Should You Buy Gold as a Hedge Investment?

The year 2020 is destined to be a defining moment for this generation of humans. The economic success of countries around the world, the lack of global conflict, and the technological advances of the past seventy-five years created a sense of personal security, unlike that experienced at any time in history.

The possibilities of worldwide economic collapse, famines, and political chaos were considered events of the past, eliminated by mankind’s ability to control its destiny and optimistic expectations of a prosperous and safe future.

On January 11, 2020, the Chinese government reported the first known death in the Wuhan city from the new virus, commonly known as Coronavirus or Covid-19. Less than one month later (February 2), the first death outside China from the illness occurred in the Philippines. Less than two weeks later, France announced a virus-caused death followed by the first reported death in the United States on February 29, 2020.

Governments around the world declared national emergencies and instituted quarantines and stay-at-home orders. Thousands of businesses – small and large – terminated, furloughed, and cut the pay of employees. Many closed their doors, unable to survive without resources to survive. With the loss of customers and productive capacity, countries’ GDPs quickly contracted, triggering massive amounts of new government debt to sustain critical programs and relieve suffering. In the United States, the Congressional Budget Office estimated a 38% drop in GDP and a single year deficit increase of over $2 trillion.

The Investor’s Dilemma

No expert predicted the extent of lost incomes, consumer product hoarding, ineffective or absent critical healthcare supplies, projected food shortages, or the confused, often conflicting governments’ response to the Covid-19 pandemic. No one can forecast if or when the virus will be controlled. Will today’s environment become the new norm?

Robert Shiller, the 2013 Nobel Laureate economist, writing in the New York Times, claims the world has never experienced an event like the Covid-19 pandemic. “The tools of Statistical analysis and machine learning, powerful as they are, can’t adequately assess what the world is experiencing.” When asked if the market is cheap today, Shiller replies, “It’s not as highly-priced as it was just months ago.” He worries that the market might replicate the experience of the Great Depression. From 1929 to 1932, the S&P 500 lost three-quarters of its value and did not return to the same level until seven years later.

Investment firms Goldman Sachs and J.P. Morgan predict a worldwide recession of indeterminate length following the virus. Few reputable stock market investment firms are willing to make a clear prediction about the direction of the market in the next few years, preferring to rely on simple advice that stocks will be profitable over the long-term. It is unclear whether they mean one year, two years, five years, ten years, or more. Nebulous, mealy-mouthed advice is little help for investors who have seen their portfolios drop 20%, 30%, or more and do not know what to do.

Likelihood of an Extended, Deep Recession

By the end of 2020, global government debt will exceed $53 trillion, with an estimated global GDP of $85-$87 trillion. Most of the world’s industrial countries’ GDP is expected to shrink in 2020 due to the coronavirus. Factors that could further imperil economic growth in the near term are the

• Repeated epidemics of Covid-19

  An inability to find a vaccine for the rapidly evolving virus could result in rolling shutdowns of industry and communities in the future…

• Decline in petroleum prices

  The failure of the producing countries to stabilize prices amid a global decline of demand disrupt distribution channels and escalate international tensions, especially in those countries that rely significantly on oil revenues…

• US and China conflict

  The confluence of trade, Covid-19, and Hong Kong issues during a hotly contested campaign for the U.S. Presidency escalates tensions that might end in war.

• Demand for social programs

  Citizens in many countries have experienced mass layoffs, deficient or absent health care, and stagnant job growth. They will pressure national, state, and local governments to expand service despite reduced revenues from income, property, and sales taxes.

• Higher interest rates

  Nations have been able to service growing levels of debt due to historically low-interest rates. If interest rates rise, the cost to maintain the existing levels of debt in the world will increase significantly. For example, a return to the 30-year average interest rate of 5% would require interest payments of $825 billion, or half the amount collected on all personal income tax.

• Excessive low-grade corporate debt

  U.S. corporate debt at the end of 2019 was almost $10 trillion, prompting many investment firms to warn their clients of the increasing risk of holding low-rated investment corporate debt. The BBB-rated debt accounts for more than 50% of the total market value of investment-grade debt.

Are investors headed to the Perfect Storm? Probably not, but the odds of an extended recession are high. If not likely. In past times of confusion, gold prices increase because people want a safe place to put their cash. In this uncertain environment, hedging your investment portfolio with gold is warranted.

Safe-Haven Investments

Investing in a safe-haven investment is defensive (averting future losses) and offensive (preserving value that can be used for future opportunities). Many Investment managers recommend portfolios with 10%-20% of their value in assets that function as an insurance-like hedge that increases in value whenever systemic markets crash.

Assets such as fine art, wine, exotic cars, and real estate are sometimes promoted as recession-proof investments, generally by those who stand to profit from the recommendation. Such items are illiquid and often require extraordinary expertise to value.

