Gold, Silver and "MAD" Money

For the past two months, I have been distributing commentaries of my
views on the current state of the financial markets. Part of this
effort has been to proliferate information that I read or listen to from
the financial press or through my own experiences in the asset
management industry. This is mainly directed at my friends, colleagues,
and acquaintances (and now - friends of friends) that would not
otherwise be privy to this information - or they just wouldn't care -
many of them still don't care.


The reason that I'm doing this is that I fear that we - as a society,
perhaps even globally - are headed towards a cliff. The cliff is still
in the distance but it is there, so we have a choice - we can try to
avoid going off this cliff, or we can plow full steam ahead and take our
chances. While I can't force every American to save 10% of their income
and diversify their portfolios across industry, currency and asset class
- I can at least try to get this message across to some of the people
closest to me.

GOLD

So this brings me back to a subject that I have been harping on for a
while now - GOLD. If you would have told me five years ago that I would
be advocating that people invest their hard earned savings into gold, I
would have laughed, cried and thought you were crazy. However, it
appears that I was the crazy one, along with the other millions of
people caught up in the "New Economy" now known as the Tech Wreck. I
was wrong and now I have completely changed my mind and proudly consider
myself a gold bug. I can admit that unlike the idiot politicians that
run our country, and every other country for that matter, when the facts
change - or at least my interpretation of them - I can change my mind
and admit that I was wrong.

Why gold? There are so many reasons that I can only touch on a few of
the ones that have hit home with me. Here we go:

1) Historical staying power - Since the time of the
Egyptians/Persians/Romans etc. gold has been used as a means of
exchange and measure of wealth. During that time, thousands of fiat
(paper) currencies have come and gone - all worthless in the end. So
yes, hundreds (and maybe thousands) of years from now gold will probably
still be used as means of exchange and measure of wealth, I have less
confidence in the USD or any other fiat money run by government
beaurocrats with ties to politicians.

Our current experiment with fiat money only started in the early 70s
when Richard Nixon severed the link between the USD and gold (for people
in my generation and younger, you used to be able to get gold for each
dollar that you owned). This ended Breton Wood I (BW I) which was a
fixed exchange rate system between the U.S. and the other industrialized
countries of the post-World War II era. Most of the European countries
ended their use of the "gold" standard during World War I. See below
for how BW I ended - as we are currently in a less formal arrangement
called BW II with the Asian countries.

Here is a chart of the value of the USD against other currencies (A) and
against gold (B) over the past 45 years and 100 years, respectively (can
you figure out when BW I went bust and Nixon closed the gold window) .
(Charts constructed by Dr. JP Bonardi - Richard Ivey School of Business)


(A) chart not available


(B) chart not available



Every defunct currency has a similar story to tell, some fall faster and
other take longer to fall. I would get into a long and sordid history
of Roman Imperial currency, but the moral of the story is that the
Romans debased their currency and the chart of its value against gold
would look a lot like (B).


2) The CPI is a fraud - Back in college I remember that in one of my
economics classes they told us that Alan Greenspan was trying to get
Congress to change the calculation of the CPI. The reasoning had
something to do with holding down spending on entitlements that were
calculated using the CPI. I wasn't too bothered at the time since at
that point in my life I was more worried about maintaining my GPA rather
than actually learning something or questioning the current thinking.

Now I actually get physically nervous and stay awake at night thinking
about stuff like this. The whole point of any macrostastic is not that
it is correct down to the last penny, but that it is actually
consistent. The importance in these statistices is comparing current
data to the past so that we have a yardstick for our current economic
situation and a information base for future projection.

The amendment to the CPI calculation has two main components:

a) Hedonic Price Indexing - If a new computer that is twice as powerful
as an old computer is launched at the same price as the old computer,
then the CPI is "adjusted" to reflect the added value of the new
computer. Therefore, even though you are paying the same amount for a
computer, your cost of living has just decreased.

b) The substitution effect - The premise of this is that when the cost
of one good moves up, the consumer will substitute a lower cost good.
The CPI only reflects the difference in cost between the original good
and the lower cost substitute good. So if the price of beef increases,
then it is assumed that people will start buying chicken. If chicken
increases in price, then it is assumed that people will start buying
tofu (ok - that is a cheap pop). Do people really change their buying
habits so easily, I don't know but I have never actually seen or heard
of someone doing this. Doesn't mean it doesn't happen.

