Speech by Mr. Nick Barisheff, president of Bullion Management Services Inc., at the 2005 Empire Club's Annual Investment Outlook luncheon, Toronto, January 6th, 2005.
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It's January, the beginning of a new year, and the time when economists, analysts and even astrologers like to prognosticate about what lies in store for the next 12 months.
With respect to gold, opinions on the price vary from $400 to $500 dollars per ounce for 2005. These opinions presume that current conditions will remain relatively stable, and if they do the $400 - $500 range is reasonable. Since the range is quite broad, a review of some history, and an examination of some current trends may be helpful in gaining additional insights.
First, it is important to realize that the 70% rise in the price of gold since 2001 is not because of any supply/demand imbalance, as an industrial commodity. Merely speculating on the price of gold ignores its other benefits and relegates it to a commodity with no more stature than copper or pork bellies. But gold has an important monetary role, as confirmed by the billion ounces still held by Central Banks, and by the clearing turnover of $6 billion daily by members of the London Bullion Market Association.
Although various paper proxies and gold derivatives can provide trading opportunities, they may not provide the wealth preservation and hedging benefits of bullion itself. In order to achieve these benefits, gold holdings must be in the form of fully allocated, segregated bullion with reliable custodial arrangements. Since mining shares and other gold proxies are either someone else's liability or promise of performance, they may not provide these benefits at a time when they are needed most.
Wealth preservation has been an attribute of gold bullion, and it is the reason gold has functioned as money for over 3,000 years. Although gold prices in local currencies may have fluctuated during both inflationary and deflationary periods, gold has maintained or even increased its purchasing power in both instances.
Gold's ability to preserve purchasing power was discussed in detail in an essay written in 1966 by none other than Allan Greenspan, entitled Gold and Economic Freedom.
We have all heard that you could always buy a man's suit with an ounce of gold. I can remember that in 1971, the price of a basic car was about $2,500, or 71 ounces of gold. Since then, the dollar price of the car has increased 5-fold to $14,000, but for the same 71 ounces of gold, you can now buy two cars. This relationship holds true for real estate, oil, and the number of ounces to purchase the DOW, where the cost in gold ounces has either remained the same or decreased over the last 30 years.
The same cannot be said for paper currencies. Throughout history, currencies have come and gone as they were inflated away by emperors, kings and politicians. Since 1971, when the US abandoned gold convertibility, the purchasing power of both the Canadian and the US dollar has declined by over 80% due to inflation.
Because of wealth preservation and hedging benefits, gold bullion cannot be viewed like other portfolio holdings.
The hedging benefits of bullion are achieved because gold is negatively correlated to traditional financial assets such as stocks and bonds. These hedging benefits become particularly pronounced during periods of economic stress. When you compare how poorly stocks, bonds, real estate and currency performed relative to gold during recent currency crises in Russia, South East Asia and Argentina, these benefits become apparent.
The old Wall Street saying - "Put ten percent of your money in gold and hope it doesn't work", is particularly applicable today.
Often when I mention this saying I am asked what it means. Why would you hope it doesn't work? Aren't you in the precious metals business?
Over the long term, a portfolio allocation of at least 10% to physical bullion reduces overall volatility, improves returns and provides a form of portfolio insurance. With our investment portfolios, we would all like to maintain an optimistic outlook, hoping that the economy will continue growing and our investments continue appreciating. However, since financial markets are cyclical, it is only prudent to maintain some portfolio insurance, in the form of bullion, in case markets move against us. Even though we pay for house insurance year after year, we would still rather that our house does not actually burn down.
Unlike traditional insurance or other hedging strategies, bullion is an asset rather than an expense. It has a price floor approximately equal to the cost of mining it. Unlike stocks and financial derivatives, the value of bullion cannot decline to zero.
Because of the recent equity rally, many investors feel that the worst is over and there is no longer a need to diversify and hedge. However, an increasing gold price is like a financial barometer warning of an impending storm.
Is the storm over, or are we actually in the eye of a hurricane?
Leaving aside the impact of natural disasters, terrorist attacks and wars, are the economic conditions that have contributed to a rising gold price still relevant as we go forward into 2005 and beyond?
Are the financial vulnerabilities arising from a mortgage-induced real-estate bubble still present? Are the concerns expressed by both Warren Buffett and Alan Greenspan about the $200 trillion of derivatives exposure still present? By historical measures, are equity markets fairly valued? Will the looming peak in oil production and increasing global demand cause a continuous rise in the price of oil, thus impacting global economies and industrialized societies?
But the worst threat of all comes from the continuous increases in the money supply through the expansion of credit, at all levels. Simply put, there is an ever-increasing amount of paper money chasing a limited supply of physical bullion. Unless corrected, the inflationary growth of the money supply, federal budget deficit, trade deficit and current account deficit will cause the US dollar to plunge in value while the gold price climbs. In looking forward to 2005 and beyond, we need to determine whether it is realistic to expect that this credit growth will be stopped or even reduced.
Today, the annual increases in the US federal budget deficit are greater than the total federal government debt was in 1971. This is an alarming trend. Even during reported budget surpluses in 1998 and 1999, total government debt still grew year after year to the current level of $7 trillion. The US is now paying over $300 billion in interest to holders of federal debt. If this rate of increase continues, eventually annual tax revenues will not be enough to even service interest costs.
