November 5, 2020
The Gold Investment Thesis - Understanding Gold's Importance in a Diversified Portfolio.

Is it possible to save money?

Imagine for a moment that after some years of spending less than you earned, you had accumulated some savings and wanted to put it into cold storage. You weren’t looking to make an investment profit and you weren’t willing to take on the associated investment risk. You just wanted to store the purchasing power of your savings somewhere safe. What would you do?

Your first thought would probably be to put it in cash, just deposit it in a bank account. Well despite the fact that the word “deposit” seems to suggest that your bank is acting as a custodian of your funds, putting them aside in a safe with your name on it, the truth is otherwise. Under the law, when you deposit funds in a bank you have simply made the bank a loan and are now a general creditor. They borrow from you and lend to others and if that doesn’t work out well for them, then you have a problem. In fact it’s worse than that, since most countries have recently passed bail-in laws which allow the bank to seize your deposit and convert it into a long term loan or equity in the bank if they run into difficulties. And side note for a future discussion: banks have not looked as dodgy as they do now for a really long time.

Ok what about real cash - actual paper money? Surely that is safe? Well yes and no. Legally paper money is a liability of your local central bank but in practice, cash is a bearer instrument, meaning if you have it in your possession, it’s yours. In practice there is no counterparty and therefore no credit or default risk. However cash does not meet the test of storing the purchasing power of your accumulated savings. The purchasing power of cash goes down every year as a result of inflation. Even using the government’s measure of inflation of around 2% right now means the purchasing power of your savings would lose about 25% of its value every ten years. But independent measures of inflation which are more reliable suggest the loss would be even greater.

Anything else we could safely invest in? Well the government issues inflation indexed bonds. These bonds pay a percentage of face value every year and every year the face value rises with the official inflation rate. Looks like this may be the solution! Not so fast. Firstly, the rate of interest on these bonds is currently negative at every maturity, so that’s a fail right there. Not only that, but as we said above, the rate of inflation the government uses to increase the face value of the bonds is a concoction that systematically understates the actual rate of inflation.

Given up yet? Yes? Just as well, since it was a trick question. The answer is that there is no way to safely store the purchasing power of your accumulated wealth. So why ask the question? Because it is a good introduction to understanding the place of gold in the investment universe.

For much of human history gold has been used universally as money, and like cash, it is a pure bearer instrument, and thus has no counterparty risk, but unlike cash it had little purchasing power risk either, since it can’t be diluted through overprinting. In the days of the gold standard therefore, there was an answer to the question we raised at the beginning of this story. If you worked and saved your money in gold over a lifetime, you could safely assume that when you retired it would have the same purchasing power as it did when you first put it aside. Now that is not precisely accurate, but it is very close, and we will pick this up in a future discussion dedicated to the subject of inflation. In any case, we need next to go just a bit deeper into the history of the gold standard in order to appreciate the purpose of gold.

A brief history of gold as money.

Gold has been used as money, on and off, for most of recorded human history. It was first used as money in coins almost 4000 years ago by the Lydians in what is now Turkey. Subsequently the Romans, Persians, and Greeks all used gold coins as money. The Venetian Ducat in the middle ages and the Dutch Gulden in the 17th century were gold coins used widely in international trade in their day, and in 1817 Britain reintroduced the use of the gold sovereign, which became an international standard given the reach of the empire during the Victorian era. In the mid-nineteenth century, France, Italy, Switzerland, and Belgium formed the Latin Monetary Union, a sort of precursor to the euro, and many other countries informally joined in. Under the union, a 5, 10, 20, 50, or 100 franc or lire coin was made to the same specifications in each country and contained the same weight of gold and were therefore interchangeable. In short, the world has been on a gold standard pretty much forever, until just recently.

It was not unusual to slide off the gold standard briefly in times of war (in other words the right to convert paper money into gold was temporarily suspended, which allowed governments to print more money than they had gold to back the money) and then to resume convertibility, but towards the end of World War II in 1944, the international community adopted the Bretton Woods standard, a form of gold exchange standard, whereby the major European currencies adopted a fixed exchange rate to the dollar and the dollar remained convertible into gold by foreign central banks. That arrangement finally ended in 1971 when the US abandoned convertibility and for the past 49 years, the entire world has, for the first time in many centuries, been on a pure fiat system of unbacked money and floating exchange rates.

