"On the opposite side of every crisis there is an opportunity." - Mike Maloney, The Hidden Secrets of Money
In a prior installment, I suggested that gold would be a prudent investment choice. I said that I would write my next piece (the one you're reading now) on the fundamentals driving the yellow metal. I want to be clear, the fundamentals are long term fundamentals, and nothing that will cause us to do anything in a short term trade. Also in my last piece, I suggested shares of Franco Nevada (FNV), Sprott Gold Miners ETF (SGDM), Sprott Junior Gold Miners ETF (SGDJ), and the Europac Gold Fund Class A Shares (EPGFX). I own shares in all four of these securities. What I didn't say was that the traditional portfolio allotment for physical gold is 5%-20%, and what is right for you is highly dependent on your risk tolerance as well as your overall financial goals. Regarding that you should seek advice from two people: your financial advisor and your tax advisor.
I also didn't say what else I own. In the name of full disclosure and transparency, my portfolio of gold related holdings includes one-ounce gold eagles, Pretium Resources (PVG), and Asanko Gold (AKG). Other precious metal holdings include one-ounce silver eagles, First Majestic Silver (AG), Endeavor Silver (EXK), First Mining Finance (OTCQX:FFMGF), and Silver Wheaton (SLW). I bought each of the assets and securities listed for different reasons, with different goals in mind, and at different times. I also like several other companies, though I am not invested in them yet. This is not an offer to sell any of these to you either, and it doesn't even imply that I think it's appropriate for you to buy any of these. If you are interested, you must do your own due diligence.
Notice that I don't hold GLD or IAU? A much better option is PHYS (or PSLV for silver), because if you own GLD or IAU, it says in their prospectuses that if you want to redeem your shares for physical gold, you can't. You're not an institutional, "approved" investor (approved business partner of either ETF) and you don't have redemption rights. They also retain the right to dilute your shares. Same for SLV. And many speculate that neither GLD nor IAU actually hold the gold they claim their shares represent. I'm not going there, but if you do the research you'll see it's actually not too farfetched. But for now…
Let's take a walk down the yellow brick road, shall we?
What Is Gold And Its Economic Function?
Gold does many things. It is used in electronics, especially by the military and aerospace industries, and in surgical equipment that mean the difference between life and death. It's in your cell phone that you're holding while reading this, and it's in the computer you could be using to read this. We use it for jewelry, dental fillings, fancy faucets and door knobs, picture frames, and all kinds of everyday items. It is also the oldest form of money in the world, and as far as we know gold coins have been found from 4000-5000 years ago. All cultures and countries of the last several millennia have used gold for money, and we still do.
But gold is not the only money we use, right? The $20 bill in your pocket is also money. Or is it just cash/currency? We have two forms of currency in the world: fiat currency and precious metals coins. Depending on who you ask, they share anywhere from 3-6 properties (easily portable, unit of account, medium of exchange, durable, divisible, fungible). Sadly, most people don't know the difference between real money and the fiat currency in your pocket called cash, including bankers, accountants, financiers, hedge fund managers, insurance agents, and anyone else who deals with your money. Regardless of your country of residence, all cash holds all six of those properties I've mentioned, and we use it because our governments hold bigger guns than we do and implicitly tell us "I said so, so you have to." It's cash by government fiat, or decree. But it's not real money.
The singular advantage that gold holds over your cash, and what makes it real money, is that it is a store of value. In other words, over very long periods of time, everything maintains about the same price when priced in gold. I don't mean to say from one year to the next, or even if the economy takes a temporary downturn of nine months while the price of gold spikes. I mean really long periods of time, as in 50-100 years or more. Housing for example, would cost you about 180-200 ounces of gold to buy the average single-family house in America. It is true now, it was true 100 years ago, and it was true when the country was formed nearly 250 years ago. This is because the value of the house is not in the price you pay.
The value of your house, all else equal, is the roof, plumbing, HVAC, security, etc. Value is what the house is worth to you, what you get out of it. Price is merely what you paid in dollars and cents. The value of gold hasn't changed, and neither has the value of a house. So the price of a house in ounces of gold hasn't changed either, even though the price per ounce, denominated in dollars, changes daily, and so does the price of housing.
From an economic perspective, gold levels the playing field on everything. You can price stuff in fiat dollars and cents (or Canadian Dollars, Yen, Yuan, Euros), but that will change over long periods of time. If you price stuff in gold, the amount of ounces of gold you pay really doesn't change over the same long period of time.
In addition to leveling the playing field, people tend to gravitate toward holding onto cash and gold during times of uncertainty, especially extreme circumstances. Let's have a look at Weimar Germany as an example. And remember that the value of everything stayed constant, whereas the prices paid for those items changed.
At the end of WWI, the exchange rate was 100 Marks for an ounce of gold. Two years later, in 1920, the exchange rate fluctuated from 1000 to as high as 2000 Marks per ounce. The value of a loaf of bread didn't change, rather only the price paid for it in Marks; imagine if you paid $3.50 for a 2 pound loaf of rye bread and 2 years later you had to pay $32 for the same loaf. By the summer of 1922 prices rose an additional 700%! That's $256 for a loaf of bread. Subsequently the German government went from printing about 45 billion Marks per day to nearly 500 quadrillion daily. Anyone who held onto their gold came out either untouched or made a fantastic gain. Anyone who only held cash suffered tremendously, as the purchasing power of their cash fell by 100% in just a couple years. It was worthless.
How Does Gold Function In My Portfolio?
Let's get one thing straight here: gold is not in your portfolio, and should not be in your portfolio, because it pays you dividends. Gold does not pay dividends. Companies pay dividends. But just because gold doesn't pay dividends doesn't mean you shouldn't own gold in your portfolio, either. That's because gold serves a completely different function from your dividend stocks, bonds, REITs, or any other investment you own.
