Nirav at "LivingOffDividends" just gave me some more grist for my opinion mill.  I hope he doesn't mind being my debatee in the Socratic tradition. 

"LOD" is somewhat Goldbuggish, which is not a scathing criticism.  LOD does a great job of exploring various classes of investing and living life.  The overall theme and site moniker is an outstanding recommendation.   But, while I think gold is a terrific financial asset and has its place in just about any portfolio, one must be careful to advise that people flee to gold because of the prospect of inflation / deflation or everything in between.  Gold has lost people a lot of money over the ages.  It is a store of wealth, but not much of an investment as it does not grow, or help a business grow.  It just sits there like a pretty lump.

Here is the LivingOffDividends post and my rebuttal:

Insurance Company Buys $400 Million in Gold

I just can’t let this one pass without a challenge. Sure, money supply has exploded at the Federal level. But it has done so by deliberate effort to replace the value of assets destroyed by the financial crisis and real estate panic. I think a healthy way to look at this is as a transfer of the financial bubble from weak hands to strong hands that can absorb and dissipate the bubble. By the way, this is the same financial bubble that has been traveling through the American economy since the early 1980s, if not before. The private sector seems to be unable to deal with the hot potatoe, so it had to end up in public hands at this point. But as you say, the wealth will gradually be transferred by the Feds back to the private sector over the next 5-10 years.

Once money is created, it cannot be destroyed. It is similar to Einstein’s Theory of Relativity and the Conservation of Energy. That theory everyone knows as E=M*C squared. Mass can be transmuted to energy, but it always will exist in one or another form. Money (wealth)  is not only preserved over all of time once created, but can be  increased by the productive enterprise of humans.  Once created, it can be transferred and transmuted into different forms of assets, but it cannot be destroyed (call this “Brian’s Theory of Monetary Conservancy”).

Consider the history of great civilizations that have risen and fallen.  The political structure of those civilizations has ceased and political power has disappeared in the Greek Empire, the Roman Empire (Italy), the Spanish Empire, the British Empire and the Chinese Dynasties.  But the wealth created by those political systems has lived on and been passed down over the generations.  Even World Wars have proven unable to destroy wealth, as inconceivable as this seems.

I wrote about this idea on my blog back on May 4th. http://wealth-ed.com/2009/05/04/gmo-and-the-persistence-of-stock-market-returns/

I quoted one of the true financial experts of our time, Jeremy Grantham regarding the phenomenon of indestructible wealth:

“The Great Depression is far and away the most striking period on the chart (see linked article for charts). Real GDP fell by 25% from 1929 to 1933, in what was easily the worst economic event to hit the U.S. since the Civil War. But that fall, as extraordinary as it was, was a fall in demand relative to potential GDP, not a fall in the economy’s productive capacity, and so the economy eventually (by 1945) got back onto its previous growth trend as if the Depression had never happened.”

So, while it is very interesting that a life insurance company has decided to buy some gold to diversify its assets (I am sure a very small percent of its total managed assets), there is nothing about this that should indicate anything significant about gold for the future. Gold is just another class of asset. That is all. It has no special place as compared to other real assets, and it may be less important or significant than assets which have some productive use, like copper or oil.

I also refute the assertion that gold has a use as an asset offering protection when an economy is “weakening”. Gold has some short term panic value, as it did last fall. But if it didn’t shoot to $2500 an ounce during the worst financial crisis since 1930, then it probably is not even good as an insurance policy during a crisis.

The statement: “CEO Zore believes that the price of gold could double “or even rise fivefold” if the economy continues to weaken.”, just tells me that Mr. Zore should not be running a major insurance company. That statement is shear stupidity and shows a lack of financial understanding. Gold might increase by five-fold if the dollar weakens to 20% of its current value. But that is the only way this scenario will play out. For the dollar to weaken in that way, the economy would have to be going strong. We just saw that the dollar STRENGTHENS as a global safety trade when the economy tanks.

Yes, gold will appreciate while the dollar depreciates.  It is a fiat currency alternative. That is a given. But while people have been watching gold trade between $900 and $1000 the past 3 months, oil has gone from $30 to $70. So which asset has more potential to protect against inflation while providing investment opportunities?

A response to a post by my good blog friend, Nirav:

Nirav, this is the problem with professors having opinions. Some people may want to think those opinions are more meaningful or well-informed because a given professor happens to be employed by a school like Stanford, or NYU (Roubini). But, such professors opinions about the future are no better than yours or mine. Professors should teach, and not opine.

