The Midas Touch

Our first post on this site in October 2009 quoted Mark Twain, who once said, “A gold mine is a hole in the ground with a liar on top.”  That may or may not have some truth to it, but it certainly hasn’t prevented that hole along with that liar’s balance sheet from appreciating significantly in value since then!  With most of “the street” now looking for gold to surpass the $2000 market in the short term, we thought it made sense to review what we wrote at the time and consider what may have changed since then gold was trading around $1000 per ounce.

“Our current Chairman of the Federal Reserve, trapped by Milton Friedman’s view of the Great Depression, and aided by the most aggressive fiscal policy we’ve ever experienced, has promised to resort to all means necessary to reflate this burst bubble and refill the gaping hole in credit, primarily through a policy referred to as “quantitative easing” – a fancy term economists coined for “printing money”. 

“It is safe to assume that if our Fed Chairman is determined to debase the currency, he will succeed.  Historically, gold has rallied in the face of geopolitical instability or inflation, but we don’t believe either is necessary to drive gold prices higher today.  Gold should move higher because investors throughout the world are becoming increasingly apprehensive holding fiat currencies.  At home, the size of the Fed’s balance sheet is exploding, and the impact is clearly seen in the Dollar’s Dive.  But unprecedented global monetary and fiscal stimulus around the world, have created a sea of liquidity to offset the deflationary forces associated with deleveraging.  Investors, who are by definition net long in paper currencies, will increasingly look for insurance in the form of gold.”

It would seem that some things never change.  In fact, it is quite obvious that the world’s apprehension toward fiat currencies has only heightened and may soon reach “the tipping point.”  Milton Friedman once advised that “US Dollars have value because everybody thinks they have value. Everybody thinks they have value because in everybody’s experience they have had value.”  We wonder what “everybody” thinks today?  We think that this is more than a dollar problem.  All major currencies have depreciated in the past decade when measured against the world’s oldest store of value – gold.

Our friends at Wikipedia tell us that Debasement is the practice of lowering the value of currency. “It is particularly used in connection with commodity money such as gold or silver coins. A coin is said to be debased if the quantity of gold, silver, copper or nickel is reduced.”  For example, the value of the denarius in Roman currency gradually decreased over time as the Roman government altered both the size and the silver content of the coin. Originally, the silver used was nearly pure.  From time to time, this was reduced. The denarius continued to shrink in size and purity, until by the second half of the third century, it was only about 2% silver. One reason a government will debase its currency is financial gain for the sovereign at the expense of citizens. By reducing the silver or gold content of a coin, a government can make more coins out of a given amount of specie. Inflation follows, allowing the sovereign to pay off or repudiate government bonds. However, the purchasing power of the citizens’ currency has been reduced. Another reason is to end a deflationary spiral. Debasement lowers the value of the coinage, causing inflation. Over time, it may even lead to a new coin being adopted as a standard currency. Note that last part, “To end a deflationary spiral.”  It’s a doozie.  We discussed it at length in our last two Broyhill Letters.  Lucky for Bernanke, he doesn’t even have to bother with “shaving coins.”  He can just hit the print button on his keyboard like a Monetarist Monkey.

Clearly, gold prices are stretched to the upside here.  As one technical analyst put it, “I have written reports on commodity markets since the 1970s and my experience has been that, when a tight upward price channel is broken decisively to the upside, the odds are 90% of the time the commodity will decline back toward the top of the channel or re-enter the price channel. The problem is that the other 10% of the time the move turns parabolic which I would define as a burst to 2300-2400 by November.” I don’t know about you, but we’d sure like to be there if the move turns parabolic!  The good news is . . . we can, and we can do it with a large margin of safety today.

While gold has risen from $250 to over $1900 in the last decade the percentage gain in the gold mining stocks has been about a third of the metal’s rise.  This extremely disappointing performance is only more frustrating when we consider that gold miners should outperform gold by a wide margin in bull markets.  This divergence has left the Gold/XAU ratio at historical extremes, indicating that gold stocks are exceptionally cheap. In addition to dirt cheap valuations, the macroeconomic backdrop for gold shares is now exceptionally strong, presenting a combination of factors that support a large allocation in portfolios.  In an article written by John Hussman in October 1999, we can see that in the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. Don’t look now, but more than a decade later, today’s backdrop is extremely powerful.

Gold equities are relatively flat this year compared to double digit gains in precious metals. The reasons for their underperformance is well known and well discounted in today’s price.  Profit margins were squeezed due to higher energy costs, but oil prices are now lower and should continue falling as economic growth grinds to a halt. The free cash flow generated by the miners is soaring with gold prices at record highs. Virtually all of the major producers are raising dividends. Gold is still a completely under-owned asset class representing less than 1% of global financial assets and institutional investors are drastically underweight. Eventually, the “smart money” will be forced to buy gold. Recall that the University of Texas recently took delivery of $1 BILLION in physical gold bullion. Net gold purchases by governments year to date have totaled 200 tons, nearly triple last year’s purchases.  Prior to that, the world’s central banks were net sellers for the past decade! But outside of the few paranoid “Spam and Shotgun” types, most committee-driven institutions are more likely to jump on the gold stock bandwagon then to stockpile bars of gold that don’t generate income or cash flow for their investors. Once the gold stocks begin to outperform as the natural forces of mean reversion assert themselves, the momentum investors won’t be able to resist the Midas Touch.

Disclosure: At the time of publication, author was long SPDR Gold Trust Shares, Market Vectors Gold Miners and Market Vectors Junior Gold Miners, although positions may change at any time.