Game Plan

by Kevin D. Freeman

  Gold sometimes fails in the short term to protect against inflation or disaster. James Pethokoukis of the American Enterprise Institute cautions, “Gold returns are surprisingly correlated with stock returns, suggesting gold may not be a reliable safe haven asset during periods of financial stress.” He also notes, “In time of crisis, you may not be able to get to your gold.” Unless it’s literally in your mattress, it’s not going to save you from the apocalypse.35

  While Pethokoukis is right about the short-term high correlation between gold and stocks, over time the correlation falls sharply. The reason is that in a panic, all assets can be sold if cash is needed, and gold is no exception. When the smoke clears, however, people will return to gold as a safe haven. Overall, we view gold as an essential part of long-term portfolios. Sometimes it acts as a hedge. Sometimes it acts as a store of value. Sometimes it acts as an insurance policy. Sometimes it is a drag on performance results. But it is a good thing to hold as part of a portfolio.

  Where Is Gold Headed?

  I just said that it’s very difficult to predict where the price of gold will go. So now let’s try to predict where it will go.

  If the currency collapses or there is a return to a gold standard, the price per ounce could go to $5,000, or even $7,000. That’s the opinion of Jim Rickards, the author of Currency Wars, who sees the dropping price of gold as an indicator of the weakness of the dollar:

  So today [in the summer of 2013], with the dollar price of gold coming down very sharply in recent months, what that tells me is that if gold is constant, then the dollar is getting stronger. Well, think about it. The Fed wants a weaker dollar to create inflation, but they are getting a stronger dollar, which is deflationary. The Fed is actually getting the opposite of what it wants. It’s a pretty scary thing when a central bank wants inflation and they can’t get it. That shows you how powerful the deflation is, and that’s what the price of gold is telling us.

  That leaves the Fed with two options: stop inflating the currency, or blow up the inflation to record proportions. And Rickards thinks he knows which way this one will go: “[I]n the world where the Fed gives up and deflation takes over, gold could go to, let’s say, $800 an ounce, but the problem is, the S&P will be at 800 also. . . . But I don’t think the Fed is going to do that. I don’t think they are going to throw in the towel. What they will do, as I said, is to try harder.” That means inflation, and a real increase in the price of gold again.36

  Rickards isn’t the only one. MacNeil Curry, head of foreign-exchange and interest-rates technical strategy at Bank of America Merrill Lynch, said in September 2012, “We will be focusing on gold. Ultimately we think gold can trade between $3,000 and $5,000 an ounce going forward. Certainly not within the next few months, but on a long-term basis we are on a well-defined uptrend, and we have got more to run before that runs its course.”37

  There is a question, though. If growth and higher interest rates kick in, who needs gold?

  The argument here is that we could return to a 1980–1999 style economy, when gold prices fell about 70 percent from their high. Does this mean that gold could fall to just over five hundred dollars an ounce? Absolutely, especially if central banks felt confident enough in the paper moneys of the world to use them as reserve currencies. Some respected analysts believe that this will happen, and they suggest gold has been in a bubble.

  Michael Novogratz of Fortress Investment thinks that gold is in a “classic bubble” that could drop to five hundred dollars an ounce. “I personally think gold is toast,” he says. “We peaked out at $1,900 two years ago.”38 Interestingly, a drop to five hundred dollars would simply be a return to 2005 price levels. Of course, for gold to drop this sharply, we would expect to see some real positives, including a further run-up in stock prices. Those who hold a portion of their assets in gold would be disappointed in their holdings but likely pleased with their overall portfolio.

  There are some fundamental factors that cut in favor of gold ownership. The cost of producing gold has risen. In mid-2013 the average cost to produce an ounce of gold (“all in” costs) was approaching a thousand dollars.39 This cost may provide a floor under the price, as yearly demand for jewelry is substantial and the supply from people “cashing in their gold” will drop with the lower price. Of course, central banks can supply a great deal of gold, as can frustrated investors. Over the longer term, however, we would expect the price to match or exceed the costs of production.