The first thing wrong with Taylor’s opinion is his lack of command of basic financial math. A 100% change in nominal GDP over 10 years (and the resultant 50% cut in debt to GNP ratio) does not require a 10% annual inflation, but a 7.2% inflation, according to the Rule of 72, something any college finance or economics professor should know. I fully expect a 6-7% inflation within 2 years and think the Fed and Treasury are actually trying to orchestrate that.

The second thing wrong with the Professor’s opinion is the statement that a “permanent 60% tax increase would be required” to balance the budget. That statement is inconsistent with the 10% inflation conclusion. I think taxes could be left unchanged, or only increased to the degree Obama proposes, along with spending decreases, and inflation will do the rest. Not only will inflation cheapen the debt over time, it also will increase the number of dollars in which the debt is paid off. Anyone who owned a home in the 1970s remembers what a good deal inflation was at that time, so long as the mortgage was fixed. You could buy a $40K home, watch it appreciate to $80K with inflation, but pay off the debt as though it were still $40K. To the degree the Feds fix our interest costs (by issuing 30 year bonds which they should be doing in a big way right now), we will all benefit from the repayment in debt with ever cheaper dollars.

Inflation is the only way out of this box. I think the 1970s scenario is not only likely to occur, but welcome. It helped us resolve our Johnson era “guns and butter” Great Society debt of the 1960s, which in its time, was every bit as problematic as where we are today.

I would go on to say that as a responsible investor, it is important to try and anticipate the future, and not wait for it to run you over.  If inflation is in our future, as I think it most surely is, then a prudent investment strategy will take that into account.  The way to not only beat, but prosper from inflation is to own hard (real) assets, or stocks thereof. 

Oil, natural gas, industrial metals, precious metals, timberland, ag commodities, all the equipment suppliers to those industries (Joy Global, Deere, Cat, Monsanto, Nabors, Transocean, Dow Chemical, Dupont), and even real estate or REITs in the near future (once RE stops deflating) will all benefit from a long period of moderate inflation.  The Fed has demonstrated in the past its ability to prevent hyper-inflation, so that should not be a great worry.  Ben Bernanke knows the economics playbook very well.  So, rather than nashing teeth over the course of easy money and tax deficits, instead, put those actions to your own advantage.

Here is his post:

How to Reduce a Trillion Dollar Deficit

As we begin to move towards economic recovery, it begs the question "what next?"  It is unlikely America will have a strong economy, as measured in 4+% GNP growth, for many years to come.  We have oceans of debt to pay off.  Even if the Feds are able to transfer the enormous debt hole from the private to the public sector to assist the economic recovery (and save the banking system), that debt still must be paid back in some form. 

There is a high liklihood that the public debt will be paid back through several different means: higher taxes, limited spending and most significantly dollar devaluation (aka inflation) over a long period of time.  Higher taxes and limited government spending will put a cap on American economic growth and will ensure a very slow economic recovery or even stagnation.  An extended period of 1-3% GNP  growth can be expected.  But with a weakening dollar, it is possible that rate of growth will not keep pace with inflation of 5-7%.  So, real GNP will be negative for several years undermining domestic investment returns.  All this is very remiscent of the late 1970s.

But there was a way to make decent, and maybe even excellent, real investment returns in the 1970s.  It was by investing away from America in hard or real assets like commodities and in the growth of non-dollar economies like Japan. 

In the 2000s, the new Japans are the BRIC nations: large, motivated and politically willing.  Today's post is on investing in three of those four.  Brazil, India and especially China meet my requirements for foreign market investing.  But Russia, I do not trust.  Its political system has shown contempt for foreign investment.  It very much resembles the politics of the USSR, with a newly energized "politburo" that controls the economy and stifles free enterprise (though we here in America are catching up fast on this front).  So, I will focus my non-dollar investments in BIC, not BRIC. 

As of today, I am selling all of my long term international mutual fund investment in Fidelity Diversified International (FDIVX) and will gradually move those dollars in equal amounts to IFN (India Fund), EWZ (Brazil ETF) and FXI (China ETF).  I will dollar cost average in because all three markets / funds have just experienced a very strong surge from the bottom of the market crash and may correct. 

My goal will be to move my portfolio to 20% in non-dollar market investments.  Beyond the country ETFs, I also will buy strategic investments in Canada, Australia and non-China Asia.  I will have another 35% of my total portfolio invested in commodities and energy.  This position is already in place with most of the commodity portfolio in Canadian Royalty Trusts (Canroys).  I am also adding FXC and BHP to provide more industrial metals exposure along with additional precious metals exposure, adding to VGPMX and GGN by buying gold miners like AEM and AUY.   The balance of my portfolio will be in domestic stock and bond funds, especially high yield bonds which can keep up with the devaluing of inflation.  In this way, my portfolio will have less than 50% US dollar exposure to protect against inflation and a decade long weak economy.