Gold – the Oldest Safe-Haven

Mark Spitznagel, Founder and Chief Investment Officer of Universa Investments, writes in Barron’s magazine that gold, as a safe haven, “looks pretty golden.” The Motley Fool, one of the stock market’s best-known stock advisory group, concurs: “When capital markets are in turmoil, gold often performs relatively well as investors seek out safe-haven investments.”

Finally, the editors of Yahoo Finance write, “Gold has a knack for retaining value, and it is especially popular during downturns when it typically performs well as an investment. For some reason, humans place value in the tangibility and allure of gold, like Gollum to the ring.” The implied message from these and other financial experts appears to be: “Buy Gold.”

The fact is that, if paper money were to suddenly become worthless, the world would have to agree on something of value to facilitate trade, most probably gold as in the past. This is one of the reasons that investors tend to push up the price of gold when financial markets are volatile. Gold has maintained its purchasing power over a vast span of history, and that is not likely to change.

Between November 30, 2007, and June 1, 2009, the S&P 500 index fell 36% while the price of gold rose 25%. This is a decade-old example of a prolonged stock downturn. Still, it is pertinent because there were very real concerns about the viability of the global financial system then as is the case today.

Man’s Attraction to Gold Metal

The yellow metal has fascinated men since the beginning of recorded history. It was valued in ancient societies including the…

• Varna culture

  A grave site dated to 4600 BC contained the oldest gold treasure in the world, including a gold mace, jewelry, and objects made of gold.

• Sumerians

  Men and women of the world’s oldest known civilizations wore gold chains and jewelry.

• Egyptians

  Prized by pharaohs of 3000 years ago, the capstones of the pyramids in Gaza were made from solid gold. The death mask of King Tutankhamun was covered with gold leaf.

• Incas

  The Peruvian civilization considered the metal as “sweat from the Sun God”. Their Spanish conquerors found rooms, statues, and a throne of pure gold, fueling rumors of a city of pure gold, El Dorado.

Multiple mentions of gold are found in the Torah (the Old Testament of the Christian Bible). The Roman and Greek cultures valued gold, even decorating themselves with jewelry and gold adorned clothing.

The appeal of gold and the possibility of “striking it rich” has drawn thousands of adventurers to remote, often hostile regions around the world whenever news of gold discoveries appears.

Brazil in 1693, Australia (the 1850s ), South Africa (1886), the Klondike (1896), and Kenya (1932) are just a few of such migrations during the past five hundred years. Some observers claim the discovery of gold at Sutter’s Mill, California, was the critical impetus leading to California’s statehood and the building of the transcontinental railroad system.

Gold and Mercantilism

Adam Smith, sometimes called the Father of Capitalism, created the Mercantile system that affected foreign trade between nations for several hundred years. His theory was based on the belief that a nation’s wealth depended on its gold and silver stores.

To boost a country’s coffers, the government restricted imports (keeping gold in the country) while boosting exports (drawing gold from other countries to the Treasury). The consequences of England’s restrictions on imports to the American colonies are considered one of the Revolutionary War causes.

For centuries, governments around the world tied their currency to gold, effectively limiting the potential supply of money to the country’s gold reserves (the Adam Smith effect). Because of World War II and the need for foreign debt to fund the war and rebuilding, most countries agreed to back their national currency with gold at a fixed exchange rate (Bretton Woods).

Gold and American Currency

Before America adopted a gold standard in 1879, the country’s currency was backed by silver (each dollar could be exchanged for 371.25 ounces of silver with a ratio of silver to gold set at 15 to 1. In other words, the de facto rate of a dollar bill was 24.75 grains – a grain is equal to 0.00228571 ounces – or 0.056 ounces of gold. The Gold Standard Act of 1900 eliminated the exchange for silver, establishing gold at a ratio of $20.67 in currency to 1 ounce of gold.

Facing the ruins of the Great Depression, President F.D. Roosevelt forbade banks to export or redeem paper currency for gold in 1933. He subsequently required all gold coins and gold certificates in denominations of $100 or more to be turned into the Federal Government in exchange for currency. After the gold was collected, the official gold price was raised to $35 per ounce, where it remained until 1971.

The President also made the private ownership of gold coins or bullion illegal for Americans, punishable by up to ten years in prison. The action was thought necessary to back new currency issues since gold remained the official exchange medium between countries.

President Nixon abandoned the gold standard in 1971. Since then, the dollar has been a “fiat currency” whose value is backed by the United States’ full faith and credit. His action eliminated the practice of foreign governments exchanging dollars for U.S. gold reserves. On January 1, 1975, restrictions on the ownership of gold in any form by Americans were eliminated.

Deficits, Inflation, and Gold

When governments run significant budget deficits, the temptation to print more money can be irresistible. Many economists justify the politicians’ deficit spending by theorizing that printing money is just a “merger of fiscal and monetary policy.” Their analysis effectively rejects the commonsense adage, “There is no free lunch.”

