly track the underlying commodity.  Sometimes they'll go up more than the underlying commodity, but because of the nature of commodity markets, they usually underperform.

    So if you buy GLD, you're technically buying shares of a trust that holds a whole lot of physical bullion.  GLD will move in almost perfect lockstep with the actual price of gold.

    Owning gold through a trust is cool, but owning physical gold is really cool.  Show someone a 1oz gold coin and watch how they react.  It's a great party gimmick and is guaranteed to impress your friends.  You can buy gold coins through the US Mint or through a local coin dealer or an online dealer like Monex.  You can even buy gold coins on eBay.  There are all sorts of places to get it, but the most important thing here is that you should alwaysexpect to pay a premium for physical gold.  When you see the price of gold on the news expect to pay a bit more than that for some coins or bars.

    Another way to own physical gold is by buying jewelry.  No joke!  It's definitely not the most efficient way to get it, and it's probably one of the least liquid forms of gold, but it does happen to be the most fun.  Your wife will thank you for it, too.   And surely that's worth the extra cost?   Wives, if you're the one reading this – kudos, by the way – have your husband study this newsletter top to bottom and tell him it's a good way to diversify your investment portfolio.  Really!

    Just make sure the jewelry is of good quality – as an investment, more pure gold is better, but my mother-in-law has informed me that 24 carat gold (99.9% pure) doesn't make for the best jewelry. So the two of you will need to compromise.  But hey, that’s marriage.

    GoldMine

    If you're looking for a little more kick, try picking up some stocks of companies that mine gold.

    These are familiar names here in Nevada.   Most of you, especially those of you between Lovelock and Elko, are familiar with the Newmont (NEM), Barrick (ABX), and Coeur d’Alene (CDE).   You can also check out Randgold (GOLD), AngloGold Ashanti (AU), Agnico-Eagle Mines (AEM), Goldcorp (GG), or Kinross (KGC).

    Traditionally, these have been a more “leveraged” way to invest in gold; these gold stocks typically go up more than gold if gold's rising, and fall farther than gold if gold's going down.  They don't typically move with the broader market to the extent that other economically-dependent stocks do, so if you're building a simple portfolio of stocks, gold miners are a great way to get equity diversification.  I'm not a mutual fund manager, but if I were, I would absolutely own gold stocks in my fund.  You can buy a straight basket of all the gold miners in one easy purchase with GDX, an ETF that mirrors the NYSE Arca Gold Miners Index.

    If you don't mind the extra layer of fees, you can also pick up a gold mutual find like Tocqueville (TGLDX) or Gabelli Gold (GOLDX).  They'll hold a mix of actual gold and gold stocks and sometimes some related positions.  Sometimes it can be worth it to have a professional fund manager’s expertise.

    I feel as though I need to make one final thing clear.  It's subtle distinction, but when I say that every investor needs to own some gold, I'm not saying that I think that gold is necessarily going up in price.

    I do think that a decade from now it will be higher than it is today, but I'm a lot less sure about where it's headed over the short run.  Unfortunately, that's a call you'll need to make on your own.  But if you've made it this far in this article, you're certainly equipped to do so, and with confidence.

    Caveat Emptor

    Dwarf Miner

    As you’ve listened to me pontificate about gold, you need to understand who I am in order to put my comments into proper context. As with any advice you hear dispensed from any fountain of so-called expertise, you need to develop an understanding of the source before blinding accepting its ideas as your own. You need to be aware of my biases and predilections.

    I am a second generation native Nevadan. I was born here, raised here, then ventured out into the world only to return here. I love living in Nevada, and not only that, feel spiritually bound to the region. As a kid I spent many a summer vacation in the South and would later live and work for 6 years in Los Angeles. So I understand powerful local cultures, to be both a part of them and exist within them as an outsider.

    Nevada is who I am, and Nevada itself is a composite of others like me, individuals from present and past.

    Gold is a key part of our state and our history.

    Nevada produces a whopping 80% of all the gold mined in the United States. Those of you readers from other states or outside the country might not understand how proud we are of our mining heritage. The discovery of the massive Comstock Lode underneath Virginia City was one of the most influential factors in Nevada being admitted as an official Union territory. Abraham Lincoln saw the opportunity and welcomed us to the Union, ensuring that our silver riches would assist their cause and not the Confederate's.

    As a state of no-frills pragmatists, Nevadans understand mineral wealth. To us these metals are not “bling”. They’re not a fad, nor are they for speculatin’. These metals are practical, useful. Necessary, even. They are hard assets.

    What kind of person holds gold through a 40-year rollercoaster from $100 to $850 back to $250 and onward above $1000?

    Nevadans do.

    Like Tolkien’s Dwarves of Moria, we are transfixed by gold’s eternal, timeless worth. We are the ones who work so hard to pull it up from deep in the earth only to re-bury it in our vaults for subsequent generations.

    Perhaps we do have an innate understanding of gold that others don’t. But we couldn’t possibly be considered objective – which isn’t to say you should regard this aspect of our regional culture with complete skepticism.

    All I’ve really given you thus far has been facts.



    Disclosure: Long GLD
    Themes: Gold Price, Commodities Stocks: GLD, GOLD, NEM, ABX, CDE, AU, AEM, GG, KGC
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