Gold for the Long Run

20 Sep 2017

Gold for the Long Run

The idea of me rebuking a cornerstone of finance, Stocks for the Long Run, by Wharton's Jeremy Siegel will bring smiles to the faces of my Wharton classmates as I was an undistinguished student during my days at SteinbergDietrich Hall. But sometimes the smartest people can miss the biggest icebergs – just consider Ben Bernanke who missed the financial crisis of 2007 apparently pinned under mountains of data that blinded his views of ridiculous leverage and excess.

The bottom line is that Stocks for the Long Run, like most financial textbooks, is myopic and does readers an injustice. It is built upon some assumptions that are questionable at best and focuses virtually all of its guidance on the extrapolation of those assumptions ignoring other key tenets from what is really "the long run" of investing history. Siegel concludes what may be the most important section of his book for the next ten years:

"The message of this chapter is that stocks are not good hedges against increased inflation in the short run. However no financial asset is…Fortunately for shareholders, central bankers around the world are committed to keeping inflation low…and they have largely succeeded."

Such a statement is inaccurate, and as it relates to bankers, is also naïve. One would be hard pressed to argue that bankers are committed to anything other than their own self interests and to say that they are committed to low inflation is ludicrous given their actions. Furthermore to say that no financial assets are a good hedge vs. inflation speaks from the myopia of Wall Street which only seems to consider "assets" as being paper instruments that can be created for a fee from their syndicate desks. This narrow and flawed perspective permeates Siegel's work, and in his defense, most tomes written on investing that have been popular in recent years borne from years of declining interest rates.

One imminent danger of following Siegel's advice is that we are heading into an inflationary period thanks to the untested lab experiment central bankers are playing with currently. To build a portfolio upon Siegel's findings ignores that the tenets he uses as building blocks are not valid in many cases. A more sage approach would be to make no assumptions about the skills and interests of bankers and to have a diversified plan designed to ride through any storm rather than naively betting one's future on domestic and global governments looking out for your family's best interests.

In constructing such a portfolio, investors need to quickly understand that gold and silver are time proven excellent hedges from inflation and both are financial assets. Not only are they financial assets, gold and silver belong in the cash portion of every portfolio as they were ordained by the Constitution of the United States as our only legal cash (Article I, Section 10). Indeed it is "dollar cash" rather than "gold cash" that is the fleeting currency impostor and it is "dollar cash" that was the focus of the death penalty in the Coinage Act of 1792. Why did our founding fathers make such a radical law? Because they saw firsthand that if individuals saved in an asset (think any fiat currency, especially US dollars today) that became worth less than its holders expected, it would be devastating. The source of our fathers' concern? Every paper currency in history has failed. Despite this abysmal fiat track record, Siegel makes no mention of the insanity of having nearly all of one's safe money in one fiat currency, aka checking and savings accounts, CDs, etc.

This is a disservice to readers because even Siegel would not suggest 100% of a portfolio be allocated to stocks and the divergent performance of the dollar vs. gold over time has been dramatic and needs to be addressed. Although Siegel does not discuss it at all, his data set of real returns from 1802-2006 shows that gold cash went from $1 to $1.95 while dollar cash went from $1 to $.06. This divergence proved the difference between wealth and poverty for many, and holds true when looking only at the last century as well. Indeed, in contrast to simplistic models you may have been taught, checking and savings accounts belong in the high risk, low reward quadrant of risk/return charts given the consistently negative performance of dollar cash.

We make no bones about how horribly gold performed from 1980-2000. Investors need to realize though that the key input in valuing hard and paper assets, namely interest rates, went from 20% to near 2% over that period. Such a move is generational that mathematically cannot be repeated from current levels. That move provided a brutal headwind for gold and was the afterburner for paper assets. Now that we are poised to see rates move higher rather than lower, the headwinds will reverse, providing the fuel for hard assets and a multiple compressor for equities. The fundamental landscape is more like 1970 than 1980 so investors may be well served to recognize the period from 1980-2000 bears few similarities to today's markets.

