Gyroscopic Investing

For those interested, John Hathaway wrote an outstanding article here:

http://kingworldnews.com/kingworldnews/ ... Mania.html

He discusses many of the most misunderstood elements of a gold bull market--such as negative real interest rates and the lack of political will to realize financial losses nominally rather than via inflation.  He does a great job of saying what we could do to make it right, but most likely what we will do is altogether different.

IMO, the debt ceiling issue is political theater.  In reality, if the U.S. does not continue to step into the breach and deficit spend enough to make up for the retrenching credit market, we'll get net money & credit contraction (ie-deflation).  Since that would result in a resumption of equity losses, it's unlikely to happen--especially near an election cycle. 

Gold will end it's bull market when positive real interest rates resume in earnest and we accept our punishment for the bad decisions we've made.

Side note about credit:

The consumer credit market has contracted about $210B YOY from 09-10.  That's fine and dandy until we start talking about the REAL deflationary threat: the financial sector--which is bigger than the consumer sector.  In the same time frame, financial credit has contracted 658% more--$1.382 TRILLION.  Between the two, it amounts to $1.591 Trillion in lost credit in only one year.

Guess what the total increase in federal government spending is?  $1.580 Trillion.  If the budget hawks win, we get deflation.  If the doves win, we get stagflation at best and a complete restructuring (has a hyper in the name) at worst.  Losses will be realized one way or the other.  Pick your poison.

Those that position themselves in a PP (only 20% for me, but that's another story) will do well regardless and can watch the storm from inside the fortress.  I feel somewhat bad for the indexers in Boglehead-ish stock/bond allocations.  They are going to get rocked in the years ahead (as if 11 years of negative real returns isn't bad enough).

Wonk wrote: Those that position themselves in a PP (only 20% for me, but that's another story) will do well regardless and can watch the storm from inside the fortress.  I feel somewhat bad for the indexers in Boglehead-ish stock/bond allocations.  They are going to get rocked in the years ahead (as if 11 years of negative real returns isn't bad enough).

Great article, Wonk.  I think I know where you're coming from, but would you mind sharing why you are 80% VP rather than 100% PP in your allocation?  I'm guessing it's because you made the (probably correct) bet that gold/miners are going to have much higher gains over the next 3-4 years than the other components of the PP.

Great stuff Wonk.

I also feel bad for the millions of people nearing retirement age who are going to need a lot better advice than they have been receiving through the conventional investing wisdom.

These people will come around to gold ownership at some point, but unfortunately that will probably be the time to sell.

Wonk wrote: IMO, the debt ceiling issue is political theater.  In reality, if the U.S. does not continue to step into the breach and deficit spend enough to make up for the retrenching credit market, we'll get net money & credit contraction (ie-deflation).

IMO the U.S. Gov't is only one source of additional money liquidity.  The credit market or even liquidity could be addressed directly.  The Fed Reserve could for example, create as much liquidity as desired.  One technique is, as Bernanke is (in)famous for mentioning, to simply distribute money.  Another would be for the Fed to guarantee bank loans in such a way that terms would become extremely appealing (e.g. no payments for 5 years).  Or as another alternative, the gov't could simply step in and modify existing credit agreements as it has done in the past.  One helpful modification would be a payment holiday.

As for the original article, either I missed it or he did not address the issues of credit, monetary deflation, fractional reserve, etc.  I appreciated the thoughts on a gold standard, but he's a lot more optimistic than I regarding the perception of politicians.  Many, many countries have experienced currency crisis or even complete currency collapse in the past 100 years and did not resort to a gold standard.  Indeed, it appears a gold standard would not be needed to reconstitute a currency.  (E.g. Wiemar Republic, 1923)  I tend to agree with the assessment of austerity vs. current politicians.  I expect the welfare state to continue, no matter who gets hurt as long as it isn't the politicians and bankers.  Viva la gold!

It was a good article, thanks for the pointer.

Very good.  Thanks for posting.

I'm not a crystal ball gazer, but I agree that it's very hard to see any kind of Paul Volcker moment creeping up on the horizon.  Very high short-term interest rates would set the national debt piling up at an (even more) alarming rate due to all of our short-term debt rolling over.  In addition, the fact that Reagan's popularity sustained incredible (although very temporary) damage in the wake of those higher interest rates makes a Paul Volcker moment seem even less likely.

I'd have really enjoyed being able to hear what Browne might have to say about all of this.  In his radio broadcasts he characterized gold as doing well when "inflation threatened the value of the dollar" and prices were increasing at 5, 6, 7 percent or more.  What the past several years have shown, though, is that more mild price increases can see gold moving higher so long as real interest rates are not compensating dollar holders for their inflation losses.  In other words, once the dollar becomes a less reliable store of value, gold wins and this does not necessarily require outlandish levels of price inflation.  When the dollar becomes a (temporarily) sturdy way to preserve wealth, though, gold gets flattened.

