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October 28, 2008

The Trial of Gold
by David Galland

They filed into the docket, faces bright and smiley despite the shackles around their arms. The leader of the gang, Mr. Gold, was pushed forward into the defendant's chair. The rest, including Ms. Silver as well as the members of the resource share clan, Biggie Goldshares, Junior Goldshares and Ms. Silvershares, were manhandled onto the hard bench just behind. Rather than looking discomforted at the treatment or the ugly smells and sounds of the crowded courtroom, they just looked around pleasantly, as if on a church-sponsored outing to the local zoo.

Calling the court to order, the bailiff announced that all should rise for the judge. Shortly thereafter, Judge Market entered from stage left, a stern look in his eye. Approaching the dais, he arranged his robes around him and took his seat before gaveling the court to session.

The trial of Gold had begun.

"Mr. Gold, you and your cohorts have been accused of misleading investors into thinking that you would help them preserve their wealth, when exactly the opposite has been true of late. How do you plead?"

"Not guilty, Your Honor," Mr. Gold answered brightly, receiving a dour look in return.

"Mr. Cuomo, you may question the witness," Judge Market announced impatiently.

As Mr. Gold made himself comfortable in the witness stand, Andrew "Son of" Cuomo, taking a break from his well-oiled political career, I mean, job as New York attorney general, to serve as the public prosecutor in this high-profile case, rose smoothly to his feet, patted an imaginary loose hair into place, shot his cuffs, and approached the defendant.

"Mr. Gold, behind me in this court are good folks, hard-working folks, who believed in you. Yet you have failed to perform as advertised. How can you sit there, all shiny, and claim that you have not deceived the public in this regard?"

A pleasant and, some might say, radiant smile fixed on his face, Mr. Gold responded in an even voice. "I'm just a simple metal. I've never made any claims one way or another, so I don't know where people got it into their heads that I'm anything special. But for thousands of years now, people have been chasing after me, all over the world. Beats me why."

"Your Honor, if I may." The defense attorney, Mr. Reason, rose to his feet.

"Yes?" asked Judge Market, looking grumpy.

"I know it's a bit unusual, but Mr. Gold is not exaggerating when he says he's, well, kind of simple. If it pleases the court, it might speed things along if I could ask some expert witnesses to assist in answering the prosecutor's questions. Can do?"

"Highly irregular," said the Judge, glancing over at Mr. Gold where he sat, his smile and countenance oddly reassuring in the dark, smelly courtroom. "Mr. Cuomo, any objection?"

Seeing the fond looks in the eyes of many in the courtroom as they stared, fixated, at Mr. Gold... and after a quick consultation with his internal popularity meter and coming to the conclusion that he didn't want to appear mean-spirited, Cuomo nodded in agreement.

"Thank you," Mr. Reason said reasonably. "Then I would like to ask the Ghost of Murray Rothbard to join Mr. Gold on the witness stand."

As the court watched, their collective mouths somewhat agape, Rothbard's ghost floated softly to the witness stand and landed on the rail next to Mr. Gold, who winked at him amicably.

"Ahh, okay, well..." Mr. Cuomo, stammered, looking a little discomforted by the sight of Rothbard's ghost, his transparent bow tie ruffled slightly by some unfelt celestial wind. "How do you answer the charge against Mr. Gold that he has lured people to him under false pretenses?"

"I'd like to answer by quoting from an excellent book on the topic, the very best, in my opinion," said Rothbard's ghost with a wry smile. "It's called The Mystery of Banking and it is written by... me!" ((http://mises.org/story/3122))

In all countries and all civilizations, two commodities have been dominant whenever they were available to compete as moneys with other commodities: gold and silver.

At first, gold and silver were highly prized only for their luster and ornamental value. They were always in great demand. Second, they were always relatively scarce, and hence valuable per unit of weight. And for that reason they were portable as well. They were also divisible, and could be sliced into thin segments without losing their pro rata value. Finally, silver or gold were blended with small amounts of alloy to harden them, and since they did not corrode, they would last almost forever.

