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A Very Few Elements of Gold Strategy

By: Michael S. Rozeff

-- Posted Thursday, 30 July 2009 | Digg This ArticleDigg It! | | Source:

Gold strategy depends on age, wealth, anticipated labor income, one’s expectations, and risk preferences, among other things.

A complete gold strategy covers alternative metals, alternative ways to own gold, and shares in metal and mining companies.

I will discuss none of this. One finds plenty of articles on those things on the internet.

I’m going to mention only a very few elements of gold strategy that have to do with the general position that I think is appropriate, which is being long or owning gold as a long-term holder. The long-term means years.

These elements suggest that one may well want to have a core position in gold.

I base my strategy on the following ideas:

1. That gold has a current fundamental value of a minimum of about $1,000–$1,100. This estimate is my own. It is based on the size of various monetary aggregates that I think relate most closely to the price of gold. Other monetary aggregates suggest higher values to me, which I why I think $1,000 is a minimum. This estimate has a high margin of error. One possible range that reflects the uncertainty might be $700 to $1500. A more extreme range is $500 to $2,000.

2. That inflation remains a fact of economic life, due to the presence of the central banks. In the U.S., that’s the FED. These banks have always inflated over the long-term. That is their only tool, and that is the tool that they believe in as a remedy for various economic ills. This implies that gold will not tend to fall against the dollar over the long-term. It will tend to rise.

3. That gold is insurance against a catastrophic collapse of the paper money system in the U.S., or in the G7 countries.

4. That the paper money system is not functioning well, and that it is likely to be reformed eventually with gold as a component.

5. That central banks will accumulate gold by necessity in order to maintain their currencies and benefit their economies. Some central banks are doing this already.

6. That not only is inflation a fact of economic life, but it is a fact of political life. The existence of great amounts of debt, and political struggles between debtors and creditors against a background of state power make this a fact. The debtors tend to win these battles, and we get inflation.

7. That with very high government deficits and promises of future benefits, the risk of dollar depreciation has gotten much larger than at any time in the past; and that government has a long record of continuing deficits and greater promises.

8. That with the FED’s large balance sheet and political pressures upon the FED to inflate, the risk of dollar depreciation has gotten much larger than ever; and that the FED’s record is one of inflation.

9. That, despite factors 1–8, gold can still decline in price and remain depressed in price for significant time periods. This occurs because those who demand and supply gold need not follow any model or assess any risks or act against them according to any particular time table, so that gold may, for reasons unknown, fluctuate in unaccountable ways for significant periods of time.

10. That, although gold is not being used widely as a medium of exchange or a store of wealth, it still is functioning as the monetary unit of account for many major paper currencies in the world. The market for gold, in other words, is pricing the dollar in terms of a weight of gold.

But this shows that gold, in fact, has maintained its purchasing power for goods priced in dollars and that gold is in fact a good store of wealth. Gold is a useful and durable physical asset with low storage costs that has been in demand for thousands of years through thick and thin, and part of its attraction is that it maintains its value compared to other goods. Its supply does not change drastically over time, usually, because it is difficult to extract.

These are the primary ideas that, to my mind, suggest that a core holding of gold will be prudent for many investors. Consequently, a gold strategy might involve the following elements.

A. Accumulate a core holding of gold. The idea is not to make a "killing." It is primarily to protect wealth and store it in a form that will not disappear if inflation heats up or if worse political or economic difficulties crop up.

B. Maintain that core holding long-term, since the long-term factors that make gold a good holding have not changed. Do not sell the core holding, whatever the price of gold does because its fundamental value is greater than the present price, and because that value will probably rise over time, and because gold is insurance against a currency breakdown.

C. Gold’s price can do many unexpected things, even if the long-term trend is up. It can remain steady for years. It can drop by 50 percent or so and stay depressed for years. It can rise to several times its fundamental value. It can rise and then drop precipitously. My rule of thumb is that the price in any market can deviate by a factor of 2 from its fundamental value. That is, if something is worth $10 in normal times and by normal value standards, it can still sell on occasion at $5 or at $20.

If one has a core holding at current prices, there is no need to chase gold at prices that go clearly above its basic value.

If gold declines in price, convert more dollars to gold, the reason being that declines in gold prices while it is still below $1,000 are probably making it more and more undervalued. These holdings, if this happens, go into core holdings. They require lots and lots of patience and a long-term outlook. One does not cancel an insurance policy because no accidents occur.

D. If one wishes to trade in gold or speculate on short-term price changes, this should be done with non-core holdings. Have a separate pool of money to do this. The form in which one holds this gold need not be the same as the form for one’s core holdings. Core holdings should generally be in physical form under trusted custodial care, if not one’s own care. But one can speculate in an exchange-traded fund like GLD over short periods of time with relative safety and with convenience, liquidity, and low transactions costs.

Once a core position is in place, there is no need to buy gold if price rises for that core position. Any such buys can be in the speculative portion.

How large may a core position be, including amounts possibly bought on dips? This depends on many factors and decisions unique to each person. The usual recommendations run from 5 percent to 25 percent among those advisers who favor gold.

How large should a speculative position be? That again depends on personal tastes and abilities.

What should be done as conditions change? That is a hard question. I ask it only to alert you to the fact that conditions are bound to change. If the conditions that I mentioned in 1–10 above alter, the suitability of gold may alter. One might want more gold. One might want less gold.

At this point, you are on your own.

July 30, 2009

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

Copyright © 2009 by Permission to reprint in whole or in part is gladly granted, provided full credit is given.

-- Posted Thursday, 30 July 2009 | Digg This Article | Source:

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