Gold, Energy, and Unintended Consequences in the Headlights

Serendipity - the occurrence and development of events by chance in a happy or beneficial way.


Ok it's already late, and I want to cover a range of items in this article.  So let's jump right in...

Even More on Gold

A few hours after I posted Gold, Another Diversification Option, I received John Mauldin's free weekly Outside the Box newsletter to which I am a subscriber.  This week's letter provided some background on why investors like Warren Buffet think of gold as a bad investment choice.  Simply stated, Benjamin Graham, Warren's mentor, never invested in it.

According to Graham, while no one can tell the future, there are periods when the valuations of stocks and bonds would deviate from fair value by becoming excessively over- or undervalued. To enhance returns and reduce risk, investors should alter their portfolio allocations accordingly. A quick look at a long-term chart supports Graham's theory clearly shows periods when one asset class offered a better value than the other:

But what of the periods when both stocks and bonds stagnated or fell together? For much of the 1970s and again from 2001 through today, any portfolio allocated solely between stocks and bonds would have at best treaded water and at worst drowned in a sea of stagflation. To earn any real return, an investor would have needed to seek alternatives. 

It's clear from this next chart that gold was exactly that alternative, a powerful counter-trend investment for periods when both stocks and bonds were overvalued. Yet gold is conspicuously absent from Graham's allocation model. 

But this missing asset class is entirely understandable: for most of Graham's adult life and the most important years of his career, ownership of more than a small amount of gold was outlawed. Banned for private ownership by FDR in 1933, it wasn't re-legalized until late 1974. Graham passed away in 1976; he thus never lived through a period in which gold was unmistakably a better investment than either stocks or bonds. 

All of which makes us wonder: if Graham had lived to witness the two great bull markets in precious metals during the last 40 years, would he have updated his allocation models to include gold? 

We can never know.

This confirms what I said in Gold, Another Diversification Option:

Just like all investment classes go in and out of favor, I believe the same is true for gold. 

As I mentioned, I am a John Mauldin subscriber.  John puts out two well thought out newsletters weekly - Thoughts from the Frontline and Outside the Box.  These letters are free and you can sign up at www.johnmauldin.com.

Wrapping Up the Gold Discussion

After writing Gold, Another Diversification Option, I received the following request.

Could you describe how you go about selecting which gold fund to invest in? What tools / logic do you use?

Whenever I buy into a mutual fund or an ETF, I follow the basic premise behind lazy investing as told in Maybe I'm Not a Lazy Investor.

Thus if you build a diversified portfolio of low-cost stock and bond index mutual funds, you stand a very good chance of earning a higher return than you would otherwise. Why is it called lazy investing? Primarily because the only action required is an annual rebalancing of your portfolio to ensure that it stays diversified. Total time required to rebalance is less than 15 minutes for the entire year. (Read the How To Build a Lazy Portfolio here) 

This information all made perfect sense to me. The only hiccup to implementing this in my 401k plan was the lack of low cost index mutual funds. So I did my best by picking the lowest cost funds that gave me exposure to the large company US stocks, small company US stocks, international stocks, and bonds.

There is not an index fund for gold or gold mining companies, so I look for funds that have a low expense ratio and good performance over the last 10 years. Low cost (expense ratio) is important because it's the only choice that I have control over. Yes investing is a choice too, but when you're in a mutual fund or ETF, it's the investment manager that chooses the individual investments. Cost is all I can control.

Additionally I want good performance over the past 10 years because gold's in a big bull market. If a manager cannot make money in a bull market, then it's time to find a new manager.  Note you will also want to screen for no load funds.  Loads are a fee mutual fund companies collect to pay financial advisors for recommending their product.  Stay away from load funds as that's lost money from the beginning.

Finally, you can use any screener to find this information.  For mutual funds, I had the best luck using Morningstar.com with the following settings:

• Fund group: Commodities
• Morningstar Category: Equity Precious Metals
• Load Funds: No Load Funds Only
• 3, 4, & 5 star funds
• 10-year return greater than or equal to: Category average

There were 11 funds listed, most with an expense ratio around 1%.  

