In Transcripts

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, today we are looking at gold, and there is a reason we are looking at gold. This is the 11th successive annual rise in the gold market. I think it is worth discussing the overall viewpoint of why a person owns gold in the first place, and what the supply and demand fundamentals are.

David: Kevin this is one of the great bull markets of the century, and it is still progressing steadily. That is one of the things that we will look at today – the progress that it has made. It feels to many like it is the tail end of a bull market, and what we would suggest is that while we have made great progress, there is still much that lies ahead. That is borne out, not only in the fundamental statistics, which we will discuss today, but also in the changes which still have to occur in both the fiscal and economic spheres, both here and abroad.

Kevin: David, if we were to look back 100 years, back to 1911-1913, in that era, we would see that during that period of time 100 years ago, the world was very solidly under a gold standard, and in a way, we did have a solid one-world currency. But things started breaking down from there, and I think if we start about 40 years ago, we start looking at the destruction of the system that was backed by gold, and shouldn’t we look at it from that point on?

David: Right. Essentially, Kevin, if you are saying these are periods in time that we can understand, in light of the policies that were in place, we have, as you said, the 11th annual rise in the gold price, and that is on the heels of a 40th anniversary. In August of 1971, we left the Bretton Woods era, that era where currencies were related to something real, and for the first time on a global basis, entered into a fiat-only world. This is an experiment which has now run its course after 40 years.

Kevin: Talk about an experiment. Nixon said that was going to be a temporary move, taking the dollar off the gold standard. They called it the closing of the gold window. Well, they’ve never opened that window back up again.

David: What we had then was a generational re-pricing of the metal. It had been stuck in the mud at $35 an ounce, set there arbitrarily back in the 1930s and kept there through the Bretton Woods era. It was 30 years ago, as of January 2010, that gold reached its nominal peak.

Kevin: For those who remember, in 1980, gold hit $850 dollars an ounce, but that was because of that decade-long re-pricing of gold.

David: And it was moving to reflect an increase in inflation over a longer period of time. That, essentially, is what we have today – a generational re-pricing. It ultimately will reflect both the present inflation, which would take us, actually, to about $2,473 dollars per ounce, but also the future inflation, I think over the next 3-5 years, most intensely.

Kevin: Let’s put this in perspective. If we were to take that $850 high back in 1980, and put in what the government has called CPI, the inflation rate, that would be $2,473 today, but is that really factual? The government seems to always understate CPI.

David: That is a great point, Kevin, because the real-world inflation-adjusted prices are probably $1,000 to $1,500 higher. It is interesting that some academics see the long-term average price of gold reflecting, really, a neutral value change, as really, any increase just accounting for the annual inflation rate. Obviously, this takes place over a long period of time. It is not as if gold is an automatic adjustment for inflation.

Kevin: So for the last decade we are talking 10% a year? Is that accurate to what inflation probably is?

David: Well, we have had between 10% and 12% annual returns in the precious metals market, more if you are talking silver, than gold, but say, 10-12% for the gold market. And actually, this is a perfect overlap to how Volcker used to count inflation, the calculations that he used then when gold was hitting its peak, to look at what inflation was. If we used his metric, applied it to today’s number, instead of the sub-3, which is currently assumed, we would have north of 11% inflation.

Kevin: So it is accurate. If gold was a neutral defender of value, let’s say, or just a preserver of value, it is really only rising what the inflation rate should be, valuing it the way Volcker counted inflation.

David: Right, and I will be quite frank with you, Kevin. I don’t think inflation is the only, or even the primary, mover of the metal, but it is one thing that it remains sensitive to. There are a whole host of other things we can discuss at length today.

Kevin: If we were to look back a decade, and go to the year 2000 or 2001, gold was less than $300 an ounce. I think we just assume our listeners know what has happened over the last 10 years.

David: This is what is absolutely remarkable, because when you look at $300, and then you look at $1,600, you say that is massive move. But on a year-by-year basis, let me just go through a laundry list of prices. This is where each year the gold price began, in this progression of a 10-year bull market. What you will note is that these moves are very modest. It is only in the accumulation of these years that you begin to see a dramatic thing happen, and it is one of the great bull markets of the century.

Kevin: The growth was so subtle in 2001, 2002, 2003, people barely realized, without going back and looking at the calendar, whether they had made any money or not.

David: Between 2001 and 2002, it was up $7. We will just take a look at, again, where gold opened in each one of these years.

Kevin: Okay, Dave. Let’s start with 2001.

David: It started the year at $271.

Kevin: Okay, now. I’m going to yawn here. In 2002?

David: $278.

Kevin: Okay, almost still yawning, but a little more exciting. (laughter). 2003?

David: $343.

Kevin: From $278 to $343. Now we’re starting to see some motion. 2004?

David: $416, up from $343.

Kevin: Okay, we’re still not super-excited, but we are seeing that we are getting an increase that is matching the inflation rate, anyway.

David: And then by 2005 it is $427. Over $416, we are not talking about a huge increase, but we are also not talking about a decrease.

Kevin: Okay, but $500 was a huge psychological barrier. I remember that.

David: And we broke that in 2006. It began the year at $530, so we actually broke it in 2005, late in the year.

Kevin: And 2007?

David: We began the year at $637.

Kevin: Now, we go into the crisis year, Dave. Everybody remembers from 2007 to 2008, we had the Bear-Stearns situation starting to brew, we started to see the Lehman thing coming down the road, people were starting to get nervous in 2008.

