FOCUS: GO FOR GOLD -- BUYING AN INSURANCE POLICY
79% match; The Edge (Malaysia) ; 22-Feb-1999 12:42:39 pm ; 2072 words
Hong Kong-based Marc Faber, author of the Gloom, Boom and Doom report, is known for his
contrarian views of financial markets. Here, we reproduce the latest report where he says it
is surprising how few investors insure themselves against a systematic risk in the world's
financial markets, and how, in fact, he believes that the time has come to gradually shift some
financial assets into gold.
While most people happily purchase health, theft, fire, life, and all kinds of other insurance
policies, it is surprising how few investors insure themselves against a systematic risk in the
world's financial markets.
In spite of a painful recession in Japan, the Asian crisis, the Russian meltdown, a Chinese
economy which looks increasingly shaky, and the most recent devaluation of the Brazilian
real, it is assumed that a major financial accident cannot occur because central bankers
around the world won't let it happen.
Equally surprising is that at a time of so many imbalances in the global economy, and the
enormous volatility of bonds, currencies, and equities, US investors are behaving as if they
know for sure that corporate earnings will rise for the foreseeable future by more than 15
per cent a year, by paying a record of over 30 times earnings for the Standard &Poor's 500
(S&P). But compared to Amazon.com, which at its peak had a market capitalisation of over
US$30 billion and sold for over 150 times sales while still showing growing losses and
despite uncertainty about whether the company will ever really be profitable, the S&P
valuation may indeed be conservative.
What I wish to stress is that despite the current great uncertainty, when even George Soros,
in his latest book The Crisis of Global Capitalism, is questioning the ability of our capitalistic
system to survive (a point already made in 1996 by Lester Thurow in his excellent book The
Future of Capitalism), investors in the US and Western Europe still perceive equities to have
little downside risk.
There are some sceptics and investors who are concerned about the world's economic and
financial stability, but they insure themselves against a financial accident by buying bonds or
holding cash. In other words, these investors may not like equities, but they believe in
financial assets such as bank deposits or short-dated government securities denominated in
US dollars, the euro, or the yen.
Now, one may not have to agree entirely with David Roche of Independent Strategy, who
believes that "the world's three major currencies all look vulnerable" (after all, weakness in
one currency would lead to strength in another), but Roche's basic point is that it is difficult to
make a strong case for any of the world's three major currencies. As far as this observation
is concerned, I agree with him. Where I am in some disagreement with him concerns his
conclusion that gold should be avoided, because of deflationary pressures, in favour of
investing in Australian and New Zealand dollars. In fact, I believe that the time has come to
gradually shift some financial assets into gold, and that within a few years its price will have
risen substantially.
I wish to emphasise that I am neither a gold bug nor an expert on the gold market. For an
expert view, read the article by Frank Veneroso and Marshall Auerback of Veneroso
Associates, an investment advisory firm which follows the gold market much more closely
than I do.
Case for gold
Nevertheless, the case I wish to make for gold is based on the following considerations.
Since 1970, I have been paying almost US$5,000 a year for a private health insurance policy.
Since I have never been sick nor had an accident, it has obviously been a bad investment.
But the fact that I haven't been able to use my insurance policy doesn't meant that I would be
tempted to stop paying the premiums, as a health disaster could still strike at any time. In the
same way, investors should consider acquiring gold -- not necessarily in the hope that a
financial accident would occur, but as insurance against one occurring. If an investor is
convinced that an accident is bound to happen sooner or later, he could always increase his
gold allocation -- in an extreme case, to 100 per cent or more of his assets.
The present cost of buying a "gold insurance policy" is relatively low. Gold prices are
hovering around an 18-year low, while Western equity markets are near or at a 16-year high.
I have previously pointed out that one Dow Jones Industrial Average will purchase more
ounces of gold now than at any other time this century. Simply put, relative to equities, the
price of gold is low. This also applies to other commodities, which have been in a vicious
bear market relative to all other assets since the 1970s. From Figure 1, one can see that an
index of commodity prices, such as the PPF Commodity Index, is at an extremely low level
when adjusted for the consumer price index. (This index includes 12 different commodities.)
And while declining commodity prices and rising financial asset prices are consistent with
Kondratieff's long-down wave, we should keep in mind that the down wave will bottom out
between now and the year 2004. Thus, while further intermediate weakness in commodity
prices cannot be ruled out, from a longer-term perspective, important or secular lows should
occur sometime between now and the year 2004. Furthermore, it is possible that although
commodity prices may continue to decline in the event of a deflationary global recession,
such an event would likely depress the highly-priced Western equities even more. Thus, we
may find that gold will shortly begin to outperform equities.
At present, total above-the-ground gold in existence is estimated at about 110,000 tonnes,
with a value of about US$1,100 billion. (About 30 per cent of this is estimated to be held by
central banks.) Annual supply (mined and recycled scrap) amounts to around 2,500 tonnes,
with a value of about US$25 billion.
Now, consider that the total stock market capitalisation of just six US technology stocks --
Microsoft, Intel, IBM, Cisco, Lucent, and Dell -- adds up to US$1,200 billion. In other words, all
the gold ever mined by mankind is worth less than just six technology stocks.
