How To Invest in Gold and Other Hard Assets

Allow me to preface this article by saying that I’ll be making no mention of the ‘manipulation’ of the price of gold. Let’s put that issue aside for now because, in the long run, it just won’t matter. We are in the midst of a financial crisis – not just any financial crisis mind you, but arguably the worst and most pervasive the world has seen in almost a century (second only to the Great Depression… thus far). In the sea of financial assets and currencies that are being decimated the world over, the one true safe haven continues to be gold.

During these times, it is understandable that the prevailing investor sentiment is fear. People are fearful of their savings, fearful of their jobs, and especially fearful of risk, having just witnessed how quickly a bear market can decimate portfolios. The other major factor currently affecting markets is deleveraging. As we all know by now, the 2002-2007 credit bubble was all about leverage. Leverage in housing and real estate. Leverage in the banking system. Leveraged hedge funds. As long as all asset classes continued to go up, then leverage was the winning formula. Although such a myopic strategy paid handsomely in the short run, the premise of the preceding sentence is, of course, false over the longer term. Thus, the winning strategy of yesteryear is now a ruinous one, leading to a vicious circle of deleveraging that is gutting the value of almost all assets.

Today’s financial system, with the institution of the central bank at its foundation, has proven to be anything but as stable and prosperous as once thought. For the first time in a long while, the very foundations of capitalism are being put into question. Once infallible central banks of developed nations have become almost irrelevant. The financial markets, even the stock markets, are completely ignoring them. Central banks have shown, to their chagrin, that they can only solve one problem by causing another. The system is in such a state of disarray that the leaders of many of the world’s developed countries, including the US, Britain, France and others, are now proposing some sort of massive overhaul in the way the world does finance. How it will all play out remains to be seen. Certainly it will involve greater government involvement and therefore greater waste and inefficiency. But be that as it may, we would not consider any paper-based asset as ‘safe’ right now. Especially not currencies, as we will explain shortly.  The markets realize this, the outcome is being realized with an all-time high being made in the price of gold today.

One of the key features of gold, and by gold we mean physical gold (not ETF’s, not futures), is that it is one of the very few assets that has no one else’s liability attached to it. We believe this point is particularly relevant today. At its heart, this financial crisis is all about the systematic lack of trust in the liabilities of others. Everybody is worried about default/counter-party risk. One example, yet to fully play itself out, is derivatives. The fallout in this area could be disastrous, as we’ve written about several times in the past, adding fuel to the fire of the global financial rout. But the problem, clearly, is by no means only relegated to derivatives. It’s the problem with all financial assets, even the traditionally safest ones. Banks don’t want to lend to each other because they don’t want an asset that is another bank’s liability. The money markets seized up because nobody wanted to own another business’s liability, even over the very short term. Even bank deposits, traditionally one of the ‘safest’ assets around, is some bank’s liability and therefore a new-found cause for concern. Like it or not, in the financial world everything is someone else’s liability and every financial asset has default risk. Even cash under the mattress is someone else’s liability… it’s the liability of the central bank. Which is why nobody should be breathing a sigh of relief that central banks are now guaranteeing everything. They guaranteed all bank deposits. They guaranteed money market funds. They guaranteed interbank lending. But at what cost? As they are wont to do, they only traded one problem for another. For what does a government guarantee really mean? It means they are the buyer of last resort for other people’s liabilities. It means they are ready, willing, and able to print money in any quantity to back the guarantee. It means they are trying to solve the problem of default risk by causing the equally nefarious problem of purchasing power/inflation risk. (Conversely they could tax their citizenry into oblivion, but this would be much less politically acceptable than printing money, especially in a debtor nation such as the US.) During times of financial crisis, it is best not to trust anybody, especially not the central banks. When even the safest counter-parties can no longer be trusted, gold should be the asset of choice. It is the only asset that has absolutely no default risk whatsoever and, in our opinion, it is the only true safe haven asset.

For now (though we believe it a temporary state of affairs) the “average person” seems to believe that cash is king. They are still content to own paper in times of trouble, particularly US dollars and US Treasuries. But such confidence is misplaced, for many reasons. In the current environment, deflation à la the Great Depression is highly unlikely. Ben Bernanke, the head of the Federal Reserve, is already on record as saying deflation cannot happen, using the helicopter drop analogy to prove his point. Under a fiat currency system this is true enough, and made abundantly clear with the central banks assuming the role of buyer and guarantor of last resort. But regardless of what the central bank does, we believe the fundamentals have never looked worse for the US dollar. On top of the money to be spent bailing out the financial system (at least $1 trillion… likely $2 trillion and more), there is also the recession to deal with. Even during the best of times the US government ran sizable deficits, in the worst of times these deficits will go through the roof. Going forward they could easily exceed $1 trillion per year. Then there are the social security and medicare payments the US government has promised to baby boomers, that will begin to escalate exponentially as they begin to retire starting this year. The present value of these obligations, according to the 2007 Financial Report of the United States Government, is $41 trillion using a 75-year horizon and $90 trillion using an infinite horizon.  It is the amount of money that needs to be set aside today in order to meet the obligation in the future. It’s not a long run problem anymore. It’s here and now.

For the above reasons, I believe the current flight to US dollars is a knee jerk reaction that won’t have staying power. Though the Euro has suffered dramatically, the dollar as a safe haven is likened to promoting the “smarter idiot”. When asset prices fall, people take comfort in the fact that one US dollar will always be worth one US dollar. But this stability is only illusory. The real question should be, what will one US dollar be able to buy in the future? Is a sub-4% yield sufficient to preserve wealth over the next 10 years? Much less, is a 2.7% yield likely to preserve wealth over the next five? We find it highly unlikely, especially in this environment where the Federal Reserve is throwing everything it’s got at the crisis. We believe the next leg of the crisis will see people becoming fearful of cash and bonds. Although, to date, the US dollar has fared relatively well versus other currencies, in the long run we believe it’ll fare relatively poorly versus gold.

With gold coins in a physical shortage and selling at a premium to spot, there is evidence that investors are starting to flock towards gold. It won’t take much buying to catalyze the price of gold to the $2000 level. At today’s price, the total amount of gold ever produced is worth only $4 trillion, a mere drop in the bucket compared to the world’s financial assets which, financial crisis notwithstanding, still total somewhere in the neighborhood of $100-$150 trillion. If some of these paper assets were to be redistributed to gold – nothing would be more prudent – then the price of gold even now presents a tremendous buying opportunity for the astute investor.