  The Untold Risk

  One of the problems with a full gold standard is that the money supply needs to grow with the economy. But, the supply of gold doesn’t increase or decrease at a set rate. There can be new finds, and old mines can run out. Would our lives be substantially better if someone discovered a massive supply of new gold under the ocean or on an asteroid? Or would such a discovery have the same effect as doubling the supply of paper money? What if we suddenly discovered an amount of gold greater than several moons? Some scientists believe that is how much gold was formed with the collision of two exotic stars thousands of years ago, as reported in USA Today:

  A team led by Harvard astronomer Edo Berger now reports that gold is likely created as an aftereffect of the collision of two “neutron” stars. Neutron stars are themselves the collapsed remains of imploded stars, incredibly dense stellar objects that weigh at least 1.4 times as much as the sun but which are thought to be less than 10 miles wide.

  Observation of the cloudy aftereffects of the burst suggest that each merger of two neutron stars produces several moons worth of gold by weight. “At today’s prices, that amount of gold would be worth 10 octillion dollars,” says Berger. (That’s $10,000 trillion-trillion or $10,000,000,000,000,000,000,000,000,000, for anyone counting.)40

  So much for the scarcity factor if true. The question is, how much of that gold will we find on earth or in space?

  Milton Friedman argued that the ideal rate of growth of the money supply is the rate of economic growth (which includes population growth). It is highly doubtful that the amount of gold above ground would ever grow at exactly the rate of the economy. And, as we have noted, if the United States based its economy exclusively on gold, could foreign governments manipulate the price or supply to affect our economy?

  There does appear to be an effort, or at least strong rumors of one, by Russia and China, supported by other BRICS nations, to create an alternative global reserve currency backed by gold, as we’ve discussed. This effort appears even more ominous as China and Russia have declared their relationship the most strategic ever on the planet.

  So it all gets complicated and confusing. When is the ideal time to own gold? Is there ever a time to sell? Is there a time to go short? This will require a very careful reading of global markets, and even then it involves a good deal of short-term insight (or at least luck). If you want to own gold, and we believe it prudent for at least a part of your portfolio, consider owning other precious metals as well. Include silver, which has so many industrial uses and could partially offset the manipulation of gold. There are good reasons, actually, for owning silver instead of gold. It’s cheaper and easier to monetize. European states can’t sell silver, because they don’t own it. Other precious metals with substantial industrial uses are also great diversifiers.

  How to Own: Diversify

  Diversify by owning several precious metals and owning the metals in various forms. Own the bullion, coins, and jewelry. You can also buy mining stocks, ETFs, and a variety of other assets. Each has different pluses and minuses. It’s probably worthwhile owning some bullion—physical silver and gold. Unless you know what you’re doing, don’t mess around in the volatile futures market.

  There are tax implications to owning gold, too. Gold can be held as tangible property or intangible property, capital gains, or personal business. Normally applicable property taxes may not apply to gold, since it is movable. Until ownership changes, federal taxes don’t kick in. Some U.S. states, however, do tax ownership of precio
us metals. Proceeds from sales are taxable as capital gains.

  In the end, gold is not the only answer, and it can be painful in the short term—but you should own some. It’s ideal as a long-term non-correlated asset; it’s like an insurance premium that can pay off in disaster. By the same token, too much of it in your portfolio can be a drag on your performance. How much you should own is largely dependent on your investing style, age, and needs. Professionals should help you determine how much gold to own.

  In an uncertain world, however, don’t hold a portfolio without it.

  CHAPTER SIX

  What about Stocks?

  The 2008–2009 market collapse centered on the stock market. Many who had bought shares during the technology bubble a few years earlier finally threw in the towel in early 2009, when the Dow Jones Industrial Average sank to 6,500. The stock market has become synonymous with financial collapse as a result.

