Omar´s Outlook - Mar 2020

Barbarous Relic?

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As any astute investor would know, gold bullion price has had a great run over the past year or so, having reached new record in a majority of the world’s main currencies.

Here is the chart as it applies to the Australian dollar over the past 12 or so years (click to enlarge).

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This performance has resulted in a number of enquiries from our clients along the lines of “Is gold too expensive now? Should I sell?”

To properly answer that question, we first need to realise that it is not in fact framed properly. As it stands, it equates gold to an “investment” – that is, something comparable to a company share or a bond.

With those two, we can look at discounted cash flows of future expected profitability, the company’s presence in its area of operation and so on – basically what is known as “fundamental analysis”.

Gold, however, is not really an investment. It is and always has been predominantly a store of value and the free market’s chosen form of money.

Consider this:

When the Spanish conquistadors arrived in South America some 600 years ago, their language, culture, scientific achievements and so on had virtually nothing in common with the local Inca Indians.

There was, however, one commonality.

Both the Spanish and the Incas considered gold to be extremely valuable and used it as money.

This can be traced down history for thousands of years. Whenever there was a free choice, gold resumed its role, to be used as money and store of value, because of its relatively scarce nature, easy portability and the inability of counterfeiters to make more of it.

Gold has traditionally imposed discipline on rulers and governments. They could spend only what they had been able to collect in taxes and then borrow only so much, before the lenders increased interest rates or stopped lending altogether.

The increase in the supply of gold – the equivalent of modern “monetary inflation” - was also directed by the market. If money was in demand, its value went up, which made marginal mines more profitable and eventually increased supply. The value would subsequently drop again, with the circle repeating.

Thus gold “inflation” almost never exceeded some 1.5% p.a. on average, and the market could properly function without its price signals being distorted by the modern equivalent of counterfeiters – central banks.

Every time the link to gold was severed and a form of government-mandated paper (“fiat”) money imposed, the forced discipline disappeared, leading to overspending, overprinting and eventual collapse of the currency in question.

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Politicians, the modern ones being no exception, of course do not like gold, which has been referred to by some of their ilk as “barbaric relic of a by-gone era”.

They much prefer their own money, which they can spend almost without restraint, because their friends at the RBA and other central banks can create any amount at a press of a button. As can be seen from our own broad money supply over the past decade or so.

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So with this introduction out of the way, let’s look at how well gold has lived up to the “store of value” moniker.

I would refer any interested reader to a site from which many of the charts below have been reproduced. It is called Priced In Gold and has a veritable trove of information on this topic.

First, let’s look at just how well our own fiat currency, the Australian dollar (AUD), has held its purchasing power in comparison to gold.

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As you can see, the dollar has lost almost 80% of its value against gold since 1990. Not great, but in line with pretty much any other major fiat currency out there.

Well, perhaps we have been compensated for the loss in purchasing power by higher earnings, right?

Not so fast. The next chart shows the Australian GDP as denominated in gold. Our GDP is basically at the same level it was 25 years ago, in 1995! No wonder the average Australian is feeling the pinch as far as cost of living is concerned.

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How about the stock market? It’s at record high, right?

Well in gold terms, it’s also at around the 1995 level. In other words, on average, you can buy about as much with your profits now as you would have 25 years ago. The “gains” have, as I stated on this blog before, been almost entirely inflationary.

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So how well has gold kept its purchasing power against everyday goods?

I would again refer you to Priced In Gold for numerous examples, but here are a couple of charts, covering electricity and food costs (US-centric, but they are sufficient to illustrate the point).

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Clearly, gold has retained its buying power of those basic staples a lot better than the paper currencies.

Now that we know that gold is not an investment, but a store of value, and that it “goes up” mostly because of the fiat currencies continue to lose purchasing power, we can look at whether it is “overvalued” at this time.

To do that, we can use two proxies.

The first one is the global gold mining sector. Remember that when gold is expensive, mines are reopened, profitability goes up and, after a bit of delay, supply increases. We can assess approximately where we are at on the long-term scale, using the senior gold miners’ index HUI.

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Clearly, we are a long way from “expensive” on that metric.

Additionally, looking at the fact that actual monetary inflation (i.e. the M3 chart above) has been running at well above 7% on average for the past 10 or so years, we can extrapolate that the gold price, as denominated in AUD, has not yet gone anywhere near compensating for the comparative increase in the AUD in circulation.

Obviously this blog is not investment advice, but it should be clear that gold, far from being “obsolete” has been fulfilling its role as insurance against the machinations of the global monetary central planners and it is likely to continue doing so.

 

Stock Markets Update

In my last month’s article, I observed that the recent run-up of both the global and domestic stock markets has been due not to increasing company profits and a strong economy, but to plain old monetary inflation. That inflation is a by-product of extremely low interest rates we are now experiencing almost everywhere.

An extreme recent example of something similar can be seen in Venezuela, where even though the market went up by hundreds of percent, the economy has been effectively destroyed and the seemingly large nominal net profits to investors, as denominated in the Bolivar, would not buy a great deal due to the enormous rate of intermediate inflation.

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I have since come across a very good summary of the factors that have been driving the stock markets. Consider the following data points:

The Australian stock market has finally, after some 11 years, exceeded the previous record high set in 2007.

However, while that seems to be great at a first glance, 2019 company earnings for the Australian S&P/ASX200 were 20% lower than in 2007.
Or, said another way,the market today places the same value on the companies within the index as it did in 2007, despite the fact that these businesses are only 80% as profitable as they used to be then.

If we account for the intermediate inflation, company earnings today remain woefully below their pre-GFC levels.

Instead of earnings growth, the bull market, both in Australia and the rest-of the developed world, has been underpinned by investors willing to pay substantially more for company earnings than they did before.

The reason for this is quite simple: The artificial push by the global central banks toward record low, or even negative, interest rates.

Domestically, those rates have between 2008 and now fallen from 7.25% to 0.75%. Investors, robbed of safe ways to make any real returns, have been driven to risky assets – like shares – in droves.

In the USA, despite ever “record-er” stock market levels, close to 40% of all listed US companies lost money in 2019. Additionally, almost 74% of initial public offerings (IPO) were for loss-making companies.

It seems that fundamental analysis - and real profits - are no longer relevant. Markets have never been as expensive as they are now, but seemingly nobody is too concerned.

We have been at the same place before – during the Dot Com bubble in 1999/2000. The eventual outcome of the current mega-bubble will be no different.