David: Fast-forwarding from 2008 to 2009. In 2008, as we mentioned, it was $846. In 2009 it was $874 – not much of an increase, but still, steady progress.

Kevin: And then the big psychological barrier. I talked about $500, but that was nothing compared to when gold broke $1,000, and that happened between 2009 and 2010, didn’t it?

David: It did, and if you will notice, these barriers, frankly, are multiples of the previous numbers. So $500 to $1,000. Really, the next psychological barrier, the critical one is $2,000. We went from $500 to $1,000. $1,000 to $2,000? Again, these are where the considerable barriers lie. After $2,000, I would guess that the next major psychological barrier is $4,000.

Kevin: And we are working our way up there. In 2011 we started at $1,388.50.

David: And we began this year at $1,598. So, again, when you look at it from one year to the next, there is very little change, but it is an aggregate. This is one of the things that I would like to emphasize. If you don’t have patience, in the context of a bull market, you never get to benefit from it. This is a characteristic which is not common for investors to have. It is usually, “What have you done for me in the last three nanoseconds? How have I traded myself to success and to retirement bliss in the last five minutes?” There really is no healthy conception of time.

When you are dealing with money, the healthiest way to approach it is to include the largest swath of time as possible. That is if you are thinking about intergenerational wealth planning. If you are talking about, as we are here, riding through a bull market, again, being patient is absolutely requisite to success, because again, the journey from $271 to $1,600 is very impressive, but it has been both laborious and boring at times, wherein we had periods of time where there was nothing happening, and yet, it was still constructive.

Kevin: David, something you pointed out about a week-and-a-half ago when gold did dip down to the 65-week moving average, which is an average of the price taken over the last 65 weeks, of gold. Gold is relatively stable, almost a yawner, as far as its rise goes, but when gold goes down to that 65-week moving average, usually it has bottomed out, or close to bottomed out.

David: Kevin, as you say, bottoming out at a particular point is not without coincidence. The reason we use the 65-week moving average is because it smoothes out the price action of the market and shows you, basically, where the baseline is for that market.

Kevin: You could almost use it as a straight edge. Even though we see the actual day-to-day fluctuations looking like a sawtooth, if you flatten it out, you could almost use it as a flat edge.

David: Right. Take a ruler and you are basically defining the general trajectory of the market, only breached once in 2008.

One thing more on the 65-week moving average, because before we move past that, it is important to note, and we drew attention to this as a significant place where we thought the market would bounce, in terms of where the decline in price would end and we would see some recovery from there. Kevin, it has been less than two weeks, and we are now $100 higher than that level, and this week we have passed the 200-day moving average. It is a shorter-term moving average. All I can say is that this is constructive. It is very productive, still constructive, and we look at this as a very fundamentally and technically sound market.

Kevin: Even with the 65-week moving average, or just taking the daily prices at the end of each year, there seems to be a steady progression. There are changes in supply and demand all through that curve that probably aren’t quite as equitable to that rise. The mining industry, for instance. Talk about a volatile industry. It is so difficult to actually extract gold from the ground, even when the price increases, that it doesn’t necessarily mean there is going to be increased production, does it?

David: I just read a report from Goldman-Sachs. It was interesting, the analysis that they had on this. It was basically, “Here are the miners that we think are going to do very well, particularly if they can just increase their output.” I thought to myself that, as bright as these guys are, they have failed to understand, we aren’t talking about creating widgets here. We are not talking about running an extra shift so that the factory can crank out ounces. We are talking about a very limited supply coming from mines. In fact, over the last decade we have seen a slow erosion between 4% and 7%, depending on the year. That is a decline in mine supply. So if we want to talk about supply and demand, let’s address the supply side first. It is not like you can just crank up production.

Kevin: It reminds me of an old commercial with Jay Leno for Doritos. He said, “Doritos – munch all you want. We’ll make more.” Well, it’s not quite like that with gold.

David: No, you can’t do that with Krugerrands, you can’t do that with the Canadian mint, or what have you. But we continue to see a decrease in mine supply, with recycled gold filling the gap. This has been an interesting component, because there have been waves of people swapping out of their out-of-fashion jewelry and moving into cash, just to raise a few bucks.

What is interesting is: that is diminishing in scale as western sellers have already taken advantage of what they consider to be already high prices. We saw a huge wave at $1,000, we saw another wave between $1,200 and $1,300. We saw another wave, one of the biggest, around $1,500, and they were considering themselves the fortunate few to be picking high prices, to be taking this old junk gold and recycling it, at, again, “historically, the highest price ever.”

Kevin: This is not intended at all as an insult to the people who were taking jewelry in. Sometimes there were liquidity needs, or other things, maybe having to pay for school. But it is more the unsophisticated investor, or person, who is taking that gold in at these prices. They are not necessarily looking at gold from a historical perspective, they just know they own something that is worth more now.

David: Here is the fascinating thing, Kevin, because while current numbers are roughly 1,500 tons per year, 1,500 tons next to the 2,500-2,600 tons which is from new mine supply. So we are talking about, in aggregate, 4,000 tons a year of available gold, but we are talking about supplies which are not increasing organically. In fact, we have seen these waves of liquidations of gold, and they are diminishing each time, because it is not like you can empty your jewelry box twice. Once it’s done, it’s done. You captured that wave at $1,000, or you captured that wave at $1,500. We are actually seeing the demand side fade, not only on the new mine supply, but also on the recycling side, with these progressive waves.