Gold never disappeared as money, it just stopped being used as official money. But it remains a key reserve asset of central banks and one of the few assets you can take anywhere in the world and use in trade, to this day. It is still the third or fourth most actively traded form of money.

Gold lasted so very long as money because it was the most perfect form of money imaginable.

Aristotle stated that good money had four characteristics, that it be durable, portable, divisible, and intrinsically valuable. Gold is the most unreactive of all elements; it is certainly durable. Gold is among the rarest of all the elements and thus small quantities are quite valuable and therefore it is portable. Gold is also the most ductile of elements and easily divisible. Gold is arguably also intrinsically valuable - it was called the metal of kings because before its use as money many centuries ago, it was amassed by monarchs and since then seen as intrinsically special. Even today, a primary demand for gold is for jewellery, although in many eastern countries gold jewellery is used interchangeably for adornment and as a store of value.

But one of the greatest features of gold as money is that unlike the fiat money of today, it did not lead to systematic inflation

Fiat money, the paper money issued by modern governments, can be printed at will. Between March and September of 2020, the United States increased the supply of base money by some 65% on an annualized basis. This dilutes and eventually cheapens the value of all previously issued money. You can see that in the fact that stocks and bonds have gone up in price (i.e. your dollar won’t buy as many stocks or bonds as it did before) and the price of consumer goods and services will follow in time. The supply of gold on the other hand has grown at an average rate of about 2% per year for centuries. And since the population has been growing at a similar rate, the supply of gold per capita has been fairly stable, helping to maintain its value. The reason for this growth rate of supply is not hard to fathom. As gold is discovered and extracted, new deposits become harder to find and are generally either deeper in the earth or more remote, making the cost of extraction higher, and therefore supply only responds to increases in price, which make such new finds economic.

There were bursts of inflation periodically under the gold standard, for instance when major finds were made in the 19th century in South Africa and California, but gold held its value over time. Because of improvements in productivity, prices normally should fall over time. For example a century ago, half the population had to focus on farming to feed the other half, whereas today 2% can do the same job given improvements in farming technology; thus food has become cheaper - this is deflation. Under the gold standard you could benefit from this natural deflation. If you saved some money throughout your working career, you knew that when you retired, it would buy as much or more than when you saved it years earlier.

And briefly as a side note, gold as money had other advantages. Governments could run neither fiscal nor trade deficits for long, as they soon ran low on gold and had to stop and reverse. It was an automatic stabilizer.

The investment merits of gold today.

Which takes us full circle to where we started: how can you set aside some of your savings with the intention merely of storing that value and not subjecting it to risk. Under the gold standard you could. Today you can still buy gold and it has proven over the years to maintain its purchasing power, but not evenly over time. If you bought a one ounce gold coin in 1971 for $35 when money stopped being backed by gold, today it is worth about $1,900. That’s an increase of 54 times. According to the official measure of inflation in the U.S. a dollar in 1971 has the purchasing power of $6.50 today, so gold would have more than maintained its purchasing power. But official inflation is a poor measure of actual inflation. While the Bureau of Labor Statistics (BLS) says that inflation over the last 10 years has averaged less than 2% per annum, independent analyses (for example the Chapwood Index) suggest that prices have grown at around 10% per annum during that period. And since the money supply (base and credit money issued by banks) has also grown at about 10%, that should not come as a surprise.

But getting back to our story, since gold is not the official money, if you invest in gold, you can be assured of maintaining value over the long run, but in the short run, the “price” of gold in dollars or pounds may move in your favor or against you. For now (i.e. until and unless we return to a gold standard), there is some short term risk in investing in gold, if you measure your savings in official money.

Nevertheless, gold has been far and away the best major investment class this century, outpacing stocks, bonds, and real estate. By major, I am excluding smaller classes such as Bitcoin. So the question is, will it be a good performer in the coming five to ten years? We believe it will be an excellent performer and so the rest of this discussion will focus on why that is likely.

The five to ten year thesis for gold.

The history of fiat money is that it can thrive for years but eventually every single one collapses entirely and disappears. It has happened dozens of times in dozens of countries all over the world. And though currencies sometimes disappear because of wars, most of the time the reason is that the government which managed the currency chose to print too much of it to address short term needs. Print enough and it becomes worthless. Really the examples are everywhere.

