The advantages of investing in gold, the real money

“Betting against gold is the same as betting on governments.
He who bets on governments and government money bets against
6,000 years of recorded human history.”
--Charles de Gaulle

There is much confusion today over the role of gold. It is viewed as a commodity, as an investment, as a position to be traded. But if we set aside these preconceived notions and examine why gold and precious metals are resuming their historical role as money the world over, if we establish a gold mindset, we will see that their real value lies in forming the foundation of an investment portfolio, because precious metals provide the ultimate in wealth protection.

While gold is a commodity that has multiple industrial uses in the fields of electronics, engineering and medicine to name a few, it is much more than that. Quite simply, gold is money. Throughout history there have been many forms of money, from salt to grain to shells to the fiat (paper) currency that is used today. Most don’t stand the test of time. Gold, however, has endured as money for over 3,000 years. This is because it meets all the criteria for money, where others have failed.

To satisfy the functions of money, an item must be a unit of account, a medium of exchange and a store of value. Gold is all of these things; it is durable, portable, divisible, consistent, intrinsically valuable and, of crucial relevance today, it cannot be created by central banks. Gold is a tangible asset; fiat currency is merely printed paper created by government decree. It is only the promise written on the paper that gives it any value. Paper money is not a store of value; both the US dollar and the Canadian dollar have lost over 82 percent of their value since 1971.

Gold is traded on the currency desks of banks, not the commodity desks. The financial institutions of the world understand gold is money. The daily turnover in gold at the London Bullion Market Association is over $20 billion, but the actual volume traded is estimated at five to seven times that amount. This isn’t jewelry being traded, this is money. Central banks hold gold as part of their reserves, they understand gold is money, and since 2009 have become net buyers of gold for the first time in decades.

The financial debt situation in the US has become unsustainable. In 2010, US federal revenue was $2.16 trillion. Today, total outstanding public debt is $14.3 trillion and growing at a rate that nearly equals revenues. However, if we include unfunded liabilities such as Medicare obligations, Social Security obligations and military and civil servant pension obligations, the real total amount is over $120 trillion. It is not remotely realistic to assume that the US can support or repay $120 trillion of debt with $2 trillion of revenue. Is this situation being taken seriously? The answer is no, the US is driving past the stop sign and through the red light. This year, the US has distinguished itself by being the only advanced economy to increase its underlying budget deficit in 2011.

If we take into account over-the-counter (OTC) derivatives, the situation is even more dire. Total OTC derivatives – conservatively estimated - amount to $600 trillion (several sources say it is closer to $1 quadrillion). This is an incomprehensible number considering that world GDP is only $60 trillion. How is this possible? Using the conservative number of $600 trillion, the entire world’s GDP is swallowed if 10 percent of the $600 trillion fails and requires a bailout. Renowned gold commentator Jim Sinclair describes the characteristics of OTC derivatives and I’ll paraphrase. OTC derivatives are:

1.Without regulation;
2.Without listing on a public exchange, there is no open market for bid/ask;
3.Not transparent;
4.Dealt in private treaty negotiations;
5.Unfunded without financial guarantee of any kind;
6.Ability to pay dependent on balance sheet of the loser;
7.Evaluated by computer assumptions that assume all markets return to normal relationships regardless of disruptions;
8.Notional value becomes real value when the agreement is forced to be sold;
9.85 percent of OTC derivatives are interest-rate sensitive.
Does the fact that there is a minimum of $600 billion of these “weapons of mass financial destruction” (Warren Buffett) concern anyone?

So, is it remotely realistic to assume that the US can support or repay $120 trillion of debt with $2 trillion of revenue? The answer is no. The debt, the unfunded liabilities and the potential/probable percentage of further OTC derivative failure bailouts cannot be supported without resorting to QE3, 4, 5 and so on.

The US is “cash flow insolvent,” as they can no longer meet their debt obligations on time as they become due. If it were not for their ability to monetize trillions in debt and bailouts via the printing press, this saga would have been over many years ago. The debt has been kicked down the road and it will only get worse as time goes on. Accept the pain now and it will hurt. Delay it and it will be extraordinarily painful.

While the rate of increase in money supply is increasing, the concept is nothing new. The Federal Reserve has expanded money supply since 1971, when the US came off the gold standard, from $776.6 billion to $13.937 trillion as of December 2010. The increase of currency has become exponential and is already leading to inflation sweeping throughout the economy. This ‘scheme for the confiscation of wealth,’ as former Federal Reserve Chairman Alan Greenspan described inflation in 1966, has been devouring purchasing power ever since the gold standard was cut.

 In fact, as the rate of money supply increases, so does the devaluation. All the world’s major currencies have lost between 70 and 80 percent of their value compared to gold in the last decade alone. Gold, meanwhile, has gone up nearly 4,000 percent since 1971. In truth, it is not only gold that is rising, it is currencies that are depreciating compared to gold.

