Serpo
6th December 2010, 06:31 PM
The 3475% Gold Analysis Difference Between Pros And The Uninformed
-- Posted Monday, 6 December 2010 | Digg This ArticleDigg It! | Share this article | Source: GoldSeek.com
By Daniel R. Amerman, CFA
Introductory Quiz
Let's start with two quick questions for gold investors. We're going to assume, as will be illustrated in detail later in this article, that 10 to 15 years from now a dollar is worth a nickel, that after a tremendous bull market gold has returned to more or less its long-term average value in inflation-adjusted terms (meaning a far higher dollar price for gold than today), and that as governments struggle financially around the world, the future average marginal tax rate on gold profits is 50%.
Question One. If the future dollar is worth five cents, and gold is trading around its long-term historical real (inflation-adjusted) value, which would be $9,000 an ounce in future dollars, did you:
A) Make a killer investment that's really multiplied your net worth? Or,
B) Lose more than 80% of your net worth, with much of that going to the government?
Question Two For Extra Credit. Let's say that gold eventually returns to something close to its long-term historic average value, and we'll call that $450 an ounce. Which of the following scenarios gives you a higher after-inflation and after-tax net worth?
A) Gold is nominally at $9,000 an ounce but in inflation-adjusted terms is only worth $450 an ounce.
B) Gold goes straight from $1,350 an ounce down to $450 an ounce with no significant inflation.
The correct answers are B and B. If the dollar becomes worth five cents and gold eventually returns to its long term average value in real (inflation-adjusted) terms, then you lose over 80% of your net worth on an after-tax basis. Also, if gold is going to return to its long term inflation-adjusted value, you are almost three times better off if gold is selling for $450 an ounce, than if it was selling for a nominal $9,000 an ounce.
How did you score?
You may doubt the answers right now, but will come to understand them as we cover these questions in step by step, irrefutable detail. If you missed either correct answer, or if anything at all came as a surprise, let me suggest that it is very much in your long term financial interest to read this complete article, and then learn some of the professional grade tools that you will need to get ahead in real terms (after-inflation and after-tax). If you are a long-time reader, please also note that what is quite different in this article from my previous articles on gold, is that it addresses how gold asset deflation in purchasing power terms affects investors when they buy into a precious metals bull market that is followed by substantial monetary inflation.
Gold and silver can be superb investments for the current times, and when you use a professional level strategy – then a heavy precious metals weighting can be a key component in not only surviving the destruction of the value of currencies, but potentially building multigenerational wealth even after adjusting for the corrosive effects of inflation and taxes. Also please note that the principles illustrated herein are not dependent on the specific example of gold regressing to a long term valuation mean, but are even more important in a spectacular bull market where gold could hit the highest real valuations of our lifetimes. But whether we are looking at long term declining valuations or short term soaring valuations, to understand the difference between the gold investors who will be highly successful, and the gold investors who will lose most of what they have, we need to look at the difference between examining gold using professional level methodologies versus the alluring but deceptive surface level used by so many gold investors.
The 3475% Gold Performance Difference
For this reasonable illustration, let's start with you. We'll assume that you've been a gold investor for some time, because you've been looking at the irresponsible financial and monetary decisions of your government for many years, and you have concluded that the destruction of the dollar was the most likely result. Unfortunately for us all - you are turning out to be exactly right. Now you're seeing the madness that has officially consumed the Federal Reserve with QE2 and the creation of new money in an amount equal to 9% of the US economy. In other words, a thousand dollars per household per month, is being created directly out of the nothingness by the Federal Reserve and then used to purchase treasury bonds. You believe that the end of the dollar as we know it is indeed approaching, and you buy still more gold at the current market price of approximately $1,350 per ounce.
