A Case for Gold by Navin Doshi (December 2002)

In Roy Jastram’s intriguing book, The Golden Constant, he mentions that anthropologists while studying ancient cultures discovered that gold has always been a constant for the appreciation of beauty, the storage of riches, or the exchange of goods and services. It is cherished and it is indestructible. It is never cast away and it never diminishes, except of course, by outright loss. It can be melted down, but it can never change its chemistry or its weight in the process. Consider this: the golden wedding band or class ring on your finger may contain particles of gold mined in the time of Egypt’s Pharaohs or India’s impressive Vedic civilization.

Gold broke the $300 an ounce mark several months ago and currently is around $325 an ounce while the Dow Jones Industrial Average is around 9600. You might wonder what’s so unusual about that? Well, generally, investors flock to precious metals when there are fears of inflation or catastrophe. The idea is that since paper money is losing its value at such times, hard assets, like gold, are safer. Historically, when hard assets are appreciating, financial assets (stocks and bonds) are lagging.

There are four extremes one needs to look at when investing. During deflationary periods bonds are good. In growth periods, growth stocks are good. In inflationary periods, hard assets, like real estate and collectables, are good. In a chaotic economic environment, which could involve war or stagflation, gold is excellent. Based on current economic indicators today, gold is the item to carry with you to migrate from a chaotic or bad economic situation, or even a country at war, to a place where stability exists. From the Jews fleeing Europe under Nazi persecution, to the Chinese fleeing Mao on the mainland to Taiwan, refugees have turned to gold as a secure asset.

Having crossed a major psychological barrier and breaking out of the trading range, the upside potential in gold appears very likely. As Jastram points out in his aforementioned book, gold is more universally accepted than any other material as a store of value. It is the ultimate reserve of value since nature controls its supply. Gold’s purchasing power is very nearly the same as it was in the middle of the 17th century, hence Jastram’s title for his book: The Golden Constant. Gold used to be a monetary standard. In America in the 1930’s the Yankee “greenback” was backed by gold at 35 dollars an ounce. Back then it was also illegal to own gold with the exception of gold coins. By 1969 under President Nixon, the gold standard was discontinued and today the American dollar is no longer backed by gold. To avoid abusing the monetary system, many conservatives still believe that we should go back to a gold standard. If that became the case, gold price would rise due to a higher demand.

Gold is unique because it is a credit risk free asset. Gold is also quite liquid and the supply of gold, or the lack thereof, appears to be at the root of this recent climb in gold. Investor’s Business Daily recently reported that many in India/Asia’s burgeoning entrepreneurial and middle classes have been putting their savings in gold rather than in inflated local currencies because they see it as a safe haven during the current world financial crises. Besides avoiding devaluation, gold in the form of jewelry often gets passed on quietly by people in this country as family heirlooms, thus avoiding costly gift or estate taxes.

Gold maintains its purchasing power over a long period of time. However, gold is not completely a good hedge against major inflation in a short period of time. The price of other commodities goes up much faster than gold because gold is not an essential commodity, like food or living spaces, which rise rapidly in inflationary periods. However, gold holds its value and its purchasing power in major deflation, or when confidence is lacking in local currency, and political situations are unstable. The price of gold grudgingly goes down in deflation and goes up slowly in inflation, but catches up with other essential commodities in long periods.

We currently are embroiled in a costly war against terrorism, both at home and abroad. The Middle East and South Asia are engulfed in terrorism turmoil, and America has projected plans for a possible invasion of Iraq. With the Enron fiasco among several corporate bankruptcies, and many technology companies going broke or about to go under (including major losses in AOL among others) we are seeing deflation in technology and information related companies. There is deflation in some segments of the economy and inflation in other areas like real estate and essential items. There are two very positive trends that could bode well for gold. Regulation is being reduced, thus making exploration more readily allowed. Plus, technology is helping reduce costs for mining companies.

Why is gold doing better today? There are many reasons. In the 1990’s traders were “shorting” gold. To sell gold “short” means to sell gold at a fixed price and use the proceeds to buy bonds paying 7 percent interest. When you short the borrowed gold there is a cost of less than 1 percent. If the gold remains at same price, a person selling gold short has made over 6 percent profit. Today that incentive is gone. Bond interest currently is around 4 percent. If the gold price increases over 4 percent, that will put the borrower in the red after paying the cost of borrowing. Therefore, the short selling of gold has diminished due to lower short term interest rates and rising gold prices.

A second reason gold maybe going up is based on contrary market sentiment. Wall Street and major publications have not encouraged investment in gold, even proclaiming in business publications like the Financial Times last year saying: “gold is unlikely to soar,” or other publications touting “there is no need for gold because it’s just a commodity,” and the like. Financial markets have been strong, keeping the gold market weak for the last 20 years. This trend appears to be reversing.

A third reason gold may be going up is the demand and supply equation. The law of demand and supply in economics is the supreme law just as the law of evolution is supreme in science. One corollary of the law of demand and supply is that money flows where there is a perception of higher return with acceptable risk. When the price of gold descended from a high of $800 an ounce in the late 1970’s to a low of $270 an ounce in the late 1990’s, top mining companies backed off developing new mines because of the lower price. This action has now contributed to a current supply crunch of gold and a current market perception that gold will always be supplemented by new mines, or central bank sales, or producer hedges. Currently, there is a tighter market because mining companies have stopped hedging. They see the price of gold holding or going higher. Mining companies are increasing their exposure to gold because they have determined based upon their research that gold now is in a bullish trend. In the words of investment guru, Marty Zwieg, “the trend is always your friend, and one should ride the trend.”