Kevin: David, when investment demand in increasing, and you don’t have enough supply to actually meet that demand, what you are saying is that a lot of the jewelry has already been sold into the market. And even so, the mines can’t keep up with the demand, as it increases.

David: Kevin, these are the two greatest inputs in terms of supply – 2,500 from new mine supply, and 1,500 from recyling. Those are the most recent numbers, in rough terms. Those are the two greatest supply inputs. Both of them are in decline while demand is increasing. If you go back to Econ 101, this is not supposed to be the case. From a business standpoint, you can continue to increase supplies to meet demand, and you are fine. This is a case in point where there is not enough supply to meet demand, and that is where you begin to see the price not only continue to edge higher, but ultimately move in a parabolic rise.

Kevin: David, I would like to shift to the demand, because that is actually the larger factor. If you think about supply in the gold market, okay, so it is 4,000 tons. That still makes up less than 3% of the total world gold supply that is already out there, so it’s not like an incredible supply increase each year. It’s just very slow progress.

David: Kevin, I think one of the things that we suggested a few weeks ago in the commentary is that there have been a number of substructural changes in the marketplace. And one of those substructural changes is this assumption that we have in the West that the gold market is oriented to the West. That is a faded memory from the 1970s and 1980s. Let’s talk about the numbers, specifically, because North American and European buying was very considerable. In 1970 it represented close to 50%. Exactly 47% of the global gold market in 1970 was North America and Europe.

Kevin: So you are basically counting what we would call the Western world at this point. It was about half of the gold demand in 1970.

David: And it rose to a peak in 1980, with the gold price peaking at around $850. It peaked at 68%, though it has been shrinking since then. With the 1970s and 1980s in mind, fast-forward to 1990 and we had already shrunk considerably. We were at 68% of the peak, but by 1990 it was just 38%. If you fast-forward to today, Kevin, we are about 27% of the gold market, that combines both European buying and North American buying as a percentage of the total global gold market.

Kevin: David, you jumped from 1990 to present, but there was a fascinating phenomenon that occurred in Europe and America, going to the top of the tech stock boom. Back in 2000, before the World Trade Center, we had the stock market rising. 14,000 sounded like nothing. Guys were coming out saying the stock market was going to be 35,000 in a matter of a couple of years. We had commercials that were saying that we wasted 2 million bucks and yet they wouldn’t even tell you what their product was. Paper money was flowing. We didn’t need gold. In the year 2000, the Western world had less than 5% of the demand. It was incredible.

David: And specifically, the U.S. market was infinitesimally small at that point. It is interesting that while the West was so enamored with paper investment products, it was Indian and East Asian investment demand that in the year 2000 accounted for 80% of the gold bought for that purpose.

Kevin: Think about that. That was before the bull market. That was before they were getting the payoff. They were buying that gold at low prices.

David: Exactly. That is a lot of buying at a very, very low cost basis. When we look at why things are transitioning in terms of this investment component, we do have to continue to look at the geography and the change in terms of the distribution of these purchases. Like we said, it was North American- and European-centric up until 1980. Since then, there has been a massive shift toward the East. The Indian subcontinent and East Asia, comparing to our 1970 numbers, were at 35%. Now they are at 58%.

Kevin: You are talking about just East Asia and India, that they are taking up almost 60% of the gold right now.

David: Right. We have seen a dramatic shift in terms of who is buying, and in what quantities, and for what purposes, which adds an interesting component, which we will talk about in a little bit, Kevin, in terms of gold correlation factored to Western markets. In fact, it is very noncorrelated, making it very attractive to an international audience.

Kevin: David, yesterday we were sitting and talking, and you said, “Is there anything we are missing in the gold market? Is there something that we, as close as we are to it on a daily basis, are missing?” I am going to admit that I understood the Asian component, I could spout off how much they were buying on an annual basis, but I hadn’t really thought about it. We have this tendency here in the America, and I think our investors do, and I know I do, to focus on how things move around, or circle, the United States or the European markets, but in reality, what is going on in the gold market is almost disconnected from the Western markets, because the Asians are the ones who are running this thing.

David: Out of that 4,000 tons that is used up every year, how is it used up?

Kevin: 2,000 tons of it goes into jewelry. Basically, half the market goes into jewelry. What is interesting is that investment demand is now at about 38%, and the difference is going into industrial purposes, and technology. So 38%, 50%, and a small difference in between, for industrial purposes. That 38% does not include central bank purchases.

Kevin: You are talking about central bank purchases right now, but for the career that I have had here over the last 25 years, for the most part, central banks were selling gold. They just became net purchasers over the last few years.

David: Up until 2009 when it virtually stopped. If you look at the central bank gold agreement liquidations, they occurred regularly for decades, and that was like clockwork. You could expect each of the European central banks to dump product. And Kevin, frankly, we were the beneficiaries of that. For years, and years, and years, we had access to mint state coins, stuff that had never been circulated, sat in bank vaults, original bags of Dutch gilders and British sovereigns and things that had been held as a currency reserve, and now are coming to us for the first time, and this is when a British sovereign was $102 a coin, now 4-5 times that, in terms of a retail purchase price. The world has changed, in large part because those supplies are no longer available.

Kevin: Central banks don’t want to sell that stuff.