While we're making assumptions, we will assume that what I have been writing about for many years comes true, and in addition to the above, the government uses massive inflation (such as that so conveniently eventually caused by QE2, QE3 and QE4) to effectively meet the Social Security, Medicare and pension promises that would otherwise be impossible. For a nice round number we'll take the example developed in the article linked below, "Bailout Lies Threaten Your Savings", and assume that the bottom line is correct and the dollar becomes worth a nickel.
http://danielamerman.com/Video/BBL1B.htm
Now if gold is currently selling for $1,350 an ounce, and gold were to entirely keep up with inflation, (which it is likely to do and even exceed in the next few years), then gold would rise to 20 times its current value, which would be $27,000 an ounce. Which sounds spectacular, but keep in mind that when we adjust for inflation, the real (inflation-adjusted) value of our investment is merely constant at $1,350 an ounce in today's dollars.
However, for our example we are not assuming peak valuation (i.e. selling near the top) but rather a long term buy-and-hold strategy for an investor who truly believes in the wealth retention power of gold. So the peak of the crisis came and went some years ago, we're a more impoverished nation than we were, and this relative impoverishment is concentrated among the retirees and boomers whose savings, retirement accounts and investments were shredded in the Great Collapse. We'll assume that a new and poorer financial "normalcy" has returned, as some form of "normalcy" almost always does eventually, Zimbabwe notwithstanding. So we're looking 10 or 15 years out and saying that gold has returned to its long-term historic average value. Like it eventually did after the last great gold bull market of 30 years ago that accompanied the stagflation of the 70s and early 1980s.
The graph below tracks the long-term inflation-adjusted value of gold, using New York market prices from 1791 through 2009. There are difficulties involved with the calculation of long term inflation rates, and the numbers need to be taken as a ballpark range rather than being precise values. Therefore the average shown of $458 an ounce is likely more indicative of a valuation between, say, $433 an ounce and $483 an ounce. By coincidence, $450 an ounce, which is near the middle of the range, is precisely one third of today's price of about $1,350 an ounce, which makes illustration calculations easy to follow.
As illustrated in this reasonable example, when we compare the $9,000 an ounce value in the "surface" column, and the $259 "real" value in the spending power column, let me suggest that there is a 3475% difference between looking at gold performance using professional analysis tools, and performance when measured with the simple surface approach.
The sources behind our going from an apparent huge gain to losing 81% of our real net worth are that (1) the value of money was destroyed (aka monetary or price inflation); (2) that gold eventually fell in real terms in a regression to the mean to its long term average value (aka asset deflation in purchasing power terms), and (3) that even partially keeping up with monetary inflation created a false income that was taxed by the government (aka inflation taxes). When all three parts work together, we take what on the surface looks to be the best investment decision of our life and we instead lose most of our net worth.
When (1) the Federal Reserve and European Central Bank are creating new money out of the nothingness on a massive basis; when (2) you are buying at the highest gold prices in real terms in almost 30 years; and when (3) your government is effectively bankrupt and highly likely to be raising tax rates in the future, let me suggest that what we just illustrated are three of the most important factors in your life when it comes to determining what your future standard of living will be for both yourself and your family.
We do not have to be helpless victims, however. Right now and the years coming up may indeed be some of the most advantageous times of our lifetimes to create wealth through purchasing gold and silver – but we've got to get there using a little different path than the simplest and most popular strategies.
The Risk Is Not What People Think
Gold investors are well aware that gold is trading at high prices relative to where it has been for most of the last 30 years, and that while we may have strong opinions about where investments are likely to go, we rarely have guarantees. Serious investors know that there is a risk in buying gold at current levels, that gold may return to previous levels, and that they could lose a good deal of money if that does happen.
Now, I happen to agree with the assessment that $1,350 an ounce is not bad at all given what the government is currently doing, in combination with the long term fiscal situation of the US government. It could even be called bargain basement when we consider that the US government is massively monetizing for the first time since the Civil War. And while I don't think $450 an ounce in nominal dollars is at all likely - the possibility can't be dismissed altogether, and indeed, explicitly considering the possibility that an investment will return to a long term average valuation should be one of the scenarios considered as a part of any responsible investment evaluation process. (Taking a good, long look at inflation-adjusted gold prices over the last couple of centuries as shown in the 1791-2009 graph can be quite compelling, when we consider the potential inflation-adjusted price of gold in the long-term future.)