The first function of gold is that it's a hedge against inflation. "But Howard, you're such a fool! Stocks hedge against inflation already, so I don't need gold for that purpose." I hear that argument and present you with the evidence (as of March 2017): The NASDAQ between its prior peak at 5132 (November '99) and its current level at 5860. Your annualized growth is 0.78% over those 17 years. The S&P 500 index went from 1527 at its prior peak (March 2000) to nearly 2400 now. That's an annual growth rate of 2.87%. The DOW was 11723 at its peak in 2000, and now sits at 21000. That's 3.71% per year. Gold was $255 and is now over $1240, for an annual growth rate of 10.39%. In fact in June 1932 the DOW was sitting at its depression years bottom at 765, and from then until now (85 years) your annual return would have been 3.97%, whereas gold has gone from $20 to $1240, which is an annual rate of return of 4.98%. That means the DOW would have multiplied your investment an astounding 28 times. But gold would have multiplied it over the same period by 63 times! If you use the statistics from the BLS from 1913 until now, average annual inflation in the country is 3.12%. So where would you rather be if you are trying to protect against inflation: stocks or gold? Both beat inflation, but the return on gold is much higher. Gold looks like a sure thing so far.
Note: Many thanks to reader "Toke O." for pointing out the bottom for the DOW during the Depression, as he said "The Dow bottomed at 41,22 on July 8, 1932." He is 100% correct, and I greatly appreciate his correction. This implies that since that bottom, the DOW returned 7.6% until now. On an inflation adjusted basis, the DOW did need nearly 30 years to recover from that drop, meaning investors at the time waited until Summer 1959 before their value and full purchasing power were restored. However, I maintain my case for gold as the rest of this blog post points out.
But being the best hedge against inflation is not the only function of gold. The second function I'll describe to you through an analogy. If you own a car, by law you need insurance coverage. Even if it isn't the law, it's a wise idea to pay a small premium to transfer the risk of financial disaster to someone else. And so it goes with gold.
By owning gold, you own an insurance policy on your wealth. Remember what we said about Weimar Germany? Anyone who owned gold came out unscathed in the worst case scenario. The insurance you need for your portfolio is not against the other companies you own (stocks) or lent to (bonds). The insurance is actually against government devaluation of your currency via inflation of the currency supply, i.e. printing the dollar into oblivion. You see, hard assets like gold maintain their value, even during the periods of the worst uncertainty, financial or political or otherwise. Other assets like stocks and bonds either tend to implode or they just don't keep pace.
The third function of gold, and perhaps the most important, is ownership of an asset that has no third party counter risk. "Well what the heck is that, Howard?" Glad you asked. Third party counter risk, in this context, means that someone else has control over your assets, and there is a risk associated with that third party. If you have cash in the bank, your third party counter risk is the bank itself. So far this year two banks have failed. FDIC insurance might not cover everything, because they only cover certain accounts up to $250,000. If your account is not FDIC insured or if it's over $250,000, you're out of luck. More importantly though, the FDIC only has $25 billion in cash to support several trillion of insured accounts.
Another third party risk is the government printing more cash. The more of something there is, the lower the value, and therefore the lower its purchasing power. The less of something, the higher the value and the higher its purchasing power. It's for this reason that the Mona Lisa would fetch several hundred million at auction, but the 2015 Derek Jeter baseball card would only fetch a few pennies. The same holds true for the cash in your pocket. The more of that cash there is, the less it's really worth, and the reason it will take more and more to buy the same stuff.
Finally, if you own equity in a company that is traded on the stock exchange, someone else has complete control of your investment until you sell. That is, if you can find a buyer in time. The CEO and all the other employees control what happens in that company you just bought, and you can't do anything about it. Your voting rights are meaningless unless you are the institution that owns 10% or more of the company, or if you sit on the board of directors or sit in the C-Suite. And if you don't control the company, that means whatever happens to the price of the shares is out of your control too. In other words, someone else is in charge, and that person(s) can take your investment to zero in the blink of an eye.
Physical gold does not carry third party counter risk. If you hold it in your hand, there is no one else controlling it for you. Your bank can't shut down and hold it. The government can't call a bank holiday and prevent you from accessing it either. No other person on earth can tell you what to do with it. In fact if you hold your gold in either coins in your pocket or jewelry that you are wearing, you can cross the border without worry of customs officials bothering you; jewelry is just an adornment, and an American Eagle has a face value of only $50 (even though the melt value is much higher). And the best part is that aside from being real money, gold always retains intrinsic value because of its varied commercial and industrial applications.
Aside from the inflation hedge and avoiding third party counter risk, gold serves an additional function. You see, you can go anywhere in the world with your local currency, but that doesn't mean it will be accepted when you want to pay for whatever you want to buy. But this is just not true of gold. Gold is accepted everywhere in the world as a form of payment. Until recently it was the only form of payment that nations would accept from each other, and it will soon return to being the same.
Hopefully by now you understand the economic function of gold, as well as its function in your portfolio…more than just looking nice on your finger or around your neck. Let's delve a little bit into the economic fundamentals that strengthen the case for owning gold bullion and coins, especially now in the spring of 2017. There are several factors that contribute to the fundamentals (probably too many for this piece), and individually it might not matter so much. But if we take all of these factors together, it becomes a case of the whole being greater than the sum of the parts. I count more than 15 factors, and I am sure there are more:
The first factor was already mentioned above. That is the fact that the Department of Treasury can't stop printing more and more cash. As Treasury prints more, the value of the dollar lessens further and further. By contrast gold is money that can't be printed, and it can't be keystroked into existence. It has to be dug out of the ground (the costs of which are rising). As more and more currency is printed, the value of the currency falls. The value of gold will hold. And therefore the price of gold, priced in currency, will rise. Gold will correct itself to the upside as the dollar falls.