David: Actually, there was only one liquidation in 2010, by Germany. Since then, the balance has tilted in favor of central bank purchases. Kevin, we saw a significant trend change here in the last few years, but we continue to expect net purchases to increase because we have total reserve ratios, relative to gold, which are still very, very low. Kevin, we have a lot of these surplus countries that have resources that need to invest, and do they want euros? Not particularly. Do they want dollars? To some degree they have to. But the question is, how do you offset your currency exposure in fiat paper that you don’t particularly like, and you basically create the antidote within your own portfolio by owning gold?

Kevin: The central bank purchases have begun to make an impact, but in reality, even without them, investment demand is 38% at this point. We are seeing it rise very quickly.

David: The argument is often used, going back to the largest component of gold demand, which is still jewelry, that we see demand destruction, if you are following me, as the price increases. In other words, as gold goes from $1,000 to $2,000 an ounce, people just aren’t interested, they are not willing to pay the price.

Kevin: It’s too expensive, they feel.

David: But that’s actually not the case. If you look, for instance, at Indian demand in this last year. It was constant in rupee terms. Actually, there was a couple of percents increase in terms of the money spent on gold, but because of the increase in price, it bought less ounces and that is how most people consider this sort of demand destruction equation.

Kevin: Smaller bangles, but you are still buying bangles, for the same amount of money.

David: Right. Exactly. So let’s say you are in India, and last year you spent a trillion rupees on gold. The next year you spend a trillion rupees on gold, but this time around it doesn’t buy you as many ounces.

Kevin: A little less gold.

David: Are you spending less on gold, or are you just getting less gold for the same money? That is what is actually happening. We are seeing folks who had started IRAs 4, 5, or 6 years ago, who put in $5,000 and it would buy 800 ounces of silver. Today it buys less than 200 ounces. It doesn’t mean they are any less committed to buying silver or gold today, it just means that because of the increase in price, they can’t afford as much as they used to be able to buy.

Kevin: David, I was thinking about that when we talked about this earlier. We, as a company, used to have a two 20-dollar gold piece minimum – two 20-dollar gold pieces at $400-500 was just about a $1,000 minimum. Right now, those same two pieces cost what ten of them did back then. We are still seeing people come in with $1,000, but they will have to buy half an ounce of gold or less. This is probably what we are seeing overseas in India, for example. People are still buying gold, but they have to buy less of it. That points out again what you were talking about with mine supply. They may not be able to increase supply, but people still buy, at the higher price.

David: Let’s go back to the 1980s, Kevin, because that was a period in time when the U.S. and European buyer was active, and 50% of the demand was going into investment-related things. It was the U.S. and Europe. Today it is 38%, with us basically not even factoring in, while it is Asian and the sub-Indian continent which is dominant in that 38% investment demand component.

This is the point I want to get to. The West has not shifted gears meaningfully and engaged this bull market. It is fascinating, Kevin. We suggested this about 3 or 4 months ago. I was just coming back from Europe and supplies were nonexistent. You couldn’t find gold available, even in the retail space, because demand was off the charts. We were seeing tens of tons, and then ultimately, hundreds of tons in the fourth quarter, consumed for investment purposes in Europe.

Finally – finally – after ten years, it captured the European imagination that they needed to own gold as an offset to losses and volatility that they had in their other assets. What brought it home was a crisis in the banking arena in Europe. We don’t have anything local in the U.S. that has focused U.S. buying attention, and I think that is very interesting, because if I had a prediction for 2012-2014, it is that Western demand, both European and U.S., and I mentioned European has already launched higher with the focus on European bank issues – that will add an extra ten percentage points onto total investment demand, in an environment where supply is not keeping up. You can’t afford to say, “This is Jeff Christian from the CPM group, saying, listen, you are going to make the market go higher, even with 2% increase in investment demand.” I would suggest that over the next 24 months we see between Europe and the U.S., an increase of ten percentage points to that investment demand component, driving up competition for limited ounces. This is where you get into a very aggressive growth environment.

Kevin: David, we talked about the analogy, that people from Europe were jumping into gold, but they were also jumping into dollars. The dollar has really benefited this last quarter from Merkel/Sarkozy trying to solve the European crisis that continues to get worse, but we likened that to jumping from the Hindenburg onto the deck of the Titanic. There is point where they have to jump into this little bitty lifeboat, and there aren’t enough lifeboats. They are the gold. The Hindenburg is the euro, the Titanic is the dollar, and hopefully people are getting the analogy here, the lifeboat is gold, and you don’t have any way of increasing the amount of lifeboats when you need it.

David: Kevin, this is, again, just a reminder of how U.S.-centric we are, or even Western-centric we are, in our analysis. We look at the growth in the exchange-traded funds, and when you look at the numbers, it is actually more of a Western institutional product. We have seen a huge bias – people buying gold and it isn’t ETFs. The primary interest in bars and coins globally has gone into private holdings. It has not gone into ETFs, and this is the major component in investment demand. The ETFs are almost a side note, even though that has been a critical variable in adding liquidity to the U.S. and European market.

The rest of the world could care less about selling gold – they are buying bars and coins. And we will get into the reasons why they own it, but it is not just a trade. It is not just a convenient exposure. It is not just an asset allocation. For most of the world, particularly the Asian and Indian subcontinent, we are dealing with something that comes into the family portfolio, and never leaves. That is a very interesting component.

Kevin: Let’s try to not look myopically, here, as United States citizens. Let’s look at how the world views gold. Let’s take the East, for example. They are wealth preservers. We already know how the Asians save. They will save 25-30% of their paycheck, even if they are hungry.