For ETFs, I used google and found the ETFdb: The Comprehensive & Original ETF Database.  This wasn't around years ago, but made finding the ETFs available easy.  I'll make it easier on you by linking directly to:

• Gold ETFs
• Gold Miner ETFs

By the way, I've invested in both gold and gold miners for diversification.  They tend to move together, but just in case one soars, I want to take advantage of it.  Also please remember that you need to investigate all ETFs and mutual funds thoroughly before investing.  Otherwise please talk to you financial advisor. 

Moving on to Other Thoughts

This past weekend I played golf with one of my best friends, Rudy.  It had been awhile since we had last seen each other, so we caught up on each other's lives and eventually I brought up this blog.  The conversation immediately turned to investing, and to a topic where my buddy is intimately familiar - energy.

Rudy's knowledge of energy comes from working for a large construction firm that among other things builds and maintains power plants and storage facilities. He mentioned that while things have been steady, energy expansion is ramping up quickly to keep up with demand.  I wish I had kept notes, but needless to say, my friend is bullish on energy.

My conversation with Rudy focused my mind.  I have always liked energy as an investment because everyone uses it every day.  I admit that I have been cautious about the sector (probably too cautious) because when recession hits again, energy demand will fall, which will lead to lower prices.  On the other hand, energy will always come back because as I said, everyone uses it every day.

While driving home from the golf course, a number of recent issues came to mind:

• Tensions with Iran could lead to higher oil prices.
• Japan has shutdown all nuclear power plants, so it'll need to find another energy source somewhere.
• Germany pledged to shutdown all nuclear power plants by 2020, so it too will need another energy source. 
• Central bank liquidity needing to find a place to call home.

I think this bodes well for energy producing companies, countries, and those companies that support them.

Unintended Consequences

Unintended consequences seem to happen any time there is a mix of politics and economy.  As Bloomberg reports in Euro-Area Central Banks Said to Swap Greek Portfolio Bonds.

Euro-area central banks will swap the Greek bonds in their investment portfolios for similar securities to avoid enforced losses during a debt restructuring, a euro-area official said.

The swap will happen today and is identical to one the European Central Bank carried out last week with the Greek bonds acquired in its asset-purchase program, the official said. The new Greek bonds will be immune to collective action clauses, or CACs, ensuring central banks don’t incur any losses when a private-sector debt write-down takes place, the official said on condition of anonymity. A spokesman for the Frankfurt-based ECB declined to comment.

Central banks decided that they didn't like their bond contracts that they voluntarily entered into when they purchased said bonds.  So they decided to change the contract by swapping old bonds for new bonds that wouldn't be subject to any losses.  What could go wrong here?  

Essentially central banks have told all other bond investors that their holdings are now junior to central bank holdings.  A dangerous precedent has now been set for other countries where central banks have bond holdings, namely Italy and Spain.  While the EU wants investors to buy sovereign bonds from Italy and Spain to keep rates low, what investor in his right mind would now did so since central banks have proven that they can change the rules of the game in the 2nd half?

The ECB better hope that the Long Term Refinance Operation (LTRO) money is used to buy sovereign debt because they will one day find out that no one else is going to buy it.

Looking Ahead in the EU and U.S.

Ironically what made me start this section was looking back at what I've written so far. The first big date to look ahead to is February 29th in the EU.  The second installment of the LTRO is due, and I've heard that it may loan out LESS money than the first issue this past December.  

We'll have to wait and see what happens, but remember as I stated in It's Only Good for a Limited Time:

... by unleashing a flood of liquidity in the form of low interest rates, quantitative easing, and refinancing operations, world central banks distort financial markets encouraging investors to take on more risk. Stocks are a natural fit, especially with reports and prognostications of an improving economy.

If there is less money loaned out, that means less liquidity added.  Stock may well fall as they have stalled at the current level several days.  

The payroll tax cut has passed Congress, but don't count on a large boost to spending as reported in the Big Picture Blog Greece/China/gasoline prices. 