Let's go back to the 2nd quiz question. On the one hand we have gold at $9,000 an ounce, which on an inflation-adjusted basis is equal to $450 an ounce. On the other hand we buy gold at $1,350 an ounce, and we could say that it works out that to everyone's great surprise - Bernanke really is the greatest economic genius in history. The economy does fully recover. The dollar maintains full value. Social security and Medicare pay in full without the value of the dollar falling, just like the politicians have promised us. (Again this is an illustration, not a prediction.) In this scenario, if we purchase gold at $1,350 an ounce and we sell it at $450, we would take a $900 per ounce loss. And let's assume that we generate a tax loss that is usable for us at the current collectibles rate of 30%.
Our $900 loss allows us to reduce our tax payments by $270 ($900 X 30%). If we take the $450 we got in sales proceeds and add the $270 tax loss benefit, we've got $720. This equals 53% of the $1,350 that we originally spent, meaning we took an after-tax and after-inflation loss of 47%.
We previously calculated that with a dollar being worth a nickel and gold going to $9,000 an ounce (which also returns us to the long term average inflation-adjusted value of $450), that we end up with $259 in after-tax and after-inflation terms. Which represented 19% of our original investment. If we compare ending up after-tax and after-inflation with 53% of our net worth intact, to having only 19% of our net worth intact, we see that selling gold at $450 an ounce can indeed leave us with almost 3 times the after-tax and after-inflation net worth that we would have if we sold gold at $9,000 an ounce under the assumptions shown. (Raising the tax rate from 30% to 50% to make the examples uniform would just increase the advantage to $450 gold).
-- Posted Monday, 6 December 2010 | Digg This ArticleDigg It! | Share this article | Source: GoldSeek.com
By Daniel R. Amerman, CFA
Introductory Quiz
Let's start with two quick questions for gold investors. We're going to assume, as will be illustrated in detail later in this article, that 10 to 15 years from now a dollar is worth a nickel, that after a tremendous bull market gold has returned to more or less its long-term average value in inflation-adjusted terms (meaning a far higher dollar price for gold than today), and that as governments struggle financially around the world, the future average marginal tax rate on gold profits is 50%.
Question One. If the future dollar is worth five cents, and gold is trading around its long-term historical real (inflation-adjusted) value, which would be $9,000 an ounce in future dollars, did you:
A) Make a killer investment that's really multiplied your net worth? Or,
B) Lose more than 80% of your net worth, with much of that going to the government?
Question Two For Extra Credit. Let's say that gold eventually returns to something close to its long-term historic average value, and we'll call that $450 an ounce. Which of the following scenarios gives you a higher after-inflation and after-tax net worth?
A) Gold is nominally at $9,000 an ounce but in inflation-adjusted terms is only worth $450 an ounce.
B) Gold goes straight from $1,350 an ounce down to $450 an ounce with no significant inflation.
The correct answers are B and B. If the dollar becomes worth five cents and gold eventually returns to its long term average value in real (inflation-adjusted) terms, then you lose over 80% of your net worth on an after-tax basis. Also, if gold is going to return to its long term inflation-adjusted value, you are almost three times better off if gold is selling for $450 an ounce, than if it was selling for a nominal $9,000 an ounce.
How did you score?
You may doubt the answers right now, but will come to understand them as we cover these questions in step by step, irrefutable detail. If you missed either correct answer, or if anything at all came as a surprise, let me suggest that it is very much in your long term financial interest to read this complete article, and then learn some of the professional grade tools that you will need to get ahead in real terms (after-inflation and after-tax). If you are a long-time reader, please also note that what is quite different in this article from my previous articles on gold, is that it addresses how gold asset deflation in purchasing power terms affects investors when they buy into a precious metals bull market that is followed by substantial monetary inflation.
