Money Is Gold, and Nothing Else
Following the Panic of 1907, John Pierpont Morgan was called to testify before Congress in 1912 on the subject of Wall Street manipulations and what was then called the ‘money trust’ or banking monopoly of JP Morgan & Co.
In the course of his testimony, Morgan made one of the most profound and lasting remarks in the history of finance.
In reply to questions from the congressional committee staff attorney, Samuel Untermyer, the following dialogue ensued as recorded in the Congressional Record:
Untermyer: I want to ask you a few questions bearing on the subject that you have touched upon this morning, as to the control of money. The control of credit involves a control of money, does it not?
Morgan: A control of credit? No.
Untermyer: But the basis of banking is credit, is it not?
Morgan: Not always. That is an evidence of banking, but it is not the money itself. Money is gold, and nothing else.
Morgan’s observation that ‘money is gold, and nothing else’ was right in two respects.
The first and most obvious is that gold is a form of money.
The second and more subtle point — revealed in the phrase ‘and nothing else’ — was that other instruments purporting to be money were really forms of credit unless they were redeemable into physical gold.
Regular Daily Reckoning readers know that I am a big proponent of gold. We should all be mindful of Morgan’s admonition, and not lose sight of the way in which real wealth is preserved through manias, panics and crashes.
Today I’ll provide an overview on why I believe gold is important for every portfolio, and why gold may be the best performing asset class in the years ahead.
Specifically, my intermediate-term forecast is that gold will reach US$10,000 per ounce in the course of the current bull market that began in December 2015.
I believe every investor should keep 10% of their investable assets in physical gold (with room left in the portfolio for ‘paper gold’ in the form of ETFs and mining stocks).
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Here’s the analysis:
We begin with the 10% allocation. The first step is to determine ‘investable assets’. This is not the same as net worth.
You should exclude your home equity, business equity and any other illiquid or intangible assets that constitute your livelihood. Do not take portfolio market risk with your livelihood or the roof over your head.
Once you’ve removed those assets, whatever is left are your ‘investable assets’. Investors could allocate 10% of that amount to physical gold.
This gold should not be kept in a bank safe-deposit box or bank vault. There is a high correlation between the time you’ll want your gold the most and the time banks will be closed by government order. Keep your gold in safe, non-bank storage.
The next part of the analysis concerns my US$10,000 per ounce forecast for the dollar price of gold. This is straightforward.
The US dollar is extremely vulnerable to a collapse of confidence on the part of foreign investors and US citizens alike.
Here’s why: Excessive Federal Reserve money printing from 2008–2015 combined with projected US government deficits over $1 trillion per year for the foreseeable future, and a US debt-to-deficit ratio of 105% rising to over 110% in a few years.
That collapse of confidence will not happen in a vacuum. It will coincide with a more general loss of confidence in all major central banks and reserve currencies.
This loss of confidence will be exacerbated by malicious efforts on the part of Russia, China, Turkey, Iran and others to abandon dollars entirely and to bypass the US dollar payments system.
The evolution of oil pricing from dollars to IMF-issued special drawing rights, or SDRs, will be the last nail in the dollar’s coffin. All of these trends are well underway now, but could climax quickly into a general loss of confidence in the dollar.
At that point, either the US acting on its own or a global conference resembling a new Bretton Woods will turn to gold to restore confidence.
Once that route is chosen, the critical factor is to set a non-deflationary price for gold that restores confidence but does not lead to a new depression.
Here’s the maths on how to compute a non-deflationary price of gold using the latest available data:
The US, China, Japan and the Eurozone (countries using the euro) have a combined M1 money supply of US$24 trillion. Those same countries have approximately 33,000 tons of official gold.
Historically, a successful gold standard requires 40% gold backing to maintain confidence. That was the experience of the US from 1913 to 1965 when the 40% backing was removed.
Taking 40% of US$24 trillion means that $9.6 trillion of gold is required.
Taking the available 33,000 tons of gold and dividing that into US$9.6 trillion gives an implied gold price of just over US$9,000 per ounce.
Considering that global M1 money supply continues to grow faster than the quantity of official gold, this implied price will rise over time, so US$10,000 per ounce seems like a reasonable estimate.
I believe this kind of monetary reset is just a matter of time. It could happen through a planned process such as a new Bretton Woods or a chaotic process in response to lost confidence, heightened money velocity, and runaway inflation.
That’s why investors should explore the possibility of diverting 10% of investable assets into physical gold as a diversifying asset allocation and as portfolio insurance. The following example demonstrates that insurance aspect.
For purposes of simplification, we’ll assume the overall portfolio contains 10% gold, 30% cash, and 60% equities. Obviously those percentages can vary and the equity portion can include private equity and other alternative investments.
Here’s how the 10% allocation to gold works to preserve wealth:
If gold declines 20% (unlikely in my view), the impact on an overall portfolio is a 2% decline (20% multiplied by 10%). That’s not highly damaging, and will be made up as equity assets outperform.
Conversely, if gold goes to $10,000 per ounce, that’s a 650% gain from current levels, and highly likely in my view. That price-spike gives a 65% gain on the overall portfolio (650% multiplied by 10%).
There is a conditional correlation between a state where gold goes up 650% and where stocks, bonds and other assets are declining.
For this purpose, we’ll assume a scenario similar to the worst of the Great Depression from 1929–1932, where stocks fell 85%.
An 85% decline in stocks making up 60% of a portfolio produces an overall portfolio loss of just over 50%.
In this scenario, the gains on the gold (650% separately and 65% on the total portfolio) will more than preserve wealth against an 85% decline in stocks comprising 60% of a portfolio (85% separately and 50% on the total portfolio). The 30% cash allocation holds constant.
So, if 60% of a portfolio drops 85% (about equal to the stock market drop in the Great Depression) and 10% of a portfolio goes up 650% (gold’s performance in a monetary reset), an investor would lose 50% of their portfolio on stocks but make 65% on their gold portfolio.
They’d see their total wealth preserved and even increased slightly. Total portfolio performance in this scenario is a gain of 15%. That’s the insurance aspect at work.
- Gold has asymmetric performance characteristics. It has limited downside (20%) but substantial upside (650%).
- The gains on gold are likely to come at a time when stocks are crashing. That’s an example of conditional correlation.
- In the scenario where gold rises 650% and stocks fall 85%, the gain on gold (10% allocation) exceeds the loss on stocks (60% allocation), so the overall portfolio is enhanced.
Investors without an allocation to gold will be wiped out. Those with a 10% allocation will have survived the storm with their wealth intact.
You can now see the importance of gold.
All the best,
For The Daily Reckoning Australia