You might think the US dollar is safe. Well according to the BLS, inflation in the US over the last century averaged around 2.7% resulting in a 93% loss in the purchasing power of the dollar. Just since 1980 it has lost about 70% of its value. Properly measured, the actual loss in purchasing power has been much worse but that is a topic for another paper. This loss of value is the result of a deliberate inflation of the currency. Every year the government collects some of what it wants to spend via taxes and the rest by borrowing from the public or printing money. Printing money is a form of taxation since it provides the government with money directly by lowering the value of everyone’s savings. In 2020 the US for the first time collected more money via money printing than direct taxation. Since inflation of the money supply today results in reduced purchasing power tomorrow, this increased rate of money printing foreshadows an increase in the rate of devaluation of the currency.

So how has gold fared during all of this. As we pointed out earlier, the track record since leaving the gold exchange standard in 1971 is stellar: prices up 6.50x, gold up 54x. This century so far: prices up 1.5x, gold up 8x. Over the last 100 years: prices up 13x, gold up 95x. Going back further to when the gold price was fixed under the gold standard, the track records would be expected to converge, but only when we dispense with the government’s official measure of inflation and use a measure that actually records the change in price of a fixed basket of goods and services.

If you accept that printing money results in inflation and that inflation results in an increased price of gold, then the following chart showing the growth in money, defined as cash plus checking accounts, suggests that gold is good to go. You can see clearly the acceleration of money growth after the panic of 2008 and even more clearly money growth going nearly vertical this year. It should not surprise anyone that gold recently hit a new high above $2000.

In fact the strength of the dollar against other currencies has held back the price of gold in dollars. Measured in most other currencies, gold has done even better. In any case the chart gives reason for optimism regarding the price of gold.

Another yardstick investors sometimes look at is the price of gold relative to the stock market. Generally gold and stocks move in opposite directions over medium periods of time, as gold is historically driven by fear and stocks by greed. But both are largely driven by inflation over the long haul. Gold is driven by inflation in that it is a form of money with a relatively fixed supply and therefore it rises in value as fiat money is diluted through printing. Stocks are also driven by inflation in that their value ultimately derives from the prices they can charge consumers and the latter is directly driven by inflation. Thus there is a clear oscillation in the relationship between the two, as the chart of the Dow/Gold ratio below shows.

You can see that if you bought gold or stocks in around 1930 when the Dow/Gold ratio was about 15, and held them for the last 90 years until today, your performance in terms of pure price appreciation would be exactly the same, since the Dow/Gold ratio is once again about 15. Now to be clear the total return of stocks has been higher than gold over this period because stocks pay dividends and over 90 years those dividends really matter. And that shouldn’t surprise anyone, stocks involve more risk and enjoy the prospect of a higher return than gold. But the chart also makes clear that buying stocks is best done when the Dow/Gold ratio is low. It is also important to note that the price appreciation of stocks, just like gold, is driven to a large degree by inflation. If we had remained on the gold standard over the last 90 years, gold would not have changed in price and neither would the Dow Jones Industrial Average of stocks as the chart shows - a reminder of the central importance of inflation in the world of investments.

Generally the high point in the Dow/Gold ratio occurs near stock market tops and the lows near stock market bottoms, since gold, being money, is the relative constant. What the chart above shows is that measured in gold, which is real money, the Dow peaked in 2000 and has been drifting lower ever since. If it hits the usual low point relative to gold in due course, the ratio should get down to around 1:1. That doesn’t mean gold will do well, only that it should do a lot better than stocks. How they both do will be a function of inflation. If inflation is high, they may both go up, with gold going that much higher.

Clearly we do think inflation may be a factor in our future and if it is, we believe gold will do well. In fact under those circumstances we would expect that the current investment climate, which is one driven by the need for yield, will change to one driven by the need for inflation protection.

But what if we don’t get inflation? The economy is extremely weak and debt is piling ever higher, which is usually a good prescription for a deflationary recession or even depression. Perhaps governments will be overwhelmed and their tsunami of money just won’t be enough to overcome the natural forces of default. In those circumstances, everything but cash is going down. Other than cash we would expect gold to hold up best for the simple reason that it is the one asset other than cash that can’t go bust. Under that circumstance, we would still expect the Dow/Gold ratio to approach one, meaning gold will have fallen to earth but stocks will be tunneling towards the earth’s core.

There is much more to be said on this topic and I intend to write further pieces on the importance of Gold in a diversified portfolio over the coming months.

I hope you found this article interesting and looking forward to any comments or questions you might have.

Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.

Written by
Mark Borwick
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