Thus, because gold and silver are supremely "moneylike" commodities, they are selected by markets as money if they are available. Proponents of the gold standard do not suffer from a mysterious "gold fetish." They simply recognize that gold has always been selected by the market as money throughout history.

Generally, gold and silver have both been moneys, side-by-side. Since gold has always been far scarcer and also in greater demand than silver, it has always commanded a higher price, and tends to be money in larger transactions, while silver has been used in smaller exchanges. Because of its higher price, gold has often been selected as the unit of account, although this has not always been true. The difficulties of mining gold, which makes its production limited, make its long-term value relatively more stable than silver.

Concluding with a large smile and a wave of the hand, Rothbard's ghost graciously accepted Mr. Reason's words of gratitude for taking time out of his schedule to make an appearance, then stood on the rail of the witness box and, with a flourish, took a deep bow before flying out the door to return to his ethereal seat in the heavenly branch of the Austrian School of Economics.

Mr. Cuomo played for a moment with a well-manicured cuticle before whipping around, his finger jabbing in the direction of Mr. Gold. His voice rose dramatically.

"And what, Mr. Gold, do you have to say on the topic of inflation? Can you deny that you and your friends claim to be inflation hedges? If so, then how do you answer to the fact that you are now selling for a lower nominal price than back in 1980! And, in inflation-adjusted terms, you are well behind! You, sir, are a fraud!"

Mr. Gold's smile remained unchanged, his countenance pleasant as always. "I'm sorry, but I really don't understand what you are talking about."

Mr. Reason again took to his feet. "Mr. Cuomo, if I may?"

"Oh, alright. Have at it."

"The defense calls Terry Coxon of The Casey Report. Mr. Coxon, would you be so kind to answer Mr. Cuomo's question."

Coxon made his way from a seat at the back of the courtroom where he had been enjoying the show and walked over to stand next to the witness box. Unable to help himself, he reached out and gave Mr. Gold a pat on the arm.

"So, Mr. Coxon," Son-of-Cuomo barked, "How do you explain that in 1980, gold touched $850. And here, 28 years later, it is trading for less than that - even though inflation has been persistent throughout the period. The claim that gold is an inflation hedge is simply false!"

Speaking slowly, to be sure that Mr. Cuomo understood, Coxon replied...

What moves gold isn't the rate of inflation but the change in the rate of inflation.

When people expect higher inflation, they bid up gold. When people expect lower inflation, demand for gold drops, even though "lower" may still be very high. That's why gold trended down in the 1980s, even though the inflation rate was high. The inflation rate was high, but it was declining.

There is a simple reason for this relationship. Gold and the dollar are both a store of value. Gold is more reliable in the long run, and the dollar is more reliable over shorter periods. Because they do somewhat the same thing for their owners, they are competing products, but with different attributes.

For example, the cost of holding dollars for their usefulness as a store of value is the gradual erosion of purchasing power -- price inflation. In a period of rising inflation, using dollars for storing value becomes relatively more expensive than using gold. So the demand for gold increases. And since the supply of gold - in ounces - is nearly fixed, the price per ounce goes up.

To sum it up, the price of gold is lower today than in 1980 because the rate of inflation now is lower -- much lower -- than in 1980.

Judge Market looked thoughtfully at Mr. Gold. "Mr. Cuomo, any more questions for this witness?"

"Not at this time, Your Honor," Cuomo said, flicking an imaginary piece of dust off the sleeve of his silk suit as Coxon returned to his seat and the bag of popcorn he had left there.

"But I do have a question for you!" he said, with a glare at Mr. Gold. "You sit there so calm, nonchalant, even. The public looks to you to remain a bastion of stability in challenging times. But as the financial crisis has swept over the land, you have been gyrating wildly. I accuse you of luring in investors by pretending to be calm, but in actual fact being dangerously volatile!"

Mr. Gold smiled and shrugged. Again, Mr. Reason took to his pins.

