Disadvantages of gold as an inflation hedge

It is an article of faith among investors worldwide that gold is THE hedge against inflation and hyperinflation.

They are wrong.

Gold has numerous disadvantages in the role of hedge against inflation. It is a commodity. There are many indications that not only would a broad-based commodity index better match the consumer price index or inflation otherwise defined, but almost all other commodities individually would be better than gold to hedge against inflation.

1. 28% capital gains tax rate. Almost all long-term capital gains are taxed at 15% or 20%. Obama’s “rich” paid 20% starting in 2013 and real estate gains from depreciation are taxed at 28%. Long-term capital gains in gold and other precious metals, art, and collectibles, are also taxed at a 28% tax rate. [IRC§1(h)(4)(A)(i) and §408(m)(2)]

This is exacerbated by the fact that in the United States, unlike the U.K. and Australia, the basis of the asset sold for a gain is not indexed for inflation. So a mere drop in the value of the dollar would trigger a “gains” tax even though the owner-seller of the gold enjoyed no real gain in purchasing power. That is a form of “phantom” gain that triggers real tax liability right now, but which produces no real money to pay that tax liability. Therefore, a capital gains tax for which the basis is not indexed to inflation is simply a government confiscation of part of the net worth of the capital asset owner.

When the subject of tax rates comes up, many immediately say it does not apply to them because they hold their gold in a pension account. In fact, withdrawals from such accounts are sometimes penalized and almost always taxed.

Pension accounts also limit the form of the gold investment and thereby subject the investor to counterparty risk that could, if there were no pension account, be eliminated by taking possession and storing the metal in your safe deposit box. Loss of storage flexibility and the requirements that pension investors trust institutions, exchanges, and counterparties are disadvantageous and hard to quantify.

If you take possession and store the gold in your safe deposit box, which means it is not in a tax-on-growth-sheltering pension fund, you will pay tax on your gains at the 28% rate.

In contrast, Campbell’s soup is also a commodity. If you buy $500 worth of it now, and we have high inflation over the next year, it will appreciate in value like other commodities, including gold. But with gold, you have to sell it, pay capital gains tax, then use what’s left to buy soup. If you start with soup, you’ll probably make a bigger profit—because soup is not currently selling for double its historical average price (Gold sold for $726 in 2018 dollars on average since 1968)—and the gain (from not having to buy the soup after its price goes up) when you eat it is tax-free. Gold forces you to go through several middlemen: gold company, postage and insurance, safe deposit box rental, and IRS. With soup, you cut all those guys, and costs, out.

2. ‘Confiscation’ with below-market compensation. In 1933, as a result of various federal government actions, Americans were required to turn their bullion gold (all gold other than jewelry or rare coins) into the nearest Federal Reserve Bank by May 1, 1933. They were paid $20.67 per ounce for it, a below-market exchange rate at the time.

The same bunch of laws prohibited American citizens from owning or exporting gold. That was initially done by Executive Order 6102 signed by FDR shortly after he was inaugurated. You can see the actual order wording here. It was later reissued in a more legal form. Americans were not allowed to own gold again until 1973. The U.S. Supreme court said this was constitutional.

See http://en.wikipedia.org/wiki/Gold_Clause_Cases. That’s because the U.S. Supreme Court is composed of political hacks, not honest men and women.

This alone should have killed the idea of gold as a hedge against monetary instability. At the very least, if you must buy gold, put it in another country.

I PRESUME THIS WOULD NOT APPLY IF YOU KEPT THE GOLD OUTSIDE OF THE UNITED STATES.

3. Gold clauses invalidated. After the Civil War, because of inflationary greenback dollars issued during the war, Americans put gold clauses into many, if not most, long-term contracts.

These functioned like cost-of-living adjustment clauses have since the 1970s. During World War I, the federal government could not sell enough “Liberty” war bonds so they changed them to gold certificates.

