Dateline: 12/02/97

Earlier this month I looked at the theory of gold as money. ( All That Glitters Part 1 ). Though seductive in its logic, I went on to argue in Part 2 that ultimately it is the market, not ideology, that determines what money is. Fiat money can be effective money, and, with an international system of floating exchange rates, governments are driven by market forces to maintain a stable currency. This has been the driving force behind such events as Brazil managing to turn an economy with 5000% inflation around to one with less than 5% inflation. It was the spur behind the dramatic changes in the New Zealand economy. And it was the factor driving both the American and Canadian governments to control their deficits and start soon on the long road to paying down their mammoth debt loads.

I further argued that gold, as a natural resource commodity, must go down in price in the long run (at least in real terms). This conclusion was based on Julian Simon's arguments in his book The Ultimate Resource.

In this final installment I look at gold and precious metals as an investment.

Gold as an Inflation Hedge

Traditionally gold has been held as a hedge against inflation. People have always turned to gold when war or some other catastrophic event might result in government turning on the spigots and flooding the market with cash or when government is perceived to be adopting an inflationary policy. As Ned Goodman, Steven Kelman and Jonathon Goodman put it in their book Investing in Gold, gold is recognized universally "as money that cannot be created or destroyed by government."

George Bernard Shaw said "You have a choice between trusting the natural stability of gold and the honesty and intelligence of the members of the government. I advise you vote for gold."

And it still holds true today. While gold is down against the dollar, it is up against many other currencies. A Reuters report out of Manila Friday reports that in Thailand, where the baht took a beating, people are selling gold to maintain liquidity. People who held gold as an inflation hedge (or a hedge against currency devaluation, which is really the same thing), are saving their bacon as a result.

In fact, in countries with a perceived weaker currency, gold is a very popular hedge. Asia is a huge market for gold. In fact, fully one quarter of the world demand for gold this year has come from one country, India. (535 tonnes out of total consumption of 2191 tonnes), according to the Reuters report.

So where does that leave us in Canada? The Canadian dollar has dropped to its lowest level in years, threatening to drop below US 70 cents. It lost over one percent in the past month…several percent on the year, but still, gold declined even more. Holding gold as a hedge against the Canadian dollar's decline would have proved more than fruitless. It would have been very costly.

But in the seventies, inflation was running rampant. Gold started the decade at $35 an ounce and on January 21, 1980, peaked at $850. It certainly was an effective inflation hedge then.

The chart below shows the price fluctuations throughout the decade. Prices are monthly averages and so does not show the peak at $850, but rather the January 1980 average price of $675.30. Only fluctuations greater than 10% are recorded here. If we took daily figures rather than monthly averages, there would be more spikes and the prices shown here would be higher at their peaks and lower at their troughs. (Source: Kitco. All prices in US dollars.)

As can be seen from the table, the inflationary 70's were a great time to own gold. $10,000 invested in gold at $35 an ounce would have grown to $193,000 by January 1980 if you sold at the average monthly price. If you were fortunate enough to sell at the peak price of $850, you would have received $ 242,857. Not a bad return for ten years! (By contrast, the highly rated Templeton Growth Fund for the same period returned only $60,527) If you had bought gold stocks, you probably would have fared even better.

Nevertheless, the yellow metal experienced some remarkable fluctuations during the decade. An investor could have been badly burned by buying in December 1974 and bailing out in August 1976.

By late 1979, fears of hyper-inflation were rampant. I remember standing in lineups over an hour long to buy a bar of gold on every payday. People were not motivated by greed, but by fear, a very real fear of a currency collapse. Many were older people who had experienced or read in the news about the German inflation of the 1920's or the Hungarian inflation of 1946.

And although the gold price moderated after its peak, inflationary fears still held sway into the early eighties when interest rates rose to 20%. The Aden sisters, gold analysts operating from Costa Rica, predicted $4000 gold by the mid-eighties based on an analytical model they developed.

Governments Smarten Up

But the eighties proved to be an anomalie. Expectations of a runaway inflation did not materialize. Instead we got the conservative revolution. Ronald Reagan, Margaret Thatcher and Brian Mulroney (and I really hesitate to include Mulroney in the same league as the former two) started programs of deregulating the economy, privatizing government operations, and lowering taxes.

