Something to think about

[Wonk]

None of the following should change your asset allocation in the PP.  Now that's out of the way...

On some forums, you'll hear all about how gold is in a bubble and it will soon crash to $600/oz or less.  But is it gold that's in a bubble or the currency it's priced in?  For most of modern human history, gold has been a means of settling transactions--especially international transactions.  Until 1971, you could almost always convert a currency unit into some form of hard asset that had supply/demand fundamentals influencing it's availability.  After 1971, the only means of conversion has been to use that currency to purchase the hard asset outright.

If you look back at most hard-asset currency arrangements prior to 1971, a 1:1 convertability between gold and the currency in circulation was most common.  Until then, holding currency was preferred to bullion due to the costs of storage and insurance, along with convenience.  When investors get paid a positive real rate of return, they don't need to convert their currency to gold.  It's inconvenient to do so.  However, when investors are presented with persistent negative real interest rates, it's advantageous to convert back to bullion. 

Today we don't have anything close to a 1:1 ratio backing any currency unit on the planet.  At least in the U.S. at $1500 USD/oz, we have a 1:6 ratio, or 15%.  1979-1980 serves as a useful case study of what can happen when investors are presented with a 1:1 ratio and positive real interest rates--they'll store value in that currency again.  As we witnessed from 1981-1999--in a free-floating currency arrangement--as long as investors are paid positive real interest rates, they will tend to allow the currency supply to drift away from a 1:1 ratio.  By 1999, the amount of currency backed by gold at prevailing prices was only 10%, or 1:10 ratio.

So, I'd submit that gold is not the bubble.  As we all know, it doesn't do anything--it just sits there.  I'd submit that our confidence in monetary leadership (in the absence of a gold standard) led us into a fiat currency bubble, and it's been deflating for 11 years.  As more and more people realize that the bubble was in currency confidence, you'll see more conversion back into gold.  At that point, cynics will continue to call it a bubble and others will call it "a new normal."  In reality, it will just be history reverting to the mean.

[Lone Wolf]

Excellent analysis.  This is taking the long-term view of what it means for something to be in a "bubble".

Just a few years ago, I had never been comfortable with gold.  But the more time I spent studying economics and history, the more rickety and untested the fiat currency experiment appeared to me.  In the end, the evidence was (to me) overwhelming that a weatherproof portfolio must contain hard assets.  My search for the best gold-wielding portfolio led me fairly quickly to the Permanent Portfolio.

In essence, you've laid out in a few short paragraphs what I spent months figuring out in order to get here.  It's not that I "know" that the dollar is doomed in the short- or medium-term or anything like that.  It's simply that I realize there's little or no bedrock underneath the fiat currency soil.  Maybe this will be fine or maybe it won't.  Either way, I don't want my portfolio suddenly collapsing into a Guatemalan sinkhole.

[MediumTex]

Either way, I don't want my portfolio suddenly collapsing into a Guatemalan sinkhole.

Not to get off topic, but that sinkhole is amazing.  It looks like a missile silo.

It's funny that they are trying to figure out how to fill it up.  I predict that it will be filled up with garbage.

[moda0306]

Very good.

It's the mistrust/misunderstanding of precious metals that dooms (ok, maybe not dooms, but really hampers) most portfolios.  Without precious metals (gold being the absolute best), it's extremely difficult for most people to go very long with their bonds, so they go short.  Often, with short bonds or cash, treasury rates are unattractive, so they chase yields by buying bonds from the same companies they hold their stocks with or a bunch of hampered local governments.  Not only do short bonds and cash not have the volatility needed to offset stock losses in horrible markets, but they often share some of the same risks if not treasury bonds.  So most people are either suffering way too large of swings with their portfolios, or they are way overinvested in poor-returning (and sometimes risky) short-term instruments.

So the gold is really what makes the whole thing possible.  Without it as insurance (even if 10-15% of some kind of "alternative" portfolio), you really hamper your ability to offset stock losses, since it is so scary to take on LT bonds alone as a hedge.

[Lone Wolf]

Not to get off topic, but that sinkhole is amazing.  It looks like a missile silo.

It's funny that they are trying to figure out how to fill it up.  I predict that it will be filled up with garbage.

The first time I saw that picture I thought to myself, "Is that CGI?"

To transition back to the topic at hand, I predict that they will fill this 60 foot wide, 300 foot deep sinkhole with... fiat currency.

[Storm]

Wonk, this is a really great post.  Another thing that most investors have not taken into account is that the increase in gold and silver has been brought about primarily due to the devaluation of the dollar, not necessarily by the increase in the value of the metals themselves.

If you look at the euro/dollar spread for the last two days it is easy to see why gold and silver might be taking a temporary beating.  Of course there were margin requirement hikes on silver as well, but a 560 basis point drop in the euro against the dollar is huge in just a two day timeframe.

[Wonk]

Storm, that reminded me about the USDX.  I keep seeing all this stuff about "watch USDX at 72!"  It kind of drives me crazy because the USDX only measures how attractive the USD is vs EURO and other garbage currencies.  The real measure is against gold and commodities.  It could cost $20/gallon for gas with the USDX still trading at 72 because everyone is debasing like crazy at the same rate.

LW, one of the interesting things about the "dollar is doomed" scenario is it looked the same way in the 70s, apparently.  Everyone was convinced the dollar would go to zero.  It didn't, and it doesn't have to become toilet paper now, either.  We've got problems, but we've still got the reserve currency, the most gold in the world (as a country) and a very mighty military.  If we fix some structural problems, we'll be fine.  We just won't be able to get away with the same shenanigans again in the future.

[AdamA]

Wonk, this is a really great post.  Another thing that most investors have not taken into account is that the increase in gold and silver has been brought about primarily due to the devaluation of the dollar, not necessarily by the increase in the value of the metals themselves.

I would say that some of the increase in the price of precious metals (especially gold) was brought about by dollar devaluation, but that more is caused by the fear of inflation in the future.

[moda0306]

I would say that some of the increase in the price of precious metals (especially gold) was brought about by dollar devaluation, but that more is caused by the fear of inflation in the future.

I like to also think of it as fear that other instruments (stocks & bonds) will have a hard time beating inflation in the future.  During the mid-80's through the 90's, gold did pretty awful, not because there was no inflation, or even no predicted future inflation... it did awful because the future inflation was 1) looking to be lower than previously expected, and 2) more and more apparently going to be more than beaten by stocks and bonds.

Look at stock/bond returns from 1985-2000 (amazing, handily beating inflation), what inflation was (started high enough, but lowered), and what gold did (consistantly sank).  Then look at stock/bond returns from 2000-2009, what inflation was, and what gold did.  Looked at over the longer-term, it makes sense that if neither corporations nor governments are looking like they'll be able to beat inflation in their payments to you, people zero in on precious metals like a laser.

Inflation is just a number if you're raise, your home value, and your investments are handily beating it (psychologically, to most people in the country).