That means they put gold clauses in them. A gold clause says you can choose to be repaid in gold if you want. That would protect you from inflation if gold more or less followed the consumer price index.

The Emergency Banking Act of 1933 invalidated all gold clauses in the U.S. including those in World War I Liberty bonds. That means the U.S. government said to its citizens, “Yes, during World War I we promised to pay you back in gold if you wanted. We lied. Tough luck, suckers.”

Also, all persons who were due money in long-term contracts not involving the government were also cheated out of the purchasing-power difference between the gold they agreed to and the fiat money paper currency they were paid after the gold clauses were invalidated.

Gold clauses were not allowed again until 1977. The U.S. government had “suspended specie payments” on a number of prior occasions in U.S. history. That has the same effect as invalidating gold clauses. The U.S. Supreme court said this was constitutional. See http://en.wikipedia.org/wiki/Gold_Clause_Cases. That’s because the U.S. Supreme Court is composed of political hacks, not honest men and women.

I PRESUME THIS WOULD NOT APPLY IF YOU KEPT THE GOLD OUTSIDE OF THE UNITED STATES.

4. No one commodity is likely to match CPI movement. Saying gold is an excellent hedge against inflation means you are roughly saying that a graph of the price of gold where the prices have been adjusted for inflation will be a flat horizontal line. It is not. Page 185 of my book How to Protect Your Life Savings from Hyperinflation & Depression, 2nd edition has a table showing the annual closing prices of gold from 1968 to 2011 adjusted for inflation to 2011 dollars. From 1968 to the present, the annual price of gold in 2010 dollars ranged from a low of $209 2011 dollars to a high of $1,673 2011 dollars. (The daily peak on 1/21/80 was $2,320 2011 dollars.)

5. Gold is still half its peak price in terms of purchasing power. As just stated above, $2,320 was the peak gold price on 1/21/10. When you buy gold at the beginning of 1980, because it is a “great hedge against inflation,” and more than 30 years later, the purchasing power of that gold is still not much more than half what it was in 1980, you have to admit it is, at best, a rather slow-acting remedy, if any remedy. Probably, most of the people who bought gold at that price in 1980 have died waiting to get their purchasing power back.

6. Regression to the mean. Regression to the mean is the tendency of variables to move toward the average over time notwithstanding moving to high and low extremes in the interim. A pendulum is a classic illustration of regression to the mean. It reaches extremes to the right and left at times, but it always goes back to the middle or average. If gold regresses to the mean, which seems likely to me and which it always has by definition, it will regress to $726 per ounce in 2018 dollars. See How to Protect your Life Savings from Hyperinflation & Depression, 2nd edition.

I laughed out loud at a recent gold commercial on the radio. They cited the fact that gold peaked at $2,320 in 2011 dollars in 1980 as evidence that it will soon go back to that level. That statistical phenomenon, heretofore undiscovered by mathematics, would be called, “Regression to the peak.” It would be the dream of every commodity salesman that “Regression to the peak” be believed by the public, that is that the prices of every commodity will soon return their all-time, record, highest-ever price.

Another way to state regression to the mean is the age-old observation about both good and hard times, “This, too, shall pass.” In this context, it means, “This gold price of $1,690 an ounce shall pass when gold reverts to its normal price of $726 an ounce or thereabouts.”

It is roughly true that gold rises during inflationary times. But the people who cite that as the reason to buy gold are forgetting gold falls in good times and inflationary times are never permanent.

It goes up and down like everything else. Furthermore, no one knows whether we are at the end of the hard times or the middle or just the beginning. The financial graveyards of human history are full of people who thought they could forecast and time markets. Even the legendary “value” investor Benjamin Graham, author of The Intelligent Investor and Warren Buffett’s business school mentor, lost his ass in spite of only buying “value” stocks in the stock market in the Depression. (He would have lost it worse if he had bought gold.)

