Macro Tsimmis

intelligently hedged investment

BUY streetTRACKS Gold Shares (GLD)

Posted by intelledgement on Tue, 02 Jan 07

My father has been a gold bug for as long as I can remember. Canadian mines, gold mutual funds, Krugerrands stashed in the bomb shelter (yep, true child of the 50s: my family had a bomb shelter), you name it, he tried some.

When I was a kid, this sounded like a good idea, particularly once I learned to read an inflation chart and looked at what had happened to the dollar since 1945. $35 an ounce? Ha! Tell me another one. However, by the time I got to college and had some economics under my belt, I became more skeptical.

Mathematically, the main dynamic behind the value of gold (taking on faith for the sake of argument that it is intrinsically valuable to humans for whatever reasons) is that a growing demand—as people grow more numerous and richer—is chasing a fixed supply—given that whether yet mined or not, there is an effectively fixed supply of gold on the planet. However, consider that based on the dynamics of supply and demand the market price for risk capital is 10% per year. For gold to increase in value 10% per year, year in and year out over time, the human population of the planet would have to be increasing 10% per year. Fortunately for us all, the human population is increasing at a much smaller rate than that: less than 2% (although some consider that dangerously high).

Anyway, aside from jewelry and some arcane industrial applications, gold is really not all that useful. If not for its history of being used as money, or to back paper money, historical demand would have been much smaller…maybe even $35 an ounce would not seem so outlandish.

So the point is, long term gold is actually a pretty lousy investment. Or, more precisely, it should be a lousy investment. Actually, when you look at the numbers, since the USA unilaterally ended the Bretton Woods system in August of 1971, the S&P 500 index has a compounded annual growth rate of 8%—a tad below historical norms—while gold has a CAGR of 9%. Go figure.

But never mind, because in the event, we are not adding gold to the portfolio as an investment. We are adding it as a hedge against the probable demise of the dollar. Even if gold were sporting a 35 year CAGR of only 2%, we would still be recommending it here, because history demonstrates that when fiat money fails, gold shines.

And the dollar is at significant risk of failing here. The government has a current accounts deficit. We are staring a looming demographics-triggered entitlements deficit in the face with no solution in sight. Individuals in the USA have undertaken more debt per capita than at any time in history, and savings rates have fallen so low, they are actually running in negative territory. And our trade deficit is setting historical highs nearly every month as we fail to produce stuff as valuable as the stuff we buy. All this debt is being financed by foreign lenders who retain confidence in our ability to meet all obligations…for the time being.

As the risk of default rises, normally the only way to get the lenders to keep stepping up to the plate is to raise the interest rate to counterbalance the increased risk with increased reward. In present circumstances, however, increasing domestic interest rates in the USA risks crashing the housing boom-funded economy. No one—presumably excepting Al Quaeda—want to see that.

As it happens—and it’s not entirely clear this is a good thing—there are lenders out there who have big incentives to keep the cycle going—even as the risk for them increases—either because they already own huge quantities of dollars and don’t want to do anything that will increase the rate at which those are depreciating, or because they are big net exporters to the USA market and need to keep those sales happening while they build up their own economies…or both. As my father is wont to remind me, if you owe the bank a million dollars and can’t pay it back, then you’re in big trouble…but if you owe the bank a billion dollars and can’t pay it back, then the bank is in big trouble.

Of course, everyone with lots of dollars can see that the value of the currency is in decline, if not in a death spiral. So there’s lots of folks wanting to cash out dollars for real property, or failing that, for a more stable currency. The problem is that with so many depreciating dollars facing a relatively limited supply of available and durably valuable property, there is a real danger of getting stuck in the exit door, should everyone attempt to stampede out of the theatre at once. So it is a delicate queuing theory problem, with crowd psychology complications.

On top of all these many pressures on the value of the dollar, however, comes the killer: the specter of default. The only way we will ever be able to avert default and pay back all this debt is to inflate our way out of it. And the biggest debtor of all—our own government—still owns the printing presses. The logic is simple and inexorable: if the dollar is worth less, then dollar-denominated debt is easier to pay back (assuming it is not indexed for inflation, that is).

Our best guess is that an immediate crisis is not likely. The Chinese middle class is not yet spending enough to absorb the loss of the USA consumer market, so as long as the American saps keep extending their credit card debt, it is in all the powers-that-be’s interests to retard the decline of the dollar and keep the party going. Of course this non-solution only allows the underlying structural problems to fester and worsen. And as we continue to skate further and further out onto thinner and thinner ice, the situation is progressively harder to manage; the wrong failure by the wrong hedge fund or the wrong terrorist attack at the wrong time could engender a panic that no one can head off before it engenders a selling plunge right through the surface ice into the cold, black depths below.

Whether the final collapse comes next winter or next decade, it is important to keep one’s assets protected from the declining dollar. Owning some gold through this time of turbulence is part of that plan.

The streetTRACKS Gold Shares (GLD) exchange-traded fund (ETF) is not the only gold ETF, but it is the gorilla in the band, with some 80% of the market ($7.5B marketcap). The trust that constitutes the fund actually owns bullion; when the fund started out in 2004, each share was equivalent to one-tenth of an ounce of gold. (As the trust’s 0.40% annual expense load is provided for through the sale of small portions of the gold, this fraction declines modestly over time.)

GLD is not our answer for the end-of-civilization. There is no way for retail investors to redeem shares in actual gold. (Brokerages can buy 100,000 share blocks, or redeem them for gold; that is where the shares we buy come from.) If the NYSE closes due to an overall market collapse, it would be helpful if you had already traded in your GLD shares and used the proceeds to buy actual gold coins, or probably better still, razor blades, alcohol, aspirin, ammo, chocolate, and some pre-1965 circulated US coinage (when they still contained silver). Assuming you know how to use the ammo effectively, that should set you up well for post-apocalypse life…but we digress.

What GLD does do for us is provide a cost-effective, convenient way to maintain an interest in gold bullion. Because GLD is an ETF, one can trade it whenever the market is open (in fact, it trades until 4:15pm most days). No hassles with insurance, transport, storage, or transaction fees. So long as the NYSE is still operating, GLD is a good way to hedge against a decline of fiat currency in general, and the dollar in particular.

For more information about the GLD ETF, check out the streetTRACKS website. For more about ETFs in general, see the “How Intelledgement can make a difference to your life” section of our website.

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