Gold - A Barbarous Relic?

 One hundred years ago, in 1924, the seminal macro-economist, John Maynard Keynes, called the gold standard (and by proxy gold) "a barbarous relic." That said, with a 6,000-year history of stored value and cross-cultural popularity, gold remains relevant to this day and the foreseeable future. Due to the unprecedented fiscal irresponsibility of the major sovereign nations, especially over the past score years, the future importance and pecuniary value of gold may increase at an exponential rate. For historical context, it should be noted that the basis for our current global monetary system was established near the end of World War II in 1944 under the terms of the Bretton Woods Agreement. The most important provision of this Agreement was the United States dollar becoming the world's reserve currency. Other currencies were in turn pegged to the U.S. dollar, which in turn was backed by gold. The gold backing was discarded in 1971 when President Richard Nixon ended the direct convertibility of the U.S. dollar to gold. With the collapse of the gold standard, the reign of fiat currencies began.

Why is gold valuable? First and foremost, it is rare. Extremely rare. It's estimated that the amount of mined gold in the history of the world comes in just under 200,000 tons, with the majority of that total being unearthed since 1950. All of the world's mined gold would make up: "one cube with dimensions of 20.5 meters. If it was all melted, it would fit within the confines of an Olympic-sized swimming pool." On average, the global supply of gold increases by between 1.0% and 2.0% per year. It is difficult to discern the amount of gold remaining in the earth's crust that will eventually be mined. Obviously, there is a finite supply of gold. We do know that the easiest and least costly extraction of gold is nearing the end. Production from the known big geologic formations has "hit the wall" in recent years. People in the industry believe "peak" gold production is either at hand or will occur in the next 10 years. Based on known reserves, estimates suggest that gold mining could reach the point of being economically unfeasible by 2050. If demand continues to rise while available supply stagnates, the basic economic theory of supply and demand would suggest that prices will rise substantially in the future. Besides rarity, gold is durable. It does not corrode, atrophy, or deteriorate. For these reasons and others, gold has commercial applications in such areas as jewelry, electronics, aerospace, dentistry, and mobile phones.

The spot price for gold recently (8/16/24) closed above $2,500 (per ounce) for the first time ever - closing at $2,509.65. At that price, the value of all the gold in the world approximates $16 trillion. Central banks have been hoarding gold for the past few years - buying gold at a record pace - adding 1,037 tons in 2023 and 1,082 tons in 2022. For the first quarter of 2024 - global official gold reserves increased by 290 tons, the largest quarterly increase since 2000. Central banks are attracted to gold because of its safety, liquidity, and return characteristics. They also see it as a way to diversify away from the U.S. dollar, which has historically made up the majority of their reserves. Foreign central banks are wary of the United States weaponizing the dollar and our financial system to achieve adherence to U.S. foreign policy objectives. That is especially the case after the imposition of severe economic sanctions on Russia after it invaded Ukraine. At the individual retail level, Americans have been net sellers of gold in the past few years. That has not been the case in Asia where investors, particularly in China and India, have aggressively been buyers of gold.

There are powerful reasons why an investor would be wise to allocate a portion of their investment portfolio to gold. Under the principle of extra portfolio diversification, it makes sense to spread the value of one's portfolio across various asset classes. This allows you to minimize losses, as it's unlikely every asset will suffer from the same market conditions. Historically, gold has consistently provided a good hedge against inflation. When the inflation genie escapes from his bottle, the dollar's purchasing power goes down, sometimes precipitously. It is unsettling to an economy and a society when it takes more dollars to buy the same level of goods and services. Gold is considered a safe-haven asset. A war in the Mideast or another sensitive area in the world can elicit buying demand for gold and send the price for this commodity soaring. Investors often buy gold to protect their savings in the event of a market crash. They seek portfolio "insurance" in the event an overvalued equities market gets whacked 30%-50% in a bear market (something that happens on average every 7-10 years). It would be unbalanced not to mention a couple of drawbacks concerning gold ownership. Unlike bonds, real estate, and dividend-paying stocks, gold does not generate a stream of income. The only way to make money investing in gold is through price appreciation. There can also be storage or holding costs if physical gold is held by a third party.

There are fundamentally three different ways to invest in gold. One way is to own physical gold either in the form of coins or bars. Depending on the amount of gold, it can either be held in a bank safety deposit box, a safe in the investor's primary residence, or with a business providing safekeeping services. Some investors prefer to indirectly own gold via investing in ETFs or mutual funds that hold physical gold. The value of these investment vehicles is directly correlated with the market price of gold. Another play on gold, a riskier one, is to purchase stock in gold mining companies. The price volatility and management quality of these companies can pose problems for risk-averse investors. However, when conditions are favorable, outsized capital gains can be realized on gold mining stocks.