Today's Barrons runs a great story on this same subject. 

The [most important factor in the coming commodity boom is the] growth of the middle class in the rapidly developing economies; large-scale infrastructure investments in many developing nations; and the emergence in these regions of a huge new consumer cohort, which has developed out of the poverty of the past.  The size of this low-income cohort dwarfs anything the global marketplace has ever seen. Approximately one billion people, one- seventh of the world's population, are moving out of poverty and entering the market as consumers. If these billion consumers were a nation, they would have the third-largest population in the world and the 10th-largest gross domestic product.

China lacks the raw materials it needs to manufacture steel. This has turned it into the world's largest importer of iron ore. It has been accounting for 40% or more of the international iron-ore trade in recent years.  China's need for steel will continue long into the future. Remember that the U.S. took 35 years to finish its Interstate highway system. It took 16 years for Japan to build its New Trunk Line railway. Even with China spending a reported 9% of its GDP on infrastructure, it will take decades to bring its roads, ports, airports, power-generation capacity and other infrastructure systems up to speed.

Read the entire story here:

Commodities' Coming Rebound

I feel compelled to pen my opinion of gold as a long term investment. Today, February 18, 2009, Gold has suddenly become the popular investment. When Jim Cramer (the ultimate contrary indicator) starts beating the drum for gold on CNBC, the game is all but over.

What is wrong with gold or other precious metals like platinum or silver, as an investment? One word: productivity, or more precisely, the lack thereof Gold is passive It doesn’t do anything, has no fundamental uses, or promote economic growth in any way It is symbolic alone, even as jewelry It is the ultimate “safe haven investment” So, at times like now with rampant fear, gold will outperform relative to other investments But unlike equities, those gains will not, can not stick Because gold is safety in a stormy sea, once the seas calm, the need for gold is gone And down it will drop like it has many times before.
We need only go back to 1980 to see the last time gold served as a safety valve for a world fearful of energy crises and out-of-control inflation in the world’s biggest economy, America On January 21^st of that year, gold peaked at $850 The next day, it was back down to 737.50, a whopping 15% drop in 24 hours Soon thereafter, Paul Volcker alleviated concern over the declining value of a dollar by jacking up interest rates, eventually to 20% in June 1981 This not only changed the perception of inflation, but also provided a very attractive alternative to gold in terms of return: US Treasury bonds By the end of 1980, gold was back under $600 not to return to that level until 2006, over 25 years later.

This time around, gold bugs are in opposing corners in their reasoning for gold: the thesis goes it is a great investment, a) because the economy is collapsing and we are heading for global deflation, or b) the global governments are printing paper like crazy to “reflate” and we are heading for global inflation as that printing inevitably overshoots The fact that both theses arrive at the same conclusion, which is “buy gold”, is suspect Deflation should devalue all hard assets, including gold, as paper currencies strengthen Reflation is currency neutral, causing neither appreciation or depreciation of the dollar in respect to gold, as printed money replaces money supply lost to debt writedowns Only significant inflation (more than 5%) caused by money supply expansion overshoot as in the late 1970s, should logically result in higher gold valuation in respect to money (the dollar).

Another anomaly that must be resolved to make a long term case for higher gold prices is the current disconnect between gold and oil A long term 50 year plot of gold prices against oil prices shows they move in tandem by a ratio about 15 to 1 (oil barrel to gold ounce) This is logical Both are hard assets Oil actually provides more economic value than gold, but as a commodity, it is seen in markets as being an alternative to paper currency, as are all commodities in the long run (wheat has been used as currency in the distant past) Gold and Oil ran together by the 15:1 ratio until October of 2008, a date also marked by financial panic At that time, they diverged in a big way As fear subsides, this divergence MUST be resolved at some point, through higher oil prices, lower gold prices, or a little of each (which is my choice)

Still, as the title suggests, there is a strong short term SPECULATIVE case for gold that can be made As long as we live with all our economic uncertainty, gold will shine I have argued in the past on several occasions going back to 2003, for gold to spike to a 1:1 ratio with the DJI, which it last achieved in 1980 This could happen during a super spike to $7000 (or maybe $5000 if the DJI continues to decline) Gold with its very small supply base, can do this when it becomes the crowded trade, which it is quickly becoming But remember that the day the next Paul Volcker arrives with a brilliant plan to change the paradigm and correct the economy, gold will dive and dive fast as the 1980 chart shows Those looking for a chair on that day will have a hard time finding one and will be left standing, out of the game The exit door for gold is small and only a few can get out at a time Prudence dictates that investments in gold should be hedged with puts, which diminishes the already questionable return.

