Bonds and Gold

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I’ve been surprised to see both gold and bonds do so well over the last decade.  After all, deflation and inflation are opposites: when one performs well the other usually doesn’t.  This makes bonds and gold both doing well a bit of a paradox. 

But in today’s mixed message environment, it makes sense from a certain perspective.  Investors are running scared.  They seek safety in some form–any form. 

They correctly see that bad debt (lending which can’t be repaid) leads to deflation, so they want to own bonds as protection.  Just look at Japan over the last 20 years: bonds performed much better than stocks.  Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services.  Witness Weimar Germany in the 1920’s or the United States during the 1970’s.  In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works…until it doesn’t.  Let’s look at what Paul Harvey called “the rest of the story.” 

Bonds were a lousy investment from the bottom of the Great Depression until the 1970’s.  Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany…until hyperinflation ended.  Then it tanked.  Same with 1970’s inflation here in the U.S.: gold was great…until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing.  It only pays to ride the wave as long as you know exactly when to get off.  Getting the timing wrong–even by a little–will lead to poor results.  But, in case you don’t know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it). 

Warren Buffet doesn’t time the market.  Neither did Peter Lynch.  Look at the Forbes 400 some time and scout out the market timers–you won’t find a single one.  Trying to time the market doesn’t lead to permanent wealth–it leads either to temporary or decreasing wealth.

Which is why most investors shouldn’t focus on bonds and gold.  If you can time the market perfectly–and good luck on that–you can ride bond/deflation or gold/inflation.  If you are a mere mortal, then don’t try juggling nitroglycerin. 

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do–buy productive assets at cheap prices, which is when everyone hates them.  Productive assets are things that generate cash.  Gold doesn’t.  Bonds do, but the cash they generate isn’t protected against inflation (except for TIPS, but they have their own problems).  You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc.  These are assets you put money into and get back over time.  They can adjust to both inflation and deflation. 

Does that mean they do well in all markets?  NO!  Investing is not about what does well over a week, month, quarter, year, or even 5 years.  You invest for the long term, not for a short term kick-back–that’s speculation!

But, producing assets work like a charm during both inflation and deflation.  Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation.  They do poorly initially, but work very well over time.  That’s because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while…until they get slaughtered.  The cycle on bonds and gold tend to turn very quickly.  It will only be obvious in hindsight that the tide has turned–and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well–over the long run–regardless of whether we experience inflation or deflation.  That’s how I’m betting.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds and Gold

Gold is money, but that doesn’t make it a sound investment

“Gold is money.  Everything else is credit.” – John Pierpont Morgan

I must admit, I’m a bit of a gold bug. 

After studying economic and financial history for over 16 years, it’s quite clear to me that wealth is not pieces of paper, but economic goods.  And money–as a store of value or medium of exchange–is not pieces of paper, either, but an objective equivalent of wealth freely chosen by economic participants. 

Over thousands of years of human history, economic actors chose first rocks and cattle, then base metals like copper, and finally precious metals like silver and gold as mediums of exchange. 

Governments, starting with Croesus in Greece, started minting coins of precious metal not because they arbitrarily decided what money should be, but because market participants were already using it and they grabbed the market for themselves (not for the first or last time, I might add).

After seizing that market, every government has proceeded to debase money by reducing the amount of precious metal in coins, and every time economic participants have adjusted their actions accordingly, revealing the debasement for what it really is–inflation.

Every time, inflation got out of hand and led to price controls that, as always, caused shortages instead of reducing inflation.  And each and every time, this led to a slowing and contraction in economic growth that eventually led people to demand money backed by specie–metal or metal-backed currency.

Both the Chinese and French boldly tried paper currency only to find it yielded the same disastrous result as metal coin debasement–but faster.  Since the 1930’s, U.S. currency has not been redeemable in specie.  Since the early 1970’s, U.S. currency has not been backed by specie at all.  Want to guess why the 1970’s witnessed a huge spike in inflation?

Look at a dollar bill some time and you’ll see written across the top “Federal Reserve Note.”  A note, for those of you who don’t live on planet economica perpetua (I do!), is a debt instrument–in other words, credit.  As Mr. Morgan put it, gold is money and everything else is credit.

With that overlong introduction, you get an idea of why I believe gold is money.  But, let me be clear, that doesn’t necessarily make it a good investment.

I think Warren Buffett put things clearly when asked a question about inflation protected assets at his most recent annual meeting.  He noted that there were three types of assets: 1) assets backed by currency, like dollars, euros, bonds, savings accounts, 2) assets backed by something tangible, like gold, art, antique cars, diamonds, land, and 3) producing assets, like stocks, farm land, rental real estate. 

In an inflationary scenario, you can expect the first type to lose value (perhaps badly), you can expect the second to maintain value, and you can expect the third to grow in value.

