Gold Does it's Job
"The Japanese people themselves are reportedly buying gold like it is going out of style, carrying it home in bags loaded up with the stuff," writes the Mogambo Guru. This underscores the notion that gold is the ultimate hedge against government mismanagement. They recognize that their own government is debasing their currency, and they are rightfully scared. Thus, gold again performs its job."
Gold’s job is to do nothing. I have recommended it to you in these letters at the beginning of each of the last two years. It has not gone up. But neither has it gone down. It has gone nowhere.
Under the circumstances, nowhere has been as good a place for an investment to go as any. Bernie Ebbers’ stock fell 84%. Amazon is down 90%. Cisco knocked investors for a $60 billion loss. Gold bullion, on the other hand, is worth roughly as much today as it was 2 years ago, and in real terms, about what it was worth 20 years…or even 2000 years ago. In the Roman era it was reported that an ounce of gold would buy a man a decent toga with a belt. Today, an ounce of gold – at $289 – will still probably buy a decent toga, if you can find one.
Gold goes nowhere. It may be portable, but it is immobile.
Paper money, on the other hand, moves. Give it a good gush of air and it gets whipped up like trash in an alley.
Today’s letter is inspired and informed by an article entitled "The Investment Case for Gold," found on the website of the Tocqueville Funds. To make a long story short, it argues that the tailwinds that have blown paper assets forward since 1979 have already begun to swing around. In the coming storm, the dollar and the Dow could lose up to 85% of their value, relative to gold.
One day to the next, it is impossible to say what will happen to gold, the dollar or stock prices. But a chart at the Tocqueville site shows a longer-term pattern. It is, we imagine, a pattern imprinted on humans’ hard drive…
The chart plots the Dow against the price of gold from 1915 to 2001. From 1915 until 1926, the currents blew the Dow up to a level that was 15 times the price of gold. Then, in the whirlwind of a bear market and depression, people turned their backs on paper and clung to gold. In the financial debacle of the ’30s, people lost confidence in paper; not in the dollar, which remained strong, but in stocks. Their distrust of stocks was so great that it took 22 years – from 1926 to 1948 – before the Dow began to rise against gold.
But once the trade winds got behind paper assets again, they blew steadily for the next 17 years, until 1965. By then, the ratio of the Dow to gold had reached nearly 30, whereas it had been below five in 1948.
Once again, after 1965, the winds changed direction and blew so hard, the ratio of the Dow to gold fell to below one in 1980. In that year, gold sold, briefly, for more than $800 an ounce. The Dow at the time was only 796. You could have bought the entire Dow for a single ounce of gold.
You should have done so. Because never again would the price of gold be so high and the price of stocks so low. The Dow began its epic rise in 1982…taking it to a new record high against gold in 1999. In that year, the Dow/gold ratio topped out at 42.
The hot air that carried the Dow and the dollar so high have cooled. The Dow is on its way down. The price of gold, more than likely, is on its way up.
Why should the dollar fall against gold?
"The Enron bankruptcy, the de facto default on sovereign debt by Argentina, and a looming financial crisis in Japan," says the Tocqueville report, "are random but high profile reminders of a deteriorating global credit environment."
The lie hidden in the deepest entrails of modern central banking is that "money" can be created out of thin air. If the economy is growing too slowly, economists are heard urging the central bank to "put more money" in circulation. Of course, if more "money" could really make people rich, the Argentines of the 1980’s would have been fabulously wealthy.
Instead, they became pathetically impoverished. How come? Because the central bank cannot really put more "money" in circulation. All it can do is circulate more of what appears to be money…paper currency or credit…in order to make people feel that they are richer than they really are. Under ideal conditions, the mock money causes people to spend and invest a little more freely…and gives a sluggish economy a boost.
But people cannot really spend money they do not have. Money must represent real wealth…real resources… or it has no meaning. Printing extra bills does not increase the amount of real resources available. So, handing out the extra cash and credit is a kind of deceit…which is welcomed by almost everyone, until it blows up.
The phony money causes people to change their behavior. They spend money they don’t really have…and invest in projects they shouldn’t. Money seems delightfully easy to come by in the boom stage and gets tossed around casually. But what happens? Eventually, people become aware that their investments are not producing the profits they had hoped for. They cut back. Consumers cut back too – realizing that they are not as rich as they had thought. And lenders, who were happy to extend credit to Enron and household pets when the economy was booming, become worried. Question marks begin to appear. Will debtors really be able to make their payments? Are earnings really what the company says they are? Will sales really go up in the future?
