Andrew Millard's Blog: November 2010

I'm always amused by conspiracy theorists, but sometimes you just have to speak up when you hear something that's completely outside the realm of all reason. I hesitate to even mention it, but it's a good illustration of how far we have fallen from reasonable discourse.

You may have read that nothing good can come of making financial decisions on the basis of political ideology. That doesn't stop people from doing it, of course. Here's the latest:

Last week, a client told me that he had heard "Obama is going to start dipping into our 401(k) accounts to get money to pay off the deficit." As you might imagine, the client viewed such a scenario as highly unlikely, but since he had heard it from a financial services professional, he wanted to know if he should cash in his retirement plan and bury it in the yard. So I looked into it, and here's my take:

Hmm, how should I put it? How about this: Get real. It's not going to happen.

First of all, nobody within the government has suggested such an idea. Second, just how far do you think someone would get with this kind of scheme? "Hey guys, I have an idea: let's take money from private retirement accounts to pay off the deficit! That should be pretty easy, don't you think?"

Let's say the administration tried it. There are a couple little organizations called Congress and the Supreme Court that might have a thing or two to say about it. Regardless of one's opinion of the Obama Administration, they're smart enough to know that attempting to take money from personal investment accounts would be political suicide. Please, gimme a break.

Okay, so now you know that the President of the United States is not going to steal your hard-earned retirement fund. Breathe a sigh of relief, and enjoy a great week!
-Andy

Welcome to a special Day-After-Halloween Doomsday edition of the update.

As you are no doubt aware, there are some people who believe the economy will get much, much worse before it gets better. In fact, some even believe in the collapse of economic prosperity as we know it. This week, we address two of the most widespread topics related to economic doom: the potential for a collapse in the dollar, and the supremacy of gold as a long-term investment.

Read one or both of the articles following this week's economic news for a reality check.

Don't forget to vote. And have a great week, will ya?

-Andy

How Healthy is the Dollar?

The strong dollar policy is long gone, but the greenback isn't in peril just yet.

A favorite doomsday scenario. Have you heard about the forthcoming collapse of the dollar? Well, if you turn on your computer, your radio and even your TV, you just may. With the Federal Reserve poised to increase the money supply, the commentary on this topic is heating up again.

The scenario has variations, but the basic outline goes like this: An unexpected political or economic event leaves the dollar so weak that all confidence in it is gone. Foreign nations sell Treasuries in a panic and the Fed becomes the buyer of last resort. Traders and individual investors dump dollars for whatever they can get. Interest rates leap. Next stop: hyperinflation. America's economy suddenly resembles that of Zimbabwe in 2007 or Germany in 1922.

So is there any validity to this scenario? Could the dollar collapse?

Let's just say that the odds are very long. While the Federal Reserve will likely ramp up quantitative easing in the near future, it is highly unlikely that the dollar will suddenly become too cheap.

Why it is unlikely to happen. Foreign countries don't want the dollar to collapse. Fundamentally, that is because some of the world's biggest manufacturing economies rely on a great customer for their exports - the United States of America.

China and Japan currently hold 41% of America's debt.¹ In the worthless dollar scenario, they are the key dominoes that fall. But what incentive do China and Japan have to sell dollars? Their economies are tied to U.S. consumer spending. Selling dollars would not benefit them - it would drive up the prices of their exports to America, it would wreck the economy of their best customer, and it would harm their own economies in turn.

The dollar is also the world's reserve currency; it has been so since the U.S. abandoned the gold standard during the Nixon administration. While the central banks of China and Russia have argued that it should be supplanted or replaced, no challenger has knocked it off its pedestal. In spring 2010, the International Monetary Fund concluded that the dollar still accounted for 61.5% of global foreign exchange reserves, with the euro coming in a very distant second at 27.2%.²

In a way, the dollar has "collapsed" - and America is still standing. The dollar is much weaker today than it was in the 1990s, or even in the early 2000s. Its value has gradually declined and may decline further despite recent surges. In mid-October, the U.S. Dollar Index had slipped about 7% since August, and was approaching an all-time low set back in April 2008.³

America's debt was less than $3 trillion in 1990; it has doubled since, and the federal Office of Management and Budget thinks it will hit $15 trillion by 2015.¹ The federal government would certainly rather pay those debts back using a declining dollar.