David: But see, this is the problem, if they are putting it in a bank. Let’s say, for instance, that you are in Vietnam, and you are facing, not 5% inflation, but last year’s numbers are between 22 and 25% inflation.

Kevin: Right. What do you do?

David: At least on the point of inflation, we do see an Eastern emphasis, as inflation and wealth preservation are connected ideas. But to some degree, actually, if you are looking at wealth preservation, that is really a Western bias. You own it as an offset to losses. There are other things that I think we see emerging in Asia, and that is, profit motive. We have had such strong returns.

Kevin: They have had 30 years of growth. They are starting to get that taste that we had during the real estate move.

David: Exactly. Not only do they see growth in their economies and new sources of income, with which to feed their savings, and thus their gold purchases, but they are also looking at the growth in the gold market over the last several years, set against their local inflation rates, and they realize, “Hey, this is something that we can actually make money on.” Strong returns are also an appeal.

Kevin: It is not just wealth preservation, they are actually speculating on price.

David: Right. In that part of the world we also find that gold is a status symbol, and you see this to some degree here in the United States.

Kevin: India, especially.

David: Absolutely. How many bangles are you wearing? It is a statement of, “This is how well I am taken care of. This is who we are as a family. This is a part of our identity.” Status does play into it, and that is not something you sell at high prices. That is something you want to communicate even more of. “Look what I have at these high prices. What does this tell you about the rest of my wealth?” There is very much a social statement in the ownership of gold, for the largest part of the world, which is, today, buying it.

Kevin: Speaking of Asia, it’s not just selfish status. Look at the earthquake in Japan. How much gold was given as gifts to show just how deep the relationship was with the person who was affected?

David: That is exactly right. Last year was a fascinating period in time, because the consumption, specifically, for jewelry and things like this in Japan, was off the charts. It was actually in the aftermath of the quake, and again, it was that reappraisal of relationship. “I want to show you how much you mean to me.” There was a huge increase in gold gifting, if you will, and actually 2012 sets up to be a pretty nice year for that, too.

If you are looking at the Pacific Rim in general, China specifically, this is the Year of the Dragon, and gold gifts for newborns is a very popular idea. You and I might think, “What are you doing? You are giving a gram of gold, you’re giving an ounce of gold, you’re giving a piece of jewelry that, in terms of its total weight, means nothing. In aggregate, we are talking about 2,000 tons a year for these kinds of little, itty-bitty gifts. That is staggering. It is in aggregate that you realize that this is where the billions and billions and billions of people buying a little bit of gold makes a big difference.

Kevin: That’s not really a Western phenomenon. This is, again, in an effort to try to think a little bit differently, to say, “What are we missing?” We don’t have that Eastern mindset, that mentality.

David, we have talked about Volcker’s numbers being about 10% on inflation, and we have talked about the government calling it 3%. Both of those sound pretty “affecting” to us, but in the developing world, inflation can be much higher than that. You have to hedge, like you talked about before.

David: Kevin, that is where you see, in developing nations, a major emphasis on gold as an inflation hedge. Whether that is in India, whether that is in Vietnam, you can pick your country, but where we have benign inflation, even if it is low double digits, you end up with much more aggressive inflation elsewhere. Whatever we have created, in terms of exporting fiat currency, ends up showing up on the shores of our foreign trade partners, and creating real havoc in the money system. So I think, as an inflation hedge, we continue to see that, as a primarily developing nation emphasis, but something that is coming front and center to a theater near you in the West.

Kevin: When we talk about portfolios growing over in these developing countries and in Asia, they have to diversify, because the stock market isn’t necessarily the choice of everyone.

David: Except in China, and you may have read this morning that the Chinese government is enforcing pension purchases of capital assets. In other words, they want people to buy stocks and bonds now. This is a last-ditch effort, frankly, to save the stock market in China by forcing the hand, putting a gun to the average investor and saying, “You’ll take an interest in this, whether you like it or not.”

The instinct of the average investor is to buy value and to avoid that which has what might be called an air pocket underneath it. Where they think there is going to be an immediate decline, they step aside. Portfolio diversification and this notion of correlation among stocks is something that is very important, not only to those in the East, or those in the West, but this is a global issue.

Kevin: Explain correlation to the listener who doesn’t understand what you are talking about – worldwide correlation of the stock market.

David: Right. It’s just this. We know what correlation is – two things being very related. So you would assume that if you are buying different kinds of companies that they are going to behave differently in the marketplace. Buying a biotech stock – it’s probably going to perform differently than a consumer staple, or something like a miner. But, guess what? In 2011, and we are talking about the global equity markets, not just the U.S. market – 86% correlation, with 80% being about the norm, the average for the year.

Kevin: So if stocks are up, stocks are up. If stocks are down, stocks are down.

David: And it doesn’t matter what stock you pick. It doesn’t matter if you have a particular insight. It doesn’t matter if you are applying Graham and Dodd, and doing great research analysis into what represents the greatest value. You may have bought the best company and it is moving exactly in line with the general equities market, up or down, it doesn’t matter the homework you put into it.

Kevin: So to correlate a portfolio, how much is gold correlated to the stock market?