In the US, gasoline prices according to AAA rose for the 26th straight day yesterday, up by .03 over the weekend to $3.57 per gallon. Over this time frame, prices are up about .20 which equates to about $28b annualized out of consumer pockets, almost 1/3 of the payroll tax cut.

Finally QE3 is still waiting should stocks drop to much.  Again from the Big Picture: Here Comes Dow 13,000. Then What?

The post credit crisis sequence seems to operate thusly: Markets slide lower on weak fundamentals. They accelerate down on stop losses and risk management. They plummet on panic. The intervention of some sort occurs. The experienced market/Fed watchers know the impact, and jump in. As markets move off lows, some value types, cycle historians, and then technicians jump on board. The rally may be distrusted or even hated, but eventually trend followers then momentum boys join the party. Pretty soon, its all aboard the Love Train, and not too long after, markets reach their over bought condition. The cycle begins anew.

I wonder what the plan is when the payroll tax cuts and income tax rates expire come January 2013? Or is that going to be the next administration's problem?

Parting Thoughts

For the first time since 2007, I'm thinking that I need to add stock exposure in my retiree portfolio.  In particular, I will be investigating, with the intention of buying, mutual funds that invest in energy companies.  As I'm not sure what the market will do, I plan on scaling my purchases.  This means I'll divide up my total investment and make my purchases over many months.  In other words, this method is really dollar cost averaging in disguise when investing a preset amount. 

Did I mention that you need to read the disclaimer below?

Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.

With that said, don’t let your investments keep you up at night. If they do keep you awake, you may be taking more risks than you are comfortable with. Talk to a professional about reallocating to less risky investments so that you can sleep. During your conversation with said professional, ask why they believe that their recommendation is less risky. If you are not convinced by their explanation, don’t invest. Remember:

1. It’s your nest egg.
2. Opportunities are easier to make up than losses.

It's Only Good for a Limited Time

It's the economy, stupid. - Bill Clinton

What keeps you up at night?  Recently I can say this blog is keeping me awake, though it's because I'm busy typing in front of my computer instead searching for the cool spot on my pillow.  Still in the spirit of the question, one item that keeps recurring in my mind is bullish stock analysts versus my hesitance to reallocate into stock mutual funds.  As I wrote at the end of To the Moon and Back:

I'm still not sold on buying stocks for my "retiree" nest egg, but I do find that I'm questioning it more every day.

For new readers, please read Maybe I'm Not a Lazy Investor and Stay True to the Path or Take the Fork in the Road for the background on why I'm bearish on stock investing.  If you don't have the time right now, I can boil it down to a simple phrase - it's the debt, stupid!

Now About Those Bullish Analysts

I wish I was keeping a list of headlines that articulate the views of bullish stock analysts since I started this blog.  Likewise, I could keep a tally of bullish stock commentary on CNBC, but I don't think my 2 and 5 year old would buy my argument that my count is more important than Curious George on PBS.  Nonetheless my point is that the quantity of bullish stock commentary I'm seeing dwarfs calls for caution.

To be fair, the analysts in To the Moon and Back spoke about how central banks have calmed markets down and provided optimism, which lead to a recommendation of buying stocks for the months ahead.

Additionally in How Many Bulls in this Rodeo, Clowns Want to Know, David Kotok from Cumberland Advisors stated:

The key to watch is in the credit markets. Credit spreads tell a story of overwhelming liquidity being applied to the financial-system open wounds like a steroidal salve. Such treatment can alleviate interim pain. It is treatment for the symptom; it works for a while. It does not provide a permanent cure. (emphasis mine)

Ok, by unleashing a flood of liquidity in the form of low interest rates, quantitative easing, and refinancing operations, world central banks distort financial markets encouraging investors to take on more risk.  Stocks are a natural fit, especially with reports and prognostications of an improving economy.  Furthermore, the Federal Reserve has strongly hinted at more quantitative easing in December and January.  

