Monday, June 20, 2011

Dealing with Financial Repression

Given the article posted today by Econophile on the WSJ and inflation, I thought it timely to submit some quantitative considerations for anyone with savings who has to deal with interest rates on savings that are below the rate of price increases for consumer goods and services.

The WSJ writer's view is that the authorities "should" inflate away debts. I fully agree with The Daily Capitalist's different viewpoint about what "should" be done. It is further my view that what Mr. Arends of the WSJ advocates has in fact been "the plan" ever since the economy began collapsing in 2008. I believe that the Consumer Price Index understates price inflation and that if one removes housing from the CPI (because houses are financial assets rather than costs for most adults), the real cost of living has been rising at least at 5% per annum for the past year for the "average" American. I further believe that this policy of imposing negative real interest rates on savers, which is being called "financial repression", will continue for some time.

Thus gold ownership in various forms remains appropriate in my view even for small savers unless they may need access to those savings soon (e.g. retirees or people who are not able to save from their income). To review the reasonableness of current gold prices, which are around $1540/ounce, I have gone back to 1976 prices and interest rates, when gold was in the $100-140 range.

I chose that year because it allows time for the legalization of gold ownership by Americans, which was made legal again on Dec. 31, 1974, to have taken effect and for the post-Viet Nam War dislocations and severe recession of 1973-75 to have worked their way through the system. I also looked at the 10-year bond rate present in 1976 and the 10-year rates present in 1981, 1991 and 2001.

It turns out that depending on exactly what price one uses for gold in 1976, the rate of gold's price appreciation is about that of the average return from Treasurys for that 35-year span. In other words, gold's price "inflated" roughly at the same rate of return that fiat money paid on itself.

Coincidence? I think not.

So I think it's conservative to project that 10 years from now, gold will increase in price by 3% per year, which equals the current 10-year Treasury bond rate. That gets one to $2000/ounce in 2020. Now of course, Treasury interest is taxable, whereas the appreciation from personal ownership of a gold coin may lead to an untaxable transaction, or the coin could perhaps stay in one's possession, and one's family possession, indefinitely.

Given the policy propounded by the WSJ, though, I think that most of the "risks" to this gold price are to the upside, potentially dramatically so.

Even in the $2000/ounce case by 2020, my recent review of multiple gold mining companies suggests that after taking account of extraction and refining costs, taxes, etc., gold in the ground can on average be purchased a good deal more cheaply through the stock market than gold bullion. Please however be aware that whatever competence I might have in certain financial matters does not extent to the gold mining business. And of course, a stock is a thoroughly different type of asset than a gold coin or bar in one's hand.

Continuing on the subject of currency debasement and investing, it is relevant to consider quantitative stock market predictions from qualified people. I receive free E-mailed updates from Jeremy Grantham, who is known for multiple accurate asset allocation calls that look 7 years into the future and thus pay no heed to predicting the unknowable intermediate fluctuations. (His letters can be E-mailed to you; one can sign up by starting HERE.) He has very recently projected a 7-year average annual return from the US stock market of 2.5% per year, which is equal to his projection for price inflation. This projected zero real return from stocks includes dividends. This in turn means that the 7-year Treasury bond interest rate of 2.6% for a zero coupon bond is by his model equal to the return from stocks, and with less risk (other than the inflation/default risk that gold should provide a hedge for).

Second, the fund manager and Ph.D. economist John Hussman puts out an erudite weekly market letter accessible HERE (from which see "Weekly Market Comment"). His calculations, which include the effects of monetary inflation, project a 10-year return from stocks of 4.0% per year. Of course, this is approximately that available from a zero-coupon 10-year Treasury bond.

We do tend to seek out and emphasize opinions and facts that support our bias. So perhaps I have presented the opinions of an overly-gloomy duo of financial prognosticators.

When I put my own thinking cap on and consider matters as objectively as possible (a necessity as I am investing my own money based on my thinking), I come up with the idea that the best way to keep up with monetary debasement is through a trade or business with pricing power. From an investment perspective, I see the stock market as lacking an appropriate margin of safety over "safe" fixed-income vehicles. I therefore think that for taxable accounts, muni bonds and other properly-selected bonds have a better risk- reward profile than does the stock market as a whole. But because it looks as though the US authorities are not rushing toward financial prudence, I continue to (unhappily) believe that gold and gold mining stocks are substantially under-weighted in the holdings of almost all Americans who are fortunate enough to have financial assets. I also believe that from exploration companies all the way up the quality spectrum to the majors, gold miners that are "real" companies tend to represent better fundamental value than does gold bullion. This happens to represent the first time I have believed this ever since I became interested in gold and weak dollar-oriented investments after Alan Greenspan responded to the 9/11 attacks by forcing interest rates yet lower.

Nothing herein or in my other blog posts constitutes financial advice. Also please be aware that the concepts I have described in this post are not related to my views on short-term investment decisions. I have no (public) interest in predicting day-to-day movements in financial markets, but nothing has changed in my view that for weeks to months ahead, investors and speculators are likely to have to accept that the "establishment" predictions for US and global economic growth for the rest of 2011 remain too high (even though they have begun to come down lately). In my humble opinion this phenomenon, if indeed it proves out, will continue to pose a headwind for the price of most stocks and almost all commodities, and will have conflicting and unpredictable net effects on gold.

Copyright Long Lake LLC 2011

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