A week or two after I posted this article, on 5/22/10, Jason Zweig’s Wall Street Journal column quoted “legendary investor” Seth Klarman saying,

I am more worried about the world, more broadly, than I ever have been in my career. All the obvious hedges are already extremely expensive. [Especially gold which is] Near its all-time high, it’s a very hard moment to recommend gold.

You read it here first.

7. Gold bugs. There are people called “gold bugs” in the gold market. It’s a semi-nice term for kooks. I know of no other commodity or security that has “bugs.” For example, there are no “copper bugs.” If you want to use a commodity to hedge against inflation, use one that does not have “bugs.”

There is quite enough irrationality in the securities and commodities markets already without adding a group of people who are not applying logic to their price determinations. American Indians called gold “the yellow metal that makes the white man act crazy.” There is no place for that sort of nonsense in investment decisions.

8. Price is no object. Gold is the only thing on earth that we are told we should buy regardless of its price. “Gold is good,” seems to be the extent of their thinking. One of the books I read researching gold is titled, “Buy gold now.” It literally says to buy it regardless of the price!!? People are all over the media saying buy gold. They were saying it when it was $600, $700, $800, $900, $1,000, $1,100, $1,200.

Well, which is it? At what price does it become too expensive? Apparently, never. Indeed, gold bugs and other not very bright people cite the fact that the price has recently gone up as evidence that it will go up even more. Huh? What is that theory? “Regression to a new high?” The more you stretch a rubber band the more it’s likely to stretch even further!?

In fact, gold is like everything else. There is a price that is a bargain, a normal price, and a high price. The higher price you pay, the greater the probability you will lose money on the purchase. That applies to every commodity or security. In the case of gold, the normal price appears to be $726 an ounce.

Does recent spectacular fiscal mismanagement warrant a higher price than the prior fiscal mismanagement? Not really. Remember gold is a commodity. The effect of too much deficit spending should affect all commodities equally if that is what’s driving up the price of gold.

A change in fundamentals, like discovering a new industrial use for gold, would cause the price of gold to go up more than other commodities. That has happened before when it was discovered tha platinum could reduce smog by putting it into catalytic converters in cars and trucks.

But a drop in the value of the dollar does not cause the price of gold to go up. It causes the price of everything to go up. When gold goes up more than inflation, it is getting ahead of inflation and is overpriced. How can that be hard to understand?

It may be that a better analysis would come up with a more accurate base price of gold than $726. That’s beside my point. The point is gold bugs and gold TV and radio commercials advocate buying at all prices. The answer to what is the correct price for gold may be $700 or $900 or whatever. But it sure as hell is not “all of the above!”

9. Usury. Some state courts have held gold clauses violate state usury (charging too much interest) laws.

I PRESUME THIS WOULD NOT APPLY IF YOU KEPT THE GOLD OUTSIDE OF THE UNITED STATES.

10. Inconvenient denomination and counterfeit/burglary/robbery risk. Gold is so valuable per weight and volume that it is an inconvenient denomination. At present, an ounce of gold, or a one-ounce gold coin, is roughly the equivalent of a $1,315 bill. I have never laid eyes on a $1,000 bill let alone used one to buy something. Silver is the convenient-denomination metal. Here are the current (3/21/18) values of pre-1965 U.S. (90% silver, 10% copper called “junk silver”) coins:

dime $1.19
quarter $2.97
half-dollar $5.95

This same issue means silver coins are generally not counterfeited and are less of a target of burglars or robbers. I have no evidence, but I would expect that robbers would find persons approaching or leaving a gold store attractive targets. The high value of gold means it is worth the trouble to counterfeit gold coins. So there is an increased counterfeit theft risk with gold as opposed to silver and to base metals like nickel or copper.

Here is an article about counterfeit gold bars in NYC.

I PRESUME THIS WOULD NOT APPLY IF YOU KEPT THE GOLD OUTSIDE OF THE UNITED STATES...becasue you would be selling to a legitimate dealer, not a black market seller.