David: That is an interesting shift, because again, going back to the demand side of this, what we have seen is a shift away from North America, we have seen a shift away from Europe in terms of the consumption of gold, which really represents a shift away from correlation for gold, because the consumption component is not really oriented to Europe or North America. The financial centers there, the buyers of gold there – when they have to liquidate, for whatever purposes – even a John Paulson, who liquidates a third of his gold position because he has to meet redemptions, lost a ton of money last year, and had to meet client redemptions.

Okay, so he is liquidating. Guess what? It really doesn’t affect the supply and demand variables, because most of the buying is not being done by U.S., New York, and London hedge funds. This is being done in Asia, so it is creating even more of a non-correlation between gold and financial assets. At most, we saw about a 15% correlation this last year, whereas most securities were trading 86%…

Kevin: If a person is trying to diversify outside of the equities risk/reward market…

David: That’s a portfolio diversifier.

Kevin: They have to do gold.

David: You bet.

Kevin: That brings us to risk reduction, in general. Diversification in a portfolio reduces risk, but we have talked about reducing the risk of inflation, and we have talked about reducing risk, actually, of a complete currency collapse, or some sort of regime change. Looking at China back in the 40s, when the regime changed there, people rushed to try to transfer from their currency into gold before that changed.

David: Risk reduction is definitely a variable, and I think this becomes front and center, as we head into 2012, 2013. We have so many onion layers of complexity in the derivatives world, Kevin, where it is impossible to calculate what happens when one firm fails, and that is why our Fed, and the ECB, have been so defensive, in terms of allowing firm failures, let alone country defaults. That is what we are really talking about here. In terms of risk reduction, more and more people are looking at gold and saying, “Hey, wait a minute. This is great collateral if I do need to get a loan, but furthermore, if someone is willing to pledge it, it is collateral that has no fuzz on it. We like this as an asset class on the balance sheet. We like this as something where we have some clarity as to what the value is.”

Open the newspaper and you have your ounces times the current price. There’s your value. So there is a risk reduction as people are trying to put it into a portfolio, to say, “I don’t like my counter party risk. I know what this is, I know where it is, and I have control of it.” That’s an interesting component in terms of risk reduction.

Kevin: In an effort to think differently, to think outside of the American box, one of the things that has really boxed our thinking is that we see cash as neutral, because it had been, and still is, the reserve currency of the world, and it had been backed by gold, so we still have momentum from that period of time where we had a gold-backed reserve currency. But let’s consider the person who has seen their currency change three or four times in their lifetime. Their savings is what they think of as gold. They don’t think of currency as neutral, they think of gold as savings. I’m thinking of the Taiwanese.

David: Kevin, what you are really talking about, in terms of us having a reserve currency, and there being this privilege of saying, “We can move to cash, and it’s a neutral position,” is that it assumes a certain position that doesn’t exist any longer. It’s a little bit like when you graduate from high school. You’re at the top of your game. You may have been the high school prom queen, or the quarterback of the football team, but what happens between your senior year of high school and your freshman year of college is a total recalibration. You get no privilege. There is no free pass. It doesn’t matter how good you were, because there are lot of other valedictorians who are starting out as freshmen.

We don’t realize that. As investors, we look at cash and we say, particularly if it is dollar-denominated, “I’m moving to a neutral position.” Balderdash! You’re choosing to take risk. At times we do choose to take that risk, and at times we don’t, but to assume that it’s neutral is to assume that we still have the legitimacy which was implied in that Bretton Woods era where there was some sort of correlation to gold.

Kevin: David, it is amazing. I will talk to clients and I will say, “Where are your other investments?” And they will say, “Oh, well I don’t invest. I just keep my money in the bank.” That is just validating what you are saying. I think the same way oftentimes. Even though I have gold, and even though I don’t trust cash, what is the first thing that I do when I get paid? I put it in the bank first and then I figure out where else to go.

David: And you assume that is a neutral position, but it’s not. You are speculating in a volatile currency, a currency which is backed by nothing, and represents a balance sheet which is totally bankrupt. That’s what you’re speculating on when you are at the bank, not that the bank, itself, is insolvent. This is the same appraisal, Kevin, that is happening on a worldwide basis. We’ve talked about a couple of things here, Kevin – wealth preservation, strong returns, the status that it entails, gifting, an inflation hedge, portfolio diversification.

Kevin: But nothing beats gold as a monetary asset.

David: And it became that in the 1970s and 1980s, and then fell out of favor as structured products and securities gathered the imagination in one mass within the marketplace to invest on one theme. Kevin, we are different here in the West. If you look at the East, the Taiwanese have had a gold passbook program since 1997. You could take your savings and put it directly in gold, and basically, write checks from your gold account, in Taiwan.

This is the same thing we talked about in several of our public speeches two years ago, as the CIBC – Commercial Industrial Bank of China – and the World Gold Council were putting together at that stage, and now have successfully completed, savings accounts in China. Note to self: CIBC – how many branches do they have throughout China so that they can help distribute this gold savings program? Oh, only 18,000 – small branch banking. But we are talking about, Kevin, a program that you can add to 1 gram at a time, and they are now into several tons of gold stored for that particular program.

Most bankers in the West don’t know what to do with gold. They don’t know what to with it because it doesn’t have a cash flow. Because it doesn’t have a cash flow, they are not even willing to consider it as collateral. This goes back to what I mentioned just a minute ago. In Europe and Asia, gold has been used as reliable collateral, a real pledge, for many, many decades, if not centuries. It is only here in the U.S. where bankers don’t know what to do with the stuff.