Notwithstanding that the US Dollar Index has declined by over 35%, the trade deficit grew to a staggering $600 billion in 2004, and now totals nearly $5 trillion cumulatively. The phenomenon of a growing trade deficit during a currency decline is without historical precedent. We don't have to look far to find the reason for this anomaly. Since the US has outsourced a great deal of its manufacturing and is dependent on commodity and energy imports, the trade deficit has become an ongoing systemic problem. For the past 60 years the US has enjoyed special privileges because of the dollar's reserve status and the willingness of foreigners to invest in US dollar assets.
The US Current Account deficit now stands at over $650 billion, and represents about 6% of GDP. But what has this got to do with the price of gold? This ratio is the highest since 1929. Most economists consider 5% a critical level for current account deficit/GDP ratios. In the past, when third-world countries reached that level, a currency crisis followed.
Could the US be the next Argentina?
This credit expansion has led to a total US debt of $34 trillion - over 300% of GDP - the highest level in history. In addition, we need to add $55 trillion in unfunded pension liabilities and Medicare obligations. In all, this mountain of debt requires that the US borrows about $80 million per hour, and absorbs over 80% of the world's savings.
Here is a startling fact - it now takes $7 of new debt for every $1 increase in GDP. How much confidence would you have in a corporation that needed to borrow $7 annually just to increase its gross revenues by a dollar? Clearly this can not go on much longer.
No wonder Alan Greenspan recently warned that - "foreigners' appetite to continue to invest in the US may not be adequate to fully sustain the expected growth in the net indebtedness of the US".
Translated into English, his statement means that eventually foreign investors will stop lending the US any more money.
No one knows for certain when that day will come. It may be next week, or several years from now. You may think that it can not happen in the US, but history gives us numerous examples of excess debt leading to a currency collapse. Unless there is the political will to reduce or eliminate the current mountain of debt, the day of reckoning must eventually come. The longer it is postponed, the worse it will ultimately be. Since politicians are not known for their ability to control their spending and are not elected on platforms that propose unpleasant financial medicine, it is difficult to imagine that the steps necessary to fix the problem will be taken.
Canadians need to pay attention to these issues as well. While I have focused on increases in the US money supply, you may be surprised to know that the Canadian money supply has risen at twice the rate of the US. Because of the fractional reserve banking system and global fiat currencies, the US has exported credit bubbles to the countries that run a trade surplus with it. In Canada, we are particularly vulnerable to the state of the US economy and its monetary policy. We depend on the US to buy our exports, and US dollars represent 50% of our currency reserves. Canada is now the only G8 country without any gold bullion to back its currency.
Bearing this in mind, is it likely that the Canadian dollar will maintain its recent gains against the US dollar?
Up to this point, we have simply assumed a continuation of current conditions. Maybe the US and the global economy will "muddle through", and business will continue as usual. But is it really prudent to maintain a long-only bias in your portfolio and assume that the longest-running bull market in history will continue for another 20 years? After all, markets are cyclical - not linear. A 10% allocation to bullion for its hedging and wealth preservation benefits seems more than justified.
However, if one of the previously mentioned vulnerabilities experiences a trigger event, then bullion may provide impressive capital gains over and above hedging.
Since February 2002, the US Dollar Index has declined 35%, wiping out $3 trillion for foreign investors. If the dollar continues to decline, the day will come when the world will no longer be willing to increase their US dollar holdings. The US Federal Reserve will then be faced with a no-win situation: increase interest rates dramatically, or let the dollar fall.
If foreign investors get nervous and start selling some of their 10 trillion dollars' worth of US dollar holdings, it may create a descending spiral of further dollar declines coupled with financial asset declines. If that happens, the line between hedging and capital appreciation will become blurred. In the 1970's, a loss of confidence resulted in the US dollar declining 70% in German marks and Swiss francs. Gold, however, experienced a 2,300% increase.
Historically, a reliable indicator for the trend direction of gold and equities is the DOW:gold ratio. When the ratio increases, it is a good time to be overweight equities and when it declines, it is better to be overweight gold. The ratio was 1:1 in 1935. In 1980, when gold was $850 and the DOW was 925, it again approached to 1:1. The ratio peaked at 43:1 in 2001, but has steadily declined to its current level of 25:1. Richard Russell, publisher of the DOW Theory Letter since 1958, predicts that the DOW:gold ratio will once again be 1:1. The question is, will both gold and the DOW be at& 1000, 2000, or 5000?
As far-fetched as these possibilities may sound today, they may in fact come to pass. In 1989, investors would have found it hard to imagine the 80% decline in Japanese equities that ensued over the next 13 years. Equally difficult to foresee in the early 80's, when the NASDAQ was 400, was its rise to 5000. In 1971, when gold was $35 an ounce, no one imagined the 23-fold increase that gold would experience over the next nine years.
We now appear to be entering the second leg of the precious metals bull market, a time when institutions and hedge funds are beginning to invest in physical bullion. Because of the tremendous market-size disparity between financial assets and precious metals, bullion prices would rise dramatically if a minute percentage of global investors allocate 10% to bullion.
While there is $50 trillion in global financial assets, there is less than $1.5 trillion in above-ground gold, less than $1 billion in above-ground silver and practically no above-ground platinum.
Eventually there may even be shortages. You can not simply print more bullion to meet demand. New mines take 5 - 10 years to bring into production.
In 2005 whether the price of gold will be $400 or $500 does not really matter. Would it have mattered whether you bought the NASDAQ at 400 or 500 in the mid-80's?
It is only important that you did not buy at 5,000.
No matter what the price turns out to be in 2005, it is still wise to put 10% of your money into gold and and hope it does not work.