It isn't just the central bank of the United States. It's all central banks around the world, most especially the major economies. Here's a short list: America, Argentina, Brazil, Europe, China, Russia, Japan, Singapore, Australia, India, South Africa, and more. In fact, in all these countries except America, the price of gold in their local currency is still rising to new highs each year. And the same will happen in America as well.
It's not enough that Treasury will print and print and print. We must also consider the reasons Treasury prints. Entitlement programs like social security, multiple wars all over the world, national debt growing faster than GDP, rising interest on national debt, budget deficits, just to name a few. Treasury must continue to print because government spending is out of control, and the government itself has already told us that it will only worsen over the next several years and decades, right here in the full federal budget. In fact, this is the very reason that the FED so perversely fears deflation. Because if Treasury prints and the dollar loses value, it actually becomes cheaper to pay for debt. Additionally, debt could be increased. If the dollar gains in value, on the other hand, that means less and less dollars are circulating and it becomes harder and more expensive to pay for the same or more debt.
If the federal budget deficit is not enough evidence that Treasury must continue to print, just remember that markets will eventually wake up to this fact. When markets wake up and realize that the US government can no longer pay with currency that holds any value, all confidence will be lost. At that point the value of the dollar will absolutely be zero. In the words of former FED chairman and Princeton economist Ben Bernanke himself, "The large US current account deficit cannot persist indefinitely because the ability of the United States to make debt service payments and the willingness of foreigners to hold US assets in their portfolios are both limited."
If you had a dollar for every time I agreed with Mr. Benanke, you'd probably be pretty poor. But on this point I agree with him. What he is saying is that 1) the country cannot continue to spend beyond its means, because eventually it will not be able to pay back all the money it has ever borrowed, and 2) once the world recognizes that the US can't pay, they'll foreclose the loan and the country will be left bankrupt. This would cause a massive deflation, the greatest fear of all central bankers.
How do you know the government is printing more than just the budget deficits? Whenever you hear that the FED is lowering interest rates, engaging in quantitative easing, easing monetary policy, operation twist, taking emergency measures of any kind, bail-outs, bail-ins, announcing any new program with a catchy acronym, engaging in any open market operations, or anything else of this nature that sounds like they're making it easier for banks to do banking and for the economy to flow more easily, you'll know that Treasury will be asked to print. And by printing, again, we mean devaluing or debasing the currency.
Speaking of the FED engaging in easy monetary policies, the main focus of easy money is low and negative interest rates. There are actually two rates to have in mind. One is the stated interest rate. For example the federal funds rate is currently targeted for 0.75-1.00%. That is the stated, or nominal rate. However, the real interest rate takes inflation (or deflation) into account. The real interest rate is very simple, and it's the stated rate minus the inflation rate. If the inflation rate is 2.5%, then the real interest rate would be 1.0 minus 2.5, which equals negative 1.5%.
Whenever you find negative real interest rates, it means your cash is losing value and you are losing purchasing power. If you are earning 1% interest on your deposit, and inflation is 2.5%, you are losing 1.5% of your cash every year. Even if the balance looks like it's going up on your bank statement. You are able to purchase less and less over time with the same amount of cash.
Once we enter a negative real interest rate environment, people move out of cash. Currently, people have moved into anything that pays interest, however, over time they will realize that this is not the best placement for their cash. They will realize the quality of the assets they purchased in place of cash is very low quality, and move out of those assets as well. That's because any asset denominated in the local currency, in our case dollars, will lose ground as the currency falls. Eventually what happens is people move to the one and only place that they can maintain their wealth safely, and that is gold.
When it comes to printing, devaluation, and low or negative real interest rates, you need to know that all central banks around the world are engaged in all of these activities. It used to be that very few banks would ever engage in this type of activity, because they know the effects are devastating and cause revolutions. What we see now is completely unprecedented. Never in the history of the world has there been a coordinated attempt by all central banks to devalue their currency at the same time. In effect, a race to the bottom.
The race to the bottom is precisely the reason why all asset classes are now moving upwards in unison. Housing is rising. Stocks are rising. Commodities, while not at their all time peak, clearly are trending up again, for example here, here, here, and here. Paintings, classic cars, violins, and other collectibles are rising. And so it is with everything that is considered investable.
Here is the overly simplified explanation of what we should expect from investable assets. Imagine that there are 5 assets available, and there is $1 of value in each asset: a house, a business, a loan, a vehicle, and some manufacturing equipment. In order for the house to appreciate above $1, at least one of the other assets must depreciate commensurately with the house rising. That is what should happen.
But what if I introduce $5 of additional currency units? All of a sudden, the house can appreciate, and so can the business, the loan, the vehicle, and the manufacturing equipment. Everything is appreciating in tandem in this scenario, and that is exactly what is happening all around the world. While it is true that you might find individual assets that are losing value, generally all asset classes are rising. This scenario can't continue forever. It will come to an abrupt end when people realize that their currency has lost its value, and the reason is because of currency debasement and printing.
Now the point is that all of these assets, priced in the local fiat currencies, are rising in price. But what if we could use a different unit of measure to figure out the true value of all of these assets? If you price the stock market in gold, it is falling. Price other commodities in gold, and they are falling. Price cash in gold, and it is falling. And so it goes with all asset classes. When priced in gold, all other assets are falling. In other words, it takes less and less gold to buy stuff than previously. Even more onerous is that when priced in any other asset class, the stock market is losing serious ground. I don't mean that its gains are lower. I mean it is losing. Less oil to buy stocks, less houses to buy stocks, less pork bellies to buy stock, less copper to buy stocks, and less gold to buy stocks.