These corporate decisions to not hedge gold (not selling it forward), speak louder than the negative voices about gold on Wall Street. Gold producers are moving away from the practice of selling their delivery of the metal forward to lock in the current price. Such hedging stimulates the lending of gold by central banks and others, thus diluting any gold metal rallies. In the past central banks would let you borrow gold, but that tendency is slowing down. Banks are less inclined to sell if they believe prices are going up and when they see miners are not hedging. In the past, when the price of gold was flat or down, banks had more incentive to sell the gold. Today bankers are keeping their gold in reserves because the price is going up.

Another way of predicting gold could go higher is to predict its price using a ten year average. Based on gold’s ten year average of 350 dollars an ounce one could say gold is still well below its moving average. Some people even believe gold could go to 400 dollars. The gold price movement can be compared to a vibrating “stretch cord.” When you pluck a stretch cord the cord vibrates up and down around a stationary position. The price of gold does the same. Currently gold price is down so it should go up to the average price or even go higher.

A third indicator of gold prices rising is to look at the ‘ratio’ of the Dow Index to the gold price. When the Dow peaked in March of 2000 at 11,500, gold was valued at around 280 dollars an ounce. The ratio at that time (11,500/280) was 41. However, recall in 1982, when the Dow was 800 and gold was close to 600. That ratio in 1982 was 1.33. Currently the ratio of the Dow to gold is close to 30. Considering inflation and the GDP , the ratio should be around 16. The peak of the ratio of the Dow to gold price came around 1928, 1965, and the year 2000. The value of those ratios were 15,12, and 40. The bottoms of the ratio occurred at 1.5 in 1934 and 1980. The average of these five numbers comes out to be 14. So there is an implication the Dow has to go down or gold has to go up, or possibly both could happen.

There are many ways to participate in the potential gains in gold by buying either the index of gold mining companies (symbol: XAU), or purchasing the closed end fund (ASA), hopefully at a discount to net asset value. The closed end fund invests primarily in South African mining stocks which gives the added benefit of diversification and investment in stocks trading at lower valuations compared to other mining companies. A significant rally has already occurred in both of these issues, so one needs to be careful of timing. Note that one makes a lot more money buying mining stocks. Why? Mining companies make money when the cost of production is lower than gold price. When the gold price is rising the margin of profit is also rising. Many miners mine the metal from the ground, thanks to improved techniques, at a cash cost far less than 200 an ounce. If the gold price is 300 they’re making over 100 dollars each time they sell an ounce.

In summation, it appears that an investor should consider diversifying their portfolio by investing in gold. Buy the straw hat in winter not in summer. I try to buy when the supply is plenty at a lower price and sell when the demand is high. And as a true contrarian I believe the bullish trend of gold should end when you start seeing the headlines in popular magazines and the news expressing the bullishness in gold. As a native of India I have believed always, as most Indians do, that we have gold in the form of jewelry, for it is certainly one of the places to put money in a diversified portfolio.

More thoughts on gold:

One common aspect of gold & GOD has been the greed of wealth associated with gold & (power, control) connected with God and religion—wars have been fought over both. What’s emerging & coming close to the Absolute but also exists in nature? What is revered through human experience and is close to being unchanging? First is light. Man needs air, water, and food to survive. The worshipping of fire and sun goes back thousands of years. At the next level of existence, of human evolution is human interaction. It is the trade and medium of trade (currency)—closest that seems to be unchanging is gold—historically one of the most desired mediums.

When one compares gold with any other medium of exchange like paper currency, gold stands for permanence, beauty, honesty, stability and privacy. An ounce of gold is no one else’s liability. It is the physical manifestation of truth. Gold has never failed anyone owning it in matters of its value throughout human history. In nature’s pair of opposites, gold represents truth and permanence, closest to the concept of God. As opposed to paper currency which represents lies, fraud, deceit, and devilish attributes. For all of recorded human history, paper money degrades in time. The reverence Indians had for gold and silver, associating them with goddess of wealth Laxmi, was observed by Maynard Keynes. It was Indian hoarding that triggered Keynes’ mind towards his later discoveries of the fundamental macro-economic relationships between savings and investment which culminated in his General theory. Keynes learned a lot from India, and the world learned a lot from Keynes, as described in the book, A History of Money, written by Glyn Davies.

What with the current rise in value of gold and the deflation of paper money, one can see just how much trust has been placed in hard assets. The price of gold has been constantly fluctuation from a low $200/oz to a high $800/oz. When its value is low, fewer companies seek it, which in turn raises its rarity and value. As the 90’s featured the most recent low of $270/oz, gold price is soaring once again. However, inevitably due to this pattern of fluctuation, the price will unfortunately fall after a peak high is reached. What could be the peak? The range of the estimated peak has been as high as $2500 per ounce.

By Navin Doshi (December 2002)
(Mr. Doshi is a financial market trader, writer and a philanthropist)

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