When Browne was doing his radio show, we hadn't seen sustained negative real interest rates for nearly 30 years and these had coincided with a period of high inflation.  I wonder whether Browne has considered that gold could climb even if price inflation was moderate (so long as interest rates were kept to artificially low extremes.)

Storm wrote:
Great article, Wonk.  I think I know where you're coming from, but would you mind sharing why you are 80% VP rather than 100% PP in your allocation?  I'm guessing it's because you made the (probably correct) bet that gold/miners are going to have much higher gains over the next 3-4 years than the other components of the PP.

Frankly, I think the precious metals sector is low hanging fruit and I'll be happy to pick it.  We're somewhere in the middle to late stages of a secular bull market and I like the risk/reward equation at the moment.  When we get closer to a few metrics, I'll get itchy and will look to scale back into the PP upwards of 100%.  The transitions between secular markets are rocky and an absolutely perfect time to be well diversified in a PP.  We're nowhere near that yet so I'll be happy to ride out the 30% corrections along the way.

Medium Tex wrote:These people will come around to gold ownership at some point, but unfortunately that will probably be the time to sell.

Good point.  Unfortunately, manias don't happen without participation from the masses--which usually means the most unsophisticated investors who hop on by way of conforming to what everyone else is doing.  I'm sure there are some folks who got burnt in 1980 during the frenzy.  As long as people keep selling their gold jewelry to MC Hammer and not buying krugs, I'll feel comfortable.

AgAuMoney wrote:Many, many countries have experienced currency crisis or even complete currency collapse in the past 100 years and did not resort to a gold standard.  Indeed, it appears a gold standard would not be needed to reconstitute a currency. 

That's true.  A gold standard isn't necessary to create confidence.  The U.S. in 1980 was a prime example.  When Volker finally got ahead of inflation at 19%, it was enough to create positive real rates.  It just so happened that the price of gold caught up to the U.S. money supply as well as debt held by overseas investors--primarily central banks.  I don't think that's a coincidence.  From 1980-1999, real rates remained largely positive so investors had no incentive to trade dollars for gold.

Somewhat ironically, even the implementation of a full gold standard or gold exchange standard doesn't mean it will last.  Usually politicians figure out a way to default on that as well.  The purchasing power of the USD was cut in half in 1934, virtually overnight.  After the Nixon shock, it was more gradual.

Lone Wolf wrote:I'm not a crystal ball gazer, but I agree that it's very hard to see any kind of Paul Volcker moment creeping up on the horizon.  Very high short-term interest rates would set the national debt piling up at an (even more) alarming rate due to all of our short-term debt rolling over.  In addition, the fact that Reagan's popularity sustained incredible (although very temporary) damage in the wake of those higher interest rates makes a Paul Volcker moment seem even less likely.

The future hasn't been written yet, but that could be the endgame.  Fortunately, we'll most likely see what happens with Japan as a case study so we know what to expect.  Under such a scenario, I would imagine we'd see a certain amount of market chaos for a short while until a new international trade agreement and debt restructuring are worked out. 

I'd have really enjoyed being able to hear what Browne might have to say about all of this.  In his radio broadcasts he characterized gold as doing well when "inflation threatened the value of the dollar" and prices were increasing at 5, 6, 7 percent or more.  What the past several years have shown, though, is that more mild price increases can see gold moving higher so long as real interest rates are not compensating dollar holders for their inflation losses.  In other words, once the dollar becomes a less reliable store of value, gold wins and this does not necessarily require outlandish levels of price inflation.  When the dollar becomes a (temporarily) sturdy way to preserve wealth, though, gold gets flattened.

When Browne was doing his radio show, we hadn't seen sustained negative real interest rates for nearly 30 years and these had coincided with a period of high inflation.  I wonder whether Browne has considered that gold could climb even if price inflation was moderate (so long as interest rates were kept to artificially low extremes.)

Well, we had 4-5 years of negative real rates and historically tame inflation by the time HB passed, so I imagine he made some mention about it.  You also made a key distinction--gold prices aren't really tied to high inflation as much as they are tied to real interest rates and credit risk.  Doesn't matter if inflation is running at 18% and rates are at 16% or if inflation is running 2% and rates are at 0%.  It's still a loss of purchasing power. 

HB acknowledged that gold could respond well to conditions other than generalized price inflation, including deflation.  I think his point was that in a PP context strong price inflation was the only condition in which we could absolutely count on gold responding positively.

Gold and gold stocks actually did pretty well during the deflation of the 1930's, but much of that was determined by political actions taken by President Roosevelt.  Those actions included outlawing gold ownership in the US (to the benefit of holders of gold outside the US) and arbitrarily devaluing the US dollar from $20.85 to $35.00 per ounce of gold (to the benefit of holders of gold stocks everywhere).  Who knows whether those economic benefits or detriments were intended, recognized or even considered by the political actors at the time.

In a VP context, I agree with Wonk that the risk/reward equation for precious metals, especially gold, looks pretty good if you can stand some big corrections.  Nothing is assured, but I don't see indications of excessive public bullish for gold now and negative real interest rates could continue to push markets for a long time.