  But this does not mean that stocks should be avoided in every financial crisis. In fact, the stock market can be an extremely useful hiding place for wealth under a number of circumstances. To avoid it or ignore it can be a huge mistake.

  To understand what role stocks can play, it is important to know what the stock market is. The stock market is an exchange mechanism where investors can buy and sell shares of companies. A share represents ownership with various rights, privileges, assets, and earnings. Being a stockholder, in its simplest terms, is owning a fraction of a company. Those who say they would never invest in stocks are essentially saying that they don’t want to own companies.

  So why do companies sell shares of themselves? The first reason is to raise money. There are only three ways for companies to raise money: sell a product, issue debt (borrow money), or sell stock. That money is then used for growth . . . we hope. At least that’s how it used to work when ownership of companies was generally united with executive leadership. In the age of widely diversified public companies, however, executives are often separated from ownership, meaning that their interests do not always align with those of the stockholders—hence golden parachutes, bad management decisions, and short-term values overwhelming long-term interests.

  So when is it smart to invest in stocks? How can you tell a good stock from a bad stock? Is the stock market the magical money machine that so many seem to think it is? Or is it a rigged casino designed to strip you of your hard-earned wealth?

  Benefits of Stock Investment

  Most financial planners will tell you that the stock market should form the biggest part of your financial portfolio. They’re right for most people. Benefits of investing in the stock market include:

  Liquidity: Unlike many hard assets—real estate, for example—stocks are generally tradable immediately and quickly. Stocks trading on the major exchanges, not merely on the over-the-counter market, often have a broad market with thousands or even hundreds of thousands of ready buyers. You aren’t going to get trapped in stocks, except in very rare cases. You’ll be able to cash out your chips.

  Market pricing: The stock market is unusually stable over time. Actually, it’s better than stable—given long enough, it has always risen. In October 1929, when the stock market crashed, the Dow Jones Industrial Average dropped from 381.47 to 198.69, then tumbled all the way down to 41.22 by the end of 1932. Disastrous, right? Only if you sold. Thanks to government interventionism, the stock market remained at about 150 at the end of 1939. But by 1960 it was all the way up to 680. By 1980 it was at 840. And by 2000 it was up to 11,500. That exponential growth is due in part to the growth of corporate earnings with new industries and opportunities emerging, but it’s also due to inflation. In general, the stock market benefits from continual addition of information and discovery.

  An increasing number of people are investing in the stock market, meaning that every company is owned by a vast network of human beings, all adding information to the system. Many economists therefore subscribe to the efficient markets hypothesis (EMH), which holds that you can’t truly beat the stock market, since at any point in time all the relevant information available on a given company has been entered into the system. As we’ll see, that’s not entirely the case, especially under the current trading rules, which often encourage secrecy from the public. The rise of trading formulas as opposed to human investigation of the inherent worth of particular companies has also undermined the notion of fully efficient markets.

  Ability to diversify: Unlike cash or gold, the stock market allows you to offset your own risk. Imagine that you’re betting on horses (although in stocks, you hope, you’re not betting at all—you’re believing that a company’s leadership will allow it to separate itself from the market and create profit). You have three horses. Let’s call them Apple, Microsoft, and Blackberry. Now, you could bet on one of them to win. Or you could put money on all three horses. You’ll have a better shot at risk mitigation if you put money on all of the horses. Stocks are like that, except that you don’t have to diversify within a given field. Think that green stocks are hot? Buy a solar energy company . . . but then buy Chevron just in case. Diversification will help prevent you from going broke.

  Business ownership . . . from a distance: You don’t have the time to manage somebody else’s business. You’re not Mitt Romney, a specialist in turnarounds, or Warren Buffett, a specialist in capital maximization. But you know you like a certain company, or your brother-in-law does. Stock ownership allows you the perks of ownership without the headaches of management. That’s why executives are paid so much to run companies—they’re running those companies not only on behalf of the employees and the customers but also on behalf of thousands of owners. They’re legally responsible for the actions of the company, while you aren’t. You may feel the pinch when it comes to the price of your stock, but until then, you’re happy. And you’ll never go to jail unless you traded on inside information.