Of course, analysts also talked about the pound collapsing and the euro collapsing earlier this year. All this talk - and expectations about what the Fed will do - sent many investors toward the precious metals market, where gold and silver futures hit new highs.

A little word about diversification. When you hear commentators talking about the oncoming collapse of the dollar, take it with a grain of salt. This much is true so far: a dollar decline has occurred, and the dollar could weaken further. So it might be worthwhile to consider diversifying your portfolio as a cautionary move.

Citations

1 - azcentral.com/news/articles/2010/09/19/20100919debt-of-us-grows-with-debate.html [9/19/10]

2 - businessweek.com/news/2010-06-30/dollar-share-of-global-reserves-declines-imf-says.html[6/30/10]

3 - bloomberg.com/news/2010-10-19/geithner-weak-dollar-policy-seen-as-path-to-recovery-in-contest-with-brics.html [10/19/10]

This article comes to us courtesy of Peter Montoya, Inc.

All that Glitters...

See if you can relate to this situation: the struggling U.S. economy experiences severe unemployment, and a falling dollar spooks investors. The stock market seems to be in a protracted tailspin, and the situation in Afghanistan is increasingly alarming. So you look for an alternative investment, and find... gold, which is generating impressive returns after a long dormant period. In fact, the precious metal has been testing all-time highs, and there are plenty of newsletters, touts and analysts that see a lot more legs to the rally.

As familiar as this sounds, it's actually a pretty good description of the latter months of 1979 and early 1980, when the price of gold rose from $400 an ounce in November 1979 to $850 by the middle of next January. Investors who poured in expecting lost more of the same were sorely disappointed; by the end of March 1980, gold was back to selling at less than $500 an ounce, leaving investors who bought at the peak holding a stunning 40% loss for the quarter. Holding on didn't help; by the end of the stock market runup in early 2000, an ounce of gold was selling for under $300 an ounce on the spot markets.

Today, of course, you're hearing a similar refrain, as the shiny metal has tested all-time highs almost monthly, most recently leaping from a little over $1,150 an ounce in late July to its latest all-time high, just over $1,365 in the middle of October. (The price has since fallen into the $1,340 range.) Is it time to jump on this bandwagon and ride the gains up to (according to some bullish newsletters) $2,000 an ounce or higher? Or is gold an overpriced investment ready to go bust?

One of the interesting problems with gold in your portfolio is how hard it is to get a handle on what its price SHOULD be. You can't compare its price to its earnings, like a stock, because when you put gold in your safe deposit box, there ARE no earnings. But there are ways to help decide whether the current price is being driven by fundamentals or yet another mania.

The first is to look at where the demand is coming from. Back in January, when gold was still riding the crest of investor disillusion with the global economy, the Commodity Online web site interviewed Miguel Perez-Santalla, vice president of marketing at the German precious metals producer Heraeus Precious Metals Management. Heraeus fabricates precious metals products for industrial use, but Perez-Santalla said that at such high prices (which have since gone higher), physical consumption of gold has fallen dramatically. "The gold investment market is the main demand driving the price up," he said in the interview. "Everything is being delivered on the Comex and to the London warehouses."

Loosely translated, that means that industrial users are waiting for the price to fall, and they will get their wish as soon as investors stop outbidding each other.

Another way of looking at the reasonableness of gold's prices is to look at the cost of extraction and refining--in other words, the cost per ounce of getting gold out of the ground and into the hands of jewelry makers, industry and investors. This information is not always easy to find, but an article on the MineWeb web site back in April 2007 estimated that gold mining companies were spending $401 an ounce in overall costs. More recently, in October of this year, an article suggested that today's extraction costs run between $500 and $600 an ounce--or a little less than half of what you would pay today on the spot market.