As Eric reported yesterday, lenders have become reluctant to make new commercial loans. Is it surprising? Bankruptcies, credit defaults, and late payments are hitting new records. Who would want to lend?
And yet, if the rate of borrowing and spending declines – the boom is over.
We think the boom is over, dear reader. Because the quality of credit has been called into question. More and more "Enron stories" will hit the news. More and more question marks will appear. How can the U.S. afford such huge new government outlays? How many dollars really are in circulation? How many more Enrons are out there?
The boom mindset…in which everything gets better and better for ever and ever…doesn’t change quickly. "Market metaphysics change glacially over decades," says the Tocqueville report. Each generation learns the same lessons, more or less. And always the hard way.
Relative to gold, we expect the dollar to fall.
Because gold production is declining. And though central banks may favor paper currencies, the currency they most favor is their own. While the dollar had the wind to its back it seemed to make sense for central bankers to lighten up on gold and hold more interest-yielding, U.S. dollar assets. But central bankers must feel the new chill wind too. They, too must be asking questions.
"Central banks will suspend gold sales," the Tocqueville Report predicts, "and balk at rolling over bullion loans. Market sentiment towards financial assets will sour further. The bear market in financial assets, already underway, will become more widely recognized."
The huge, long-term shifts of sentiment – from favoring stocks and paper assets to distrusting them – will undoubtedly continue. "How the market travels from one extreme to the other is unknowable," continues the Tocqueville team. "What is clear is the preponderance of confidence or the lack of it at each extreme."
At the most recent extreme, the Bank of America lent Bernie Ebbers millions of dollars. At the other end of the cycle, they will feel lucky to get it back. What will happen to Ebbers and WorldCom, we don’t know. But an ounce of gold, we predict, will still buy you a decent toga.
February 05, 2002 — Paris, France
The Dow slipped 220 points yesterday. But even that was not enough to put it ahead of its fleet-of-foot Japanese cousin. The Nikkei Dow is still leading in the race to the bottom, 9475 compared to 9687.
The Wall Street Journal reports that Amazon may not have enough cash to continue operations. The stock fell $1.20.
Also in the WSJ was news that TYCO had spent $8 billion on secret acquisitions. TYCO stock dropped $2.13.
And, according to the New York Times, Bernard Ebbers of WorldCom owes $92 million more than his stock is worth. Investors sold the stock, eager to unload before Ebbers.
Ebbers has done something truly remarkable. In 1999, Ebbers was one of America’s richest men. His WorldCom shares were worth $1 billion. Since then, the stock has fallen 84%. Now, he’s one of America’s poorest men. It is a rare man who can carry both distinctions with such grace.
But Ebbers only did what everyone else does – he tapped his equity when he had a lot of it…borrowing nearly $200 million against his WorldCom shares. Thus has Mr. Ebbers provided the world with an exposition on what happens when a bubble economy deflates. The "equity" disappears…but the debt remains.
How will we know when the bottom is finally reached? Look for Ebbers’ picture among the Forbes’ gallery of "America’s Poorest People"…or Enron on the new list of the "Misfortune 500."
And here’s a note from my friend Rick Ackerman:
"This one’s a doozy, Bill. Seems Nasdaq 100 companies reported $82M in losses in SEC filings for Q1- 3 2001, while claiming $19.1 billion in combined profits to shareholders, based on ‘pro forma’ methods.
"On a local note," Rick continues, "the word bankruptcy is getting tossed around in connection with UAL, a huge Denver employer. The airline supposedly is losing $10 million per day, but who knows? UAL’s supposed answer will be to ‘enhance’ revenues by raising fares. They are already the priciest carrier for business and last-minute fares, so this latest inspiration could be a very efficient way to commit suicide."
"American Enterprises’ Accounting Suspect," says a headline in today’s Figaro. All over the world, people are wondering about America’s numbers. More below…
Eric, what’s the news from Wall Street?
Eric Fry out on the left coast…
– Palm Springs was a balmy 75 yesterday. But the Dow Jones Industrial Average was an ice-cold 9,687 – down 220 points from Friday’s close. Winter on Wall Street is becoming quite frosty and there’s really nowhere to hide.
– The Nasdaq bested the Dow’s decline with a 3% plunge to 1,855. Concerns about corporate bookkeeping captured the headlines and sent investors scurrying for the exists faster than Kenneth Lay from a Congressional hearing.