In fact many people around the world have already realized that this is what is happening. Ultra-wealthy individuals like George Soros and Li Ka-Shing are aggressively adding gold to their holdings. University endowment funds are buying, like University of Texas. Countries like China, India, and Russia are net importers of the yellow metal, because their citizens have an insatiable appetite for gold. And central banks around the world, especially in Asia, are adding to their gold reserves. And not only are they buying up the metal, they are also buying up the mines.
Speaking of buying gold and buying gold mines, it is now known that gold mining is in decline. This is for a few reasons. First, all the easy mines, the low fruits, have been discovered and cleaned out. So any new supply of gold is coming from harder and harder to reach places and from deeper and deeper mines. Second, after the runup to almost $2000 per ounce in 2011, gold declined by nearly 50%. On the way up, the mining companies were wildly spending their cash on lots of unnecessary stuff. As gold fell, they really began to tighten their belts, ending the party early like parents coming home from vacation before expected, only to find their high schoolers and their friends in a drunken stupor.
As all these companies were tightening their belts, many of them went out of business. This caused a massive consolidation of the industry, which is still under way. But all the mining projects that they were working on were shuttered when the companies closed. So new mines are now slower to come on line.
The new mines that do come on line are also producing a lower proportion of gold ore. The way it works is like this: 1) build a mine, 2) drag out all the dirt and rocks from the mine, 3) extract the gold from the rocks and dirt to create gold ore, and 4) refine the ore into gold bars. All that dirt and rock used to contain much more gold than it does now. In fact, there was about 4 times the amount of gold in the ore bodies just 10 years ago versus today. It's not just in the last decade. Gradually over time, concentrations are becoming more and more diluted.
Although ore concentrations are becoming diluted, there are gold mines that have very high concentrations of gold. Alaska and Canada have several known ore bodies with very high concentrations, of 20+ times higher than the average gold project. And these are the mines that are getting bought out or funded by Eastern central banks or state run gold mining companies.
While the rest of the world is buying up gold assets, in the West (Europe and America) we are near all time lows for portfolio allocations to gold. The standard recommendation for gold allocations is 5-20%, depending on your risk tolerance and financial needs. Currently in the West, we hold less than 0.2% of our assets in gold and gold equities. Demand in the rest of the world is climbing, whereas in the West there is virtually no new demand except for a few gold bugs and industrial demand for electronics. But the lack of demand in the West can and will turn around, and when that happens it will make the supply relative to demand look that much smaller.
The evidence in this section is truly mind blowing. You'll be just as amazed as I was, and the evidence I present in this section is strengthening more and more on a daily basis. This is all about cycles, but more importantly how they are all converging right now. Truly a case of the whole being greater than the sum of the parts, and even that is an understatement.
We have to understand that in economics, there are cycles for everything. Stock market cycles, business cycles, monetary cycles, central bank cycles, and more. For each cycle, think of a pendulum swinging back and forth, like the grandfather clock that if you even came within two feet of it as a child, someone yelled at you to get away. The economic pendulum swings back and forth between two extremes, sometimes for as short as just days, and sometimes for as long as several centuries.
The first cycle is that of the rise and fall of fiat currencies, and in this case the dollar. I'll stay quick with the history. The dollar came into existence after the Revolutionary War, but not until the Continental first collapsed. Until 1913, the dollar was backed by gold. And after WWI, the rest of the nations had to pay their debts to America in, you guessed it, gold. This is how the country acquired about 25,000 tons of the yellow metal.
Most of the currency that now circulates throughout the world is the US dollar. Around 60% actually, and half of that is not even here in the USA. It is considered the reserve currency of the world, and most international transactions are settle in the dollar. Especially oil, without which there would be virtually no modern society as we know it.
But this system is quickly changing. The BRICS countries have established their own international bank, called the New Development Bank. They are transacting in their local currencies, instead of the dollar. Joseph Stiglitz, 2014 Nobel prize winning economist, has noted that this is an important step because the current institutions lack the necessary resources. He further stated that this marks a "fundamental change in global economic and political power."
The BRICS countries are quickly moving out of the dollar, already transacting in their own currencies, and the pace at which it is happening is gaining speed. Other countries are joining the mix too. Aside from Brazil, Russia, India, China, and South Africa, you can add to the list Argentina, Ghana, Japan, Estonia, Georgia, Azerbaijan, Vietnam, Mozambique, Zambia, Cuba, South Korea, and others. Some of the countries listed here are pretty surprising. All these countries are making bilateral agreements with each other to settle transactions in their own currencies, the largest of which to date was a natural gas deal between China and Russia worth over $400 billion.
And just what has happened to countries who have tried to transact oil deals outside the dollar? Middle Eastern wars are not about Bush taking revenge for daddy over a lot of money. It's more like, "They tried to do an oil deal in a currency other than USD." Like a Mafioso, the US military went in to kill Qaddafi for his sin, teaching everyone else a harsh lesson. What was that sin? He wanted to sell oil in exchange for gold instead of US dollars.
What about Iran? Aside from their nuclear ambitions, they also tried transacting oil in non-dollar denominated terms, specifically, the Euro. When this happened they were quickly banned from using the SWIFT international wire transfer system. Saddam Hussein tried transacting outside of the US dollar in 2008 (also in Euros), and look what happened to him. In Latin America, a new system called SUCRE was introduced less than ten years ago as well.
Even here in America, the state of Utah passed the Utah Legal Tender Act on March 10, 2011. Among other provisions, it states that gold and silver may be used as legal tender for all transactions, gold and silver are not subject to capital gains taxes, and that the state may use gold or silver to pay off its debts.
The first pendulum swing is away from US dollar denominated transactions, and into other currencies including gold and silver. The second pendulum is the baby boomers, and this is actually a cycle of peak spending combined with peak investments. It's a full lifetime cycle, from birth to death (about 85 years). Remember that they were born at the end of WWII when all those soldiers came home and started families of their own. The children that were born from 1946-1964 is the generation we're discussing, which is about 75 million people, of whom about 11,500 retire on an average day. Let's see how this pendulum is going to act like a wrecking ball.