"I'd like to call Jeff Clark, editor of Big Gold. I believe he has some charts that might help in answering that charge. Mr. Clark."

His step enthusiastic, Clark walked briskly up to the bailiff and handed him two charts, which were, in turn, dutifully walked up to Judge Market.

"We'll call these exhibits A and B," said Judge Market, pulling on a pair of tortoise shell specs for a closer look.

From the wings, an overhead projector was presented and Clark walked over to it, flipped it on, and laid flat a transparency. Helpfully, the bailiff lowered the lights a touch.

"I think gold has gotten a bum rap," Clark began, his face aglow from the light of the projector and, perhaps, his passion for the subject at hand.

"In fact, despite recent weakness, between January 1, 2007 and October 10, 2008, when I prepared this chart, gold is up 42.6% while the bellwether S&P 500 is down 36.9%.

"For my second chart, I'd like to address the notion that gold is more volatile than stocks," Clark said, sliding exhibit A from the projector and replacing it with exhibit B.

Mr. Cuomo, thinking about the whupping his own portfolio of Wall Street darlings had taken of late, turned to Jeff Clark and almost spat out, "Since we're on the topic of stocks, let's talk about the big gold stocks. They were supposed to do better than the physical metals, but they have been hammered just as hard or even harder than many other stock sectors!"

In the back of the room, Biggie Goldshares examined his shoes, while Clark cleared his throat and said...

No stock has escaped undamaged in the global carnage, including gold stocks. The down-drafts have been breathtaking, and it's easy to imagine that gold stocks will just keep falling. Here's what happened...

For starters, hedge funds continued deleveraging, which can cause significant moves in market prices due to their use of margin. Withdrawals in U.S. hedge funds hit $43 billion in September alone. Meanwhile, mutual funds and "basket of commodities" ETFs continued selling off due to disappointed, or frightened, investors. This means the good was sold along with the bad. Add in the intensifying fear in the marketplace and few buyers were to be found.

Second, as the sea of red numbers continued splashing across headline news, investors fled in droves. Many simply didn't want to be the last one out of what they believed was a burning building, so "Dump everything!" was the mantra. Many stocks, in a perverse use of logic, were sold because they had value. Lots of investors simply fled to cash, which is where investors reflexively go when they see a market rout.

Lastly, right or wrong, gold stocks are perceived by some as riskier than your average IBM or GE. Further, few gold stocks pay dividends, and the ones that do only yield 1-2%. Some sellers might have stuck around if they were getting 8-10%.

So, is that it for gold stocks? Look at the reasons outlined above: where does it say investors sold because inflation is dead? Where does it say the public left because the government has promised not to print money to solve their problems? Where does it indicate gold is no longer viewed as a safe haven? Has mankind lost interest in war? Does the dollar's recent rise mean its ills have been cured? Banks are fine? The economy has a bright future?

The bottom line: the base case for gold stocks remains intact, because at some point the public will see them as the place to go for profit. Gold will rise, and regardless of what the general market is doing at the time, gold stocks will separate and follow gold up. The best days for gold stocks still lie ahead, because a much higher gold price is assured by all the recent efforts to stave off a recession. Since gold stocks were pulled down by a general market panic and for reasons unrelated to fundamentals, our advice is to hold on. We're confident their day will come. And we'll sell when the problems that have yet to push gold to new inflation-adjusted highs have all played out. In the meantime, we need to be steady while others are fearful.

From the back of the room, a hand shot up. Judge Market, already resolved that this was to be no ordinary proceedings, looked over his glasses at the owner of the hand.

"Yes? And who are you? And why are you interrupting?"

"Louis James, senior editor of the International Speculator," the mysterious stranger spoke up loudly for the courtroom to hear. "I would like to add a historical fact related to gold stocks in a crisis."

"Mr. Cuomo, any objection?"

In reply, Son-of-Cuomo simply shrugged and dropped into his seat.