I place gold firmly in the second category, which makes sense.  You expect gold to maintain value regardless of inflation, but you don’t expect it to grow in value relative to the value of other things.  Gold is money, so it is a store or protector of value, not a grower of value. 

You do, however, expect the third category to continue growing regardless of inflation, because it throws off economic value.  Instead of being debased, like currency denominated assets, or maintaining value, like tangible assets, you would expect producing assets to continue producing. 

A farm continues producing corn, regardless of how corn is priced.  Stocks are priced in terms of earnings, where revenues and costs adjust to changing prices over time.  Rental real estate rates adjust to underlying currency, whether dollars, dinars, or drachma.  You get the idea. 

I know gold is money, but that doesn’t make it a great investment.  Gold may preserve value, it may provide insurance against negative outcomes, but gold is not a producing asset.  You may speculate in gold prices, but that’s not investing.  For my money, I want growth, not standing still or speculation.

Gold is money, no doubt, but that doesn’t make it a sound investment.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Gold is money, but that doesn’t make it a sound investment

Mixed up markets

When most people think of “the market,” they think of the stock market.  But, there are other markets that are equally or more important to pay attention to.

For example, bond and currency markets are bigger than stock markets.  Commodity markets are important, too, but most people ignore them.

Why are other markets important, you may ask?  Because they frequently bring warnings of contradictory premises held by different participants in each specific market.

In a normal state of affairs, currencies and gold should move in opposite directions.  That’s what’s happening right now, especially with gold flying high and the U.S. dollar crashing.  All good there.

Normally, commodities move opposite the dollar.  Commodities have been soaring and the U.S. dollar is tanking, so everything looks as it should there, too.

Next, we come to bonds.  Bonds and commodities normally move opposite each other, and here we run into our first contradiction.  Commodities are soaring and bonds are climbing, too.  The first indicates inflation and fast economic growth and the second indicates deflation and slow or declining economic growth.  Both markets can’t be right.

Furthermore, commodities and stocks usually move opposite each other, which is just another way of saying bonds and stocks tend to move together.  Climbing commodities indicates inflation and high interest rates (lower bond prices) which both tend to be bad for stocks.

Don’t get me wrong, I’m not saying these relationships exist at all times and all places.  But, when I see markets seeming to indicate different opinions, I take notice.  It means markets are mixed up and one will turn out to be right and the other wrong.

Things are pretty mixed up right now.  The dollar is sinking, commodities are climbing, as are stocks and bonds. 

The dollar is sinking because the Fed is going to print money to try to further revive our flagging U.S. economy.  That means a lower U.S. dollar, higher inflation, and rising commodities and gold.  So far, so good.

But, a lower dollar, higher inflation and rising commodities is inconsistent with high bond and stock prices.  High inflation is bad for bonds and stocks.  That contradiction must be resolved.

To further muddy the waters, rising bond prices usually correspond with higher stock prices, but not super high bond prices.  Super high bond prices means very low bond yields, which tends to indicate low growth, deflation and economic stagnation.  And, that’s usually NOT a recipe for higher stock prices.  As illustration, Japan’s bond prices have gone up for 20 years while its stock market has lost 75% of its value. 

Bonds are indicating slow or negative growth and stocks are rallying, and that doesn’t make sense.  Bond markets are right more often that stock markets, so the on-going stock rally might be in danger. 

High gold and commodity prices and a falling U.S. dollar should mean lower bond prices and high bond yields (a.k.a. inflation).  Once again, this contradiction must be resolved.

Over time, all markets will sync back up again.  Either bonds and stocks will tank and the dollar will continue to fall; or, commodities and gold will tank, the dollar will rally, and stocks and bonds will continue to rise.  It may take time, but markets will re-achieve consistentency.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Mixed up markets

Picking natural resource investments

It’s hard to avoid headlines about the price of natural resources.

Oil has been hitting new highs almost every day this week. Iron ore and coking coal have become hot investments because they’re major inputs for steel production. Even stodgy agriculture is seizing the headlines.

So, how should one go about picking a natural resource investment to benefit from the boom?

First, it’s probably too late to join the party because prices reflect a lot of the boom already. There may be some bargains to be had, though, if the global economy continues to slow down.

What should one look for in a natural resource investment?

The first thing I like to find is low costs. Low cost producers, especially in commodity products, have a huge competitive advantage. The companies with the lowest costs to extract oil, gold and iron ore, or produce wheat, soybeans and corn will exhibit higher profit margins and returns on capital.

Scale may be one reason for such an advantage. Another may be a proprietary production process or unique access to geologic locations. Yet another may be a management team that can motivate and hire more productive employees. One of the most important advantages is a management team that knows how to allocate capital to the best returning projects.