  Potential for high returns and ability to share in profits: This is the biggest reason people buy stock. Most people think of Google when they buy a stock—will it make me a millionaire in a few years? Generally the answer is no. Stocks are for long-term ownership. Unless you were one of the few who got in on the ground floor at Google—meaning, before it went public—you have earned a truly great profit, but you haven’t quit your day job. Google stock debuted at one hundred dollars per share and has since traded above nine hundred dollars. Unless you sank $100,000 into the stock in the first place, you’re not hiring a decorator for your place in the Caymans. But over the course of your life you might. Imagine the man who bought stock in General Electric in 1979, when it cost about a dollar. GE isn’t even doing that well these days, and it still trades at around twenty-five dollars per share. If that man had spent the last thirty-four years investing in other companies like GE, he’d be solid in his retirement plans. That’s the principle behind a 401(k) plan—invest now, reap the benefit later. It’s the reason that Republicans have proposed opening private accounts for future Social Security beneficiaries rather than continuing to operate the Ponzi scheme that is Social Security, in which Social Security taxes earn near zero return.

  Delayed taxation: When you buy a stock, you generally aren’t taxed until you sell it. When you lose money on a stock, you can offset gains from other stocks with that loss. That’s not true for bonds or a bank account, the interest from which is taxable every year. Were you wondering why Mitt Romney paid an effective tax rate of 14.1 percent on an income of $13.7 million in 2011? The answer is that capital gains are often taxed at a different rate than earned income. Earning makes you comfortable. Investing can make you rich.

  What are people talking about when they say that “the stock market” rose or fell? They’re usually referring to the Dow Jones Industrial Average, which tracks the stock prices of thirty large companies from a broad range of industries, such as Boeing, Coca-Cola, American Express, and Wal-Mart. It is important to remember that the Dow represents only thirty companies, and makeup of the Dow changes over time. In fa
ct, when Charles Dow created the average in 1885, it comprised fourteen stocks, twelve of which were railroads. In 1896, the average shifted to a broader array of industries. Of the twelve stocks chosen for inclusion at the time, only General Electric remains in the average today. Others, such as U.S. Leather Company, no longer exist.

  The changing composition of the Dow reflects an important characteristic of the stock market: it evolves and adapts over time. Today’s opportunities are vastly different from those of a hundred, twenty-five, or even ten years ago. A century ago an investor might have chosen the proverbial buggy-whip maker or invested in the emerging, disruptive industry of automobiles. And depending on the buggy-whip maker, you might have done okay for a few decades—the Saturday Evening Post profiled one in 1931, reporting that the “oldtime whipmaker, still doing business in an eastern city, is carrying on in a way that contradicts the notion his vocation is a disappearing trade. His yearly production includes not only 10,000 riding crops, but also policemen’s billies, polo mallets, fly flickers made of horses’ tails, sword loops, and revolver holsters which permit one to shoot from the hip. Constant research aiming at new and better products is the cornerstone of this man’s success in a century-old business.”1 Of course, you’d have done a lot better if you’d invested in Ford.

  The stock market forces business evolution. And business evolution means better products, more profits, and better stock value.

  Today’s opportunities are even wider and more diverse. For example, you can buy organic food companies, heart-transplant-device makers, gold miners, electric utilities, biotechnology companies, movie studios, gun makers, space travel providers, and just about anything else you might imagine. You can buy stocks in a variety of industries and countries. For example, you can buy German telecommunications, Singaporean water companies, Brazilian oil producers, or American retailers. Estimates are that there are 112 stock exchanges in the world and close to fifty thousand stocks available. The largest of those exchanges represented some $55 trillion in stocks and over forty-six thousand companies at the end of 2012.