Interesting doomsday article on the credit crunch. What if...?

short the dollar, short the S&P 500, long on gold

Gold has been going up and down $200/ounce in the month or two. That seems far to volatile for my taste. It seems like a sure way to get burned when you invest in something that has no intrinsic value and is prone to huge price swings based on speculation.

-john-

What can we invest in that has intrinsic value?

Stocks, bonds, CD's, money market. In stocks, you own a fraction of a real operating company. If you pick wisely, it is a profitable company that will have dividends and increase in price. In bonds and CD, you have a face value of the instrument that you will get back when the instrument matures. With the money market, you have an investment that is designed to maintain its $1 per unit value, and you can cash in out at any time.

Gold, on the other hand, has no real value. You cannot eat it, wear it, or feed it to animals. It doesn't grow, nor can you grow anything with it. It does not throw off dividends. It has few real uses, and we have a tremendous surplus of the stuff. There is no use for which gold is unique, except maybe for making women look like hookers. Gold costs money to buy, costs money to store, and costs money to sell. It weighs a lot, so it is hard to transport, and it melts easy, so it is easy to change its form to cover up theft. With all those negatives, you wonder why anyone wants any of that gold stuff.

-john-

In a real depression, I'd think food and guns would be valued above gold. I can understand the fear of a bout with hyperinflation, that might render the dollar pretty worthless, but you are right, a share of a company producing a good or service still has intrinsic value.

I enjoy the copy of some of the advertising promoting gold: "in 1920 a man could buy a suit with a $20 bill or $20 gold coin. But in

2006, $20 won't buy a shirt, and a gold coin, now worth over $500 will buy a suit."

So what? At 12%, your money will double every 6 years. Over 86 years, that's more than 14 doublings, or over 17,000 times your investment, $340,000 for your $20 bill.

Someone tell me how an ad can make an 'investment' that will grow from $20 to $500 in 86 years, an annual return of 3.8%, look good when the alternative (the S&P) would return 680X as much.

From the 1980 peak, gold would have to exceed $4800 to outperform stocks over the same period. I look at the 35 year chart at

I'm no technician, but 'down' looks far more likely than up, for all the reasons you stated.JOE

In fairness, 12% is optimistic. Ibbotson's data, over the

20th century (which included some phenomenal advances in productivity - vastly more than in most of the centuries prior) - the broad US Equity market got more like 10.7% Over 86 years, that's actually a huge difference:

Of course, at 10.7% over 86 years, that $20 goes to 6261x the original value - to over $125,000. That's still a hell of a lot of suits...

Nevertheless, if we assume that we won't get the same level of p/e expansion (p/e expansion accounted for approx 1.25% of the historical 10.7%), it becomes: 9.45%, after 86 years you get a multiple of about 2358, so the $20 becomes $47161, still, a lot of suits.

Anyway, yes, stocks are likely to be vastly better in the long run than gold. But I think suggesting that folks have even a vague expectation of 12% is overdoing it. (and, frankly, I hate to see these things done in nominal terms, too - I'd much rather talk in real terms - in which case gold seems to follow inflation almost precisly in the long run, while equities beat it (or at least have beaten it) by something more like 7%.

The moneychimp site using "Robert Shiller and Yahoo finance" data for S&P showed 12.2% for 1919-2005. I anticipated some objection and rounded down to 12%, knowing that a .20% expense was on the low side, although mutual funds weren't invented back then, were they? But for these discussions don't we use raw data, anyway and disclaim "after fees and taxes, you'll see less"?

Wait - the Gold hucksters used the past data to make these claims, and I reply with past data, I think I'm on the record as subscribing to the "waiting for average" belief that the next 10 years will center around 8%.

Is Shiller's data wrong? Or is chimp's math? The site shows 9.2% return after inflation over the stated period. Either was BWS, we agree on approach, and I think your $125,000 makes the point no less dramatically than my $340,000. JOE

Hrm. Ibbotson's 10.7 is from 1926-2000 and is pretty widely quoted. I didn't see Shiller's but I have seen a couple of others noting the 1937-1999 performance at mid 11% range. Careful selection of starting and ending points, of course, can make substantial differences.