Now put yourself in the shoes of a financial manager.  Your worst fear is the thought of underperforming your peers.  To a financial manager, underperformance is worse than losing money.  Thus it is to be avoided at all costs.  David Kotok admits as much in his recent commentary Stocks Upward Bias, Golden Cross, Risk Rising:

Liquidity-driven rallies are extraordinarily strong. The central banks of the world have increased their balance sheets by trillions, and the short-term interest rate is near zero. If you use the short-term rate to compute an equity risk premium, you get a huge number. Of course, we know that zero is a poor standard. Moreover, we know that it will not last forever. In addition, we believe there will be a penalty to pay for this prolonged period of zero-cost financing. However, while we wait the party continues. It is harder and harder for folks to stay on the sidelines. It is too soon to abandon the bull market.

One Big Difference Between Me and the Analysts

While reading this article, and perhaps previous articles, did you pick up the big difference between me and the analysts?  Time horizon.

Liquidity from central banks is much like the McRib, it's only good for a limited time.  Limited time is the same as short term in my vocabulary.  Anyone who is moving in and out of stocks over the short term is a trader.  There's nothing wrong with that, it's just not for my retiree portfolio.

Whenever I talk about my retiree portfolio, I'm referring to my rolled-over 401k from my previous employer.  The analysts I've quoted are not necessarily looking to invest long term as I am.   

Parting Thoughts

In a former life, I would have never bet on me quoting Bill Clinton for any reason.  Now that I'm older, I appreciate that he was pragmatic.  I'm not sure I can say the same for central bankers.  In order to buy time for the economy to recover, central banks add liquidity, which keeps credits markets happy and that enables stock markets to rise.  If QE3 is announced, the S&P 500 may well rise up to a new all time high above 1565.

However, central banks are playing a dangerous game.  If the economy does not recover, can central banks keep adding liquidity without consequence?  What happens when the music stops?  What happens if the music stops in Europe or Japan or China?  Remember, all that debt is still not going away.

Ultimately even if this turns out to be a legitimate economic recovery, this is a risk that I do not want to take with my long term money.  After all, opportunities are easier to make up than losses.

Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.

With that said, don’t let your investments keep you up at night. If they do keep you awake, you may be taking more risks than you are comfortable with. Talk to a professional about reallocating to less risky investments so that you can sleep. During your conversation with said professional, ask why they believe that their recommendation is less risky. If you are not convinced by their explanation, don’t invest. Remember:

1. It’s your nest egg.
2. Opportunities are easier to make up than losses.

Stay True to the Path or Take the Fork in the Road

The years rolled slowly past
And I found myself alone
Surrounded by strangers I thought were my friends
I found myself further and further from my home
And I guess I lost my way
There were oh so many roads
I was living to run and running to live
Never worried about paying or even how much I owed

Against the Wind - Bob Seger

So here I am 3 blog's into this endeavor, and I'm already contemplating how my messages are coming across to you.  Are they striking the right cord or am I missing your pain?  Am I coming across as a long term investor or someone who trades daily? Are you learning anything?  Is what I'm covering fresh or was it talked about on the 6 o'clock news?

Then I remember an email I got a few days ago:

... I wouldn't worry about writing to the masses. Write stuff that is most important to you and make that your target audience. Your personal quips and passion will draw interest. Build it for you and others will come.

With that in mind, I turn away from the news and share an article from Minyanville that struck a cord with me: Pre-Eating Some Crow in the Analytical Trap

There's a trap that's easy for analysts to fall into. Let's imagine you've been bearish for a while and anticipating a top. Let's also imagine that the market has continued going up anyway, and yet continues to give signs of a top... but it hasn't actually topped (read: a bit of self-flagellation). The longer this goes on, the more you are becoming increasingly trapped by your own prior analysis. The signs are all there for a top, and are actually increasing, but the market's kept rallying anyway. What do you do?

Do you shift your stance to bullish? Well, you can't really just jump in and randomly start buying, because the rally is long in the tooth, the indicators are overbought, and every objective piece of evidence says the rally is due for a pause at the minimum. Do you continue looking for a top? That's challenging, because the market is blowing up the bear view and busting through resistance levels like they weren't there -- plus you're starting to feel like the boy who cried wolf.