Kevin: David, lest we just sound like gold bugs – that gold is just the thing to have, all the time, for every occasion – let’s restate for a moment. We have talked for 40 years about what we call the perspective triangle. The base of the triangle is keeping at least a third of your portfolio in gold, whether it is up or down. The left side of the triangle is the growth mandate. That is the equities, stocks, bonds, or whatever you are trying to actually make grow, and of course, the right side of the triangle is the cash. With gold going up, of course, the base of that triangle continues to grow larger and larger, and you have addressed that there are timing strategies as to when we take the cream off the top, or we reduce the amount that we have of gold in the portfolio. Would you readdress the Dow-gold ratio?

David: I will, but I want to come back to the triangle first, because Kevin, you are right in saying the foundation doesn’t change. The market changes, and the valuations may change. If you started with a third, you may now have two-thirds. But here is the question I have to ask you. If you hop on a sailboat, is there at any point, whether you are done with the sail, before or after, that you say, “Okay, let’s get rid of the keel?”

Kevin: Sailboats don’t work without the keel. You and I both know that, because we had a sailboat, David…

David: And we lost the keel at the bottom of a lake! (laughter) And it’s not easy to sail without a keel.

Kevin: You need the gold as a keel for your portfolio.

David: But it’s not the water, and it’s not the wind in the sails, it’s not the things that you consider more elemental in the sailing process. It’s one of those things that is taken for granted. We would suggest that the base of the triangle is what you take for granted. It’s what stays, it’s what stabilizes, it’s what allows a clear course, and it’s what should be a part of your wealth structure, from heretofore.

The question is, and you raised this earlier, if you have a third and it’s now 50% of your portfolio because of the growth in gold, as we have seen that growth occur from 2000 to the present, radical growth, 4-5 times the increase in value, then guess what you need to do? You need to have a reduction strategy. Again, it’s that taking the cream off the top, Kevin. And as more cream is created, if it is, if you see continued growth in that investment, then you continue to take cream off the top.

Kevin: And you move it to the other two sides of the triangle.

David: You re-allocate. Kevin, there is no silver bullet in investing. Anyone who says you should be 100% in gold, frankly, is over-confident, and thinks that they know more than they actually do. Anyone who thinks they should have 100% in cash, and this would be defining the deflation camp, frankly, defines a group that thinks they know more than they do. Anyone who assumes that you should be 100% in equities, which largely defines the Wall Street crowd, again, defines a group of people that think they know more than they actually do.

We like the balanced approach because it starts with one of the things that we predicate success on in the investment world, and that is humility. What do we know, and what don’t we know? And we need to continue to ask that question. There are changing variables in the marketplace and we want to maintain that balance. So, as risk reduction, what we were talking about earlier as a portfolio diversifier, certainly the strong returns, but for us, it has nothing to do with that.

Frankly, our orientation is not toward the returns, which are just gravy, it is toward the wealth preservation. It is the role that the foundation plays. Again, if you want to use that other analogy of a keel of a ship, it is a stabilizer. It does nothing else. You are still going to have to zig and zag to catch the wind, but it is a stabilizer on whatever course you choose, and that is why it stays with you as a mandate, as an insurance mandate. The mandate doesn’t go away.

Kevin: But David, what about the Dow-gold ratio? You have used that as an example of when we are going to start telling people to reduce the size of that keel back down to a third of their portfolio.

David: Kevin, this is the challenge, and I think this is why the math makes some sense of the challenge ahead. As we move into a phase where gold is $3,000, $4,000, or $5,000 an ounce, we are going to see the world around us look very ugly, very grim, and very hopeless. And that is, classically, when you have the best values, in terms of productive assets. So when it seems darkest, that is when people want to hold onto their insurance, want to hold onto their gold, and do nothing but buy more, even at higher prices, when, in fact, they should be in that reduction stage, in that re-allocation stage, buying assets that are now trading at extreme discounts.

This comes down to a point of view. Is the world coming to an end? If it is coming to an end, frankly, it doesn’t matter how many ounces of gold you own. That’s not going to help you. Kevin, I’m not sure if in the final analysis, if the world is coming to an end, if it even matters how many rounds of ammunition you own, let alone ounces of gold. It doesn’t matter. It just simply doesn’t matter. Our assumption is that there is some repetition within history wherein you see human sentiment swing from extremes of greed to fear, and it is those periods where fear is most intense, when the mass mind is operating in absolute panic, that you have to keep your mind, and make a wise decision to re-allocate.

We like the math, because it forces an early exit. Early? Yes. Are you going to capture every dollar in this global market? No. If you wait around for it, guess what happens? Pigs get fed, hogs get slaughtered. That’s the classic Wall Street phrase describing someone who has overstayed their welcome, someone who has tried to maximize every dollar in a move. We suggest 3-to-1, 2-to-1, 1-to-1 is this gradual approach to when the Dow Jones industrial average, divided by the price of gold, gets to these ratios. You begin letting the market own some of your gold, and you begin to move into, and dollar-cost average, into a portfolio of productive assets.

Kevin: Okay, slow down a little bit. 3-to-1, 2–to-1, and 1-to-1. Let’s say that a person has well beyond a third in gold in their portfolio, and let’s say the Dow is 12,000 points, to use a round number. If gold, today, was at $4,000, a 3-to-1 ratio, you, at that point, would start looking at advising people to start reducing their gold holdings, not below a third of their portfolio, but reducing what you call the cream.

