How I've come to view Gold

[moda0306]

In coming from hating gold to not really understanding it, to not wanting any other commodity in my portfolio, I have come to a certain train of thought about how the price of gold should be viewed, as it's been tough for me to grasp.

Imagine two worlds:  

The first one, by either lack of creativity or lack of need, hasn't thought up a fiat currency yet.  It uses gold held by banks and notes backed by that gold as currency.  Therefore, its entire world economy needs to operate at an equilibrium around the usable currency available, gold (imagine no silver or other possible substitutes).  Obvously, gold's value would be quite high compared to a basket of other commodities than it is in the world we live in.

In the other world, everything's the same except you have fully functional fiat currencies.  At least the major few currencies work extremely well, and interest rates pay out real returns.  They don't run excessive debt/defecits and also don't monetize debt.  Gold, in this world, is recognized as a pretty metal that holds up extremely well to the elements and conducts electricity extremely well.  This is about all it's viewed as.  It's, basically an industrial metal, and obviously would have a much lower real value in this world than the first world mentioned, but it would still settle in based on supply and demand of its industrial/jewelry uses.

I think we exist in a world between these two.  Gold is constantly trying to "negotiate" if it's useful as money to support a certain level of economic output, or simply as a conducter and nice shiny metal.  In a world closer to the 1st world, it would have an astronomical value, as fiat currencies aren't "working."  In a world closer to the 2nd, there'd really be no purpose to burden one's self with backing things with a metal if you can always and easily increase your purchasing power.  1's and 0's, as well as paper cash, are much easier to deal with than hulking around or accounting for bits of gold.  It truly would be a "barbarous relic" (at least for now). This explains how we can have a significant decrease in the value of the dollar from 1981-2000, but gold decrease in value so much during that same period.  We were moving from what looked to be more like world #1, where gold is needed as a medium of exchange, to world #2, where gold is needed as a conductor.  That is constantly being negotiated based on one major factor:

What is the outlook for fiat currencies, and the institutions built around them, to maintain purchasing power, or at least provide real return through interest?

This implies that the future of the very institutions that issue the currency, not just the present-day value of the currency itself in terms of a basket of goods and services, is what should/does go into evaluating the price of gold.

In 1981, the outlook of the dollar's ability to at least give you a reasonable rate of return improved significantly, for example.  Gold tumbled.

The answer to that bolded question will have a tendency to slide gold on the monetary/industrial pricing scheme accordingly.  The thing is, 1) this is an EXTREMELY long spectrum of pricing.  Silver is (if I'm not mistaken) almost as good a conductor as gold.  That, and other examples, will tend to pull gold to an extremely cheap level.  On the other end, the idea of maintaining our world economy on nothing but gold (assuming the other end of the spectrum of gold pricing, where fiat currencies can't/won't exist or aren't trusted) is huge in terms of its potential price in our world economy and the amount of currency it takes to run it.  So gold, theoretically, should be priced somewhere between silver and the value of all the current fiat currencies of the world (obviously a stretch and total simplification... but kind of drives home the idea of the true potential of gold).

A lot of things can factor into the failure of a fiat currency, not all of which is necessarily currency devaluation.  The simple act of fiat currency issuers/borrowers not being able to service debt could call into question that fiat currency and push gold up more towards its monetary value.  War can fall upon a country, calling into doubt the future value of the currency due to sustainability of the government itself or the ability of the very issuer of the currency to repay its debts (assuming there may be a "no-printing" rule (think the Euro)).  Social unrest and civil disobedience can bring those same war-time doubts bubbling to the surface.  All of these things are going to have gold pulling away from its industrial value, and closer to its currency value.  Do these scares mean house prices will rise, that you'll get paid more at your job, or that it will cost more to get a back massage?  NO!  But it will make people question the sustainability of the fiat currencies controlled by the powers that be, pushing gold away from being a conductor and more towards being a currency.  The drastic implications of how differently those two things are priced are what gives gold its "canary in the coal mine" feature.

In the world as we see it today, we have a lot of the things that could challenge the outlook of fiat currencies to maintain purchasing power or pay positive real interest rates.  The US dollar, for instance, may not have any risk of default, nor are we losing 10-20% of purchasing power every year, but the dollar is losing real value without paying real positive real interest.  On the other side of the pond, we have a different type of currency.  This one is relatively "strong" right now, and is paying, in some countries more than others, positive real interest rates, but the risk of default and inability of some members to service their debts are calling into question the fiat currency's clout as a reliable store of value or medium of exchange.

Add in wars, social unrest, environmental issues, peak availability of certain commodities, respect of property rights, etc, the ability for existing fiat currencies to look appealing in terms of holding value or providing real return is much more glum than it was in 1999 when the Euro was introduced, war was minimal, balance sheets looked good, social unrest didn't threaten much of the developed world, gas was cheap and abundant, the dollar was strong and defecits were nonexistant.  

The very fact that gold is held by central banks at the very least illustrates that gold is respected as a backdrop, or a foundation, however loose, of a fiat currency.  Something to give clout to those who want to insist it's a relic, but enjoy the best form of insurance if the public starts to doubt that, thereby protecting the very paper that they insist works best without being tied to a metal that would "never work" as a world currency.  Gold is always trying to find its proper price as that form of insurance... insurance held by households and central banks alike... and many events that will tend to depress certain asset prices will actually lead to a more favorable view of that insurance, and therefore the tendency to view gold in terms of CPI, other commodities, a basket of currencies, etc, is inherantly flawed.  More often than not, the value of gold in relation to fiat currencies could have more to do with questioning the future of the institution that organized such a currency than the present-day value of a basket of goods sold in the market.

[Austen Heller]

I view gold as a way of getting some non-USD currency exposure in the portfolio.  Over the past year, the dollar has strengthened, holding the USD price of gold down.  If/when the dollar weakens, we should see a pop in the USD gold price.

Also, having 25% gold in the portfolio allows you to get rid of the foreign stock component of the portfolio, if you are holding any.  For instance, even though the pure PP only holds stocks from your home country, sometimes people split their stocks between Domestic and Foreign (in spite of the fact that many large US companies are already globally diversified).  In the last year in the US, that has been a bad move, since the strengthening of the dollar has resulted in a ~10% drag on the returns from Foreign stocks, as shown here:

http://www.msci.com/products/indexes/co ... mance.html
(Compare the returns in USD vs local currency.  Thanks to stlutz in the Boglehead forum for providing this link.)

So if the price of gold already was held back by the strong dollar, why hold any foreign stocks and get even more punishment?  25% Gold in the PP provides all the non-USD currency exposure you need.  However, I could see a case for holding some Foreign stocks if you desired to hold less than 25% gold, and also wanted to hold more than 25% stocks.  Perhaps you could hold 12.5% gold/12.5% foreign stocks to get the proper amount of non-USD exposure.

[MachineGhost]

So if the price of gold already was held back by the strong dollar, why hold any foreign stocks and get even more punishment?  25% Gold in the PP provides all the non-USD currency exposure you need.  However, I could see a case for holding some Foreign stocks if you desired to hold less than 25% gold, and also wanted to hold more than 25% stocks.  Perhaps you could hold 12.5% gold/12.5% foreign stocks to get the proper amount of non-USD exposure.

Good point.  It makes more sense to use hedged foreign equities then.