Next, we'll take a look at how gold performed compared to some of its competing asset classes over the past half-century. Between 1971 and 2024, gold returned 7.98% per annum, while the stock market garnered an annual return of 10.70%. However, if you look at the period from 2000-2024, gold has outperformed the returns of both stocks and bonds. Gold has had a good run over the past 12 months - returning 33.18% vs. the Nasdaq at 32.44% and the S&P 500 at 27.47%. The average American investor holds 1% of their investment portfolio in gold. Some investment advisors recommend an allocation of gold in the 5% - 10% range. I would be in that camp, advocating an allocation of 8%. That would be further divided as follows: 4% in physical one-ounce gold coins (American Eagles) and 2% each in the common stocks of Newmont Corporation (NEM) and Franco-Nevada Corporation (FNV).

What's in store for gold in the future, in particular, the value of gold as measured in U.S. dollars? Since gold is real money, hard money, in contrast to every fiat currency in the world, including the dollar, gold's reign as the ultimate currency for thousands of years will continue. Gold will keep appreciating as the various fiat currencies in the world depreciate. I believe the possibility exists that some governments may eventually incorporate gold confiscation programs. Between 1934 and 1974 it was illegal for U.S. citizens to own gold. In 1934 the Gold Reserve Act gave the United States government title to all of the gold coins in circulation and ended the minting of new gold coins. Forty years later in 1974 during the Ford Administration, Congress passed legislation to once again allow Americans to legally own gold. Led by the U.S. and its wayward fiscal and monetary policies, we are witnessing a train (global economy) wreck unfold. It may take another 8-12 years, and the dollar may be the last man standing, but the train and the current international monetary system (fiat money) is heading toward a violent derailment. Post-crisis, much like Bretton Woods in 1944, the major economies will meet somewhere and hammer out a new monetary system. We are not going back to the gold standard, but I believe gold will be in a basket of commodities that will back the new system. Making financial predictions 10 years out can be a fool's game. Since I at times qualify to play that game, I'm going to end this blog with a prediction that in a decade hence, the value of one ounce of gold will be closer to $15,000 than zero. 

 

 

The Myth of Obscene Profits

 At some point in the indeterminate past, the concept of business-related profits shifted from the positive side of the morality spectrum to the negative side of the spectrum. As a dyed-in-the-wool capitalist, I find this trend disturbing. With inflation in the forefront of the last 3-4 years, the mainstream media churns out a never-ending stream of specific accusations of price-gouging, profiteering, and realization of "obscene" profits. Interestingly, I have never read or heard an empirical description of what exactly constitutes price-gouging. It appears to be a wispy, vacuous claim with various consumers looking at the matter differently. Instead of a widely accepted formula or set of statistics to define price-gouging, there is a subjective "feeling" or sense that the consumer is being exploited. This doesn't fly in my book. I do not subscribe to the concepts of price-gouging and excessive profits.

In the world of physics, gravity is a fundamental interaction that causes the mutual attraction between all things that have mass. In economics, the dynamics of supply and demand represent the fundamental interaction in establishing price points for literally all goods and services. I would go so far as to say the relationship between supply and demand is the very foundation of the economic system we refer to as capitalism. The scarcity of a good or service leads to higher prices, while an abundance leads to lower prices. To a great extent, the financial goal of a business or individual selling a product is diametrically opposed to the financial goal of the business or individual buying the product. A business selling widgets wants to sell widgets for the maximum amount the market will bear and thus maximize profits. Whereas the consumer buying the widgets wants to buy them for the least amount possible and thus minimize their expense. A home seller strives to sell their residence for the highest amount they can secure. While the home buyer attempts to purchase the house for the lowest amount they can negotiate with the seller. It is simply how financial transactions work.

Following are some scenarios that many people would construe as examples of blatant price-gouging. The first three are fictitious, and the final one is not so much:                                                                    1.) I purchase a $100 raffle ticket from a charitable organization. The winner of the raffle will land four prime tickets for a Taylor Swift Eras Tour concert. The cumulative face value of the tickets is $6,400. Somehow, the stars line up and I win the damn raffle. I proceed to go on Stub Hub and sell these tickets for twice their face value, or $12,800.                                                                                                         2.) In March I purchase four season tickets for the Chicago White Sox home schedule with no intention of attending any of the games in person. My goal is to make money by reselling (at a premium) the tickets in the secondary market. Although projected to be a mediocre ball team, the White Sox surprised everybody and ended up being one of the best teams in baseball. From early June onward I sell my tickets for consistently more than twice face value. By the end of the season, I have realized a financial windfall.                                                                                                                                           3.)Based on reviewing reams of data, I strongly believe Florida is going to experience a severe hurricane season. In early July I make arrangements to lease a semi-truck and trailer through October 31st. I proceed to purchase and fill the trailer with Pop-Tarts, peanut butter, bread, bottled water, flashlights, batteries, and generators. My hurricane predictions come to fruition and I head to the hard-hit areas of Florida. I easily sell my entire inventory of products for three times face value and pocket huge profits for my efforts.                                                                                                                            4.)In 2015, while Martin Shkreli was CEO of the company formerly known as Turing Pharmaceuticals, the price of the lifesaving drug Daraprim used by AIDS patients was raised from $13.50 a pill to $750 a pill. To say there was a loud and sustained public outcry would be a sizeable understatement. Mr. Shkreli was quickly classified as the antichrist and considered the worst human being since Bernie Madoff became a household name.