And while this proved to be beneficial to the economy, both the U.S. and Canadian governments built up huge debts as well. Finally, in the nineties, governments smartened up and started tackling their debt problems. They started cutting expenditures, privatized even more government operations, continued to deregulate the economy, worked on developing freer trade and introduced user fees for many formerly free government services.

The fear of hyper-inflation had, by the end of the eighties, turned to fear of government insolvency. Today that fear is starting to wane as governments appear to have developed the resolve to make the tough decisions. The price of gold since 1980 looks as follows (same parameters as earlier chart):

As can be seen from the table, the price of gold fluctuated considerably since 1980, but the long run trend has been downwards. Each uptick peaked at a lower level than the previous uptick, with the exception of February 1996 which was slightly higher than the previous high. Does this mean that inflation is dead?

Analysts like Doug Casey in his book Crisis Investing for the Rest of the 90's and Terence Corcoran, columnist for The Globe and Mail, have pointed out that governments have been increasing the money supply steadily, but that this money has gone into the financial markets rather than being reflected in price inflation. Stock prices, they say, have become inflated.

Casey, and his confreres James Dale Davidson and Lord William Rees-Mogg (The Great Reckoning) all predict the mother of all depressions as a result of the monetary inflation and debt build-up of the last fifteen years. Call me a cock-eyed optimist, but I don't think it will happen. Much as I dislike and distrust government, I don't think today's crop of political leaders are stupid. They are serious about reversing the spendthrift ways of the past. And they will eventually pay down the debt It is government services that will suffer as a result, but not the economy as a whole. The economy will benefit.

The central bankers, Canada's Gordon Thiessen and the U.S.'s Alan Greenspan are bent on keeping inflation down. Greenspan in particular, is a hard money man, and not likely to let things slip out of control.

Investing in Gold

With the prospects for renewed price inflation slim to non-existent, where does this leave gold as an investment? If you distrust government as much as I do (and I think distrust of government is always healthy and prudent) you should maintain an insurance position in gold and precious metals against the possibility of political stupidity.

In Canada we have the example of Glen Clark and his socialist gang in British Columbia who have been spending like drunken sailors and sending the provincial debt soaring. Not too long ago, Bob Rae and his NDP crew did the same in Ontario. Mike Harris is picking up the pieces. There is no guarantee that Paul Martin will remain able to dominate his party with his fiscal policies as he has been doing. The Liberals are notorious big spenders (and deficit spenders at that) in their previous stints at government, notably under Trudeau. The party is still full of left-leaning hacks who can't wait to oust Martin and resume their big spending ways.

Bill Buckler, Jr., aka the Captain at The Privateer economic newsletter, possibly the hardest core gold standard advocate I know, states in his opening comments on his Gold Pages on the Internet that "gold is a political metal". He argues that governments are deliberately undermining gold by selling reserves. If he is correct, this is as good a reason as I can think of for not doing more than holding some gold investments as insurance and nothing more.

Governments own enough gold in reserves (35,000 tonnes) to meet current world demand for ten years according to Rod Nutt in an article in The Vancouver Sun last Friday (Nov. 28). The Netherlands, Australia, and Belgium have all been selling gold over the last two years and Switzerland is contemplating selling 800 tonnes or one third of its reserves, So it would seem that Central Bank sales are certainly having an effect on deflating the gold price. (Just the stated intention of the Swiss caused a considerable dip recently!)

Additionally, forward sales by gold producers have had a large effect in keeping gold prices down. This is the position Kelman & the Goodmans take. But eventually, they say, "as more and more of the world's production goes into unwinding these contracts rather than being sold into the marketplace, they will push gold prices higher."

Certainly, looking at the chart above for gold from 1980 to the present, it would seem that gold, after it bottoms, will rebound to almost the $400 level. I believe it is damn near the bottom now, though it could fall as low as $280, just below the $282 previous low set in February 1985. (I still think the long run trend is down, but the chart seems to indicate a definite cycle.)

I used to be a hard core gold bug and held as much as thirty percent of my investments in precious metals. In the last two years I have reduced this to ten percent (partly by selling and partly by a decline in value). I don't recommend holding more than that.