"Go ahead, Mr. James," Judge Market said, rocking back in his chair, his eyes attentive.

Approaching the witness stand, James turned to the assemblage and proceeded.

Homestake Mining Company (now part of mining giant Barrick Gold, NYSE.ABX) offers a worthwhile illustration of the potential of gold stocks even during depressions. As a bit of a background, for more than 100 years, the company operated the Homestake mine in South Dakota. For you television fans, you may recognize Homestake as being a centerpiece in the recent HBO series Deadwood.

In any event, in 1935, right in the middle of the Great Depression, Homestake recovered enough gold to make $11.39 million in net income, a record that stood for nearly 40 years - and that was at a time when the U.S. government had set the price of gold at $35 per ounce. Homestake shares showed some volatility but weathered the great stock market crash of 1929, ending that year slightly up. From 1926 to the end of 1935, they went ten-to-one, soaring from $50 to $500.

With fluctuations as you'd expect, they held on to those gains until taking off again during the 1970s bull market for gold. When you get home, you can learn more about it with some rather ugly but eye-opening charts available at this website: http://www.geocities.com/WallStreet/Exchange/9807/Charts/SP500/HomestakeHist.gif.

Cuomo rose to his Gucci-shod feet with a wicked look on his face. "Mr. James, since you are here, maybe you could tell the jury why it is that Mr. Gold's known associate, Junior Goldshares, has done even worse, almost consistently losing money for investors over the past year. Lots and lots of money! What can you possibly say in Junior's defense?"

"Sure, happy to oblige," said the ever-obliging Mr. James, then launched into the answer.

We hold a lot of gold juniors. In hindsight, it would have been nice if we'd taken even more profits than we did in August of 2007 and gone to cash - we'd now have that capital available to back up the truck for today's screaming buys. But the economic house of cards that finally appears to be coming apart could have done so last fall. At the time, cashing in on base metal plays, which can be expected to suffer with a slowing economy, and holding on to precious metals plays, for which the opposite is true, made perfect sense.

Today, we would certainly go to cash rather than hold on to any conventional investment that has exposure to "toxic paper" or that can be expected to do poorly in a slowing economy.

But gold's day in the sun is coming soon, and we still believe the stocks give us leverage on that rising star. So, as stated in the most recent edition of the International Speculator , we're not selling anything unless we think the company doesn't have what it takes to make it through to the other side.

Of course, some investors might want to do some strategic tax loss selling, then look to buy back in the new year. The problem is that often times once you are out of the market, you can miss the big moves while waiting for the right moment to jump back in.

"Not much consolation for investors who have already lost money to Junior Goldshares while waiting for the big returns to materialize," sniffed Cuomo, looking meaningfully at the jury.

"No, it's not," James agreed. "No one likes to take an investment loss. But I have to say something here in Junior's defense. Namely, I have to remind folks of the speculator's credo, because no one's ever made a secret out of the fact that Gold shares are speculative in nature.

And that credo goes like this: "Speculators invest 10% in the hope of receiving a 100% return, while investors invest 100% in the hope of a 10% return."

In the International Speculator, a very apt name for the topic we cover, it has been our constant warning that investors should invest in Goldshares with no more than 20% of their portfolio. That's for the simple reason that while these stocks can offer big rewards - life-changing rewards, in fact - investors in the sector must be willing to accept big risks. Well, today, because of panic dumping, we are seeing the worse side of Goldshares.

Even so, for illustrative purposes, let's do the math on the losses that an investor who limited their investments to just 20% of their portfolio would have suffered with Goldshares. Assume, for example, that you lost 75% on the 20% of your portfolio that you allocated to the sector. In that case, your net loss on your overall portfolio would have been just 15%. Not fun, but not particularly bad, all things considered.

Conversely, take an investor who was 100% invested in the S&P 500 over the period mentioned by Jeff Clark earlier. In that case, they'd now be down almost 40%. Actually, looking at the market action today on my iPhone, the losses would be even worse than that.