And then the real psychological trap comes: What if you shift to a bullish stance right before the market tops? Oh, the humiliation! If only you'd held onto your views for a couple more days. I think this is a trap that a number of analysts have fallen into, which locks them into being on the perpetual lookout for a top.

While this article refers to short term trading and not long term investing, it broadly applies to me. The article also saved me writing a bit of text, and after last night's writers block, it's much easier to give Jason Haver credit while raising my hand to say "me too!"

For the last 4+ years, I've been of the opinion that the risk of being invested in equities is far greater than the potential reward. The reason is simple, everything that politicians and central bankers have done to try and fix the global economy address the symptoms of the disease and not cure the disease itself.

So what is the disease? Too much debt.

What are the symptoms? Lack of consumer and business demand. Lack of credit available to individuals, banks, businesses, and governments. What is the political/central banker solution? Stimulus packages, bailouts, low interest rates, refinancing operations, quantitative easing (QE), and more borrowing & lending.

How do these solutions address the symptoms?  Let's review Table 1: Solutions Addressing the Symptoms.

 Table 1: Solutions Addressing the Symptoms

Solution	Objective	Complication
Stimulus package	attempt to stir up consumer and business demand by getting them to spend money the government either taxes or borrows.	The problem though is higher taxes reduce demand by reducing the money consumers have. The problem with borrowing is once the money runs out, consumer and business demand fall again plus overall debt has now increased.
Bailouts	prevent losses to bank bond and equity holders, which in theory encourages lending.	Taxpayers pay for poor risk management decisions yet never receive any benefit or profit from good decisions. In times of crisis, credit is tight regardless of bailouts.  People that need credit cannot get it, people that can get credit do not want it.
Low Interest Rates and Refinancing Operations	enable banks to receive cheap funding which they can then lend out for a profit.	Low interest rates and refinancing operations rob savers. Interest payments due to them gets paid to banks, which borrow from savers at 0.25% and lend at 2%+.
Quantitative Easing (QE)	create (print) new money to buy bonds from investors, which in theory stimulates economic growth by encouraging further investment.	The Federal Reserve has no control over what investors do with the new money. Investors always look for the best rate of return.  Since money is more abundant now, they invest in everyday items such as food and energy commodities causing prices to rise - think about that next time you buy gas and groceries.

Please note that none of the above "solutions" reduce debt. The only cure for too much debt is paying it off, restructuring it or defaulting on it - not bailing out, borrowing up, or easing. Those solutions work wonders in equity markets as I can sorely attest to missing the better than 100% gain since the market bottom in 2009. Yet until policymakers deal with curing the disease, the problem of too much debt remains, which means that the stock market crash and recession of a few years ago can happen again.

The time for prevention is long gone, it's time for an ounce of cure. And then I will invest.

So Here's What I'm Pondering Over


It's tough out there. For what it's worth, I know I'm not the only person out there that feels this way. I've had friends that know my interest in investing ask me what's going on, what should I do, where should I invest? Believe me when I say that I'm asking myself the same questions.

So as we all struggle to find our way through our present financial journeys, let me share the risks I see in the following investment classes.