How should you hold gold? My preferred method is through precious metals mutual funds. I converted all my precious metals holdings to one fund , Dynamic Precious Metals, in March 1996. It had a superior track record at the time in all time frames from 3 months to ten years. Since then the price has gone down 50%. (Ouch!) But since I treat my gold investments as an inflation hedge, not so much as an investment, it doesn't bother me too much.

Some of the other funds I have shares in have substantial holdings in precious metals. One could easily skip holding separate precious metals investments entirely and invest in funds that have that insurance built in. At the end of this article I will recommend some of my favorite funds that have a strong position in gold and related issues.

Investing in individual gold or silver mining stocks should only be undertaken if you can do substantial research and/or have a strong expert advisor in whom you have confidence who knows the market.

Bullion? Forget it! For the most part, it sits in your safety deposit box collecting dust instead of interest. If you want to be in gold, go for equities. If inflation resumes and gold prices skyrocket, gold stocks multiply that effect many times. And even if gold doesn't go up, good gold mining companies are still profitable and should give you a return on your investment (barring a collapse in the price of gold like we have had this year.)

Gold coins are an interesting option. I would buy commemorative coins and not bulk gold coins like the Kruger Rand. They have a numismatic value as well as a precious metals value and are fun to own in their own right. They stand to gain even if gold does not. Each year Canada issues commemorative gold and silver coins. Buy right from the government for the best price and hang on to them for the long haul if this is your interest.

If you do not currently have any investments in precious metals, you may want to consider buying soon. Prices are at an all-time low since 1980. Many companies are going under. Those that emerge intact will prosper in the future. But again, don't invest more than ten percent of your portfolio directly in precious metals.

Since my special interest is mutual funds, my recommendations are all funds. I have interests in all of them (as an investor - I do not sell funds and am not a professional advisor.).

My Recommended Funds

20/20 Canadian Resources - has a strong position in precious metals and mining (19.7% in March 1997), but is diversified enough that it has performed well even though gold is down right now. It was among my Power Performers last month.

Multiple Opportunities Fund - for those who are a bit more daring, I recommend this fund from Canaccord Capital. It is available in B.C. only and invests in moderately speculative growth oriented companies, many on the Vancouver Stock Exchange. Much of its portfolio is in gold mining issues, but it also invests in high tech and biotech. Although it is down about 30% on the year, it jumped up 6.7% in October when the market crashed, one of the few funds to gain that month.. As recently as February this year it was still among the top 25 performers for a three month period. It is still the top performing fund in Canada for a five year period with an incredible compounded annual return of 41.8%. It is also sitting on 45% cash.

AIC Advantage II - this is the sister fund of my favorite fund, AIC Advantage (which is closed to new subscribers). Baby AIC Advantage has performed solidly since its inception last year. 7.6% of its holdings are in gold and precious metals with Franco Nevada being one of its largest investments.

Gold & Mining Related Websites

The Privateer - in my view, one of the best hard money sites on the Internet. An always interesting analysis of the world economic picture. It is Australian but has an international perspective. Written by an ex-patriot Canadian.

Canaccord Capital - one of the best sites for specific stock recommendations, particularly in the mining sector. Register (it's free) and subscribe to the Daily Letter. It is chock full of great analysis. Check out their Canaccord 50 and Canaccord 100 Reports, as well as their Gold Update.

Stockscape - this Vancouver based site has daily news on mining and also is the host site to a number of gold and precious metal related newsletters, including Jim Blanchard's Gold Newsletter.

Kitco - Kitco is a Montreal based company that refines and processes gold for the jewellry and dental industries. It maintains one of the premier precious metals websites in the world with extensive historical information and an online discussion group.

Mintek BusInfo - this South African site reports on mining news from around the world and is particularly strong on news about South African gold mines.

Investing (Canada) Gold Links - hey! this is my own set of links! Check here for more links to gold, precious metals and mining sites.

Missed the earlier installments of this article? Click below!

All That Glitters Part 1

All That Glitters Part 2

Agree? Disagree? Send me your comments. I may publish them in a future article!

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