There have been pooled investments for a long *long* time, but the modern mutual fund structure really took form in the twenties (1924 Mass Investors Trust was started and it went public in 1928, just in time for the crash!). Some closed-end funds were earlier by a couple of decades, but pooled investment trusts of various sorts go back at least a hundred years earlier. Now, there's a world of difference in the transparency and efficiency of, say, a modern well-managed open-ended mutual fund (or especially something like an ETF) as compared to some of the earliest stuff.

Fair enough, though, as we both know, "history" and selection of actual starting and ending points make it easy to tweak stuff...

I'm really not sure - in a couple of moments of poking around, I didn't see Shiller's data. It seems a little high to me, but I'm generally pretty skeptical. I'd rather be surprised more on the upside than on the downside. Anyway, Ibbotson and Shiller are, of course, both Yale guys, so who knows. But Ibbotson's data is probably the most widely quoted I've seen. Shiller's been talking more about real estate lately anyway.

Talk about another asset class about which folks expectations are often out of whack with historical reality...

I think perhaps neither. But while I agree with your assessment of gold vs. stocks, you did cheat a little bit. You used the gemometric average return for gold, but you used the arithmetic average return for stocks and then you ignored volatility when projecting returns forward from

1920. The geometric return over that time period would have been something like 10.1%, closer to Bread's number (judging from the volatility stated at moneychimp). But this is still way more than adequate to support your point I think.

-Will

John A. Weeks III wrote: [...]

Gold -- always a fun topic. I think you are too easily dismissing the last 5,000 years of human history. I also cannot eat or wear my stocks and bonds. In fact these days often we don't have even a flimsy piece of paper to show for these investments, just transient pixels on display screen. Frankly I think you are misusing the term "intrinsic", since a stock certificate is an intangible personal asset and has no intrinsic value, but only the value of the rights it conveys. Tangible personal property such as livestock, machinery, or furniture does have intrinsic value. When you own stock you do not own these tangible assets, but only some rights related to same.

I agree that gold as an investment compares poorly to other investments. But physical gold as a hedge against massive collapse of current political and economic systems is still a pretty good bet.

Or to avoid prying eyes. And while there are transaction costs to owning gold, how is that any different from the transaction costs of owning food or guns (alternatives that joetaxpayer mentioned in the case of a major depression). If you live in Iraq and only have two hours/day of electricity, which do you think is going to keep its "intrinsic value" longer: your gold or your perishable food?

In my heart, I'm a gold bug (physical gold). But I've never bought any and probably never will. But I still have a vague notion that some (dooms)day all those old silver coins I have may serve a similar purpose, and in fact maybe even better than gold as they come in smaller denominations and are more familiar to many people.

-Mark Bole

Enron stock was actually worth billions of dollars at that time. Stripping the criminal activity aside, Enron still owned a huge array of legitimate energy companies. Those assets are being sold off over time, and the money is being used to pay off creditors. Several billion dollars has already been paid back. That might not be everything that Enron owes, but it is hardly in the class of the value of a roll of paper.

Those who follow rational rules of investing keep a well diversified portfolio and never have more than 5% invested in any one stock. People who invest like this were not hurt by the Enron crime. In fact, the stock market is up big since then.

-john-

This is flat wrong. Now admittedly I've seen purely or partially decorative gold dental work, but gold is used in both of these applications because of its wear properties (specifically its resistance to corrosion) and malleability. There are options, some cheaper, but not necessarily better. It is application-dependent. In any case, I highly doubt that many people choose a computer monitor based on its gold content, a gold content they cannot normally even see!

My point is that gold has legitimate uses beyond fashion, so it has legitimate demand-driven value, though obviously fashion uses and gold bugs drive the price today more than industry. But having value doesn't make it a good investment.

-Will

This is not correct. Gold is a superior electrical conductor, and more ductile and corrosion resistant than copper. If it were plentiful, all your wiring would be gold. As it is, many critical connections within electronic equipment are gold. There are companies that make money salvaging gold from old PCs.

