September 30, 2011

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

I tend to be more pensive, even melancholy on a cold and rainy day.  Does weather affect everyone’s mood?  Are there more pessimists in the UK and optimists on the Greek isles? Perhaps that’s not a fair lead in.

Always the optimist, the California Public Employees Retirement System (CalPERS) sees no reason to lower its expected (and indeed necessary) return of 7.75% per year to meet pension obligation requirements.  This is the first year they may in fact meet that number in a decade (let’s see how generous or stingy the market is from October to Christmas) – but why let real results conflict with hopeful expectations?

You may recall the $400 million Arizona land purchase they quietly sold for approximately $30 million.  It is the sanguine view that, over a long enough period of time, their average return will be sufficient to cover obligations.  We are not turning to Keynes for advice, but it was John Maynard who liked to remind us that, in the long run, we are all dead.

Here is to better days, better waves, and perpetual positivity – reflective of the nearly always bright and sunny weather of sunny California – and to hoping that, in the long run, CalPERS remains alive but with a tighter grip on reality.

1. Then Versus Now: In 1932, the dollar was worth 1/20 of an ounce of gold, just prior to devaluation in 1933 to 1/36 of an ounce.  Less than a century later, the dollar is worth 1/1650 of an ounce, which is to say that without the gold standard, our Keynesian friends have diminished the dollar’s potency significantly (by a factor of 82.5)  To look at it from the vantage point of recapturing the purchasing power of that bygone era, the dollar would need to appreciate 825% to regain its pre-Keynesian, gold-anchored purchasing power.

When we look at the same factor by which the dollar has depreciated in gold terms, we also gain an insight into the artificial wealth created via this century-long monetary inflation.  Divide the current value of the DOW by this same factor of 82.5, and you find the Index at a value of 133, slightly below the last quote we saw, and more consistent with the Dow’s trading range between 1932 and 1942.  We readily concede that truly great innovation has occurred and true wealth created in the same period of time.  The question remains, how much of that was real wealth creation versus inflated value.

There was recently a case where a young man was showing his cow in a 4-H competition, and the muscular nature of the beast was truly impressive.  It was later found out that the young man had been injecting water under the skin of the poor beast to accentuate the appearance and add to musculature.  You shouldn’t get a blue ribbon for artificial reality, either as a FED practitioner or a 4-H competitor. Yet we are in the habit of celebrating one kind of cleverness – why not the other, as well?

2. Rumors of the Bull’s Death Are Greatly Exaggerated: A matter of interest to you and us is when the present weakness in the metals will cease.  The simplest answer is we do not know.  However, it is valuable to consider the following:  Weakness in the metals is largely a function of a futures market selloff. The physical market remains very strong, with fairly tight supplies and impressive demand.

True, you can find ample 400-ounce gold bars and 1000-ounce silver bars, but these are not the products purchased by the global Everyman.  Impressive to gaze upon, but unimpressive to handle, move, or store.  I’d wager that, after wrangling with a silver bar of such size, your preference pendulum would swing to owning something like diamonds!

No, the Everyman buys what fits in a front pocket or small attaché case.  My point simply is that demand for the items popularly sought after remains strong.  There is in fact a real problem brewing:  No sellers, but lots of new buyers.  This of course flies in the face of the swoon in prices over the last 10 days.

For us, that swoon was a desired and anticipated event.  We’ve spoken to the critical function that liquidity, or cash, plays in a portfolio.  Seemingly inert, but incredibly potent if applied with discipline.  A typical investor error is to be over allocated to a particular theme, or add to winning positions as they increase in value.  These we would consider bad habits.  Maintaining large cash positions allows strategic purchases at the time and in the environment when most investors instinctively want to be 100% in cash.

3. Applying What We Know: Our buying habits at MWM are healthy.  We have been over-allocated to cash in anticipation of global market weakness, with some weakness spilling over into precious metals.  Checking the fundamentals in the metals market, we find them reinforced and stronger than ever.

Recall the number of declines that have occurred over the last ten years in the context of a mega bull market.  Roughly one major decline per year. We are in fact encouraged by the drop in prices as it refreshes our view that we are still in the orderly stage of the bull market where two steps forward and one step back are to be expected.

The more challenging environment in which to manage money is a disorderly third phase.  Granted, these are wildly profitable periods for investors, but are challenging because rational behavior is not a hallmark.  This makes exiting the market a true challenge, with the best strategy being a gradual and disciplined reallocation, not unlike the original gradual and disciplined purchases we have begun with.

With this in mind, perhaps you can appreciate why a decline is welcome, as an indication of order still existing in the pricing of the metals.  What is good and healthy is not always easy or pleasurable. Monetary madness remains the order of the day, with ample insurance now critical.

Now, we are in fact allocating to areas in the portfolio we have been interested in and waiting to purchase for over 10 months, in some instances.  The weakness of the last 10 days has been of a superficial nature.  That is not to say we won’t see further downside, but simply that the causes of price decline are transitory, with physical demand remaining strong coming through the August and September Indian and Islamic buying seasons, and just before the ramp up in buying for the Chinese new year.  The November to January window doesn’t often disappoint. We have not altered core positions in the accounts, but are able to take advantage of these prices – having been patient till now.

“Gold is a hedge against the human animal and an anchor to windward against human history, the tides of which sometimes bear along war, disease, revolution, confiscation, and monetary bungling, as well as peace, progress, and plenty.”
— James Grant

Best regards,

David McAlvany
President and CEO