The first half of the baby boom story is disputed very hotly. All these people who are boomers, like the rest of us, are obligated by law to begin drawing on their retirement savings (IRA, 401k, etc) starting at age 70 ½. This began last year, which means that they are becoming net sellers of stocks and bonds, and often they are downsizing their homes. One argument says that this will cause a wave of deflationary pressure on assets because it brings selling pressure to markets. As you know from your college economics class (which you probably slept through if you had a professor like I did), when you have more supply than demand, ceteris paribus, the price should fall.
The other side of the argument goes something like this, "No worries. They just move the assets from their retirement account to a standard account by repurchasing whatever they sold."
Personally, I lean toward the first argument of deflationary pressure for a couple reasons. First, the asset stewardship transfer doesn't apply to anything you can't hold in a brokerage account, like houses. I know retirees who have already downsized their house and are using the price difference to help with their living expenses. Second, by all valuation measures (except pricing in gold) the stock market, bond market, and housing market, are all now at higher levels than pre-2008 crisis levels. But these levels are totally unjustified based on the economics, so something has to give. Especially considering the last several rate hikes by the FED in addition to the promised future rate hikes. You can see the details in my prior articles on what to expect from higher interest rates.
The third reason I lean toward baby boomers causing deflationary pressure in assets is the statistics of what they've actually saved for retirement as well as how much they'll be receiving in social security and/or pensions. According to a recent PWC survey of retirees, 37% have saved less than $50,000 for retirement, and another 13% have saved up to $100,000 for retirement. Unless those people have serious cash flow positive business or real estate interests, they'll be spending all their savings in the next 2-3 years. That means they're selling assets if they haven't already. Over 25% more of these retirees have saved up to $300,000. Only 15% have saved over $500,000. Without the savings for retirement, where will all the cash come from?
Social security? I don't think so. The average SSI payment is now at $1360 per month, and the average couple receives $2260 monthly, or $16,320 and $27,120 per year, respectively. That pretty much amounts to $7.85 per hour full time for the average individual, and $13 an hour for the couple. I don't know anyone earning wages like this and can fully pay their living expenses, and the people I do know who earn low wages like this are on every entitlement program the government offers (which means more printing of more cash…see above). Anyone with an average SSI income or even above average will be selling assets to make up the difference in their living expenses.
So how about their pensions? I have my doubts. There are a lucky few who have a pension left, but the average American over age 65 probably doesn't have much of a pension if any at all. According to AARP, the average retiree earns about $32,000 a year, the vast majority of which comes from…SSI. That means, according to the math, the average pensioner probably receives about $5000-$15,000 per year.
Don't laugh, my envelope math is not so far off, actually. According to the Census Bureau's Current Population Survey, the median household income of people 65 and up is just over $47,000. That includes all income sources of SSI, pensions, and retirement savings.
Again, the math here tells us this will lead to selling pressure in all markets. Selling pressure will cause deflation and fear, and when the FED fears deflation they print. When people fear anything, they run for safety. Financial safety comes in one form, and one form only: gold.
But that is just half of the baby boom pendulum! The other half is a complete and utter disaster. The other half is the demographic shift in spending habits that they bring to the economy, meaning, how they spend, when they spend, on what they spend.
Imagine for a moment that you are watching your pendulum swing as you look through a window. On the other side of the window is a fish tank of 10 feet in length, but your window only shows the middle 5 feet. The surface of the water in the tank is about half way up, and as you watch the pendulum swinging from left to right, you notice the wave following it on the surface. What I am about to describe is the baby boomers, represented by the wave passing from left to right, except that the wave is so big that by the time the crest reaches the right hand side of the fish tank, the left hand side is the back end of the same crest.
At first that wave starts to appear on the left hand side, and this represents the boomers coming into the picture from ages 0-20. This age range is the maximum lack of productivity because children don't produce anything except a lot of heartache and a few laughs for their parents. They only consume what they are given. That's mostly food, clothes, and soccer balls. From age 20-45 they all begin to work, starting to pay into the social security system and other government entitlement programs. In the middle of this stage, around 35, is when they begin to become net producers and a benefit to society: they are putting in more than they take out.
From there, until 55 or 60, they are at peak spending…biggest house and car of their life, and college tuition. And then it happens. The kids get married and venture out on their own, leaving an empty nest. And then it hits like a brick falling out of the sky. "Oh my gosh! What happened to saving for retirement?! We gotta save as much as we can to pull this off in the next 8-10 years." This lasts until about age 70. From age 70 and onward, they drive the health care industry because that is where most of their spending resides, but they aren't putting anything into the government programs in taxes. They only take, so they become the maximum burden on society. At this time, to drive their lifestyle and medical spending, they are selling investments.
The baby boomer wave is actually a double-edged sword, because we are coming to the end of their cycle which will last about 35-40 years. Remember that the last boomers will retire in about 15-20 years, and they'll stay retired for another 20 years after that. To top it off, for the first time in history, the country is giving birth to less people than are dying. Less and less people are paying into the system, and less and less people are driving the economy. Especially in the sweet spot of maximum spending. Compounding this is when the boomers die, their heirs will be selling houses faster than they will buy, and more supply with less demand will crash the price of housing.
The boomers have left the stage of maximizing their savings, and they are moving from the maximum savings empty nesters into retirement. They'll be spending on their health care, we'll be spending on their health care (that's one reason why your insurance premiums are sky high), and your favorite uncle Sam is now spending in earnest on their health care. And the health care spending is to the detriment of all other spending. So even though the health care sector might be good for your portfolio or your (grand)child's income, all of this is cause for more deflationary concerns at the FED (think more printing) and a flight to safety for individuals.