• Stocks - were a roller coaster last year with almost the same starting point and ending point. This year, they're on fire. My trouble though is how quickly things can turn if a crisis erupts. Stocks get sold as people lock in profits/limit losses. If they fall far enough, margin calls go out and more assets (whether it's stocks, bonds, or gold) get sold. When this happens, investors do not always get to choose what they sell.
• US Government Bonds - did well last year due to the flight to safe assets by investors around the world. Foreigners buy US bonds not just to finance our spending habits, but also because they are thought of as a safe haven when world stock markets are falling. However as alluded to in James Bond Isn't the Only Dangerous Bond, bonds are not risk free. The US cannot keep borrowing at low costs forever. Once foreigners can earn a better return in their home markets, they will demand more of a return in order to keep their money in US bonds. When that happens, bonds will lose money - potentially a lot of money.
• Corporate Bonds and Municipal Bonds - are tempting because they always pay a higher interest rate than US government bonds as they are deemed to be slightly more risky. Yet they still have to obey the same credit market as government bonds, which means that when interest rates rise, corporate/municipal bonds will lose money too.
• High Yield Bonds - otherwise known as junk bonds, provide potentially high returns, but are among the first to get whacked when credit markets tighten.
• Inflation Indexed Bonds - pay a small interest rate plus additional interest based upon the US consumer price index (CPI). As they pay more when the CPI increases, I favor these over the other bonds. However I have a tough time thinking that these are more than a nice house in a bad neighborhood.
• Gold - whether it's gold, gold ETFs or gold miners, I am invested here to insure against too much QE and/or too much additional borrowing by the US government. Plus, gold held up pretty well during the last crash. Gold miners are attractive to me because they have a relatively fixed cost per ounce of gold retrieved. Any price increase in gold is profit.
• Commodities - are attractive to me for the same reason as gold, it's a hedge against money debasement. I especially like one thing we all need - food. Energy is also attractive though if there is a worldwide recession, it will take a fall until demand is restored. The only downfalls of this asset is there are relatively few choices for small investors. Also the choices available tend to be costly when compared to an index mutual fund.
• Cash - is a legitimate position. People will say that you lose money to inflation, which I do not deny. However I sleep better at night knowing that potentially large losses from a market crash are not possible.

I'd like to reiterate that my thoughts above reflect my attitude towards my 401k retirement money. As I am no longer employed, I no longer contribute to my 401k. Hence I cannot dollar cost average into lower priced shares when the market falls. In that regard, I like to compare my situation to that of a retiree. Capital preservation is key for me right now.

If I were still employed, I would be contributing to mutual and money market funds.  Dollar cost averaging with regular contributions is a powerful method to come out ahead once our economic problems are solved. I strongly recommend this strategy to everyone.

With that said, don’t let your investments keep you up at night. If they do keep you awake, you are taking more risks than you are comfortable with. Talk to a professional about reallocating to less risky investments so that you can sleep. During your conversation with said professional, ask why they believe that their recommendation is less risky. If you are not convinced by their explanation, don’t invest. Remember:

1. It’s your nest egg.
2. Opportunities are easier to make up than losses.

Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.

James Bond Isn't the Only Dangerous Bond

What are the three terrors of the Fire Swamp? 

One, the flame spurt - no problem. There's a popping sound preceding each; we can avoid that. 

Two, the lightning sand, which you were clever enough to discover what that looks like, so in the future we can avoid that too. 

Westley, what about the R.O.U.S.'s? 

Rodents Of Unusual Size? I don't think they exist. - Princess Bride

The best (though sometimes the worst) thing about having a blog is that you can quote whatever you like.  So why can it also be the worst thing?  Late at night when your brain shuts down, you struggle to find any quote close to resembling your article.

Tuning out the GIPSIs tonight (Greece, Ireland, Portugal, Italy, & Spain), I wanted to draw your attention to Oracle of Omaha's wisdom as reported by Bloomberg Buffett: Bonds Are Among Most Dangerous Assets

Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc., said low interest rates and inflation should dissuade investors from buying bonds and other holdings tied to currencies.

“They are among the most dangerous of assets,” Buffett said in an adaptation of his annual letter to shareholders that appeared today on Fortune magazine’s website. “Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal.”

Buffett, 81, who built Omaha, Nebraska-based Berkshire from a failing textile maker into a firm selling insurance, energy and jewelry through acquisitions and stock picks, echoed Laurence D. Fink, chief executive officer of BlackRock Inc. Fink said this week that investors should be 100 percent in equities, because of depressed stock valuations and the Federal Reserve’s pledge to keep interest rates low.

“High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments -- and indeed, rates in the early 1980s did that job nicely,” Buffett wrote. “Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.”

The Fed has kept borrowing costs near zero, and said last month that economic conditions may warrant “exceptionally low levels” for rates through at least late 2014 to boost the economy and put more Americans back to work. Buffett said other currency-based investments that may pose a risk include money- market funds, mortgages and bank deposits.

