Last week, I introduced gold and talked about the allure of this precious metal. Due to gold’s spectacular rise in recent years, interest in the yellow metal has been increasing. Ever since the 2008 financial crisis and the subsequent efforts of governments to stimulate their economies, people have been increasingly taking a hard look at the way that their governments spend their money, and some of them have started to buy gold as a hedge. Greece is now in serious trouble raising money in the markets, because investors are losing confidence that Greece will be able to pay back its debts in the future.

The same forces are at work in the U.S., which is spending unbelievable amounts of money and has a colossal amount of debt. In percentage terms, the situation is not quite as bad as Greece, but the current path of the US is certainly headed that way, and a loss of confidence in the U.S dollar could make 2008 look like a joke. It is this increasing awareness of this sovereign risk that is fueling the rise of gold and precious metals in general.

So, how has gold actually performed over the years? This is what I will analyze in this post. By 1975, the limitation on gold ownership was repealed, and it became legal for U.S citizens to own gold once again (yes, it was actually illegal before this time period, ever since the Great Depression). Here is how I will set up this analysis:

• I will compare the performance of gold against the total returns of the Wilshire 5000 stock market index, which tracks the returns of all stocks actively traded in the U.S. markets.
• Starting in 1975, our fictional investor will invest $1 000 in gold every year, at the beginning of the year, at the London P.M fix price. This $1 000 will increase by 3% per year.
• The same amount of cash will also be invested in units of the Wilshire 5000 index.

For example, if gold is $800/oz and the Wilshire 5000 index is at 40, then $1 000 will buy you 1.25 ounces of gold and 25 units of the Wilshire 5000 index. At the current valuation, both are worth $1 000. For the purposes of this analysis, I will not look at physical storage fees or assay/fabrication costs in the case of gold, nor will I look at stock brokerage fees or management expense ratios in the case of the Wilshire 5000. Also, I will assume that our fictional investor has access to an investment method which allows him to invest in fractional ounces of gold.

Sources for the following analysis:

• Gold prices from Kitco, based on the London PM fix.
• Wilshire 5000 index values from Wilshire, historical index values.
• Federal Reserve interest rates from the Federal Reserve, Federal funds effective rate.

First, let’s take a look at how both gold and the Wilshire 5000 have performed over the years:

Gold had a brief spike in value in the early 1980s; it then stagnated for more than 20 years until the early 2000s. Since then, gold has been on a tear. The stock market on the other hand made steady gains throughout the 80s and 90s, and curved strongly upwards after 1995. The market has hit two walls since then: The IT bubble of 2000 and the financial crisis of 2008. Therefore, the market has been basically stagnant for the entire decade since 2000.

As we can see on this chart, interest rates have been declining ever since their peak in the early 80s, which also coincides with the previous peak in gold. Nowadays, the effective rate is almost 0%, which means that if they want to reduce rates further and stimulate even more, they’re going to have to start paying interest instead of charging interest! It’s interesting territory to be in.

Again, we can see that the 80s and 90s were dog years for gold; gold’s fortunes changed at the beginning of the new millennium.

Let’s see our fictional investor’s performance since 1975:

Even with the market stagnation of the last ten years, the stock market has still managed to perform much better than gold, overall. This is what we would normally expect since stocks represent productive enterprises, producing goods and services and adding value to our world.

Well… what happened! If our investor started investing in 1996, using the same amounts of cash as at the same year in the previous case, then we see gold rocketing past the performance of the stock market. How can this be possible? Gold normally just sits there, looking pretty. How could it have given more value on your money than the entire ensemble of public companies and workers, working hard to produce the goods and services that people pay for?

I think what we are seeing is a loss of confidence in paper assets; understanding why this is happening is key to understanding what is wrong with our economic system and our world today, and why we may still be due for some hard times ahead, barring two significant paradigm shifts and one possibility:

• World productivity increases faster than governments increase spending; advances such as advanced nanotechnology arrive and drastically reduce production costs, providing people around the world with access to cheap goods.
• Our monetary system undergoes a radical shift, using sound currency in place of fiat currency and emphasizing savings over debt.
• Gold is actually in a long, sustained bubble.

While I do believe that advanced nanotechnology is coming, it is still a long way from the promise of material abundance for everybody. As for the second point, I don’t see it happening without a more severe crisis. The entrenched interests have far too much at stake to let it happen voluntarily. It might come through an economic collapse if productivity cannot increase fast enough to support the increased weight of government; this would entail severe social unrest and global political instability.

As for gold being in a bubble, while I don’t completely discount the possibility, I don’t think we are quite there. Firstly, while there is increased awareness of gold today, we’re not at the point where every Joe Blow and his mom is investing in gold, like we saw with the real estate market and the stock market pre-2000. Second, gold’s most valuable purpose to man is as a store of value which can protect against sovereign risk and currency collapse. Given the current state of U.S. finances and of many other countries, this is a very relevant purpose today. Even Richard W. Fisher, president of the Federal Reserve Bank of Dallas, once warned that U.S. policy will lead to “…the mother of all financial storms”. Therefore, the gold price is reflective of this sovereign risk and of the increased desire of people to protect themselves against this risk.

So, is gold in a bubble? Or is there a good reason for its stellar rise in the past decade? Here is some further reading on both sides of the subject:

• Howard Ruff: Think Outside the Box: Maverick Investing in the Age of Obamanomics Par (Investing In Gold and Silver)
• Peter DeGraaf: My expectations for the future.
• Mises Economics Blog: The Current Financial Crisis – and After
• Jon Nadler: Bye-Bye Dubai
• Jon Nadler: Great(er) Expectations and The Unexpected
• Jon Nadler: E.T.F. = Expect Tonnage to Flow. This Is A Two-Way River

Related posts:

1. How Gold Can Provide Stratospheric Returns to Your Investment Portfolio… if You Can Avoid the Bubbles!
2. Gold, Revisited: Is $1500 Near?
3. Gold Versus Fiat and the Mother of All Bubbles
4. How Much Should I Save, and Why?
5. Why Are Gold Prices Skyrocketing?

About Kevin

Kevin currently lives the white collar lifestyle, but his real dream is to get out of the rat race one day. He enjoys exploring unvisited places around the world and gaining new experiences. He believes that by properly managing our energy and time, we can learn to invest our lives wisely.

Tags: currency depreciation, debt, gold, Greece, inflation, interest rates, sovereign risk, speculative bubble, store of value, Wilshire 5000