The second thing to consider is the sustainability of such costs. Some advantages are easily competed away as soon as others recognize them. To benefit from a specific cost structure, it must be sustainable over time.

One example is oil sands. Oil sands have much higher costs of production than other oil extraction projects. But, they have reserve lives of 50 years versus reserve lives of 10 to 15 for most large, integrated oil companies. (full disclosure: my clients and I own a position in an oil sands company)

Low costs and the sustainability of a cost structure are very important in looking for natural resource investments. Does that mean you should find the company with the lowest, most sustainable cost structure and purchase it? Emphatically: NO!

It depends on the price you pay for that company. The math behind investing is simple, but not easy to implement. To find the best investment, you have to compare the economics of a business to the price you pay for it. Frequently, this means buying a second tier company whose price doesn’t currently reflect its cost structure and sustainability. The best company in an industry rarely goes on sale for a rock bottom price.

Picking a natural resource investment requires a focus on the economics of a business and its sustainability, its management, and its price relative to economics and management. If that sounds like a generalization for picking any investment, that’s because it is.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Perhaps the Fed should include food and energy prices in inflation?

Since the late 90’s, oil prices have rocketed over 1000%. Riots are occurring around the world because of shortages of such staples as rice and wheat. Even Costco and Sam’s Club are rationing rice consumption here in the U.S.!

If the cost of such fundamental necessities as food and energy are going up so much, why do economists and the Fed believe that inflation is stable and at acceptable levels?

Quite simply, they don’t include food and energy prices in their calculation of “core” inflation (that sounds like the same game as reporting “operating” and “pro forma” earnings that companies were criticized for 8 years ago).

You see, food and energy prices are very volatile, and most of the time their movements make inflation look uncomfortably unstable.

But, what happens if food and energy prices are rising because of real, no kidding inflation? The Fed and most economists have no way to adjust for this. Don’t be surprised, though, if they finally get around to adjusting long after we’ve all been beaten down by “non-core” inflation.

I’m no economist, but I think I understand what makes for a stable currency.

The central banks of the world run the printing presses, and they can print dollars (euros, yen, bahts, pesos, reals, etc.) at almost no cost. This doesn’t create value, mind you. What it creates, when dollars are printed faster than underlying growth, is inflation.

In my humble opinion, that’s what we’ve been experiencing at a faster and faster pace over the last 10 years.

The central banks of the world reacted to the Asian contagion by printing more money. Then, they reacted to the fall of Long Term Capital Management with more money printing. Y2k (remember that “crisis”?), more money printing. Telecom, technology and dot-bomb crash, print more money. Housing crash and credit crisis…you get the idea.

I don’t think energy and food prices are running up temporarily, I think this is the slow bubbling up of inflation created by the world’s central banks over the last 10 years. You can see it bubbling up through the economy from energy to metals to transportation to food.

The easiest place to see this is in the price of gold, which bottomed at around $250 and ounce in the late 90’s and is now 360% higher (after peaking 400% higher). Or, look at shipping rates. Or, look at base metals prices. Or, look at iron ore and coke used in making steel. Or, look at wheat, rice, etc. Do you suppose chicken, beef and pork could be next?

Think what you’d like about government bailouts and stable currency, I believe we’re getting more and more inflation.

Could this all be the result of higher demand, especially from China and India? In the short term, yes. In the long term, no. That’s where the rubber meets the road from a forecasting standpoint. If demand is the cause, then profits and innovation will eventually drag prices back down, as most economists are betting will happen. But, if part or all of the price rise is due to inflation, then expect prices in general to stay higher.

How long before central banks and economists start adjusting inflation for food and energy costs? Don’t hold your breath.

I’m expecting prices to go up long term, even if they take a breather as the U.S. and global economies slow down. In time, though, we’ll all have to recognize that prices are probably permanently higher, and the it’s the result of inflation caused by our central banks. When people start to more generally recognize this, higher interest rates will be another thing to deal with.

Investing in such an environment can be difficult, but also very profitable. I’m glad I prepared myself and my clients for just such a possibility years ago.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Will the Fed cut rates?

The market certainly seems to think so.

Just look at interest rate futures and you’ll see investors are expecting a 25 to 50 basis point cut in the Fed Funds Rate.

Or, more meaningfully, look at the gold market. Gold prices spiked to over $785 an ounce, today.

That’s up 17% over the last month and 31% over the last year.

Why does the gold market indicate a cut in the Fed Funds Rate?

Because the Fed does not create growth–they do not possess some magical fairy dust that makes the economy run faster.

The Fed prints money to decrease interest rates. And, when the Fed prints money more quickly than the economy grows, they create inflation.

Gold prices are going up because gold investors believe the Fed will print money, also known as cutting the Fed Funds rate, thus creating inflation.

Gold is going up because investors are guessing the Fed will create inflation by cutting rates.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.