Buying Gold in A Recession

A Golden Renaissance: Why Buy Gold Now? Historic Gold Chart

 

Although gold has been a universally-recognized store of value and medium of exchange for over five thousand years, a successful “gold standard” made gold less attractive as an investment asset for the duration of the Industrial Revolution. With the exception of a string of devaluations during the Great Depression, the convertible-paper gold standard, in which the dollar was pegged to gold at $35/oz, was generall honored until the late 1960's. Alan Greenspan then rose to national fame by showing that the Pentagon, and the Johnson Administration, were publishing wildly optimistic accounting of Vietnam War expenditures, and that the US government was effectively stoking heretofore-unrealized inflation.

International investors lost faith in the US dollar, and in 1975, the bull market in bullion began in earnest. From a fixed price of $41 per ounce, gold soared to an average price of $650 in 1980. Due to one freak trade, you often read that gold's historic peak was $845 per ounce, but that “peak” lasted all of one second. The highest daily closing price was $750 in 1980 dollars (about $1,900 in today's dollars, according to government inflation figures.)


Of course, if you're that lucky investor who has that perfect read on the market, maybe you will hit the peak just as somebody did in January 1980, when they went short gold at $845. But probability is a tenacious enemy, and for the average investor's purposes, gold established a medium-term high of around $670 in 1980-81.

After Federal Reserve Chairman Paul Volcker restored the credibility of the US dollar by raising interest rates into a deep recession, the flight to gold evaporated during the 1980's, or, more accurately, the value of the dollar soared. By 1997, gold's day in the sun appeared to be a relic of the past, as worldwide investors fled the Asian financial crisis of 1997 and the Russia default of 1998 to the safety of the US dollar – not gold. Furthermore, as the European Union moved closer and closer towards adopting the euro, central bankers and currency speculators dumped French francs, German deutschmarks, and other European currencies in favor of the dollar, as the euro was considered a highly risky asset. The United States made life still harder for the euro by paying down US Treasury debt, increasing the strength of the American balance sheet – and, by extension, the strength of the dollar – at precisely the time that the euro needed investors' support most.

Meanwhile, the “gold bugs” who remembered the stagflationary run on the dollar during the 1970's, from $41/oz to $845, had lost fortunes betting that one day, the United States Treasury would once again find itself overextended, and forced to print more money to pay its guarantees.

Stagflation once again figures very prominently in today's financial discourse. Many investors, and gold bugs in particular, do not trust the inflation statistics reported by the Federal Reserve and Treasury since 1995, in which Republican Alan Greenspan and Democrat Michael Boskin introduced a host of “hedonic adjustments” and other dubious methodology to the inflation calculation. The overall effect was to reduce the government's reported annual inflation by approximately 2 percent per year. Unstated inflation became an even greater problem after Sept. 11, when the Greenspan Fed held interest rates down at one percent for over a year.

Since 2000, the price of gold has soared approximately 250 percent. Judging by the inflationistic bias of current Fed chairman Ben Bernanke, inflation has a ways to run yet. John Williams has made a career out of calculating effective, pre-Greenspan/Boskin CPI through his website, Shadow Government Statistics.

Although John Williams spent many years in the wilderness, recent financial movements seem to have vindicated his view that inflation has been dramatically and calculatedly understated since 1995. Although CPI only rises by 2 percent a year, asset prices excluding bonds – stocks, equities, real estate and commodities – have soared by over 100 percent in the past decade and a half. Somewhere, someone is missing out on a very large aspect of inflation. It doesn't help the government's credibility that many of its entitlement payments are basically indexed to CPI, giving the government yet another reason to understate annual inflation.

As confidence in the Treasury's ability to meet all its guarantees has once again crumbled, more and more investors are flocking to gold as protection against inflation.

So how do I invest in gold?

There are three general ways to invest in gold: through a gold exchange-traded fund (ETF) such as the streetTRACKS ETF, a gold mining royalty or holding company (similar to an ETF, but not punished by arcane US tax regulations), or a gold mining company.

Gold ETFs and holding companies are less volatile than miners, and they generally offer zero leverage on the price of gold. In the last nine months, they have outperformed the S&P by approximately 30 percent. Royal Gold Inc. (NYSE:RGLD) is one example of a gold royalty company.

Gold miners offer leverage on gold. Gold mining has high fixed costs (around $400/oz, on average), so when the price of gold rises by 1 percent, the profit of the gold miner rises by significantly more than 1 percent. For example, if the price of gold is $900 per ounce, and it rises to $909 (+1%), a gold miner's profit will rise from 900 – 400 = $500/oz to $909 – 400 = $509/oz, an increase of 1.8 percent. Obviously, gold miners also lose out by a similar margin when the price drops. Gold miners with attractive price-earnings ratios include Kinross Gold Corp. (NYSE:KGC) and Barrick Gold (NYSE:ABX).

However, given the severe inflationistic bias of federal policymaking (or, from a forex standpoint, the fall in the value of the dollar – over the long run, it's the same thing) and evidence pointing to historic underestimation of inflation, gold could very well rise to a sustained peak of over $2,000/oz. Gold has the additional advantage of benefiting when any country devalues its currency. For example, if Europe decided that it didn't like a strong euro, euro holders would disproportionately flee into gold. Gold can be thought of as currency insured against competitive currency devaluation, at the price of high extraction costs and a low rate of inflation, as the global supply of gold rises slightly each year from mining. However, as confidence in global financial institutions continues to crumble, gold looks like an increasingly attractive, if volatile, bet.

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