Be forewarned you gold bugs: this time is no different and will end as it always has before: Badly!

Today, I answer the blogposts of a couple of gold bugs who are a little overwrought with the idea of a new age where gold is king:

"Another Case for Gold": http://livingoffdividends.com/2009/01/31/another-case-for-gold/comment-page-1/#comment-32504

"Boy, Nirav, is the author of this piece mixed up. There are parts of it that are correct, but the overall picture is decidedly mixed and confused.

You and I have been in agreement that gold and other precious metals and hard assets will benefit from a period of monetary expansion once the deleveraging is done. I believe that as long as dollars are printed to replace the financial assets lost in write-downs, there is no inflationary pressure created: no extra demand chasing too little supply. (and in fact, we are now entering a period of excessive inventory, whether houses, cars or clothing, which is the source of all deflations).

But once inventory (supply) is back in balance, then all the excess money supply (demand) will probably cause inflation. How much inflation will be determined by how fast the Fed and Treasury can remove the dollars from circulation. One way is as the author described: by selling Treasuries. But this also is the source of one of his misdirections. Here are the errors I saw in his arguments:

1. “if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it’s looking for — it will cause rates to rise” - POINT: when the Fed uses this policy of selling Treasuries to reduce monetary supply, it is INTENTIONALLY trying to raise interest rates (see Paul Volcker in 1980). Interest rates must go up to attract buyers to Treasuries. That is the whole point, which addresses another of his confused arguments:
2. “Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion?” POINT - NO, of course not. The Fed already knows it will need to raise interest rates to attract capital to Treasuries once de-leveraging (fear) is out of the market. The very low rates of today are a product of global fear of economic failure. I find it very interesting that global wealth is flowing to the US dollar through Treasuries and not to Gold. It really refutes the Gold Bug argument, doesn’t it?
3. “They’re not going to fund an inflationary dollar at 2%. Ever.” POINT - DUH!! Come on, the author of this piece seems smart and well-educated, but this statement makes me wonder. First, the mechanism for issuing debt of any kind, government or corporate, is through auction. The 2% rate is a product of what the market will bear, not some Federal fiat. Interest rates of all types are set by the market, not be some pre-ordained decision. The Fed officials (really, any one educated in economics) understand that when we enter a period of excess money supply (we can only wish for that right now), then interest rates will be bid higher.
4. The reason for this is also Economics 101: investors are only concerned with the REAL return of an investment, not the NOMINAL return. The real return is the investment return minus inflation. So, the market will ALWAYS require a return that is positive or in excess of inflation. 2-2.5% is the normal expected REAL return for a riskless investment (Treasury). How do we know this? It is quoted every day in the Treasury Inflation Protected Securities (TIPS). When inflation is negative, as it is right now with a contracting GDP, very low interest rates still generate positive Real Returns.
5. “[In the past] the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.” POINT - many younger writers, or those not solid students of economic history, forget the context of “the past”. In the 1950s and early 60s, America’s economic nexus, America was the only country with its economic infrastructure left intact after World War 2. America was never bombed or invaded and its manufacturing infrastructure had been built to the sky in support of the Western World’s war machine. Because hard assets were plentiful, soft assets (currency) were not widely needed. People miss this very important point. Currency is just a substitue for real or hard assets. Those assets can be buildings, machinery, coal, oil or gold. American then, like China now, had lots of assets and against those assets, loaned the rest of the world money so they could rebuild theirs. When you loan money, money supply contracts, just as when you borrow money in expands.
6. The author (and most goldbugs) forget that currencies are comparative. If the entire world prints more money in concert, how can any harm be done? The dollar is just a unit of measure that represents economic exchange. Each dollar represents a fractional claim on the national aggregate assets of America. When I was a small boy, $1 meant a lot (could buy 3 loaves of bread). Today, $1 is probably represented by $10 in making purchases (still buys 3 loaves of bread). Does that change my life in any way? NO. Does it change my buying power in any way? NO. As long as my income is 10 times what it was before (and on average for Americans, it is), it is a wash. No one cares. And as long as the rest of the world follows the same path, it matters not. But, if you hold Real Assets over that time period (gold or real estate, among others), they will hopefully be worth 10 times as much, but probably no more (at least not for long). So, does that ounce of gold today buy any more than it did in 1972? NO. Money is symbolic and comparative, and to try to make some case for a new paradigm for Gold is as hopeless and mindless as those who tried to dismiss it entirely 10 years ago.