Newsletter December 11, 2010

InvestorsFriend Inc. Newsletter December 11, 2010

Is the End Nigh?

The End is Nigh!, The End is Nigh!

It seems that humans have been predicting the end of the world since, well, since the beginning of the world.

From being cast out of the Garden of Eden to the biblical Great Flood to today, the end of civilization, or at least pending mega disaster has been predicted continuously.

During my life some of the things that were going lead to the end (of our prosperity, if not of the world) included war, communism, pollution, acid rain, ozone layer depletion, over-population, running out of energy, AIDs, flu pandemics (Remember SARs?… neither do I…) , hyper inflation, terrorism, West Nile Virus, excess debt, and climate change. I am sure I have forgotten some. Some of these have been of concern for decades but have tended to mostly be in the background and then periodically come to the foreground as the panic de jeur.

I begin to think that there is something in the human psyche that is very much attracted to the idea that humans are going to destroy themselves or that God is going to inflict some great punishment and so… we constantly expect and predict that The End is Nigh!

People also seem to generally be convinced that life is difficult and not fair. That we live in a time when making a decent living is more difficult than it used to be. Give me a break…

I’m 50 years old and when I was growing up just on the edge of a small town in Nova Scotia, there were still a few people around without running water in their houses. Lots of families did not own a car and two car families were the exception. Houses had one bathroom and certainly more than one kid per bedroom. Cottages typically had outhouses. If Mom didn’t work outside the house, it was usually because she was too damn busy working 16 hours per day at home! My parents grew up in houses without electricity. My grand-parents grew up in horse and buggy days. They lived through two world wars and an ACTUAL depression. So it truly boggles my mind when people complain quite seriously that standards of living are dropping and that life TODAY is rough. Again, give me a break!

So I don’t take all this whining and predictions that The End is Nigh! very seriously at all.

Still, as an investor it behooves me to give some thought to the worries that now circulate in some circles about the the coming implosion of the U.S. dollar and the world financial system.

Many investors claim that due to debt and the printing of money, the U.S. dollar is not to be trusted and that this is why the price of Gold has soared as people look for a store of value.

Can the U.S. dollar be trusted? Will it fall against other currencies and/or suffer from high inflation?

I certainly can’t provide a definitive answer to that. But I can look at some evidence.

Many people are predicting that the U.S. dollar will suffer from greatly reduced purchasing power in the years ahead. For Americans this can only happen if there is high inflation. For U.S. dollar holders in other countries it can also happen if the U.S. dollar falls in value against their particular home currency.

Some analysts suggest that the record high price of Gold is proof-positive that investors are fleeing the U.S. dollar due to these fears.

Now I don’t know very much about Gold. But I do know that there are lots of other possible reasons for the high Gold price that do not involve fleeing from U.S. dollars. There reasons include demand created by speculation and demand for the jewellery trade and the general scarcity of Gold.

In looking at investor attitudes toward the U.S. dollar, there are much better and more direct indicators of this attitude than the price of Gold.

One of the best indicators of investor confidence in the U.S. dollar is the interest rate obtained from buying 30-year U.S. Government bonds (known as U.S. Treasuries).

That interest rate is currently about 4.43%. This means that investors who buy these treasuries do so knowing they will receive an annual  yield of 4.43% on their money. For example $100,000 invested in such a treasury bond would provide an interest payment of $4,430 per year for 30 years followed by the return of the original $100,000.  Gee, let’s see if I had a million dollars I could get $44,300 per year, fixed with no inflation protection. Sweet! NOT! This seems to suggest that these investors are not expecting much inflation and certainly not hyper inflation. Even with 2% inflation per year the purchasing power of the $4,430 will have dropped to $3291 after 15 years and the $100,000 in 30 years will only have a purchasing power of $55, 207.  And if inflation runs at 3%, the $4,430 annual interest payment will have a purchasing power of just $2,843 in 15 years and the $100,000 returned in 30 years would have a purchasing power of just $41,199. A rational investor who expects high inflation would not agree to invest their money for 30 years at 4.43%.

