The following is excerpted, with very minor edits, from a letter to investment clients sent out on January 20, 2010.
Inflation Risk
We've explained many times our strongly-held conviction that in the years ahead, the dollar is going to lose a significant amount of purchasing power against things that people need to buy.
A longer explanation for our reasoning can be found on the site -- just adjust for the fact that this was written in late 2008 and the dollar's fundamentals have deteriorated enormously since then.
Here is a shorter version. We believe that the dollar's purchasing power is at risk due to the following:
- Future currency debasement as a means to pay down debt. Considering the astounding amount of debt that we owe to foreign countries, and considering our politicians' complete unwillingness to accept or inflict any economic pain (see the massive stimulus, quantified in this website article, for just one example), we think it's exceedingly unlikely that the American people will be asked to willfully decrease their standard of living so that they can pay the nice foreigners back. Instead, we believe that the dollars in which our debt is denominated will be purposefully rendered less valuable as a means of reducing the real burden of our debt.
- Inflated bank reserves begin circulating through the economy. The Fed created enormous amounts of new bank reserves as part of their effort to bail out the banking system. This newly created money is not inflationary because it is currently sitting in banks' metaphorical vaults. Should the economy recover enough that banks start lending out their reserves, however, that vast mountain of money could start to enter the general economy, resulting in a higher broad money supply. This would be inflationary, as more money chasing the same amount of goods renders each unit of money worth less in comparison to those goods (which is another way of saying that prices go up!). This outcome could be headed off if the Fed were to severely tighten monetary conditions, but their past history shows that this is unlikely.
- Currency depreciation. If the dollar were to fall sharply against the currencies of our major trading partners, it would result in an increase in the dollar-denominated prices of things we import, including energy and commodities as well as imported finished goods.
We believe that item #1 is baked into the cake; items #2 and #3 are not foregone conclusions but they are very real possibilities and further risk factors for dollar purchasing power loss. There is some uncertainty as to the means and even more as to timing, but a steep decline in dollar purchasing power at some point seems all but inevitable and remains our highest-confidence forecast.
The Mythical Gold Bubble
Markets seem to have cottoned on to inflation risk to an extent. This has resulted in a continuation of the dollar's long decline, as well as a robust rally in the price of gold (these trends reversed themselves to some degree starting in December, but only enough to make a relatively small dent in the progress made throughout 2009).
The strong rise in the gold price has led to a huge wave of pundits claiming that gold is in a "bubble." In short, we find this thesis to be completely indefensible.
At its core, the argument made by the gold bubble crowd is always based on a misapprehension about gold's true fundamental underpinning. Gold is best thought of as an alternate currency, and as a competing store of value against paper currencies. That is the function that gold provides. In times when confidence in the monetary system is high, there is little demand for that function. When confidence in the monetary system declines, the demand for an alternate store of value rises and the gold price goes up.
That's what gold is all about. Not "disaster insurance," nor an "inflation hedge" (though it serves the latter purpose well under a subset of conditions). Gold is a competing currency that cannot be debased by politicians, and it is a store of value during times when confidence in the monetary system is on the decline.
Looking ahead, a steep decline in monetary confidence is very likely, and most competing investments are fundamentally priced for poor returns. Under these circumstances gold is a very promising investment.
And to the point of this section, it is certainly not anywhere near a level of valuation that one sees during bubbles. It's true that the gold price has risen substantially since earlier in the decade, but that was at a time of supreme monetary confidence, when the dollar was strong and people considered Alan Greenspan to be some sort of demi-god. Confidence in paper money has declined since then, and the gold price has risen accordingly -- but has confidence declined enough enough? Not even close, in our opinion, which is to say that people continue to have a lot of ill-deserved faith in the dollar, in paper currencies in general, and in the central bankers that manage them.
It's also important to recognize that the changing gold price has taken place against a backdrop of changing fundamentals. An absolutely tremendous amount of money has been borrowed or printed into existence by the government since gold bottomed out earlier in the decade. While gold's price has risen, its fundamental value has risen as well.
It's true that more and more people have begun to talk about gold and the decline of the dollar. But this does not a bubble make. The dollar's fundamentals have been terrible (and getting worse) for many years; just because this reality is starting to spread from a small group of "early adopters" to the general populace does not make it a bubble.
After all, while you hear a decent amount of dollar-decline chatter, few people have actually done anything about it. Speculators may crowd the dollar-short trade from time to time, but the typical American retail investor continues to keep the virtually all of his or her wealth in paper dollars.
Next time you're at a party, ask your friends how many of them own more than a token amount of gold-related investments. Unless you run with a particularly enlightened crowd, the answer will be few, if any. Now contrast that answer to the type of cocktail party talk you heard about housing in 2005. It's almost absurd to compare the two situations.
The "bubble" label is properly applied when an asset class becomes extremely overvalued and over-owned based on shared misconceptions about the asset's underlying value and an underestimation of its risk. By this definition, the bubble isn't in gold -- it's in the dollar itself.