The third pendulum swing is that of wealth distribution. To understand this cycle we need to pay attention to the income of the top 1% of income earners. This peaked in the roaring 20's heading into the depression. At the time, over 20% of our income was going to the top 1% of all income earners. Then the stock market crashed, bank runs, food lines, and depression city here we come! The income distribution made a fast decent into the 1940's and kind of stayed pretty low for a while. The top 1% bottomed out of their share of national income in the 1970's with only 9% of all income.
The most recent data I found was that as of 2015, the IRS tells us that the top 1% of earners take home over 20% of national income. To be fair they also pay 38% of all income taxes. But that's not the point, rather, the pendulum has swung back to a peak and it is ready to move back toward the previous trough. And that could be a pretty hazardous deflation. The last time we hit a trough the Great Depression kicked off the swing in the opposite direction. The Depression was noted for heavy deflationary pressure. And remember that even the threat of deflation scares the living daylights out of central bankers, and we already know what they like to do to fight off deflation.
Compounding this is the fact that the last time the pendulum began to swing towards the top 1% taking less home, there were 6 people in the maximum spending category for every one person in the maximum societal drain category. This will not hold true this time around because the maximum drain category will be 75 million people at its peak, but the maximum spenders driving the economy and paying into the government programs will not make a 6:1 ratio. Not even 2:1. It will be 1:1 or worse. Think of that fish tank again and the crest of the wave having passed the right hand side, and at the same time the left side is equal or just past the top (less than the right).
The fourth pendulum swinging in our favor or that of the stock market. I've mentioned above and in other blog posts that the market is extremely overvalued. What does that mean though?
Let's imagine for a moment that in your town there is a business that you love to visit. Whenever you're there the place is full of customers and there's a long line at the cash register. Then one day you notice that the business is for sale. You turn to your spouse and wonder, "Gee, what's the price they're asking and why are they selling?" When you find the owner, he tells you he's selling for $1.5 million dollars and he wants to retire. He also says not to worry about the price because the business is allowing him to go home with over $500,000 every year. Sounds pretty good.
As you walk out of the store excited by the possibility of owning a life changing business, your best friend calls to tell you "You'll never believe it! I just got off the phone with my accountant and he said one of his other clients is selling their business for $30.0 million, and they go home with $1.5 million every year. You know that jewelry company across town? The one that everyone goes to? That's the one. It's not just the jewelry store, but it's also the fast food franchise next door and the ice cream parlor next to that. He said they own the building and the three businesses, and the apartments upstairs are included."
What would you do? One business will earn you three times what the other business will earn. But is that really a better deal? On the one hand you take home $1.5 million per year. But to do that you have to pay 20 years worth of earnings. On the other hand you can take home $500,000 and you only have to pay 3 years worth of earnings to do it. For one business you'll pay 20 times earnings, and for the other business you'll pay just three times earnings…a real bargain by comparison.
When it comes to the stock market, investors must choose between businesses like this every day. But it's not just about the difference between the take home profits. You have to consider the profit in proportion to how much you spend to buy the business in the first place. That's called valuation, or how much the value of the business is worth. Normal valuations range from paying 9-13 times the actual earnings. A ratio below that is undervalued, and a ratio above that is overvalued. Anything above a ratio of 20:1 is considered a bubble. Anything below the 5-6 range is considered extremely undervalued. And this ratio is called price to earnings, or P/E.
While there are several other ratios and metrics that may be used to place a value upon a business, this is probably the most common and the easiest to understand. At this time the P/E ratio of all the businesses combined in the stock market is well into bubble territory. The other metrics also indicate that stocks are in bubble territory as well. So no matter who you ask, stocks are overvalued to the extreme.
Just in case you're interested, the current P/E of the S&P 500 is now ever 25, the Schiller P/E is nearly 30 (which is just about equal to Black Tuesday, the day of the 1929 stock market crash and beginning of the Great Depression, and it's actually close to 70% higher than Black Monday of the infamous 1987 one-day crash exceeding 22%). Price to Book is now higher than prior to the 2008 financial crisis. Price to Sales is now 40% higher than pre-crisis levels as well.
But let's get back to the point of this pendulum, called the stock market cycle. You see, when stocks are this absurdly overvalued, eventually something has to give and the pendulum will swing first to a fair value and then it will over shoot to undervalued, and in the heat of the moment on the way down, stocks usually overshoot to extremely undervalued before returning to normal again.
Except that this time around (since 2008), stocks never went to undervalued, let alone extremely undervalued. Yeah, I can hear it now, "but stocks dropped over 40%!" Ok, but that was actually at the top of fairly valued. The stock market went down to a P/E ratio at the very top of fairly valued, with a P/E ratio of 13.5 in September 2011. The last time the S&P was this "fairly" valued was July 1989 at 13.4. in the aftermath of the financial crisis of 2008, stocks never went to undervalued, let alone extremely undervalued. Stocks have crashed 5 times in the last 100 years, and each time they went to extreme under valuation. Except this last time, when stocks bordered between the high end of fair value and the low end of overvalued.
The fifth and final pendulum swing is a topic of economic controversy. But I think that is because the economist who proposed the theory was killed by Stalin before he was able to complete his research and share it with us (he was sentenced to 8 years in prison but was taken out to be shot by a firing squad instead). Additionally, when his research was coming into focus, John Maynard Keynes quickly took the world by storm and the work of this other economist was soon forgotten by politicians and central bankers.
Nikolai Kondratieff proposed that capitalist booms and busts come in waves of about 50 year cycles, which means 50 years to wax, peak, wane, and recession. For ease of understanding many economists refer to the cycle as Spring, Summer, Fall, and Winter. It should be noted that they don't come in equally distributed divisions of 12.5 years each, as one phase may last much longer than the next. These waves are now called Kondratieff Waves, and other fields of study use his research to apply the concept in their respective fields. Kondratieff waves are so strong that in 1990, William Thompson at Indiana University published research tracing 18 waves dating back nearly 1000 years!