Saying anything remotely opposite of Warren Buffett is like trying to cross a busy street during rush hour, you know you shouldn't do it because there's a good chance of getting hit. So let's talk about what I agree with in this quote - low interest rates and inflation should dissuade investors from buying bonds.

Looking at the following graph, we see the interest paid out by a 10 year treasury bond.  For a minute, let's ignore inflation and issuance of further government debt.  Let me ask you, what do you think the odds are that the rates get any lower versus the rates going higher?

It's fair to ask though why do higher rates matter to me?  If you own bonds or a bond mutual fund, they matter.  Let's walk through an extremely simple example where the numbers are for illustration purposes (e.g. I haven't calculated anything):

• A few years ago, I buy a 10 year bond that pays 5% interest for $100.  Two years later recession hits and interest rates go down.  Looking for a good rate, you offer me $110 for my 5% bond.  Realizing a 10% gain, I sell you the bond which pays you less than 5% because you paid $110 for it, not $100.  For simplicity sake, let's say it pays you 3%.
• 2 years later the economy recovers, but is now doing so well that new 10 year bonds pay 6% interest.  You have a choice, you can either hold the bond for 6 more years to get the $100 or you could sell it to someone else who may only pay you $90 for it. 

The lesson from this example is that investors that are buying newly issued debt, especially intermediate and long term debt, are like a moth near a bug light.  The moth thinks the light is safe, but it can easily get zapped.

So Where Might I Disagree with the Almighty Oracle

Rush hour must be ending because later in the article from Bloomberg:

Buffett said investors should avoid gold, because its uses are limited and it doesn’t have the potential of farmland or companies to produce new wealth. Achieving a long-term gain on the metal requires an “expanding pool of buyers” who believe the group will increase further, he said.

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow,” he wrote. “During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth -- for a while.”

Gold prices have climbed to more than $1,700 an ounce from less than $300 in the last decade, as investors sought safety in bullion.

Hypothetical question: when is insurance cheap versus when is insurance expensive?  Insurance is cheap when there is little risk of collecting and expensive when there is a higher chance the insurer will have to pay a claim.  Gold is expensive, but there's a good reason - gold is an insurance policy.  Gold buyers are insuring that their wealth against low interest rates and the printing of money, these days known Quantitative Easing.

Interest Rates Pay Little for Much of This Period

Global Central Banks Expand Their Balance Sheets Double or More
From The Big Picture blog

Investors Seek Safety for Their Wealth

Note that the Federal Reserve has increased the its balance sheet from less than $1 Trillion to almost $3 Trillion.  The central banks in China and Europe had much larger increases.  Plus as we have already established, interest rates pay nothing.

So How Does this Affect Me

There are a variety of factors that affect bond rates.  Currently the slow economy plus the flight to safety out of Europe is keeping US bond rates low.  However, the day is coming when bond rates will turn.  While you may have seen previous posts where I state I own bond funds, those holdings are subject to change at any time and without prior warning.  I am looking to diversify out of intermediate and longer term bonds.

Regarding gold, I'm not sure when its price stops going up.  In fact, it may have already stopped.  However with the EU crisis still unresolved, talk of €1 Trillion more in ECB lending at the end of the month, increasing US debt levels, and talk of more quantitative easing from the Fed, I think the price can go higher.

There are many ways to "own" gold.  The reason I have quotation marks around own is that if you look around the Internet, you'll find quite a few differing opinions on what owning gold means.  Skipping that conversation, here are a few options that you can explore: buy physical gold (though let me warn you that might make you a terrorist), buy gold through an ETF fund, or buy gold mining equities, mutual funds, or ETFs.


Disclaimer: Please remember that I’m just a guy sharing information on a blog, and this is NOT official investment advice. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Please consult your investment adviser before making any investment decisions. During your conversation with said investment adviser, ask why they believe in their recommendation. If you are not convinced by their explanation, any action that you take or forego is also your responsibility. Just in case you missed that, you are responsible for your investments.