11. Obama slipped regulation of gold sellers into the ObamaCare law according to Thomas Sowell’s 10/1/10 column. Generally, increased regulation of any industry results in increased costs to those who deal with the additionally regulated businesses.

I PRESUME THIS WOULD NOT APPLY IF YOU KEPT THE GOLD OUTSIDE OF THE UNITED STATES.

12. Generally needs to be assayed by the buyer. How can you tells it’s really gold of the alleged purity? How can the guy you sell it to tell? I found a lot of “how do you tell if it’s really gold” web sites on line, most of them morons reciting dopey corner-tavern advice. One was a ABC 20/20 story, they said, you need it to be verified by a legit assayer. They went to American Assay and Gemological Office, an organization that Tiffany uses. The 20/20 story is at http://abcnews.go.com/2020/story?id=336457&page=1#.T4cfQHh93Gk.

Apparently the technology used is x-ray. 20/20 bought a bunch of “gold jewelry in 22 jewelry stores in Dallas, Maryland, and New York. All of it was certified in writing by the seller. Half of the gold they bought was bogus—lower purity than represented—much of it less than 10 karats, the legal definition below which you are not allowed to call it gold. When confronted by the test results proving it was not gold, the dishonest sellers just shrugged it off blaming their suppliers.

A web site on verifying gold coins said it was sort of impossible. About all you can do is increase your odds of not being cheated, but even the best experts get fooled. Having to go through this twice—once when you buy and once when you sell—is a transaction cost and one which is missing from most other investments.

Some of the “how to tell fake gold” web sites have gold ads on them! How dumb do they think we are? Apparently very and in the case of many gold buyers, they are apparently right. It has been said that no one ever went broke underestimating the intelligence of the American people.

Perhaps the most common advice, which is good advice, is to buy from a reputable dealer. I agree, but it is hard to figure out who is a reputable dealer and the most established reputable dealers charge more because of their sterling reputations.

My wife has bought jewelry from a venerable, word-renowned jeweler for 40 years. In December 2012, she started to buy an expensive pearl necklace from that jeweler’s store in the U.S. Virgin Islands. After she paid, they went in the back and packaged it. She found the package to awkward to carry and opened it in the jewelry store. They had switched the necklace she bought with a garbage one that had misshapen and dirty-on-the-inside pearls. They swore it was the same necklace, a blatant lie. She demanded and got her money back. So much for buying from a reputable dealer. It is possible, maybe likely, that the parent company did not condone the switch, but what difference does that make to you. Part of being a “reputable dealer” is making sure your employees do not engage in criminal behavior.

If you insist on buying gold, first buy a small amount, then turn right around a resell it. That will show you the actual real world transaction costs and the real world spread buy between bid and asked.

In 2012, it was revealed that the New York Fed was auditing their own gold including drilling core samples of more than 350 gold bars to make sure they were not gold-plated base metal bricks. Some readers said you don’t need to assay gold coins because everyone can recognize a “common krugerrand.” I am 71 and I have never laid eyes on a “common” krugerrand in my life. And if I ever do, I guarantee you that I will not believe the second one I see is really pure gold. I’ll tell you to convert it into Canadian dollars or Swiss francs or to meet me at a bank or American Express office where they know how to detect counterfeits.

If even the New York Federal Reserve Bank cannot convince people that its gold is real, how do you think that little old you will be able to do so without an assay?

13. I am not saying gold has no advantages. The high value density is an advantage in that it lets you store maybe a million dollars in a safe deposit box. To do that with, say, silver, would take a vault. There are coin versions of gold that are widely recognized which is better than say a lump of nickel that has to be assayed to trade it. Gold is extremely durable. The ability to sell it to a gold bug for more than it’s really worth is cancelled out by the need to buy it from him for more than it’s really worth.