Kitchin and Juglar cycles also have a strong effect in the resource extraction market, other commodities, the stock market , and more generally the economy, and this will add more fuel to the fire under gold. The Kuznet cycle may be pressuring housing too, also adding fuel to the fire. And the grand super cycle waves are exacerbating markets as well.
According to Kondratieff, the wax and peak consist of rising prices in concert with falling interest rates. Think housing, for example; prices rise as mortgage rates fall. As the economic cycle strengthens, prices begin to rise and interest rates fall. The opposite is true of waning and recession. And that makes sense, if you think about it. When the economy is strengthening, producers will take notice of stronger demand and begin to charge higher prices for whatever they produce. Concurrently, banks will begin to think that there is less risk in lending, and thereby lower their interest rates.
Ok, notwithstanding the history lesson, why the heck are we talking Kondratieff waves? And all these other economic waves and pendulum swings? Well, interest rates have followed almost perfectly with the Kondratieff wave. Wholesale prices have also fallen in lock-step with the wave. In fact the only real deviation here is that the FED has decided to bring interest rates waaay too low for waaay too long, extending the wave and disguising the contraction and recession.
Now, I mentioned above something called a grand super cycle. If you Google it you'll see thousands of hits for bicycles, but that is not what we're interested in here. We're interested in a several century pendulum swing back and forth between East and West. Technological innovations and prosperity swing back and forth very slowly between Asia and Europe/America. In other words, China was prospering (gun powder, fireworks, etc) during the European dark ages, and then they began to stagnate during the industrial revolution.
But look now at the economies of Asian nations like China, Vietnam, or India. These countries are having raging bull economies for several decades already, with GDP growth being reported at 6, 8, and 10+ percent. But here in America and Europe, our economies are stagnant. So stagnant, in fact, that the post financial crisis era has been labeled a jobless recovery. But if the economy is really growing again, all the jobs that were lost should have come back, plus more.
With all these pendulums swinging back and forth, what should we look for? Which one should we pay attention to? I think we have to pay attention to all of them, because as you are reading this, all of these cycles are converging together at the same point in time. This is a once in a millennial event whereby tremendous real wealth will be transferred. It will not be destroyed, just transferred.
If you stay in the dollar and dollar denominated assets, especially assets within the financial system, you are betting against the natural course of economics, and you are also betting against gold. If you transfer a portion of your wealth into gold and other real assets found both outside the financial system and outside of the dollar, you'll do pretty well. And you'll be betting against the dollar too. Hard as that is for most of us to grasp, it's a bet against the dollar. Nope, not against America. Americans are resilient, and every time there was a crisis in the past we came through better than prior to the crisis. Pain and suffering will happen, but if you're on the right side of history, you can limit the financial suffering of you and your loved ones, or possibly never even feel it at all.
Bringing it Together
If all this is going on, why hasn't gold continued to reach newer and newer highs? And how will I be able to recognize the catalysts? And if I decide to go into a gold position, what is the best way to do it? What should my position be?
All good questions, and regarding what you should specifically do, all the answers will be different from one person to the next. It really depends on your situation as well as your tolerance for various risks that come with each type of investment.
Just to recap risks, there are several to consider, which are liquidity, market volatility, exchange rate or forex, political, exchange risk, physical risk, and outright fraud. There are other risks as well, but these are the main categories to be aware of before buying any new asset, not just gold related assets.
What this means is like this: liquidity is how fast you can sell something when you need to. Market volatility is how much the markets can swing up or down on a given day. Exchange rate or forex is how your investment is affected by currency exchange rates if you buy something in another country. Political risk means how friendly the local government is in the location of your investment (USA, Canada, Mexico, and Australia are the best, and certain countries in Africa and South America are pretty safe too.) Exchange risk is the possibility that the exchange your investment is traded on may suddenly change its trading rules, and without prior notice. Physical risk refers to how you store your physical gold. Home safe, bank safe, or storage facility like Brinks, off shore, or something else.
Outright fraud refers to all the scammers trying to defraud you. There are dozens of stories about companies who've defrauded the public out of millions of dollars, and they do it in several ways. For example, they don't deliver what they promise. I've written more below, and I also highly recommend to visit schiffgold.com and give your email address so that you can read their report on classic gold scams and how to avoid them. No, I wasn't paid for that. It's just a really great report in plain, understandable language.
Once you have a grip on the risks involved, we must also recognize that with all the financial disarray, central banks and politicians don't want us to know what is going on. I am not a conspiracy theorist, but if your job depends on an illusion, you must keep the illusion going for as long as you possibly can. You must also do whatever you can to keep the audience from figuring out how the illusion works. The longer they can keep the illusion, the longer it will take for gold to reprice itself to the appropriate level in the marketplace. Eventually, we will all find out that the magic trick is just a trick, and when that happens everyone will leave the theater to seek the safety of gold.
And by the way, most gold experts are forecasting between $5000-$10,000 gold in the next 5-10 years. Personally I think if you look at all the currency in circulation and add all the credit (about $33 trillion), you'll find that the current supply of gold in the USA will come to about $100,000 per ounce. It's astronomical, but it's actually irrelevant. What really matters is what the gold can buy you. If it still buys you a house for 180-200 ounces, then it's fairly priced in dollars. Still buys one good suit for one ounce? You're in luck. Anything less than that and your gold is still unfairly underpriced. Anything more than that, and the gold could be overpriced, other assets underpriced, or both.