In effect, the magic occurs by printing money to buy Treasury debt that will never be repaid. The lender (the U.S. Government) and the borrower (the U.S. government) are the same. The logic also assumes that most future buyers of debt will continue to be U.S. citizens or institutions who now owe about 61% of Federal Government debt. The possibility that refinancing the 39% of the debt owed by foreign investors might not be possible in the future is rarely considered.

Governments with fiat currencies can print an infinite number of dollars and have a history of doing so to avoid facing economic realities. Printing more money does not increase economic output, only the amount of cash circulating in the economy.

The amount of goods available does not change. When more money is printed, consumers gain a temporary boost in purchasing power until firms raise prices on the products they have to sell. Cycles of printing money and raising prices can quickly become run-away inflation, or hyperinflation, as experienced in Weimar Germany after WWI or Yugoslavia in 1994.

Investors can either proceed with the new thinking about government debt or consider examples throughout history when governments exceeded their capacity to pay their debts. If you have not decided whether or not to buy gold in these troubled times, consider the advice of Jared Dillian, an investment strategist at Maudlin Economics.

As the author of Street Freak: Money and Madness at Lehman Brothers Jared Dillian writes, “The price of gold also goes up when the federal deficit grows, as it’s doing now. This was the other reason gold more than doubled between 2009 and 2011: The government’s annual budget deficit soared into the $1.8 trillion neighborhood. Now the government is talking about running the biggest deficit in the history of the United States. Even bigger than we had in World War II. And that bodes well for gold.”

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Investing in Gold

All potential investments should be scrutinized to avoid scams, tricks, and exaggerations. Precious metals have attracted their share of crooks over the years, ready to separate the greedy and fools from their money. Potential gold purchasers should recognize the difference between actual physical gold metal and “paper gold.” The latter includes…

• Gold ETF shares

  Gold ETF shares are simply a digital version of gold, not gold itself. The gold is owned and handled by a trustee, usually a bank. Shares in a gold ETF can rarely be used to redeem any gold.

• Gold mining stocks

  Companies in all industries benefit from higher prices for their products. A mining stock’s value is based on the financial operations and assets like the shares of other publicly traded common stocks. Market trends (prices going up or down) influence their value more than gold prices.

• COMEX gold futures

  Most gold futures contracts are never exercised (no actual gold is delivered or received). The Futures market primarily exists so that industry principals can stabilize prices and costs (hedgers) by transferring the risk or price movement to speculators. A single contract represents 100 troy ounces of gold. The amount of gold represented by the outstanding futures contracts is substantially higher than the actual gold held in the Exchange warehouse.

For many people, the best “gold” for investment is physical gold. It can be purchased from, and sold to, reputable dealers, assayed, and stored by owners in their choice of secure locations.

Gold Prices

In America, the U.S. Official Government’s price of gold was unchanged at $35 per ounce between 1934 and 1971. The price per ounce was raised to $38 in 1972 and $42.22 in 1973. While Americans were restricted from owning gold, investors of other nations were active buyers. The world’s price of gold per ounce rose $37.44 (January 14, 1971) to $2,061.50 on August 7, 2020.

Despite laws prohibiting ownership of gold, wealthier citizens of the world have always owned gold as a hedge investment against inflation, completing transactions and storing the metal in offshore accounts. Many, unwilling to break national laws, turned to gold coins, albeit with questionable numismatic value.

Types of Gold Metal Investments

The more popular investments are coins issued in various weights and issuers. Popular coins include the American Gold Eagle bullion coin, the Canadian Gold Maple Leaf, and the South African Krugerrand. Privately minted gold bars and rounds are also available in various weights from dealers.

The Federal Trade Commission warns that “unscrupulous sellers often overprice their coins, lie about the bullion content, or try to pass off ordinary bullion coins as rare collectible coins… private mints issue coins that look like bullion coins minted by foreign governments, but may have little or no gold content.

Your best defense is to study the market and choose your dealer carefully.”

Precious Metals Self-Directed IRA

Many dealers offer self-directed IRAs where the saver can invest in precious metals. The metals – gold, silver – are held by an independent depository through the direction of a custodian bank and trust.

Investing through an IRA may protect your savings from inflation, currency devaluation, and other investments’ price volatility. Using an IRA to hold precious metals that do not generate income is not recommended for everyone. Before establishing a Gold IRA, consult with your financial adviser to understand the benefits and disadvantages.

Final Thoughts

Gold has demonstrated its investment benefits over a long period. It is considered by financial advisers and investors to be one of the safest investments, the price often tracks in opposition to the stock market or economic swings. If you are worried that a recession and an accompanying bear market will devastate your portfolio’s value, you should consider owning gold.

Jim Rogers, a co-founder of the Quantum Fund advises, “First, do your homework, don’t buy gold because you heard me say it or even because you say it. But if people do not own [gold], they should start after they’ve done their homework.”

You’ll be glad you did.

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