In response to this article, I got several emails along the lines of the following one:

John:

I was very pleased to read your recent article about gold.  I am a former jeweler, and I come from a family that has been in the jewelry business since the late 1800s. I am constantly amazed that gold is touted as having any value whatsoever. I personally cannot figure out why precious metals hold that much value anymore.  We all know that technology has allowed us to create  alternative means that gold has been historically valued for; things like how highly conductive it is, or the fact that it can be used in other electronic applications.  We've found far better materials and/or means that replace gold's historic innate value.  I would think that these days our dollar could be pegged to commodities that have more of a "real value".  In my  opinion, natural resources such as coal, oil, natural gas, and other energy  sources seem to be of more value than a metal that happens to look very pretty.

As a jeweler, one thing that I constantly saw was people experiencing the "used car effect" when purchasing gold.  We would constantly find people (some were customers, others were strangers) coming into the store trying to sell their old jewelry, only to leave disappointed  when we would tell them that their gold was not worth as much as they thought  it was.  Even with all of the "inflation hedge" ideas lodged in their  mind, and their "knowledge" of how much gold was selling for at the time, we would often find ourselves being scolded by people who claimed that they'd find a better price somewhere else.  Of course, we would be visited later by those same people (now humbled) asking if we were still interested in buying their jewelry.  

In fact, the way I see it, outside of gold-themed mutual funds and mining company stocks, the only way you would be able to purchase gold and make any money on it would be at a wholesale level (from Credit Suisse or other distributors).  And at  that point, why bother?  If you think about it, you are better off sticking your money into a money-market or a CD, as I'm sure one cannot find any reliable source out there that can document an average gain of 2% per year like money-markets and CDs do.  Also, aside from some of the more  prominent mining companies, which I believe make much of their profits mining other metals like copper and aluminum, I do not recall any companies out there whose stock "dazzled the market".

Lastly, I must  commend you for your comments on "gold bugs".  I have done thorough research on people who claim to be experts on gold and other precious metals. The "precious metal investment" industry is plagued with con men, rip-off  artists, and creeps that will sell you on any BS idea related to precious metals, whether it's coins, bullion, mining projects, etc. Further  exacerbating this, some of your favorite people claim to have "dabbled" in the  precious metal industry before, namely Rob Kiyosaki, Robert Allen, and I believe Ron LeGrand.

Food for thought...keep up the good work!

Michael Beifeld

The 8/21/10 issue of the Wall Street Journal has a guest columnist for Jason Zweig’s“ Intelligent Investor” column. The guest columnist, Jeff Opdyke, said gold is not a commodity; it’s a currency. His evidence is a much higher correlation between gold and the value of the dollar relative to other currencies than between gold and inflation of the dollar.

Interesting, but wait a minute. In How to Protect Your Life Savings from Hyperinflation & Depression, I said inflation is just one side of a 13-sided coin. See pages 24 and 43 of the book. The other “sides” include imports and exports, interest rates, unemployment, value of the dollar relative to other currencies, and so on. My point was that a change in any of the 13 “sides” affects all the other sides, although not in lockstep. There are millions of variables that constantly affect each of the 13 “sides” so there can be offsetting or amplifying effects on some “sides of the coin.”

To an extent, isn’t Opdyke double counting his correlations? Clearly, the relative values of various major currencies reflect the market’s opinion of the likelihood of inflation in those currencies. Equally clearly, the presence of recent and current inflation drives down the value of the currency in question. So Opdyke’s inflation-currency comparison is not comparing apples to oranges as it purports, but rather it compares apples to a fruit cocktail containing apples and oranges and other fruit.

He seems to be saying dollar inflation does not affect gold prices. But his time period—1978 to present—is a time when high inflation initially subsided then never rose significantly again. It’s hard to draw conclusions about the effect of inflation on the price of gold from a period of disinflation followed by a period of price stability. And gold sure as hell was sky high on January 21, 1980 (see above) and that was because the inflation rate that year was 13.5%.