Loosely translated, that means that investors are buying at far higher prices than it costs to produce an ounce of gold. In fact, the disparity today at least challenges the record disparity back in early 1980.

Finally, you could look at supply and demand issues. If there is a worldwide shortage of gold, or much more is being used than is being produced, then this would justify a dramatically rising price. To get reasonable estimates of gold supply and demand fluctuations, you could go to the World Gold Council's web site, which notes that gold production over the past five years has been relatively stable: about 2,485 tons a year. In general, new mines are replacing the depleting production of current ones, so there has been little significant expansion in global output. It can take up to ten years to get a new mine started, which means that gold mining companies can't take instant advantage of today's higher prices.

However, the World Gold Council notes that as prices rise, the market begins to see more recycled or scrap gold--a category which includes people selling gold jewelry. Between 2004 and 2008, recycled gold contributed 28% to annual supply flows; a chart says that this amounts to another 1,016 tons a year. (The remaining supply flow comes from sales by central bankers, which may or may not continue in the future.)

Mine production and recycling together account for roughly 3,500 tons of gold coming into the marketplace each year. How does that compare to demand? According to the World Gold Council, jewelry demand--by far the largest market for gold--amounts to 2,436 tons a year. Industry uses another 493 tons--for a total of just under 3,000 tons between the two.

Loosely translated, that means that more gold is coming onto the market than industry and the jewelry manufacturers appear to need. There is no supply/demand imbalance, unless you count thousands of eager investors looking for more price runups or a hedge against inflation.

And is gold a reliable hedge against inflation? Since gold's peak in early 1980, the annual inflation rate dropped, but cumulative inflation increased--as gold was falling in value through the next two decades. According to InflationData.com, gold's 1980 peak spot price reached $2,250 if it were measured in today's inflation-adjusted dollars, and it dropped to an inflation-adjusted $370 two decades later. If gold had been an effective inflation hedge during that 20-year period, the price would have remained the same in inflation-adjusted terms.

The InflationData organization makes a good point: gold has been a lousy inflation hedge for long periods of time, but it does appear to be a pretty good "crisis hedge." That is, when people are frightened of events like the Soviet invasion of Afghanistan, as they were in 1979-1980, or when they are concerned about the global liquidity crisis and its economic hangover (as they have been for the past couple of years), gold takes off. When the panic subsides, so too does the price of the precious metal.

Of course, we can't predict whether the current fear of a double-dip recession or other nameless anxieties will continue to drive gold higher. But history suggests that as soon as people start feeling more secure about the world situation, gold will suddenly leave its investors holding significant losses.

The question we have to wrestle with is: if we invest in gold, are we investing, or speculating? If we're speculating, is the best time to do it at near-record high prices?

References:

Commodity Online interview with Perez-Santalla: http://www.commodityonline.com/news/Average-gold-production-cost-likely-to-be-$400-500-24530-3-1.html

MineWeb article on gold extraction costs in 2007:http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=112821&sn=Detail&pid=33

MineWeb article, October 2010: http://www.mineweb.com/mineweb/view/mineweb/en/page33?oid=112821&sn=Detail&pid=33

World Gold Council supply/demand statistics:http://www.invest.gold.org/sites/en/why_gold/demand_and_supply/

InflationData.com analysis of gold as an inflation hedge:http://inflationdata.com/inflation/inflation_rate/gold_inflation.asp

Chart of gold price runup in 1979-80: http://www.bullnotbull.com/archive/gold1980.html

Review of events in 1979: http://www.upi.com/Audio/Year_in_Review/Events-of-1979/1979-Business-News/12311692377023-5/

Various charts of recent gold prices: http://www.kitco.com/charts/livegold.html

This article comes to us courtesy of Bob Veres.