And imagine if on top of the inflation, you are a Treasury bond buyer in a foreign county and you expect the U.S. dollar to decline in value against your own currency. That would further erode your return. It’s hard to imagine why a rational foreign investor who expects the U.S. dollar to lose significant value due to inflation and or de-valuation against his home currency would nevertheless lock up money in U.S. dollars for 30 years at 4.43%.

Now some will claim that the 4.43% interest yield on 30-year bonds is not really set in the market but rather is manipulated as the U.S. Fed buys these bonds in the market. I am sure there is some truth to that. However, there are other buyers of U.S. Treasures besides the Fed. I would wonder why American investors would buy any 30-year U.S. Treasuries at a yield of 4.43% if in fact they expect inflation. And why would foreign investors buy if they expect both inflation and a devaluation of the American dollar. I don’t believe that any of these investors are forced to buy these treasuries. They are voting with their wallets and therefore it is fair to ask what those votes are telling us.

So, let’s take a look at who buys 30-year U.S. Treasuries.

Treasuries trade in huge volumes on the market and I don’t have a data source for who the buyers are in the market. But I do have a data source for who buys directly from the U.S. Treasury when these bonds are issued.

Coupon Auctions – Data

For the latest auction of 30-year Treasuries (November 15, 2010), here are the buyers and the percentage of the total bonds sold that each group of buyers bought.

Federal Reserve Banks 2.6%
Depository Institutions (banks) 0.0%
Brokers and Dealers 56.2%
Pension and Retirement Funds 0.2%
Investment Funds 16.7%
Foreign & International 23.9%

Now this table suggests that the Federal Reserve Banks are only small players in this market. Possibly they are much larger buyers in the secondary markets.

Another area to look at, is who are the holders of 30-year U.S. Treasury bonds?

I could not find a listing of all the major holders. I did find a list of foreign holders

Major Foreign Holders of US Treasury Securities –

China $884 billion
Japan $865 billion
Oil Exporters $231 billion
Brazil $176 billion

And it was reported that the U.S. Federal Reserve owns about as much as China $891 billion

The total debt of the U.S. government was listed at $13,861 billion, of which $9,275 billion was held by the public.

I was not able to see separate listing for the 30-year Treasuries

My overall conclusion is that it appears that there are investors who are buying 30-year U.S. treasuries at 4.43% and therefore are indicating, by voting with their wallets, that they do not foresee any great drop in the value of U.S. dollars either through inflation or a decline in value in comparison to other currencies. If they did, why would they buy?

But What of Gold?

It has often been claimed that Gold is a hedge against inflation and that it holds its purchasing power value over the long term.

Experience does not support that claim. In the 60’s Gold was about $35. Prior to 1933, Gold coins circulated in the U.S., but in 1933 citizens were forced to turn in the gold coins and accept paper dollars for them. From 1933 to 1972, I understand that foreign governments could exchange U.S. dollars for Gold from the U.S. government, at about $35 per ounce. In 1972, the U.S. removed all remaining promises to exchange $35 U.S. dollars for one ounce of Gold and allowed U.S. citizens to again buy Gold coins. Gold immediately starting soaring and reached an annual high of $595 in 1980 (the daily price peaked out at over $800 that year). Even considering the high inflation of the 70’s it is clear that Gold’s purchasing power value soared in the 70’s. Gold however then fell and languished for the next 25 years and surpassed its 1980 annual high only in 2005 when it reached $513 on an annual basis. Given inflation and its lagging price Gold certainly did not hold its purchasing power value over those 25 years. Now Gold has soared to about $1430 despite our very low inflation environment. Clearly the purchasing power of Gold has soared in the past few years. So, I can’t agree that Gold tends to hold its purchasing power steady.

