The Economic Case For Savers To Allocate Wealth To Physical Gold

The following contains the introduction and the main observations from Paul Brodsky at QB Asset Management. The paper is excellent and makes the fundamental case for gold. Readers are advised to download the paper which is to be found at the bottom of this article.

This piece seeks to make the economic case for savers to allocate wealth to physical gold (in proper form) and for investors to allocate capital to precious metal miners. Our argument orients readers with our economic and market predispositions, seeks to explain current macroeconomic events within that context, outlines gold’s fundamental valuation framework, and then applies that framework to gold and various financial asset investment choices.

Hypothesis

Due to decades of unreserved credit growth that temporarily boosted the appearance of sustainable economic growth and prosperity, rational economic behavior cannot produce real (inflationadjusted) economic growth from current levels. The nominal sizes of advanced economies have grown far larger than the rational scope of production that would be needed to sustain them. This fundamental problem explains best the current state of affairs: malaise (i.e., bank system de-leveraging and economic stagnation) spreading through the means of production and the need for increasing policy intervention to stabilize goods, service and asset prices(by depressing the first three and inflating the last?).

Observations

1. Most of the last forty years represented a golden age of financial asset investing that is unlikely to be repeated for a very long time. Consider that the last generation benefitted greatly from a unique combination of factors, including:

  • a global monetary system that for the first time (1971) allowed currency to be created entirely in the banking system through lending activities, without material constraint
  • a generation of declining global interest rates coincident with perpetually easy credit conditions (beginning in 1981)
  • very little initial debt on household and government balance sheets as a percentage of assets and income (i.e., leverage-able balance sheets)
  • the building need for post-war baby boomers to investfor retirement
  • the advent and maturing of asset securitization, asset-backed securities, and the high yield bond market, which broadly expanded systemic credit and debt distribution
  • new market technologies that reduced trading and monitoring costs and provided greater access to equity and fixed income markets
  • great technological and scientific innovations with commercial applications, which captured equity investor imaginations
  • the opening of previously closed large economies to Western commerce and financial assets
  • economic policies seeking near-term nominal GDP growth as a first priority, including central bank backstopping of market losses

2. The combination of factors above set the stage for a financial asset investment culture in which the markets could emphasize nominal growth over real growth and risk-adjusted profitability. (Indeed, record credit creation and debt assumption demanded that economies sustain asset price inflation so the value of bank loan books and bond portfolios could be sustained.)

3. Established equity indexes, weighted by market capitalization, further motivated equity market investors to seek nominal growth and de-emphasize real profits. Dedicated equity investors, such as pension and mutual funds, endowments, foundations, insurers, etc., judge their performance against these indexes. Thus, the great majority of sponsoring capital in the stock market has had incentive to reward increasing market caps over increasing profitability. (Although more independent investors have been in the position to try to time and re-allocate their investments more freely than indexed or closet indexed investors, they too have been unable to escape the pull of general market behavior towards increasing market caps.)

4. The emphasis on ever-increasing market caps further directed the incentive structure among listed businesses to continually increase their market caps. Top-line revenue is most easily increased by leveraging corporate balance sheets. Thus, competition for market share and investor sponsorship accelerated corporate debt assumption as a secular business model. Equity markets, theoretically meant to 1) aid in forming capital and 2) perpetually price the value of the means of producing that capital, instead gradually came to ignore return-on-capital metrics in favor of quarterly share performance. Real return investing suffered. Given their implicit tether to market-cap weighted equity indexes, the values of publicly traded businesses were generally punished when they shrunk their revenues to become profitable. (Private businesses, on the other hand, were under no such pressures and could behave rationally.)

5. Despite being major shareholders of publicly traded companies, professional asset managers are compensated through a percentage of the nominally priced assets they manage. As a result, they too have had commercial disincentive to encourage public businesses they have stakes in to emphasize profits over market cap growth (unless they are already distressed), and have no incentive to lobby equity index publishersto change the way they calculate their indexes.

6. There is no longer an economic “message of the market.” As a result of the financial market incentives and theirinfluence over business behavior noted above, it has become reasonable to separate nominal stock market performance from real economic growth and the expectations for it. More recently, derivative and technology-driven equity trading strategies have boosted trade volume many times its organic level, and central bank financial repression (i.e., bond monetization) has supported bond and stock prices (i.e., bigness). These trends have further obscured economic signals the markets historically provided. Presently, there are no public financial markets that value businesses or future income streams within the context of capital formation of their broader economies. Financial markets have become discrete exchanges of abstract relative value in which “investors” are forced to chase short-term relative nominal returns.

7. There is no commonly perceived place to save risk-free. Saving at a bank has not been a rational alternative to investing in financial markets given that modern economies have inflationary models supported by perpetually easy credit conditions. This, in turn, has ensured diminishing purchasing power for savers of modern currencies. Only recently (2008) has this become obvious. Central banks’ zero interest rate policies (“ZIRPs”) have pinned benchmark interest rates near zero, producing obvious negative real interest rates. Thus, conventionally storing one’s wealth in cash or in fixed-income instruments offers little or no sanctuary for unlevered investorslooking to maintain or increase future purchasing power.

8. The almost complete blending of financial markets with financial media has lent the markets a patina of transparency, constancy and stability. Financial media provides market (not commercial) news to a small niche audience (CNBC’s “Squawk Box” reaches only 150,000 viewers on a good day[2]), and serves as a platform for monetary and fiscal policy communications. Major corporate earnings and economic data releases have come to resemble made-for-TV sporting events and provide a thin financial narrative. Thus, a small investor class controlling significant perceived wealth is forced to abide by consensus macroeconomic perceptions, which do not necessarily reflect true structural commercial and economic forces.

9. Organizations that produce economic data are closely tied to organizations executing fiscal and monetary policies. Whether or not the data are managed or manipulated, as is increasingly suspected by observers, they are produced and released in a manner that evokes predictable responses from financial markets, which in turn send popularly understood (yet potentially erroneous or incomplete) economic signals. The net result for economic policy makers is that their policies are relatively easy to sell to the public. A declining headline unemployment rate or increasing home sales figures are positive political and media events, regardless of declining employment participation rates or stagnant mortgage applications, and regardless of the millions of people experiencing lifestyle distressin diametric opposition to whatthe data imply.

10. The common perception of economic and commercial health established by policy makers through financial management and media, and supported by financial market participants, defines ongoing economic and commercial reality,regardless of whether it is sustainable.

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