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Surviving the Democrat Downgrade: Stocks or Gold?

Written on Friday, August 26, 2011 by

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President Obama has long complained that he inherited a bad economy from President Bush Jr.  But one thing he won’t admit is: he inherited an AAA credit rating!   And he managed to achieve what even bumbling economic incompetents like Hoover and FDR and Carter couldn’t achieve: losing it!

In a previous column, Debt ceiling: Obama’s demagoguery vs economic reality, I documented what was required to avoid this disaster.  But the Democrats constantly refused to face the reality of what the country needs (as opposed to their own political agenda).  Now that our credit rating has been downgraded, and the stock market has tanked, they now have the audacity to call this the “Tea Party downgrade”!  Yet blaming the Tea Party is the nadir of dishonesty: shooting the messenger, like blaming the weather forecasters for the hurricane.

An insightful National Review article, Obama Makes History (of Our AAA Credit), points out:

“That this is said with straight faces bespeaks either an unshakable contempt for the mind of the American voter or an as-yet unplumbed capacity for Democratic self-delusion.

“Let us revisit the facts. The original debt-ceiling deal put forward by the Democrats totaled $0.00 in debt reduction. This would have fallen approximately $4 trillion short of the $4 trillion in debt reduction the credit-rating agencies suggested would constitute a ‘credible’ step toward maintaining our AAA rating and avoiding a downgrade. This $0.00 program was the so-called ‘clean’ debt-ceiling bill—the one that contained not a farthing of debt reduction. …

“Likewise, Rep. Paul Ryan’s budget proposal, which would have brought health-care entitlement spending down to sustainable levels while making key reforms to improve the performance of those programs, passed the House only to be rejected out of hand by Sen. Harry Reid and his Democratic colleagues, precisely because it contained entitlement reforms. It would have cut some $4.4 trillion off of the deficits over a decade, well beyond the $4 trillion mark suggested by the credit-rating agencies. But Democrats would have none of it.”

So Patriots need to remind people that this is the Democrat Downgrade, or Obama Downgrade.

Meanwhile, we still have to live with it until we can do some house-cleaning­—the White House, that is.  And the major difference between liberals and Patriots is that liberals want to live off other people’s earnings, taken by force by the IRS, while Patriots want to earn their own living and help other people out of their generosity.  So this column has some suggestions about ways to invest one’s own hard-earned income (Disclaimer: I am not an  Investment Adviser, so please obtain independent advice).

Stockmarket sense

In a recent Patriot column, I explained how the average stockmarket investor can do very well over the long term, benefiting from the productive energies unleashed by capitalism.  This also explained the folly of equating it with “gambling”, as Social Security’s vested interests claim.

The main reason it can become a gamble is forgetting to treat a stock as a piece of a business, and instead treat is as just a number that you hope will grow.  This has been called the “bigger fool theory”: I might be a fool to pay so much, but some time later a bigger fool will buy it from me at a higher price.  This is not investing, but speculating.  Nothing necessarily wrong with that; speculators have a useful role in the economy, but we should be clear about what it is.

Another reason is hearing lots of hype in the news about a “stockmarket boom”, and sinking all one’s savings into the market at a (temporary) high point, and even worse, using borrowed money.  And of course, this crowd-following is followed by selling off in a panic—like now.  Buying high and selling low, aka chasing last year’s returns, is never good!

One rule of thumb is that if everyone is talking about a boom, the average person has already missed it, and we are actually in a bubble.  We saw that with the NASDAQ crash a decade ago, and many investors lost money by ignoring “irrational exuberance”.  Rather, it is times like this when stocks are low that it’s likely to be worth buying.   As the world’s top stock investor Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.”

A much better strategy, which many investors should stick to during both booms and busts, is dollar cost averaging: investing a certain amount at regular intervals into something like an index fund.  This avoids the above error, because, as explained here, the same amount buys fewer units when the market is high, and more when the market is lower.   This is also very practical for starters without a good lump sum to invest (which might be better to invest more quickly), especially because it is “forced saving”—it won’t be spent frivolously because it is already set aside.

Gold glitter

For quite a while now, there has been much advertising urging investors to buy gold.  However, I am wary, for a few reasons.

First, gold itself produces no income, unlike dividends from stocks or rent from property.  So the only use for gold is selling it at a higher price than you bought it.  This is classic “bigger fool” speculation.  A report of this year’s meeting of Warren Buffett’s company Berkshire Hathaway discusses Buffett’s own diatribe about the uselessness of gold:

“If all the gold ever mined were melted into a single cube, it would be about 67 feet on each side and weigh around 165–167,000 metric tons. ‘You could climb on it, fondle it, polish it, stare at it. But it isn’t going to do anything. You’re hoping someone will buy it from you later on.’

“The third category is productive assets. These are assets you can make a rational calculation about and measure whether their performance over time matches your initial expectations. Buffett advised that, over time, speculating in commodities has not been the way to get rich; owning good businesses has been.

“This mini-lecture closed with a powerful illustration. Buffett said that all of gold ever mined, at today’s price, would be worth around US$8 trillion. He invited the audience to consider what else that amount of money could buy; all of the farmland in the lower 48 states (which Buffett put at US$2 trillion), 10 ExxonMobils (which boasts a market value of more than US$400bn) and you could ‘stick a trillion in your pocket for walking around money.’”

Second, despite all the hype, gold is demonstrably not a safe investment.  See this chart of historic gold prices from 1833 to 2010.  One thing you should notice is that the horrible Carter years featured a huge boom in gold prices: almost a 400% return from $124.74 in 1976 to  $615.0 in 1980, when Reagan rescued America.  Great for those investors, certainly.  But what about those who bought in 1980?  Even 20 years later, it was worth less than half that ($279.11 in 2000).  Stocks have never had anywhere near that bad a return over a 20 year period.  Au contraire, the worst 20-year period for the stockmarket as a whole was a positive 3.09%.