Another danger in accepting Siegel's assumptions is that politically it is not as clear the world is moving toward capitalism as he argues. One needs to look no further than America to see this and we can only hope that the trend towards destroying investors' rights reverses.

Ironically Siegel maintains that his impressive data set represents the long run, but next to gold's history in the Book of Genesis, a history of stock performance can really only be considered the intermediate term. We can even triangulate on the durability of gold returns from Ancient Rome where manuscripts tell us that an ounce of gold equated to a month's minimum wage. Using current minimum wages, such a calculation suggests that gold has preserved ~80% of its owners' wealth from over 2,000 years ago! This is a stark contrast to the dollar which has only preserved ~5% of its value in less than a century.

Such safety shines solely on gold and silver. It also leads to the incompleteness of an another tenet of Siegel's that is indicative of the mentality of the Internet Era and Wall Street's unquenchable need to grow in order to survive: "the focus of every long term investor should be the growth of purchasing power." This view of investing for growth crescendoed to a monopoly with the internet bubble in '99 when speculators were willing to risk everything for the chance to grow their net worth.

Since that time, we believe investors have begun the next generational investing shift of our era moving away from Siegel's view of "always growth" and towards wealth preservation. The early innings of this monumental shift are underway and are characterized by the window dressing we see today with superficial reallocations of asset portfolios to "dollar cash" and fixed income. The next phase of investors' transition to a focus on wealth preservation will be characterized by questioning "why" either dollar cash or dollar bonds should be considered safe havens given the balance sheet of the US government and the pounding bonds could suffer in a rising rate environment. This questioning has already begun in earnest overseas as we observe the Chinese, previously the biggest US debt holders, dumping American debt while the dollar is shunned from the Middle East to Moscow. We also see this occurring in oil as OPEC is moving away from dollars and starting to denominate oil in Euros and other currencies.

These foreign investors, ahead of the curve as compared to US citizens who are still mired in domestic rhetoric, are concluding what Americans soon will: There is no way out for the dollar and the erosion of the dollar corresponds with the re-emergence of gold and silver as currencies that offer safety having stood the test of time.

Lastly it is noteworthy to question several aspects of the data that Siegel presents. A hedge fund portfolio manager who wishes anonymity other than his nickname Copernicus, has highlighted a few lesser known observations in his work through the years. Consider that Siegel's numbers focus on the US during the period it emerged from obscurity to global dominance. Some other countries returns over that period were ~4.5% rather than 6.5% and many declining empires were far worse. Even using US numbers though, if one calculates returns consistently with the gold: dollar ratio of 1792, returns are only 2.5% showing the errors of using a variably defined CPI in Siegel's work. The data also does not allow for the tax implications of dividends and even modest portfolio turnover which cut equity returns by 20%.

One may say that my argument misses the bigger picture, which is that stocks outperform gold and therefore stocks are the only long run asset. Per above durable cash, i.e. gold, cannot be rationalized away in a period of stress while the real long run data set is measured in millennia. This is not to say that investors should sell all of their equities. Despite the likely equity multiple compression that will come with inflation, we expect equities to outperform bonds and dollar cash particularly for companies with pricing power and high barriers. That view leads us to several mining companies including more established companies such as KGC, GG, FCX, PAAS and SLW. We also like AEM, UXG and small cap deep value producers NGF.AU and NGX.AU. Collectively these names should be thought of as building blocks for a basket of exposure.

Be clear however - These stocks represent aggressive asset allocations as opposed to physical holdings of gold and silver bullion that are better thought of as cash. We would make physical gold and silver cash the cornerstones of your sleep-tight money, knowing that while they will be volatile in the short run (read potential heart-stopping swoons), they stand alone in terms of wealth preservation over the long run. Indeed another key difference of gold is that every gold buyer, no matter his financial acumen, has made money on his physical gold that he has held since last fall if he dealt with a good market maker. That degree of simplicity is not something that could be said about equity investors in the far more complex landscape of stock selection even at the zenith of the internet bubble.