But this is not why I am calling the CPI a fraud, here is my reason:
from the year 2000 to the year 2005, the component of CPI related to
housing (which represents around 25% of CPI) actually a showed a
decrease!!! How can that be in the years of a real estate and housing
boom? Well, an assumption was made that as home prices have increased,
that more and more people have decided to rent - even their own homes
(which is called "owners' equivalent rent"). The cost of renting has
actually decreased over the past five years (yet another sign of a
runaway housing bubble) - so housing has actually become more affordable
over the past 5 years. This is a distortion so serious that I consider
it an outright fraud. Everyone knows that home ownerhip is at a record
level and that housing prices have soared in recent years. This is a
travesty and yet no one cares. Just to throw some more dirt on this
one, as the price of buying/leasing a new car has gone up, an assumption
was ma!
de that people are now buying/leasing used cars.

Here is a chart on the CPI, using the "old" and "new" calculations:



Why is this so important, because all major government statistics use
the CPI as a direct or indirect input into their calculation. A
systematic under-estimation of CPI means that GDP and productivity
growth have both been over-reported for the past 10 years or so. Has
the market fully incorporated this data - hard to say, but I can say for
sure that people's psychology has not yet incorporated this data.

3) Growth of money supply over the past 4 years - This is taking much
longer than I anticipated and I still have a ways to go. So I am going
to make this quick. Growth in money supply in recent years has been
growing exponentially. More USD have been created in Greenspan's tenure
(since 1987) than the first 74 years of the Federal Reserve System
(1913-1987). Also, more money (not just paper currency - but also
dollars held electronically) has been created in recent decades than all
the gold ever mined since the beginning of time. Don't have the exact
numbers in front of me, but I think you get the message. Buy gold even
though the price has been skyrocketing in recent months. If it corrects
down to $500 or lower, then buy more and forget about it. I think that
gold will be at $1,000 at some point in the next 10 years.

4) OPEC and Russia - One of the main drivers of the price of gold over
the past 6 months has been the conversion of petrodollars into gold.
Russia and Saudi Arabia have led this movement and Russia has stated
that it plans to continue accumulating gold reserves. This trend could
spread to the Asian central banks if they begin to look for an
alternative to holding USD. Yes, this adds some uncertainty to the
current bull market in gold (if commodity prices crash - gold could be
hurt), but you know my views on commodities - so this will not deter me
from accumulating gold over the long run. In fact, a short-term
correction in commodities and gold would be a fantastic buying
opportunity.

This issue has the potential to be a whole commentary - perhaps I will
investigate further in the next few weeks. I need actual data - does
anyone know where I can find info on central bank purchases of gold?


SILVER

My basis for investing in silver is not as well founded in research,
however, I still feel strongly about it. Silver has also been used
historically as a means of exchange - although not to the same extent as
gold. Also, gold and silver tend to rise and fall in fairly strong
positive correlation. Two factors that could actually make silver a
better investment right now than gold: 1) It has not run up quite as
much in recent years, 2) Silver has more use as an industrial metal -
meaning that there is actual demand for silver outside its use as an
investment.

Finally, and here is the main reason why I have been investing in silver
mining companies: Barclays is currently in the process of establishing a
silver ETF. My research shows that the current supply of silver is at a
precariously low level. If Barclays is able to successfully launch an
ETF, they will have to buy physical silver for each share of the ETF
that is issued. This will further increase demand and hopefully drive
the price up. Also, silver has a large short interest and the ETF could
act break the backs of the short sellers - forcing them to cover and
further increasing the price.

Yes, this is a technical argument, which I usually don't go for - but I
think its a good investment nonetheless. Buy silver.