In a magnificently researched book, This Time is Different: Eight Centuries of Financial Folly, Carmen M. Reinhart and Kenneth S. Rogoff found that serial default on external debt – that is, repeated sovereign default ¬– is the norm throughout nearly every region in the world, including Asia and Europe. Default is likely to be accompanied by a currency crash and a spurt of inflation and, historically, significant waves of increased capital mobility are often followed by string of domestic banking crises. These crises tend to occur in clusters and one type can easily trigger another. Real estate bubbles invariably give way to banking crises. Losses in the financial sector are followed by a sharp deterioration in government finances amid bailouts and decreased tax revenue. The decline in economic output that follows the bust is sharp, but the recovery tends to be slow and protracted. The situation is especially dire when the crisis is geographically widespread.

Someone once said that there are no new things, just the same things happening to new people. This time is not different, yet it seems like many of us are blissfully unaware of the severity of the issues and not adequately preparing to benefit from this crisis. Yes, I said “benefit”. The investment winds are always blowing in some direction and we have to set our sails accordingly. Inflation lies ahead and history shows that, under inflationary circumstances, allocating to precious metals is a wise move.

When we consider that total global financial assets are estimated at over $200 trillion, but total global above-ground investment gold is a modest $3 trillion, and only growing by approximately 2,400 tonnes a year, we can see that once a shift towards gold occurs, there will be too much fiat currency chasing too little gold. This will continue to have a profound effect on the price of gold.

Embracing a gold mindset, however, can be difficult. People have preconceived ideas concerning gold that prevent them from evaluating it with an open mind. If we look at the most common gold myths, we will see they do not stand up to scrutiny.

Gold does not pay dividends
Gold is money, not an investment. No money pays dividends or interest until you put it at risk. Unlike stocks or bonds, gold cannot go to zero and unlike fiat currency, gold maintains its purchasing power.

Gold is a bad investment
Since 1971, when the gold standard was cut, gold is up nearly 4,000 percent. The Dow is up 1,412 percent. Even over the last decade, gold is up 378 percent while the Dow is up just 1.33 percent. During the financial crisis of 2008, gold outperformed equity indices in every major country in the world.

Gold is a risky investment
If we look at volatility, which is a measure of risk, we see gold has higher returns and lower risk and volatility than every single Dow component. Gold is the most negatively correlated asset class. A portfolio with only positively correlated assets such as stocks, bonds and cash cannot be diversified or be considered lower risk than a portfolio with a negatively correlated asset class.

An appropriate allocation
We have seen that once preconceived ideas are abandoned and a gold mindset is embraced, it becomes clear that gold should form the foundation of an investment portfolio. The question then becomes, how much gold should be allocated?

According to a 2005 Ibbotson Associates study, a 7 percent allocation to gold is needed in a mainly conservative portfolio, and a 16 to 17 percent allocation is required for an aggressive portfolio. That’s simply to have a balanced diversified portfolio, or what may also be known as strategic allocation.

From a tactical allocation standpoint, Wainwright Economics looks to gold as being a leading indicator of future inflation. When you have a high inflation environment, which the ongoing creation of fiat currency around the world all but guarantees, their conclusion is that you need 17 percent in a bond portfolio, and 40 percent in an equity portfolio, just to break even against inflation.

There are three dominant short-term trends that will drive the gold price this year and beyond: central bank buying, movement away from the US dollar, and the China effect. We have already seen how fiat currencies are losing value and being debased. In November 2010, China and Russia decided to renounce the US dollar and resort to using their own currencies for bilateral trade; the days of the dollar being the world’s reserve currency are numbered. In 2009, central banks became net buyers of gold for the first time in two decades. They understand the issues facing fiat currencies and are moving to protect their countries’ wealth. They understand that gold is money. The Chinese are one step ahead in terms of gold. They have already adopted a gold mindset. In the first two months of 2011, the Chinese imported 200 tonnes of gold, as much as the entire previous year. This was just individual investor demand, not central bank demand, which we know is also growing.

There are also three long-term trends that will support the price of gold for decades: an aging population, outsourcing and peak oil. For a full analysis of these long-term trends, as well as more information on the short-term trends, open-minded readers can read the BMG article, “Gold Outlook 2011: Irreversible Upward Pressures and the China Effect”, free of charge, at www.bmgbullion.com/document/806.

“The gold standard, in one form or another,will prevail long after the present rash of national fiats
is forgotten or remembered only in currency museums.”
--Hans F. Sennholz

It is only a matter of time until gold becomes universally recognized as money, and appreciated for its wealth preservation qualities. As this occurs, demand will surge. Savvy investors can benefit now by protecting their portfolios and their wealth and allocating to real money – gold.