“I’ve never let my guard down by saying, I do not need to be hedged” – Paul Singer
Preservation of clients’ wealth is the most important fiduciary duty guiding investment managers. This obligation tends to be under-appreciated in the midst of financial asset bubbles when recency bias blunts the desire to sacrifice the potential for further gains in exchange for protection against losses. Inevitably, this is made painfully clear when a bubble pops and those once popular assets lose value and the manager’s clientele suffer. My firm, 720 Global, has repeatedly urged caution as valuations are currently stretched on the back of reckless Federal Reserve monetary policy and poor economic fundamentals. This article presents the case for an asset that I believe can help managers protect their clients.
Gold – \ˈgōld\ AU #79 – A heavy yellow elemental metal of great value
Gold is neither a claim on the promise of future earnings like a stock, nor a liability owed by a public institution or a private party like a bond. It also lacks the full faith and credit of most governments, like a currency. Gold serves little industrial purpose, unlike all other commodities and is most commonly revered as a shiny metal used in ornamental display or jewelry. It is precisely these failings that make gold a unique and valuable asset and one that can play an important role in portfolio construction.
Gold is one of the few stores of value that is limited in supply, transportable, globally appreciated and not contingent upon the faith and credit of any entity. It cannot be manufactured or debased. Gold is the only time honored currency or in the words of John Pierpont Morgan (J.P. Morgan), “gold is money, everything else is credit”.
Thousands of years ago trade between people began through a system of barter. This method of payment was effective but very limiting. Trade could not occur unless both parties had the goods or services demanded by the other. If a metalsmith, for example, did not need wheat, a farmer seeking a new sickle would have to find alternative goods or services to offer the metalsmith.
These stark limitations and the growing desires to conduct trade with parties over further distances required a more robust system. Accordingly, trade graduated from the barter system to that of a common currency. Aristotle stated the rationale for a common currency eloquently: “When the inhabitants of one country became more dependent on those of another, and they imported what they needed, and exported what they had too much of, money necessarily came into use”. At first, in almost all cases, the currency was a commodity. While eliminating some of the problems associated with barter, this system presented new ones. Carrying gold or other commodities such as silver, grain, shells, or livestock can be cumbersome and difficult to properly measure for weight and purity. Dividing most commodities into fractions for ease of exchange produced additional difficulties. Paying for an acre of land with a quarter of a cow must have presented quite a quandary.
The next step in the advancement of currency was the use of sovereign issued, standardized currency typically made with gold, silver, copper and bronze. The first known instance of such a currency, the Greek drachma dates back to approximately 700BC. The benefit of this commonly accepted currency was that the supply of money became regulated and standardized. Additionally, the limited availability of the metals made it hard to increase the supply of currency in any significant manner. These currencies held their value well as the worth of the coin was always tied to the weight and the price of the metal used. That said, there are instances where governments abused their authority by decreasing, or shaving, the metal used in each coin, temporarily unbeknownst to the public.
While coins were a big improvement from the days of barter, they could not fulfill the pressing monetary requirements of escalating global trade. To fill this need national banks introduced bank notes. Bank notes are essentially paper IOU’s, as we have today. The dollar bill, for instance, is backed by the full faith and credit of the United States. However, prior to the last 50 years, full faith and credit was rarely acceptable and accordingly most bank notes were backed by a commodity, typically gold or silver. One holding a bank note backed by gold or silver could always exchange the note for a fixed amount of the metal backing the currency. In 1792 the Mint and Coinage act authorized the Bank of the United States to establish a fixed ratio of gold to the U.S. dollar. While the fixed rate fluctuated over time, there was always gold and silver backing the currencies.
On May 1st, 1933, President Roosevelt issued executive order 6102. This action ordered U.S. citizens to turn in their gold coins, gold bullion and gold certificates to the government. The order essentially made holding gold, in those forms, illegal for private citizens. The government set a rate of $20.67 per ounce for anyone exchanging their gold for cash. Surprisingly, and still deeply entrenched in the memory of many, personal bank vaults were raided in search of gold. 7 months later, having accumulated a significant amount of gold, the Gold Reserve Act was passed which raised the fixed rate of gold per ounce to $35.00. While rarely discussed in mainstream economic text books, this simple act was a massive devaluation of the dollar. With one swipe of a pen the amount of gold supporting the dollar was increased by 70%.
Roosevelt’s actions highlight an important distinction in the gold debate. Most critics of a gold standard today argue there is not enough gold in existence to back the current monetary regime. The truth is that the amount of gold is irrelevant, it is the price of gold that matters.
While the gold standard no longer applied to U.S. citizens, foreign nations were still able to exchange U.S. currency for the gold or silver backing it. In 1971, President Nixon signed executive order 11615 which suspended this right of exchange. The act officially took the U.S. off of the gold standard. Most other nations have since taken similar actions.
It has only been the last 44 years where gold plays little to no role in the backing of any major currency. Although there is still gold stored in Fort Knox and other vaults, it only represents about 7% of our monetary base at current prices. The nouveau logic surrounding this fiat currency regime states that confidence and trust for a piece of paper backed by faith will always trump the desire for people to hold something tangible.
History is littered with financial crises and other disturbing events resulting from reckless monetary policies.
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