Anyway, several events could cause the mass exodus into gold. It could be a black swan event like the Lehman Brothers collapse. More likely though, is that it will start in the bond market. The FED is currently raising interest rates, specifically the prime rate and the federal funds rate. This will cause all other interest rates to rise, for things like car and home loans, credit cards, treasuries, and business loans. As these rates rise, it will crimp the cash flow of anyone who has borrowed. The most over priced stock market will begin to fall, because unless the company is in the middle of an easy money share buyback, the price of shares only rises with profits. As the cost to borrow rises, the prices on any other asset that is bought with borrowed money will have to fall. Just think of how much less you would have paid for your house if the interest rate was hovering in the 8% range instead of 3.5%.
Before any financial fecal matter hits the fan, what you will see, and what will be the precipitator to wake people up, is a flattening of the yield curve between the short and long ends. Just compare the 2-year to the 10-year treasury. As the interest rate on the 2-year gets closer to the 10-year, this is what is called a flattening of the curve.
Why should you care? This is the biggest warning sign that something is about to blow. As the yield curve flattens, it is warning us of two distinct possibilities with similar outcomes, and neither outcome is good. The first possibility is future inflation expectations, that the expectation is for inflation to fall. If inflation is falling, asset prices will also fall, because they become worth less and less. It doesn't matter if you hold the asset, but usually when this happens the Street stampedes out of the asset and your broker will ask you to join the herd. If and when you do, you'll lose big time because most likely you'll be too late.
The second possibility is that a flattening yield curve also indicates lower expectations of economic growth. Assets will lose value in a slowing, stagnant, or shrinking economy as well. And here again, the Street stampedes out of the asset and your broker will ask you to join the herd. If and when you do, you'll lose big time because you'll be too late.
Most importantly here, the bond market is vastly greater in size than the stock market, similar to the fish pond in your back yard compared to the Mediterranean Sea. And the bond traders always, as a group, are the smartest people in the market place. If they are telling you foreboding predictions of the future, it pays to listen.
Once you see the writing on the wall (which I hope you do already), you'll want to move a portion of your assets to gold and gold mining equities. It's important to repeat that which assets you buy are up to you and your financial advisor, and it depends very heavily on your risk tolerance and your financial goals. It also bears repeating, as I've said many times to my clients, my students, and my family: you should never risk any money in the stock market that you can't afford to lose. If you risk the money in stocks and you lose it, you should be able to maintain your lifestyle as it is, and you should not have to worry about the future either. Otherwise, the money doesn't belong placed at risk in stocks.
If you do have money to risk, or perhaps better said cash to risk, there are a few prudent moves you can make. One is physical gold (and silver) bullion bars and coins. To buy this you have to consider 1) how much you are willing and able to spend, 2) where you will store it, and 3) from whom you will acquire it. For question 1, again, you must speak to your financial advisor. For question 2, there are storage programs, or you can use a safe in your house (or another good hiding spot that a thief will never find). Personally I would not store the bullion in the bank safe deposit box, because one of the reason you are holding the gold in the first place is to eliminate 3rd party counter risk. The bank vault adds back in this risk factor. But the bank vault may be considered as well.
As far as acquiring the gold, there are several reputable vendors. I recommend to stay away from any vendor who advertises on radio or TV. They typically lure you in with a phenomenal price on bullion coins, and then try to convince you to buy something else instead that will give them a much higher profit margin, usually collectors coins and rare coins (also called numismatic coins). It's a classic bait and switch.
There are several vendors who you can rely on, including Miles Franklin (ask for Andy Hoffman), SchiffGold (ask for Jon Sosnay), and GoldSilver.com. Schiff Gold is owned by famed author/investor Peter Schiff, and Gold Silver is owned by the author and lecturer Mike Maloney. All three of these are worthy of your business, and there are others as well. And even if you don't buy from Schiff, you must read his special report called Classic Gold Scams & How To Avoid Getting Ripped Off (see link above). If you can't be bothered with storing the metals, you can buy the Sprott Physical Gold Trust (PHYS).
If you want to buy gold mining equities, you really must know what you are doing to be able to pick the best of the best for your portfolio. It's worth it to read the report by Casey Research on the 8 P's of junior gold mining companies, because it applies to the majors as well. Of several thousand companies that trade on the exchanges, there are probably 20-30 that are truly worth your investment. If you can't pick them on your own, or if you don't have the time to do the research and followup, there are a few funds that will reward you handsomely in the next 3-5 years. I have recommended them before, and for miners they are Euro Pacific Gold Fund Class A shares, Sprott Gold Miners, and Sprott Junior Gold Miners.
I really don't care for GLD or IAU because they explicitly state in their prospectuses that you will not be able to redeem your shares for physical gold, and even the institutions who make the request may be declined and offered cash instead. They also state that they will dilute your shares so that the original 10 shares per ounce, over the years, may become 11 shares per ounce, 12 shares, 20 shares, or an infinite number of shares representing just one ounce of gold. I also don't care for other gold mining funds because they just buy a basket of all gold miners without concern for weeding out the bad companies and sticking with the good ones instead. The three funds I've listed above eliminate the poorly run companies, and they all will outperform the rest of the sector.
The bad news for the sector is that it is full of massive volatility. Your investment can fall 10% or more in a day, followed by a commensurate rise the next. And it can happen often. So if you don't have the stomach for the wild swings, you might consider something less volatile. The good news is that the sector is full of massive volatility. Because once you have done your research and you are confident about making a move, you should be happy if it falls by 10% in one day or 30-40% in one month. That's to be seen as a huge gift in a buying opportunity. After all, if your investment fundamentals haven't changed but you can buy more at a lower price, why wouldn't you? As the adage goes, you buy when everyone else is scared, and sell when they are greedy.
Remember that no matter what you do, you must consult your tax advisor and your financial advisor, preferably when they are in the same room with you. Good luck, and after nearly 20 pages in Microsoft Word, I hope this blog post was helpful.
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Disclosure: I am/we are long FNV, SGDM, SGDJ, AKG, PVG, EPGFX, AG, EXK, SLW, FFMGF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.