Advisor Blog

The First Law of Economics:  For every economist, there exists an equal and opposite economist.

The Second Law of Economics:  They're both wrong.

Disconnect, cognitive dissonance, in limbo.  I've heard all of those phrases used to describe the world economy - and, that's just today.  The Economist, in a recent article, points out that gold prices and the low yields on long-term treasury bonds point to opposite expectations for the economy - both inflation and deflation, respectively.  Perhaps this explains why you can turn on the television and hear a dozen conflicting pieces of advice within an hour.

One of our clients sent this photo, taken near his ranch, with the caption "this is what Obama is doing to our economy."  He also pointed out that the color of the bucket was even appropriate.  And, it's true that the cost of economic stimulus, healthcare reform, coming tax hikes, and more stringent financial regulation is worrisome.

The current direction of government policy (low fed funds rate, quantitative easing, huge deficits) certainly looks inflationary, but the economic fundamentals (slack in manufacturing capacity, sluggish growth, persistent high unemployment) look deflationary.  

Volatility in equity markets, which we've seen plenty of over the past quarter, is often viewed as being a measure of uncertainty.  Reducing policy uncertainty would encourage growth.  Uncertainty reduces the potency of stimulus because it encourages firms and consumers to hesitate and depresses spending and hiring activity.  Even incremental improvement in clarity may offer investors a chance to reassess the fundamentals that many analysts believe are still improving.

It seems that I can't turn on the radio or television lately without hearing some pitchman making the case for buying gold. But, the truth is that gold is both a poor investment and poor protection against a rapid rise in consumer prices. Scott Maxwell and I discussed this in May 2009 on our radio show. You can listen to the podcast of that show or download it here.

Gold makes beautiful jewelry and it has some value as an industrial metal, particularly in the electronics business (it's a great conductor and it doesn't oxidize). It is rare. In fact, all of the gold ever mined weighs two thirds as much as the Statue of Liberty.

No country today uses gold as a currency or even the basis of one. They stopped using it largely because commodity money was deemed too rigid to deal with recessions, when central banks create extra money to spur commerce. Whether this is good policy or not is certainly open to debate, but that's a subject for another day.

Ask yourself what makes gold valuable today. Fashion does, but tastes change. Gold is scarce. But, without demand, rarity does not support the price. Iridium is is four times as rare as gold, but fetches only about half its price. Industry does not use much gold and, unlike oil, it is not consumed. The supply only grows. Gold is valuable today simply because people want to own it. Gold does not create wealth or work to make itself more valuable.

According to Wharton professor Jeremy Siegel, a dollar invested in gold in 1802 was worth an inflation adjusted $1.95 by December 2006. In contrast, a dollar invested in large cap stocks was worth an inflation adjusted $755,163!

Many people believe that gold is a great hedge against inflation. Not so. The focus of every long-term investor should be the growth of purchasing power. The growth of purchasing power created by owning equities dominates all other assets. Only a small part of gold's price movement reflects its practical use and the changing prices of ordinary goods. The vast majority comes from frenzied speculation, infomercials, and exchange traded funds that make it easy for investors to purchase it.

Be suspicious of "financial advisors" that will try to convince you that gold and other commodities have a place in portfolios. Commodities have equity-like volatility and a rate of return that barely beats inflation. But, when inserted into a portfolio after a good run, they can make the short-term portfolio performance look great. It's deceptive - and not supported by the evidence. But, you'd probably be amazed by some of the people with big reputations that are playing this game.

One of the lines that I have heard constantly on infomercials about gold is "it's never been worth zero." But, in fact, neither has a properly diversified stock portfolio. The price of gold may double in a year or sink by half. We have no idea which to bet on, but it's very unlikely that, 20 years from now, those investing in it will be much richer.