Equally startling is that the stock market capitalisation of all gold shares in the world amounts
to only about US$30 billion (less than Yahoo!) and that the precious metal sector's weight in
the S&P is only 0.17 per cent. By comparison, Microsoft has a weighting of 3.69 per cent, Dell
0.99 per cent, Charles Schwab 0.24 per cent, and Micron Technology 0.15 per cent. Thus, an
extremely controversial company such as Micron is worth almost as much as all the gold
stocks in the S&P.
Another way to look at gold is to consider what would happen if, for any reason, people
everywhere lost faith in paper money. If every Chinese bought just 1g of gold a year (1g =
US$9.20), China's yearly demand would amount to over 1,200 tonnes (about half the annual
new supply). Furthermore, if every person in the world decided to buy 1g, the total demand
for gold would soar to about 6,000 tonnes. (Since the 900 million Indians purchased around
700 tonnes of gold in 1998, this figure is not totally unrealistic.) And if every person on the
planet purchased 1 ounce of gold, total demand would jump to 186,000 tonnes.
I mention these scenarios only to illustrate that, while central bank selling may continue to
depress the gold market temporarily, in the long run the key to the gold market will be the
demand by individuals. If people again bought gold not for jewellery but for investment
purposes (as they did in the 1970s), because they believed that its price will move up, then
an almost unimaginable bull run could propel the gold price into the stratosphere.
Just think what would happen to gold prices and gold shares if US equity mutual funds
decide to allocate just 5.0 per cent of their assets (about US$130 billion) to gold, when the
annual supply is worth just US$25 billion and the S&P weighting of all gold shares is only 0.17
per cent (not to mention the large outstanding short position).
The above figures show that, the insurance feature aside, gold actually makes a lot of sense
from a longer-term investment point of view.
Increasingly, we hear the argument that the present instability in the world's financial markets
is due to the absence of an orderly monetary system. Even US Federal Reserve chairman
Alan Greenspan admitted recently in a testimony before the US Congress that "in an
environment where the gold standard rules were tight and liquidity constrained, imbalances
were generally aborted before they got out of hand". As a result, I strongly believe that it is
only a matter of time before a new monetary system will be introduced.
This new system may not be a classic international gold standard, but it is likely to be an
arrangement in which gold will have a major role to play. Under such a scenario, gold sales
by central banks would give way to central bank purchases, because Western central banks
aside, most central banks hold less than 5.0 per cent of their reserves in gold.
If some sort of a new gold standard was introduced, it would likely be accompanied by a
significant revaluation of the gold price.
While it is true that the gold price has so far failed to give a buy signal from a technical point
of view, the Philadelphia Stock Exchange Gold and Silver Index (down 90 per cent from its
high) appears to be bottoming out (see Figure 2 on page C7). The Philadelphia Gold and Silver
Index is a capitalisation-weighted index which includes leading gold and silver mining
companies such as Ashanti gold, Barrick Gold, Battle Mountain Gold, Coeur D'Alene, Freeport
McMoran, Hecla Mining, Homestake Mining, Newmont Mining, and Placer Dome. Similar bottom
formations are taking place for the Australian All Resources Index, the FT gold Index, and the
Montreal Mine & Mineral Index.
At conferences recently, I have been asking who among the audience has invested more
than 1.0 per cent of his assets in gold and gold shares. In an audience of 200 to 300 people,
no more than two or three people will raise their hand. Thus, gold is certainly not widely
owned. It is unpopular among investors (even among Swiss banks), and expectations for a
bull market are extremely low. Economic literature 20 years ago was full of arguments why
gold prices would always rise. Today, most articles argue for the demise of gold as an
investment class.
In these newsletters I have frequently argued that the strongest bull markets emerge in
assets for which expectations are extremely low. Today, possibly Japanese shares aside, I
cannot think of any asset class for which expectations are as low as they are for gold and
other commodities.
Gold bullion or gold shares?
If an investor is interested in investing part of his assets in gold, what should he do:
purchase gold bullion or gold shares?
Historically, gold shares have been far more volatile than the bullion price. Therefore, if an
investor expects the gold price to rise by 20 per cent over the next 12 months, it is likely that
most gold shares would double in price. Furthermore, gold companies can increase their
earnings even if the price of gold held steady or fell somewhat, because of the exploitation of
new mines and higher production efficiencies. So from a return point of view, investors
should acquire a basket of gold and silver mining companies or a gold fund.
London-based T Hoare & Co Ltd, which provides some of the best research on gold shares,
recommends the following stocks: Barrick Gold, Anglogold, Newmont Mining, Placer Dome,
Normandy Mining, Franco Nevada, Ashanti Goldfields, Kinross Gold, Cambior, Western
Areas, TVX Gold, Great Central Mines, Agnico-Eagle Mines, IamGold, and Randfonstein.
Gold bullion kept in a safe deposit box, rather than gold shares, should be considered if
return on investment is less important than return of the investment. I can envision a situation
where gold prices rise strongly -- to above US$3,000, say -- that gold mines become subject
to excessive profit taxes or be nationalised at the request of central bankers. I am well
aware that a US$3,000 or higher gold price sounds like heresy, but if Internet stocks can
perform as they have, I have little doubt that in the next commodity boom the gold price could
rise by at least 10 times. |