"Now, hold on!" Mr. Cuomo sputtered. "All of this is good and well, but you can't all honestly be saying that you still think gold and even gold shares are still a good investment!"

Mr. Reason, stood again. "One more witness?"

"Oh, all right, but I want an answer to my question!" Cuomo barked, adding with a dramatic flourish, "The world wants an answer, nay, demands it!"

"Call your witness," Judge Market said, unimpressed.

"The defense calls David Galland, managing director of Casey Research.

A handsome, well-dressed man, his sublime intelligence palpable even from across the room, rose from the galley and approached the witness stand where Mr. Gold smiled happily at him.

"Okay, whoever you are, start talking," Cuomo said sharply. "You tell the jury how it is you could possibly be bullish about anything related to precious metals at this time. I mean, for gawd's sake, man, the global economy itself is collapsing. It is deflation that investors must be worried about. And yet, and yet... are you going to stand there and actually tell me you think investors should hold on to their precious metals investments? You are, I contend, either mad or deluded, or both at the same time!"

Unflustered by the bluster, Galland began to speak.

Economies and investment markets are complex systems, which is to say that predicting them with any certainty is an impossibility. Thus, my comments should not be taken to reflect certainty, but rather the best interpretation I can make of the situation as we see it.

For some years now, we have been warning that the house of cards, which has been built on a fiat monetary system, would come tumbling down.

It was because of the excess and the distortions that this system make inevitable that Doug Casey and others in the organization looked at the tea leaves and saw a Greater Depression, but one of an inflationary nature.

So, here we are, with the crisis upon us. There is no question that there is a massive deleveraging going on as individuals and corporations look to rebuild their stocks of ready money by dumping assets of all description. Real estate and equity markets are crashing as a result at the same time that U.S. Treasury instruments rise in value even though their yields are negative and falling. While buying into an instrument with a negative yield, at this point in time, many feel it is better to lose some money at a measured pace than take the sort of beatings being doled out in competing financial instruments.

Of course, as U.S. Treasuries are denominated in dollars, the inflow into those instruments has helped strengthen the dollar, putting pressure on gold and silver, which are, per Terry Coxon above, viewed as a competitive form of money. You can see that correlation in the chart here that Bud Conrad, who couldn't make it today because he is preparing for a trip to New Zealand, sent over.

The panicked reaction of investors in all sectors is understandable. The crisis we are now witnessing is not just of a once-in-a-generation scale, but once in a century. And so the scramble for safe harbors and cash is perfectly understandable. It's why Treasuries are so popular, and it's why gold has largely held its own in the broader scheme of things.

"Do you have a point to make?" Cuomo sneered from his seat.

Galland nonchalantly replied:

I was merely setting the stage for where we are at this point in history. And by that I mean, here and now, October 24, 2008. You see, when panic and confusion are the watchwords of the day, as they now are, there are two attributes of the successful investor that become especially important. The first is to stay calm. The second is to try to look beyond the immediate.

Many investors have, like the participants in the Charge of the Light Brigade - the anniversary of which, by the way, is tomorrow, October 25 -- have misread the signals and rushed straight into the cannons of the bear market, being wiped out in the process. Or, in their rush for the rear, they have dumped everything indiscriminately, suffering unnecessarily big losses on great investments.

Will the market continue to rig for deflation for the immediate future? Absolutely. And for the next little while, we can expect nothing other than bad economic news. Therefore, caution in all things financial is called for. Of course, if you have a good reserve of cash, then you could take positions in the inverse stock market ETFs and short positions on banks, financials, and real estate plays recommended in The Casey Report. But in a market as uncertain as this, such positions should be approached carefully, because of the increasing presence of governments in the markets.

Specifically, with each passing day, the risk increases of market-distorting government interventions, including short-sale bans, trading halts, direct interventions in individual stocks, increased margins on targeted commodities, etc. That greatly increases the risk for short-sellers.

