Trade of the decade

“The central lesson of history is our inability to learn from it” - Hegel

The chart below shows that the multiyear downtrend in the Dow that began in 1999 looks set to continue with the recent breakdown early this year below the 2003 lows.

Most people will be surprised by this as the news is full of stories declaring new highs in the major stock indices. Well, it all depends on what you are measuring it by. In US dollars, stock indices may well be making new highs, but if you want to measure the stock market in real money, in other words Gold, the stock market looks like it is in real trouble. Now let’s look at a longer term chart.

This chart is even more revealing. It shows that relative to gold the Dow Jones is still incredibly high by historical standards. It also shows that the trend once it turns tends to be relentless over multiple year periods until it reaches an extreme.

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Most people still measure their financial net worth is terms of US dollars and do not view silver and gold as a currency. But now the world, maybe just unconsciously, is starting to realize that their confidence in paper money may be misplaced. Policy makers have for some time been finding that the preferable solution to their issues is to cheapen their currencies one way or another. The US is even demanding devaluation against the Chinese Yuan.

At some point down this road, however, people start to realize that their currency is becoming not only an unreliable store of purchasing power but also an increasingly poor measure of their financial wellbeing. Unfortunately, history tells us that most people will remain confident in paper currencies for far too long.

Is this too alarmist, as most people will say? Surely some solution will be found, and paper currency is just too useful for everyone. Right?

What is wrong with paper money?

Well, in theory, at least, paper money should work well, but only if it is consistently well managed. For this to be the case, the first part is to admit to problems when they exist, and the second part, which is much harder, is to start to exercise some financial discipline when it becomes necessary. At the moment it seems the US is incapable of achieving even part one. We only have to examine how we look at the budget deficit to realise that we currently seem unable to even recognise any problems. Whether this is the fault of politicians or voters in the end does not matter.

While we pretend to have a small budget deficit of $300 - $450 billion in recent years, the chart below shows that US government debt has been rising closer to $600 billion a year. Even here, this is an underestimate, as we are still using the social security surplus to pay government bills and this would add at least a further $100 billion to the annual budget deficit. Furthermore, we have not even started to discuss the nation’s future unfunded liabilities which are estimated to be in the tens of Trillions.

When you hear politicians proclaim that our budget deficit, at around $400bn, is small and manageable, I’m not sure whether we should laugh or cry. The current presentation of the nation’s financial position is absurd and while this continues to be the case, it is clear that genuine fiscal discipline is not even on the radar.

 

What can we do?

First we have to realise that without fiscal discipline the US dollar is in a state of constant long term devaluation. At first people do not notice what is happening. If asset prices seem to be rising, they tell themselves, all must be well. However, asset prices could be rising because the value of the currency is falling through excessive money creation. In this case most investors think they are much better off than they really are. The wealth is, at least in part, an illusion. So although most investors believe they are becoming richer as the stock market continues to rise in US dollar terms, this is somewhat questionable if the stock market has been falling relative to gold.

Gold is by far the best gauge, simply because Gold is the commodity that is predominantly a monetary commodity. For the most part it is used as a store of value rather than a raw resource than is needed to produce something, like most other commodities. This makes it relatively unique. Also Gold is very hard to find and produce, so it’s quantity is relatively stable. If the price of gold is rising in a certain currency it is a sure sign that that currency is being overproduced, or in other words devalued.  As the chart below shows gold has more than doubled over the last 4 years in US dollar terms, so we can reasonably assume that money supply in the US has been excessive.

 

Gold as an investment

Most people still find it difficult to consider gold as an investment or even as a currency. There is no income and it does not seem very useful. But silver and gold were money long before any of the paper currencies now used ever existed, and they will be money long after all of them are forgotten. In the end it is a matter of trust. Paper money in the end has no intrinsic value and no scarcity if there is no financial discipline. In other words people at some point are forced to buy real assets, which we have been recommending for a long time now. For thousands of years gold has been chosen voluntarily as a currency and this perception will inevitably return. Ultimately, the question turns from “why on earth should I hold something useless like gold?”, to “can I afford not to hold at least some gold, even if it is just insurance?”.

Despite gold’s recent strong performance it is still probably the cheapest real asset around. We have already seen it’s long term relationship with the Dow Jones, but the charts below show it’s long term price relative to Oil. Gold is still near historic lows relative to oil.  It is also still attractive in US dollar terms despite it’s recent substantial rally. In inflation adjusted terms the price of gold is still far from it’s previous high in US dollars. The chart below shows, even with the current gold price just below $600, gold is still more than 50% below it’s high in 1979/80.

 

 

Summary

Gold should be regarded as necessary insurance and as a long term store of purchasing power. It’s value as such is now undergoing a transformation, but it still looks cheap in terms of its long term relative value compared to just about everything. Dollars, the Dow Jones, Oil, Copper, and residential real estate. It is arguably the cheapest real asset around.

Gold is, however, highly volatile and it has no income. Although I believe it should be part of everyone’s asset mix, the appropriate allocation will vary from person to person. Also for most investors I would recommend accumulating gold carefully over time rather than trying to trade it.  

Beyond gold, I still believe that real and tangible assets should still remain preferred investments.

Investors cannot afford to ignore the message of the gold price. There is still a great deal of time to act, and adjust your outlook and finances. It looks like the trade of the decade has only just started.

 

 

 

 

Notice

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