I have heard claims that an ounce of Gold today has similar purchasing power to that of say 2000 years ago. I have not seen proof of that. I think any economic data from 2000 years ago has to be considered rather suspect. Furthermore, if in fact Gold holds its purchasing power over periods of time measured in centuries but can not be trusted to so so over a period of 25 years, then that seems of little value to an investor.

I have never seen any charts of the purchasing power value of Gold over a long period of time. But, I was able to create my own chart of Gold versus U.S. inflation since 1926.

December 11, 2010_1

The red line here is the price of Gold in U.S. dollars per ounce. It starts at $20.67 in 1925 and ends up at $1430 in late 2010.  The blue line is an index of inflation from 1925 to now.

The goal of this chart is to illustrate how well the price of Gold has tracked inflation and to illustrate whether or not Gold is currently above its long-term trend line with respect to inflation. In order to best show this I have scaled the inflation index to try and line it with the Gold price. The graph shows that the price has Gold has trended up with inflation but has not tracked inflation very closely at all. And, it appears to show that Gold is currently well above its trend line. The only other time Gold was this high relative to inflation in these 86 years was the average price for 1980. Note that for 2010 I have shown today’s price rather than the average for 2010.

Before jumping to the conclusion that Gold is over-priced, we should stop to consider that from sometime prior to 1925 and up to 1971, the price of Gold in U.S. dollars was effectively controlled by the U.S. Government. (Or the price of a U.S. dollar was controlled by Gold, which amounts to the same thing). So, it may be better to just focus on the picture since 1972 when Gold, as priced in U.S. dollars, has floated freely on the market.

December 11, 2010_2

Since 1972 the price of Gold has again not tracked inflation very closely at all, although both are higher over the 39 years. Looking at the trend one would conclude that if Gold is supposed to track inflation (giving a constant purchase power for Gold) then Gold currently is above trend. In 2002, Gold at $340 was tracking well below the inflation trend line. Gold “needed” to rise to about the $600 level in 2010 just to get back up with the inflation trend line. But at $1430 it appears to be well above the trend line.

Now it may be that Gold was never meant to track inflation and that any relationship to inflation is purely random. So there are lots of reasons why Gold could remain well above the inflation trend line. But anyone who believes that Gold is moving higher simply due to its being a store of value should be aware that it appears to have moved well above the inflation trend line. (Why should a “store of value” increase sharply in value, in terms of the goods and services it can buy?)

Buying a Gold ETF

My reason for mentioning Gold here was not to analyse it as an investment but mostly to discuss Gold as a signal that the U.S. dollar is about to crater or as a signal that, as many fear, the end of the Financial World is Nigh. I don’t believe it is such a signal at all.

In fact I am pretty certain that The End is Not Nigh. Financial markets are always unpredictable. But whatever happens I am confident we will emerge on the other side and the standard of living will continue to rise.

If you are interested in Gold ETFs the trading symbols are available in our Canadian Exchange Traded Funds reference article. The prices there will be out of date but the trading symbols are there and you can click through for the latest price. And you can see there which Gold ETF owns physical Gold and which merely buys futures to mimic a holding in Gold.

Buying Stocks

I have never owned a Gold ETF. And the only time I ever owned a Gold company was way back in the Bre-Ex days when I briefly held some Bema Gold. I was lucky to get out of that without much of a loss and I never examined any Gold companies after that. The reason for that is that Gold companies are not amenable to financial statement analysis and I had no ability to analyze which Gold companies are under valued. So I will stick with stocks.

For the last decade I have done very well in a variety of stock investments. Surprisingly this has included not only no Gold but essentially no  energy or resource companies either. Instead I focused on various financial, retail, communication, restaurant, real estate manufacturing and other such boring companies that have mostly been excellent investments. To a certain extent I have also traded in and out of these stocks in an advantageous manner. If you are not already a subscriber, you can get access to the names of the stocks that I hold and full details of why I hold them by subscribing to our Stock Reports service.


Shawn Allen, President
InvestorsFriend Inc.

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