I contend that none of the previously detailed scenarios, even #4, should be considered price-gouging or profiteering. In each of these cases, the entrepreneur has exposed himself to risk, financial or otherwise. In the Taylor Swift situation, I took the risk of antagonizing my two granddaughters. With the White Sox tickets, the team could have been terrible, even the worst team in MLB history. The demand could have dried up even to the point where I literally could not give the tickets away. Insofar as the hurricane "play," the risk would be that not a single storm materialized and I was stuck paying for the truck and trailer and selling the hoard of items at a dramatic discount. Lastly, Martin Shkreli was ultimately convicted of securities fraud and sentenced to a stint in prison. His pricing of Daraprim was not illegal. However, the negative publicity garnered the attention of law enforcement and prosecutors. Shkreli painted a target on this back and put his freedom at risk when he aggressively priced a product. The moral of the story is that over-zealous pricing can come back to bite a seller in the future. A business normally does not want to destroy its image and stream of long-term profits as a result of realizing over-the-top short-term gains.

The politicians, regulators, and consumers who rail about price-gouging and corporate greed have a tenuous grasp of economics and reality. Allowed to act in an unencumbered manner, the omnipotent Market in time resolves any issues involving excessive pricing. Monopolies tend to be short-lived in a capitalistic system. History shows us that markets find a way for domestic and foreign competition to eventually surface. As a present-day and forthcoming example, watch what happens to Nvidia's earnings and share valuation as competitors and innovators attack their market share with vigor.

Stock Buybacks

 For corporations with extra cash, there are essentially four options to consider in terms of deploying their cash surplus, and they are as follows:                                                                                                       A.) Make capital expenditures or invest in other ways into their existing business.                                   B.) Pay cash dividends to the shareholders.                                                                                               C.) Acquire another company or business unit.                                                                                           D.) Repurchase their shares.                                                                                                                    Increasingly over the past few years, many companies have opted for "D" above, buying back a portion of their outstanding shares. The last three years have seen more than $1 trillion in share buybacks, for each year. It has reached a magnitude where it has become a controversial business and political issue.

In my opinion, the reason, the motive why a corporation elects to buy back shares, is the determining factor in judging whether the action is deemed positive or negative. Famous investor Warren Buffett once said critics of stock buybacks are "either an economic illiterate or a silver-tongued demagogue" or both, and all investors benefit from them as long as they are made at the right prices. He opines they should be utilized when the share price is "well below intrinsic value." In that case, the company is entirely justified in using its capital to repurchase its own stock. Share buybacks reduce the supply of stock available in the market and increase Earnings Per Share (EPS) on the remaining shares. The EPS is one of the most important metrics reviewed by investors. The argument can even be made that it is the most important piece of information. Buybacks mathematically increase the Earnings Per Share, which often translates to boosting the value of shares that management feels are grossly undervalued. 

There is no shortage of parties that believe stock buybacks should be banned under any circumstances. I don't agree with this contention, but understand why this position enjoys support. Until 1982 stock buybacks were considered market manipulation, and therefore illegal. The buy-back restrictions were swept away in the flood of market deregulations during the Ronald Reagan era. Those opposed to capitalism, in general, accuse corporations of boosting their own stock at the expense of investing in innovation and rewarding their workforce. They prefer increased wages, lowered prices, or a combination thereof. According to many on the political left, stock buybacks are the epitome of corporate greed. Of course, the denizens of the political left have never been known for acumen in economics and commerce.

There is no question, however, that some corporations have abused buybacks at times to the detriment of their workers and the majority of shareholders. Buybacks can help increase the value of stock options, which are part of many executive compensation packages. One common measurement for these executive bonus programs is the aforementioned Earnings Per Share (EPS). Buybacks artificially and mathematically boost EPS. At times this will allow insiders to profit while they have nothing to increase the company's actual value. The Federal Reserve Bank's monetary policies over the past decade or so have greatly contributed to the preponderance of stock buybacks. Until a couple of years ago, interest rates were artificially depressed to the extent that it was extremely enticing for corporations to utilize ultra-cheap debt to fund buybacks. The cheap debt distorted the value of the S&P 500 through an unsustainable pace of buybacks. Much, if not all, of the general stock market appreciation can be attributed to the buying demand fueled by share buybacks.

Starting in 2023, buybacks of publicly traded stocks were subject to a 1% excise tax. There have been rumblings in Congress that the Democrats would like to increase this excise tax to 4%. The upcoming elections in November (2024) will go a long way in determining how buybacks are treated in the future. I fundamentally struggle with the concept of the government dictating how a corporation should conduct its business. If corporate management and the Board of Directors abuse their power via ill-timed and ill-conceived stock buybacks, then shareholders should be the party that makes changes, not the government.