Also, to a large extent, currency is a commodity. The broad definition of a commodity I use in How to Protect Your Life Savings From Hyperinflation & Depression is fungibility. Governments claim their currency is a commodity when they promise its purchasing power will not diminish. It only deviates from being a commodity when the government or its central bank falls off the monetary-policy-discipline wagon. So Opdyke’s statement that gold is not a commodity, it’s a currency, is incorrect because currencies are, themselves, on-again-off-again commodities.

Plus, Opdyke’s whole exercise leads nowhere. Expertise and useful knowledge must end in a statement of a best practice. He says to decide whether to buy gold based on “your beliefs about the future of the greenback. Just don’t invest based on the idea that gold is a proxy for inflation.”

Beliefs? What are we talking about here? Investing or religion? I have often said that gold is a religion and Opdyke makes that mistake, too. Believe this: no one can forecast the future of the greenback or gold or inflation, period. If you have a “belief” in the future price of gold you are delusional as to your clairvoyance.

My best practice advice in How to Protect Your Life Savings From Hyperinflation & Depression is that you hedge against inflation, which is a market basket of goods and services, by investing in, well, a market basket of goods and services.

Buy “everything you’re going to need for the rest of your life now.” I call that investing in the You Consumer Price Index which fits your life better than the government Consumer Price index. Since the market basket of goods and services includes commodities, investing in a broad commodity price index would make sense as a way to partially hedge against inflation. By buying everything you need for the rest of your life, you are buying a bunch of commodities including many contained within manufactured products.

Opdyke’s “according to your beliefs” advice is the equivalent of Will Roger’s stock market advice: “Buy a stock. Wait for it to go up then sell it. If it don’t go up, don’t buy it.” In contrast, my best practice on the same subject—buy everything you are going to need for the rest of your life including commodity indexes that sort of do that—actually makes logical and financial sense.

One of my readers told me John Stossel was pushing gold on his Facebook. I posted a comment with a link to this article and asked what I was doing wrong in my analysis. It seems to have been immediately removed from Stossel’s web site. I was surprised and disappointed by that. I am a fan of Stossel and put him on my list of national treasures whom we do not appreciate enough. Next time I watched his show, I was looking to see if he has a gold sponsor. He does. So I must refer to my article about how hard it is to get interviewed by TV or radio shows whose sponsors sell gold when you point out gold’s disadvantages. I cannot tell if that was John’s motive. I cannot even be sure my post is not still at his Facebook page. I am not confident that my search of his facebook pages was complete. I may have missed the post and a response from him.

Millennium Minerals hedging gold

On 8/16/12, the Wall Street Journal reported that Australia’s Millennium Minerals, a gold-mining company, was selling half its anticipated gold production over the next three years at fixed prices. In other words, they want to lock in today’s prices.

Why would they want to do that? Either because they believe they can forecast the future (no one can) and they foresee gold prices going down during the next three years or because they are prudent businessmen and want to lock in the profits they will make from the current prices. There is a saying on Wall Street that if you’re not hedging, you’re speculating. Millennium is hedging.

The corner tavern bar stool gold experts know less about it than Millennium, and they are not doing what Millennium is doing. In other words, they are speculating, a.k.a. making a wild gamble with no logical basis whatsoever for thinking it will pay off.

The article also tells of other gold mining companies who are deliberately not hedging.

Gold prices will crash eventually, most likely after the U.S. tries to “print” money to pay the bills it cannot pay from bond sales or taxing. That will cause hyperinflation. That should last a year or two. Then the worthless-at-that-time U.S. dollar will be replaced by a new U.S. currency. If the public believes that currency will have stable purchasing power, the U.S. currency price of gold will fall well below its historical average of about $726 in 2018 dollars before settling long term at $726 in 2018 dollars. I am not sure why Millennium believes that might happen in the next three years.

Copyright 2018 by John T. Reed