Brian

When someone raises the question of investing in gold (client or colleague) my response is: "without hitting google, describe the market for gold -- major categories of supply and demand...GO!...." I have yet to hear an answer that is anything close to correct. I don't have these updated but they don't vary all that much - this is from 2005, in tons of gold, as quoted in Barron's 1/06:

DEMAND

71% 2950 Jewelry (mostly US, China, India) 7% 300 Central banks & industry 6% 250 Hoarding 7% 300 ETFs 3% 130 Coins 5% 200 Hedging reductions 4130 Total Demand

SUPPLY 2500 Production 850 Scrap 500 Official sales

3850

(-280) Surplus (deficit)

So if you're considering gold as a valid "asset class" within a portfolio, consider the market for it. Many of the rationales for investing in gold break down when you look at it this way. Industrial uses are a very small component of demand. It's all about jewelry and similar "non-essential" demand components (contrast this to say oil or copper which are essential commodities). Marginal demand from speculators appears to drive short-term pricing to a large extent -- check out the price spike around the creation of the gold ETFs for example. Marginal supply from central banks and exiting speculators can easily supplement existing production to drive down price. Meaning its "intrinsic value" is, in my view, a complete wildcard.

Enron is a bit of a red-herring. There are about 7,000 publicly traded US stocks most people would consider investing in, perhaps 1,000 or so on "the short list." The percentage of companies with Enron-level fraud is very small and diversification easily addresses that specific risk.

-Tad

[picking out a tiny portion of a nice post]

But that's only due to the cost. If gold were plentiful, and therefore cheaper, industrial and home uses would rise. They don't wire your house up with gold. That's not because it's not a good solution, it's probably the best, but at current prices it's not a good cost/benefit trade-off. Copper (or aluminum) is cheaper.

Brian

It's a good start Brian, but you didn't think it through to the end.

All other things being equal, gold would be cheaper if it were more plentiful (supply goes up => price decreases). I also agree the lower price would entice people to use it to wire their homes (gold's price would drop relative to substitute goods, like copper).

But what happens when everyone starts buying it for industrial/home use? Demand goes up => price goes up!!! Price begins climbing until the cost/benefit analysis once again favors (or at least equals) copper and aluminum. Buying drives up the price, ceteris parabis! Just because it falls to $10/oz. (hypothetically) doesn' t mean it wil stay at that price nor does it mean people will continue buying ad infinitum as price climbs.

Substitute goods will force equilibrium at some point lower than its current value. Would you want to be holding gold when the price drops and re-equalizes at a price lower than it currently is while things like food, water, shelter, and safety become scarce and therefore more valuable? I wouldn't. A doomsday scenario could easily cripple the demand for gold as a decorative consumable and that would easily trigger everything outlined above.

Not true. Silver is a better conductor than gold. When the US Army built the Y-12 plant during WWII, they needed the best conductor they could get, and could choose anything they wanted. They picked silver from the US Mint. You can look up the conductivity of metals on line or in a reference book. When huge amounts of power are transmitted, the power companies use aluminum.

The reason that gold is used is that it is very inert. It will not react with most chemicals that are in the air, and it does not rust in reasonable temperature ranges. That is why it is often used to plate electrical connectors.

-john-

Two thoughts, perhaps obvious, but bear with me. One poster mentioned the substitution effect. Yes gold is used in electronics, but the amount in any system is so small that gold can rise to $2000, and there would be little reason to seek an alternative. I can find gold leaf selling for a few cents per square inch. Likely the gold content of a $500 computer is measured in cents. So no issue there.

Second, as the price rises, two thing happen. People find old gold jewelry they are not so attached to, as well as coins whose gold content (value) now exceeds any numismatic value. So the supply rises that way. Also, mines tend to have supplies that vary with cost. Huh? Well, there's a cost to mining that has two large factors, yield (oz AU/ton ore) and depth (cost to dig). So if I hit an area that yields 1 oz/ton, and it costs me $800 to process, that area is noted and left unmined. At $1000, it's reopened. This is oversimplifying, but not by much, it goes back to supply/demand, explaining how supply literally increases when the price is higher.

JOE

Yes and right now Bernanke, King, and Trichet are having a feast on my funds...

They hurt the prudent investor...

All I do now is read

hoping for some newinsight...

Maybe the calculation error on Excel 2007 has something to do with the subprime mess...

There is also an arbitrage opportunity that could of and might have been exploited when the discount rate went below the Fed Funds rate....

I suggest, for the time being, setup your TreasuryDirect account... Buy some TIPS... I it all goes to hell ACH your money out of your account...

frank