David: Kevin, that’s exactly the point. You cannot, even in that period of darkest demise, if you think it is the country, if you think it is the currency, if you think it is the world as we know it, you have to read history to know that people have felt this way before.

Kevin: So, it’s no longer $4,000, David. You have called me, and you have said, “Hey Kev. Gold is $4,000, the Dow is 12,000. Remember what we talked about. We prepared for this ahead of time. Are you willing to send a little of that money to the other two sides of the triangle?” Let’s say I did. All right, now gold goes to $6,000 and I call you up and I say, “Dave, I just missed $2,000 worth of the move.” And you will say, “Well, guess what, Kev? Funny you called. It’s 2-to-1 at this point. Remember the conversation we had?”

David: And what was the cream that you were taking of the top is now buying that much more in productive assets, actually, a multiple of productive assets.

Kevin: Even though I feel like I may have lost some of the gain, I’ll say, “All right, Dave, I trust you on this, you have managed money for a long time, you have managed paper assets, as well as gold, so I’m going to move another third, or something of that equivalent, of what I have in gold, over into the other two sides of the triangle.”

Now I’m going to take you to the last one, Dave, because the reason we talk about 1-to-1, is because it has happened before. It happened in 1896. It happened, very closely, in 1932. It happened in 1980. We have seen 1-to-1 ratios before on the Dow, and they have always been very close to the bottom of the Dow. So, gold goes to $12,000. I know this sounds crazy, the Dow is still 12,000.

David: It helps our math, in terms of just showing you 1-to-1 ratio.

Kevin: Exactly, and I say, “Dave, you were right about the ratios, but by golly, I’m so sorry I missed that gain in gold,” and you say, “Well, you’re going to have to trust me one more time. I want you to move another third of what is left over.” Now here is the crazy thing. I still have more dollars in gold than I ever did, even taking a third out the first time, a third of what is left over the second time, and a third of what is left over the third time. If you do the math, I still have a very nice gold portfolio that I can pass down to my kids, but I have created a gigantic structure on the other two sides of the triangle.

David: Kevin, I am most fond of General Electric, as an analogy, because it is the only Dow component left, after the last 100 years, and so, not because it is my favorite company, by any stretch, but because it has been around for a while anyway. In the last ten years, as this Dow-gold ratio has reduced from 43-to-1, down to the current 8 or 9-to-1, what we have seen is the opportunity cost. If you had bought GE in 2000, you would be upside-down 60-70% on your purchase, and the growth in gold in that same time frame has put 4- to 5-fold on the table. So what we are really talking about is, as this ratio reduces, it increases your purchasing power in a stock like General Electric in a huge way. Modest investment in GE, or in gold, ten years ago, $30,000 would have bought you 500 shares. That same money, translated in gold terms today buys you over 8,000 shares.

Kevin: What an amazing increase.

David: From 500 to 8,000 shares! I think when all is said and done, as this ratio reduces from the current 8 or 9-to-1, down to 4, 3, 2, and 1-to-1, we are talking about what would have been an original purchase of 500 shares of GE, which is, prospective for the gold-owner today, going to be 30,000, 40,000, 50,000 shares of the same company, and we are talking about with a very modest sum. Kevin, we have an entire client base that has seen radical appreciation with very modest sums of money, and it puts them in a position to be able to capture these kinds of values which, frankly, are once in a lifetime.

Kevin: And we are not talking about dropping the keel off the boat to do it, either. You keep the keel, but you actually add to the rest of the boat.

David: That’s right. I think that’s why, part of the reason we rehearse this in our own minds, and with clients in conversation, is because by the time we get there, the environment will be so intense. Again, imagine gold at $3,000, $4,000, or $5,000 an ounce, and you know that we are in utter chaos, financially, and maybe even monetarily, here in the United States.

Guess what? It’s tough to make a decision in that environment, just as it would have been in 1932, in 1949, or in 1982, where there really were no growth prospects. The general market had thrown in the towel and said, “We’re not interested in equities. To heck with it. There is nothing but losses ahead in that area.” And in fact, those were the turning points where all you had was gains from that point forward.

Kevin, I suppose this is consistent with the fact that, on an intergenerational basis, our family, and our companies, take a contrarian view. Just when everyone is clamoring for gold, why would we be insane enough to suggest that people sell it? Because history is on our side, and has proven time and time again, when the mass mind says, “We want no more,” that’s when you want to say, “Yes, we want a little bit of it.”

It’s just to act as a contrarian, but not for the sake of being an iconoclast. We’re not trying to prove something. This isn’t the artist just proving that he is different. That’s not it. This is looking at history and saying, there is some design within human nature which freaks out, and is either freakishly greedy, or freakishly fearful, and you don’t want to operate at those extremes. When the mass mind is buying tech stocks – 1998, 1999, 2000 – there is something wrong. The sniff test should be failing. Why? Because everyone’s doing it. Everyone’s doing it!

Kevin: Yes, David, what we doing is we are looking forward, and we are mentally rehearsing for a future event, but for right now, you would keep your gold and keep your powder dry?

David: Keep my gold? I added some to it yesterday – on a personal note. Kevin, I say that from my personal portfolio perspective, because I think the opportunity that opened up, the decline from $1,920 down to about $1,538 – we are now $100 higher than that, we are in the rebound phase. Kevin, I think this is a great time to be looking at the market. Buy the dips if you can. The market is not finished.

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