Reasons Not To Buy Gold?

by Dave Kranzler

Disclosure: I am long RPM.V, EMXX. (More…)

Mark Hulbert wrote a shockingly inept article for Barron’s online which expressed reasons not to own gold: 5 Reasons Not To Buy Gold. Citing a study published by a former commodities portfolio manager (Claude Erb) and a finance professor from Duke University (Campbell Harvey), Hulbert laid out five reasons for which investors supposedly use to assess whether or not to buy gold: inflation hedge, currency hedge, hyperinflation hedge, safe haven, and hedge against low interest rates. You can download the research report here: The Golden Dilemma. To access “The Golden Dilemma” paper, you need to first download “An Impressionistic View of the “Real” Price of Gold Around the World,” which has the seminal piece linked.

Hulbert listed each of his five reasons and then extrapolated his interpretation of the arguments against gold from the research papers. In terms of the inflation/hyperinflation arguments, we have not had a period of high inflation in this country since the late 1970’s, a period in which gold ran from $35/oz. to $875/oz. Not a bad inflation hedge if you ask me.

Instead, Hulbert chooses to cite the section of “The Golden Dilemma” piece which isolates the case of rampant inflation in Brazil from 1980 to 2000. Apparently, according the authors, Brazil had an annual inflation rate of 250% during this period. And Hulbert cites the authors as saying that the real price of gold lost 70% of its value. However, if you look at page 26 of the paper, there’s a table showing the amount the Brazilian currency devalued vs. the US dollar, the rate of price appreciation of gold expressed in terms of the Brazilian currency, and the rate of inflation in Brazil. Gold appreciated 235% per year vs. the local currency vs. the IMF-measured inflation rate of 259%. I’m not really sure from where the authors of the paper derive their gold depreciation number – and they don’t explain this in the paper – but Hulbert mindlessly regurgitates this finding in order to make it fit his thesis. Quite frankly, it would appear to me that a Brazilian holding gold in his own country did pretty well with it in terms of hedging against Brazilian inflation/currency devaluation.

When I emailed Hulbert asking for an explanation, he did not reply to that inquiry (he did reply inadequately to several points of criticism I expressed). You can read through Hulbert’s article for his arguments with regard to the other points.

The last one – low interest rate hedge – I find quite puzzling because in my 12 years of spending most of my time studying, researching, analyzing and investing in the precious metals market, I have never come across anyone who has suggested using gold as a low interest rate hedge. In fact, during the 1970’s the 10yr U.S. Treasury rate went from under 6% in 1971 to over 14% in 1980: 10yr rates and CD rates went from 4% to nearly 18%: CD rates. Obviously the price of gold, expressed in terms of US dollars, worked fabulously as an inflation hedge and, contrary to the thinking of many analysts who think rising interest rates are negative for gold, gold rose in direct correlation with interest rates. Curiously, Hulbert left the experience of the 1970’s in this country out of his article.

To be frank, both Hulbert’s article and the papers written by Erb/Harvey are incorrect in their premise and surprisingly sloppy in their construct. As a University of Chicago Business School grad, where a premium is placed statistics and data analysis techniques, I was quite surprised that a finance professor would write a paper that was “loose” with its application of statistical analysis.

Now, onto the primary reason to buy gold: it’s a time-tested hedge against rampant Government-motivated fiat currency devaluation. Let’s use the U.S. dollar since we live in this country and buy goods denominated in dollars. The U.S. dollar index hit 121 in mid-2001. Currently, it’s hovering around the 80 level. That’s a 33.8% decline in the value of the U.S. dollar relative to currencies that make up the index. At the same time, the price of gold in mid-2001 was $270 per ounce. It’s currently $1650 per ounce. That’s a 611% appreciation in price vs. the U.S. dollar. In other words, the U.S. dollar has lost 83% of its purchasing power relative to gold. That’s a remarkable fact and one that gets no mention anywhere in the mainstream media.

Interestingly, “The Gold Dilemma” report has a chart on page 15, a chart conveniently overlooked by Hulbert, which reinforces gold as a fabulous hedge against currency depreciation. First, look at this chart, which shows the growth in M2 since 1971, when the U.S. went off the gold standard:

(click to enlarge)

M2 grew from $630 million to just under $10,500 billion. That’s serious money printing. Now look at this chart, which shows the real price gold, as adjusted for inflation:

(click to enlarge)

This is a great chart, because it shows how remarkably stable the price of gold was from 1791 until 1971. This was a period when the U.S. was more or less on a strict gold standard. Then look at what happens to both the money supply and the real price of gold subsequent to 1971.

As you can see, ever since the U.S. left the gold standard and reverted to a pure fiat currency, gold has been functioning as an excellent mechanism to hedge both currency devaluation and inflation in the United States. Furthermore, since 2001, gold has functioned as such without the benefit of there being perceived inflation, as measured by the Government reported CPI. Just imagine what will happen to the price of gold if/when real price inflation starts to rear its ugly head, forcing both prices and interest rates significantly higher. I would suggest that when this occurs we will see the real and the nominal price of gold really take off.

Finally, assuming I’m right and Hulbert is wrong, how do you take advantage of what I would argue is a significant state of undervaluation for the price of gold? The obvious first step is to take advantage of this current pullback in the price of gold and start by buying some physical gold that you safekeep privately. My preference is 1 oz. sovereign-minted gold coins (and silver coins) like gold/silver eagles and maple leafs, because they are recognized anywhere in the world and are very difficult to counterfeit.

If you want go beyond wealth preservation, I would recommend buying a carefully selected portfolio of gold and silver mining stocks. My favorite larger cap stocks are, Argonaut Gold (AR.TO/ARNGF.PK), New Gold (NGD) and Hecla Mining (HL). My favorite junior exploration stocks are Eurasian Minerals (EMXX) and Rye Patch Gold (RPM.TO/[[RPM.V]]). I plan on publishing some research reports in the future on a few of these stocks explaining why I like them. Please always do your own due diligence, especially with the smaller, riskier mining stocks.

Additional disclosure: The fund I co-manage is long physical gold and silver, AR.TO, HL, NGD, EMXX and RPM.V


About abwehra group

The Art&Science of Trading Gold
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