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August 10, 2006

The Ibbotson Report Revisited
by Rob Kirby

Ibbotson Associates of Chicago were contracted by Bullion Management Services Inc. of Toronto to prepare a comprehensive study regarding the effects of portfolio diversification with Gold, Silver and Platinum Bullion.

Their findings were published in June 2005 and concentrated on the period between 1971, when the price of gold was 'allowed to float' with President Nixon's abrogation of the Bretton Woods System and the present [2005].

"The three metals were chosen because gold and silver are often viewed as a safe harbor in times of crisis. Conversely, during economic expansion demand for silver and platinum is thought to increase."

The 'net result' of this study, utilizing back-testing, was the conclusion that "all" portfolios, whether of a conservative, moderate or aggressive risk appetite - benefited from the inclusion of basket of the three above named metals in the percentages of 7.1 %, 12.5 % and 15.7 % respectively. I've written about this before.

The science behind the findings mentioned above largely rest in the fact that precious metals returns are, historically, negatively correlated to those of equities and the only known asset class that is positively correlated with inflation. Simplified, the reasoning goes as follows: as equity prices fall - precious metals prices rise so as to offset the negative contribution to equity's contribution to total return. The reverse¹, one might assume, occurs when equities rise in value.

The Hidden Nugget In The Report

As a "gold bug" and a believer that the price of gold [and silver] has been nefariously 'rigged' by monetary elites, the Ibbotson Report and its findings was naturally of particular interest to me. With much of my own proprietary research aimed at irrefutably proving the notion that the price of gold has been rigged; my initial thoughts of a scholarly report like Ibbotson were that it would serve as a "smoking gun" - settling once and for all - that metals prices have indeed been surreptitiously rigged.

But there was no smoking gun, or so it appeared at first blush.

With the passage of time and after re-reading the report, I can now say that I can not only smell smoke, I can see it too - to cite a cliché - my problem all along was that I was looking in the wrong place.

The nugget that I'm speaking of, available right at the top of the executive summary is;

"Particular detail is spent on the correlations of precious metals with traditional asset classes and how this relates to diversification. From 1926 to 1969, the correlation between annual total returns for U.S. stocks and U.S. bonds was an attractive -.02 [negative]. Recently, U.S. stock market and U.S. bond market correlations have increased. This tendency is reflected in the 10-year rolling correlations from 1970 to 2004 that ranged from -.03 to +.80."

So what exactly does this mean?

The answer is quite simple.

Empirically, bond returns [or market interest rates] "used to be" negatively correlated to equity returns but, as Ibbotson duly noted, this long held relationship has largely broken down in recent years. Let's remember that market interest rates are historically "set" at a 'spread-over' inflation.

Interestingly, no credible explanation for this long held relationship "break down" is offered in the Ibbotson Report.

I wonder if there's a reason why Ibbotson didn't want to or simply would not go there?

But Everything Happens For A Reason - Doesn't It?

I now turn your attention to the work John Williams of Shadow Government Statistics. Williams provides us with "the missing reason" why this long held relationship [equity returns being negatively correlated with interest rates] has broken down. The real reason rests in changes in how inflation, and thus market interest rates, is computed;

"Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 2.7% per year. This is due to recent redefinitions of the series as well as to flawed methodologies, particularly adjustments to price measures for quality changes. The concentration of this installment on the quality of government economic reports will be first on CPI series redefinition and the damages done to those dependent on accurate cost-of-living estimates, and on pending further redefinition and economic damage.

The CPI was designed to help businesses, individuals and the government adjust their financial planning and considerations for the impact of inflation. The CPI worked reasonably well for those purposes into the early-1990s. In recent years, however, the reporting system has succumbed to pressures from miscreant politicians, who were and are intent upon stealing income from social security recipients, without ever taking the issue of reduced entitlement payments before the public or Congress for approval.

Changes made in CPI methodology during the Clinton administration have understated inflation significantly, and, through a cumulative effect, have reduced current social security payments by 30% from where they would have been otherwise. That means Social Security checks would be 43% higher. In like manner, anyone involved in commerce, who relies on receiving payments adjusted for the CPI, has been similarly damaged. On the other side, if your are making payments based on the CPI (i.e., the federal government), you are making out like a bandit."

Take particular note of the timeframes involved; distorted inflation reporting became an "issue" - according to Williams - at the precise mid point in time that Ibbotson noticed,

"U.S. stock market and U.S. bond market correlations have increased. This tendency is reflected in the 10-year rolling correlations from 1970 to 2004 that ranged from -.03 to +.80."

Remarkably, but perhaps not surprisingly, it was in the immediate aftermath of the early 1990's timeframe cited by Williams, that GATA claims that gold price suppression - under the cover of Robert Rubin's Strong Dollar Policy - began in earnest. Isn't it completely amazing how coincidences like this continue to compound one upon another?

Williams then goes on to explain, errant CPI reporting then lends itself to faulty GDP reporting, citing;

"Although the CPI is not used in the GDP calculation, there are relationships with the price deflators used in converting GDP data and growth to inflation-adjusted numbers. The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported."

Does anyone want to wager a small amount [like a gold eagle, perhaps?] as to whether improper CPI and resulting GDP reporting might have led to a little bit of 'irrational exuberance'?

Does any of this sound remotely familiar?

Consider that Ibbotson is clear in their findings that, for the period studied; precious metals provided a substantial hedge against inflation. We know factually that gold is widely viewed as competition for, or, the anti-dollar. The recent action of a good many Central Banks lends a whole lot of credence to this fact - doesn't it?

Now, take a good look in the mirror and try to convince the person looking back that their personal rate of inflation is really running around 2 - 3 % as officialdom would have us believe. Now ask yourself again if the price of gold is rigged?

*Disclosure* The author is involved in sales activity of the Millennium Bullion Fund - the flagship product of Bullion Management Services Inc. and may receive a commission for arranging the placement of "units" in the fund.

¹ The Ibbotson Report does not make specific mention of the notion that precious metals, historically, are expected to produce positive "inflation adjusted returns" even when equities are "rising in price". Of all the assets trafficked by mankind over the course of history, none has a longer paper trail than gold, with millenia of price data available to the analyst. In inflation adjusted terms, the long term return of the precious yellow is zero. This should surprise no one, as for centuries gold was money. Gary Brinson points out that an ounce of gold bought a fine men's suit in the time of Shakespeare, and so it does today. (Women's clothes are another story). Even in this era of fiat currency, the real return of gold is near zero. Consider that in 1926 the price of gold was $20.67 per ounce, and is now $380. It's return in the intervening 70 years has been 4.2% per annum -- exactly 1% higher than inflation.

Rob Kirby
Kirby Analytics