"Are we going to get back to the topic of Mr. Gold et al. at some point? I have a hair appointment at 2:00 pm," Cuomo said, looking down for his reflection on the highly polished top of the table in front of him.

"Yes. Right away," said Galland.

You see, most of our recommended investments are not short-term in nature, but rather look for big trends that you can invest in when they are deeply out of favor. Our base case about the nature of the crisis, and especially the government's reaction to it, has not changed. In fact, if a year ago, you had asked us to estimate the amount of money the governments of the world would unleash in an attempt to head off an economic downturn, none of us, not even Doug Casey, our resident guru now wandering the highlands of Argentina, would have come remotely close to estimating the actual numbers being deployed.

To put some meat on that point, over the last month and a little bit, the monetary base of the United States has increased by a previously unimaginable and unprecedented 20%.

And our own Bud Conrad now estimates next year's U.S. government deficit at better than 10% of GNP, an also unprecedented number. And that doesn't even factor in the impact on the deficit from the fall-off in tax revenues that is inevitable given the likely depth of the downturn.

And it gets worse than that, because if you step back just a bit, you'll realize that, while financial markets have been devastated, the damage to the real economy is just now getting started.

Which is to say that the scope of the government's monetary exertions to "fix" everything are only beginning to ramp up. The Democrats, who look likely to control the whole shebang in Washington, are already calling for yet more stimulus and expensive intervention, including, this week, a call for the government to guarantee the nation's defaulting mortgages. Given that 265,968 mortgages went into foreclosure in September alone, this potential bit of largess is unlikely to come cheap.

"Has anyone ever told you that you're long winded," Cuomo asked.

"Yes, they have. It is a personal problem I struggle with every day.

Be that as it may, investors today have several choices, or some combination thereof, they need to make in face of the economic crisis.

They can choose to try and time this market over the short term, but if they do, they better use some very tight controls and pay a lot of attention, because literally anything can happen.

They could also choose to sell everything, take the tax losses, and sit in cash until that point when the inflation we see as inevitable makes the cost of holding that cash too expensive.

Or they can set aside enough cash to assure that their quality of life is not at risk in a collapsing economy and cautiously begin searching out the extraordinary values to be had in gold and other inflation hedges. There is no rush, but one would want to be positioned ahead of the big demand for these inflation hedges we see coming when the wall of government money begins to hit the economy next year.

As Doug Casey recently put it, and as the ghost of Rothbard seconded above, gold's highest and best use is as money, and sometimes it can also be a terrific investment. With the caveat that the near-term deflationary pressures will continue to periodically whip up headwinds for gold and other inflation hedges, we think that Mr. Gold, Ms. Silver, and the resource share clan are screamingly good investments. Personally, I am content with my resource holdings and am holding tight.

"Mr. Cuomo, do you have any further questions or comments before I pass judgment?" Judge Market asked.

"Only that I think these gold bugs are lunatics because everyone, but everyone now thinks that we are going into a deep deflation," Mr. Cuomo said dismissively. "I rest my case."

"Yes, that is so," Galland responded. "But, sooner than most people expect, we think that everyone, but everyone will begin to believe that it is a historic level of inflation they need to most worry about. At that point, Mr. Gold and all his friends will be waiting for them."

"Mr. Reason, do you have any closing comments?"

"No, sir."

"Then would the defendants rise," the judge intoned.

"In light of the evidence presented here today, and because a sound judgment in this case involves the passage of time, I'm going to postpone judgment on this case, and release the defendants with the stipulation that they report back here in six months. At that time, we will update our arguments and Mr. Gold, you and your friends had better have made amends by that time, or else. Do you understand?"

"Not really," Mr. Gold said brightly, "but I'll be back."

Casey Research, LLC. is one of the nation's oldest and most respected newsletter publishers, providing unbiased investment guidance for individual and institutional investors. You can now kick the tires on Casey Research's flagship publication, The Casey Report -- learn more about our special $9.95 two-month trial offer. Click here.

David Galland
Big Gold

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