Gold is Out, Big Pharma In

A reader forwarded me a Barron's article about an investor who has done well in gold for the past three years (see summary). After any long move, the news media will always find and interview those who have made money off the move. Michael Milken was a superhero after the long move in Junk Bonds. He was a hero right up to the date of the collapse that destroyed great wealth. Similarly, technology fund managers were the most popular people in the world in early 2000.

The truth about gold is that the story is more simple than is commonly presented. Gold is a store of value. Over the long run, folks who own gold will be disappointed. Ironically, they will not make much or lose much money. Over time, the value will increase by about 3% in nominal terms and 0% in real terms. In the short run the price can be very volatile.

The most recent cycle has behaved exactly as one would expect. From 1995 until 2001, gold declined in value because interest rates were high relative to inflation. After 9/11, the Central Bankers of the World, led by Chairman Greenspan, lowered short term interest rates well below the inflation rate in an attempt to prevent a world wide depression. We all should be thankful that the policy worked.

To lower rates, governments bought short term bonds from banks, giving the banks lots and lots of money. The Fed Funds rate dropped to 1%. At 1% interest, banks and speculators were able to buy "stuff", including gold, cheap. Gold was financed at below the inflation rate! If you can borrow money at 1% and invest it safely in Gold that is going to appreciate at 3% then why not borrow more and buy more?

Once the central bankers got the ball rolling, the public joined the game. In just a couple of years, the public has purchased 340 metric tonnes of gold by buying shares in the new gold ETF's. The US public now owns more Gold than the overwhelming majority of individual countries in the world!

The mess is about to hit the fan. Over the past 20 months or so, the US Central Bank has taken away the "automatic win". The FOMC has gradually raised short rates until the cost to hold gold has flipped from being negative 2% to positive 3%. Specifically, the Fed Funds rate is now 5% while the PCE price deflator (which is the best measure of inflation) is about 2%. Those who recently joined the party and borrowed money to buy gold at $730 an ounce are currently enduring pain.

In the same way that it took the FOMC and other bankers a while to get the ball rolling, it has taken a while to make the ball reverse course, slow down or even stop rolling. Japan continued to stimulate the purchase of gold until just a few weeks ago. The cyclical rotation of asset allocation has taken hold.

I do not claim to know the exact top. The psychology of millions of market participants is involved. There are lots of specious side issues that Gold Bugs can use to bolster their case at least temporarily. For example, the recent steep decline in the US Dollar is being used as a sign that all hell is about to break lose. The reality of the decline is a normal consequence of market correcting forces. Investors should count on the law of supply and demand rather than on a story about what is different about today's economy. The simple truth is that the decline in the US dollar is going to "bring billions of dollars home" and thus pull one of the legs out from under the fear monger's stool.

I just looked up some of the correlation coefficients of Hecla Mining (HL). As one might expect, Hecla Mining (HL) is highly correlated (.98) with under-developed country funds, such as the Malaysia Fund (MF) and the Thai Fund (TTF). However, we know that countries such as these tend to do extremely well in the years following a world wide recession and we know that they die a violent death as interest rates rise during a strong economic expansion. Hecla Mining (HL) carries a very negative correlation to big pharma, a stock group that tends to do well during the late phase of the cycle.

The correlation of Hecla Mining (HL) to Wyeth (WYE), Merck (MRK), Eli Lilly (LLY) and Pfizer (PFE) is respectively -.88, -.87, -.86 and -.86. If you think this time is going to be different and Malaysia is going to continue to grow at the same pace as it grew for the past five years, then please do buy gold. However, if you believe in one of the laws of nature, which is that excesses revert to the mean, you might want to sell Malaysia Fund (MF), TTF and Hecla Mining (HL) and use the money to buy WYE, MRK, LLY and PFE.

I cannot call the bottom in big pharma any better than I can call the top in gold. However, I can say that an investor who buys big pharma now is buying near the bottom and that an investor who buys gold now is buying near the top. The pharma investor may need much patience. I could be off by two years or more. Besides, even when the "worm turns" pharma will not move quickly at first. Jumping in and out of gold right now could be tremendous fun. If you are lucky enough to be on the right side of the market, even though the current movements are not related highly with logic, then you will make a lot of money. If you buy and hold big pharma now, you will make a lot of money within 5 years. My estimate of your chances of success in gold are less than 50% and your chance in big pharma is more than 90%.