It’s even worse than it looks.  It wasn’t until another 27 years when the gold price recovered to the 1980 average level, never mind the peak price of $850.  Even worse, this ignores inflation: this would be worth $2300 in today’s dollars.  This means that 1980 investors are still behind after their “safe” investment!

If you don’t believe me, consider this pro-gold WSJ article Buy Gold: It’s a Safe Haven and Inflation Hedge, just so you know I am not just swallowing anti-gold propaganda:

“Gold, which is currently above $1,400 an ounce [in March], would need to top $2,000 to match its all-time high, adjusted for inflation.”

But let’s read between the lines a little: this is a tacit admission that gold is not as safe as claimed—those who paid $2000 would have lost 30%.

For even longer terms, it’s worse still.  Patriot columnist Dr. Thomas Sowell, in his lucid textbook Basic Economics, pointed out these sobering facts:

“To take an extreme example, while a dollar invested in bonds in 1801 would be worth nearly a thousand dollars by 1998, a dollar invested in stocks that same year would be worth more than half a million dollars. All this is in real terms, taking inflation into account. Meanwhile, a dollar invested in gold in 1801 would by 1998 be worth just 78 cents.”

That is, buying gold had an enormous opportunity cost; the returns forgone in bonds and especially stocks because money was tied up in gold.

Third, there is too much hyping of gold these days.  It is rather too similar to the hyping of real estate or stocks in the last stages of a speculative bubble, just before it bursts.  And a bubble it is: at the time of writing, it was $1746, twice the 2008 price.  It sounds very much like a repeat of the rapid rise under the Carter years—and for the same reason—bumbling incompetence causing economic collapse!

Just like in the Carter years, those who bought early have done very well.  But now there is considerable danger of a repeat of those who bought near the end of the Carter years, who are still out of pocket even 30 years later.  Judging from history, the worst thing for gold investors would be another Reagan!

Conclusion

I understand that some people will still want to buy gold, but just be clear that it’s really an inflation hedge rather than a real investment.  Note that even the pro-gold WSJ article cited above advises against a lot of the “switch your whole portfolio over to gold” advice:

“I do not advocate an enormous percentage allocation to gold, but I do think a responsible investor should allocate at least a portion of the portfolio (5% to 10%) to the metal.”

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  • 1776_2012

    Silver actually. When gold is on the move, silver increases faster percentage-wise. It is also easier to trade in smaller amounts and has other, non-monetary uses.

  • Nathaniel Davidson

    Same principle though. Most silver “investment” serves the same purpose as gold: to sell at a higher price than one paid.

  • Nathaniel Davidson

    Saw this recently from The Case Against Gold: Why Ron Paul is Wrong About The Gold Standard by Gregory Hilton:

    “From 1980 to 2001, gold lost 70% and silver lost 92% of its value, despite inflation. Inflation went up and gold and silver went down. They were no hedge. The safety the libertarians are seeking in the gold standard does not exist. Once again, the government can debase the value of the currency by printing too many gold backed dollars or devaluing them.”

  • John

    So,it appears that Mr. Davidson is saying that the indices are higher than they ever have been. True! BUT, the fact that many stocks on the Dow, S&P, etc., are no longer on their respective indices CAUSE THEY ARE OUT OF BUSINESS and replaced with another stock. SO, those bellweathers such as GM, Enron, American Motors, Washington Mutual, etc., LOST ALL of their value and the stock owners took a TOTAL loss. YES, the Dow may look good at 11,500 today than when it was at 800 in the 30′s, BUT, it is not the same stocks within the, say, Dow indicator. However, gold at $30 an oz. in the 30′s and $1800 today is what it is, and every generation had the opportunity to make money in gold, if bought and sold at the right time. BUT, if you look at the charts, unless you are a wizard, MOST people in EVERY generation, using the “buy and hold” method, was raped out of the majority of their retirement, unless they happened to be the FEW within a notch that were able to just fair from their investment in the stock market.

    • Nathaniel Davidson

      But an index fund takes this into account; those defunct businesses would have dropped out of the indices before they went under.

  • John

    Sorry, another fact being, when a government MANIPULATES any given market, such as it has with gold, no commodity will prosper as it should. The Washington Gold Accord intended on keeping the price of gold down for the sake of the worthless dollar and other fiat currencies. Manipulation of margin requirments kept the price of gold down as well as gold ETF’s that DO NOT have the gold in stock as required by law. It is easy for any wealthy group to sell short ETF’s on margin to keep the price of commodities down. BUT, sooner or later, reality and fundamentals DO catch up. That is where we are at now. It appears that inflation is OK with the US government except when it comes to gold and silver. WHY? Cause it is the only way that the American people can hedge against inflation. Redistribution of wealth cannot take place if the American people have a REAL means of keeping up with inflation. Yes, higher taxes can accomplish the same thing. But that is one area that citizens have the ability to rebel. And that is currently occuring in America.

  • ONTIME

    His point is well taken and all of us are living in question of a incompetent fed and a leadership full of liars and tax cheats willing to sacrifice your interest to maintain their plush life.

    I am already wondering what is going to happen to my recent tax shelter investment in TX since now the EPA and DOI are going to screw with the energy supply of the nation and TX by shutting down Coal fired energy plants with not sign of replacement energy.

    These fed people are, without ethic or scrupple and delusional…a real bad combination of traits.