– The former Enron CEO did not approve of the "prosecutorial" tone that the hearings had adopted. Lay’s got a point; Congress really should not get the chance to hang him until he has had a chance to finish hanging himself. "Blowing off" a Congressional hearing is a pretty good start.
– The financial Nor’easter blowing west from Wall Street is creating an economic ice storm for which few folks seem prepared. Consumer confidence jumped again in January. But the latest numbers might be as good as they get for a while. Confidence and the resultant consumer spending might wither in a hurry in the face of a falling stock market and a barrage of headlines about dishonest corporate accounting.
– I’m here in the California desert this week to attend the latest gathering of the Supper Club – the small group of folks who get together about four times a year to examine select venture capital opportunities. Out here in the pleasant 70-degree winter weather, I am reminded of the great majority of American investors who are wholly unprepared for the harsh economic winter that might be headed our way. (Imagine Boy Scouts with day- packs setting out to scale Mt. Everest).
– Financially speaking, the nation is prepared for only one outcome – a Palm Springs winter. We’ve donned our swimsuits, slapped on our tanning oil, plopped down on a lawn chair and started looking around for someone to fetch us a pina colada.
– How else would you describe a populace that saves no money, borrows more than $1 billion a day of foreign capital and considers Intel a great buy at 50 times earnings?
– Yet, miraculously for us Americans, in recent years there has been almost no act of financial imprudence that has not produced a favorable outcome. Whatever we do, it just seems to work out.
– Therefore, why shouldn’t we assume that the weather will be 75 degrees again tomorrow, just like it was the day before?
– But what if the economic springtime in America starts to look like a New York winter, or worse, a Fargo, North Dakota winter? Is anyone ready for that?
– Meanwhile, the shifting financial climate is blowing a favorable wind in gold’s direction. The ice block encasing Mr. Gold Market is thawing. He looks much like he did 20 years ago, except for the ghostly pallor that results from two decades on ice. But the color is slowly returning to his cheeks.
– The yellow metal bounced more than 1% yesterday to an 8-month high. Are we witnessing the little rally that could?
– Okay, I’m confused. During the "bubble zone" bull market of the late 1990s no one cared about how companies accounted for their profits or losses. In fact no one cared about profits or losses. Who can forget "eyeballs," "hits" and "page views?"
– Accounting did not matter…except, of course, accounting for personal capital gains. Then suddenly, for a few days last month, accounting was the only thing that mattered to investors as they pummeled the shares of any company suspected of presenting less than the honest truth about their operational performance. Then, last week, investors decided to put all that nastiness behind them. Forgive and forget seemed became the guiding principle. And then came yesterday…Th-whack! The whip came down on all the integrity-challenged names.
– Tyco, IBM and GE all suffered to varying degrees. But Irish drugmaker Elan suffered the most, losing more than 50% of its value in a single day.
– These financial inquisitions are fairly brutal affairs. But the markets will come out the other side purified, and they will become a more honest place to buy and sell stocks. Unfortunately, purity might not be achieved until about Dow 6,000, but it will have been worth the wait.
Back in Paris…
*** The San Jose Mercury News: "The oldest, most basic valuation measure of stocks – the price-earnings ratio – soared last week way beyond anything ever recorded, at least since 1872, for the 500 largest U.S. companies."
"This ratio for the Standard & Poor 500 index hit a staggering 60 by last Friday, as calculated by Bloomberg News. That’s twice the level it reached during the Internet bubble of 2000 and more than three times higher than its historic average.
"In other words, investors were willing to pay $60 a share for every $1 a share that companies in the S&P 500 earned during the past 12 months. During the Internet bubble, they were paying $25 a share.
"As for Nasdaq, the companies making up the index haven’t had enough earnings since last April to calculate any ratio that makes sense. The index of the 100 largest companies on Nasdaq is showing a loss of $145 a share for the last 12 months, according to Bloomberg News."
*** At the peak of the bubble economy, the Nasdaq earned $12 a share. But earnings have fallen faster than stock prices. The 230 Silicon Valley firms that reported 4th quarter earnings showed a combined loss of $4.3 billion, up 9% from the previous year.
*** Republicans, Democrats, Paul Krugman…even Jesse Jackson took money from Enron. Enron, of course, was handing out cash like a politician, to make friends and silence potential critics. Alas, a fat lot of good it did. As news of the Enron payments spreads, the payees feel obliged to attack Enron even more harshly, to prove that they had not been "bought." And why not? Enron has no more cash to dispense.
*** We want you to know that here at the Daily Reckoning, we have not been bought. Of course, we would have taken money from the company, but it was never offered to us…