Gold and silver can be superb investments for the current times, and when you use a professional level strategy – then a heavy precious metals weighting can be a key component in not only surviving the destruction of the value of currencies, but potentially building multigenerational wealth even after adjusting for the corrosive effects of inflation and taxes. Also please note that the principles illustrated herein are not dependent on the specific example of gold regressing to a long term valuation mean, but are even more important in a spectacular bull market where gold could hit the highest real valuations of our lifetimes. But whether we are looking at long term declining valuations or short term soaring valuations, to understand the difference between the gold investors who will be highly successful, and the gold investors who will lose most of what they have, we need to look at the difference between examining gold using professional level methodologies versus the alluring but deceptive surface level used by so many gold investors.
The 3475% Gold Performance Difference
For this reasonable illustration, let's start with you. We'll assume that you've been a gold investor for some time, because you've been looking at the irresponsible financial and monetary decisions of your government for many years, and you have concluded that the destruction of the dollar was the most likely result. Unfortunately for us all - you are turning out to be exactly right. Now you're seeing the madness that has officially consumed the Federal Reserve with QE2 and the creation of new money in an amount equal to 9% of the US economy. In other words, a thousand dollars per household per month, is being created directly out of the nothingness by the Federal Reserve and then used to purchase treasury bonds. You believe that the end of the dollar as we know it is indeed approaching, and you buy still more gold at the current market price of approximately $1,350 per ounce.
While we're making assumptions, we will assume that what I have been writing about for many years comes true, and in addition to the above, the government uses massive inflation (such as that so conveniently eventually caused by QE2, QE3 and QE4) to effectively meet the Social Security, Medicare and pension promises that would otherwise be impossible. For a nice round number we'll take the example developed in the article linked below, "Bailout Lies Threaten Your Savings", and assume that the bottom line is correct and the dollar becomes worth a nickel.
http://danielamerman.com/Video/BBL1B.htm
Now if gold is currently selling for $1,350 an ounce, and gold were to entirely keep up with inflation, (which it is likely to do and even exceed in the next few years), then gold would rise to 20 times its current value, which would be $27,000 an ounce. Which sounds spectacular, but keep in mind that when we adjust for inflation, the real (inflation-adjusted) value of our investment is merely constant at $1,350 an ounce in today's dollars.
However, for our example we are not assuming peak valuation (i.e. selling near the top) but rather a long term buy-and-hold strategy for an investor who truly believes in the wealth retention power of gold. So the peak of the crisis came and went some years ago, we're a more impoverished nation than we were, and this relative impoverishment is concentrated among the retirees and boomers whose savings, retirement accounts and investments were shredded in the Great Collapse. We'll assume that a new and poorer financial "normalcy" has returned, as some form of "normalcy" almost always does eventually, Zimbabwe notwithstanding. So we're looking 10 or 15 years out and saying that gold has returned to its long-term historic average value. Like it eventually did after the last great gold bull market of 30 years ago that accompanied the stagflation of the 70s and early 1980s.
The graph below tracks the long-term inflation-adjusted value of gold, using New York market prices from 1791 through 2009. There are difficulties involved with the calculation of long term inflation rates, and the numbers need to be taken as a ballpark range rather than being precise values. Therefore the average shown of $458 an ounce is likely more indicative of a valuation between, say, $433 an ounce and $483 an ounce. By coincidence, $450 an ounce, which is near the middle of the range, is precisely one third of today's price of about $1,350 an ounce, which makes illustration calculations easy to follow.
As illustrated in this reasonable example, when we compare the $9,000 an ounce value in the "surface" column, and the $259 "real" value in the spending power column, let me suggest that there is a 3475% difference between looking at gold performance using professional analysis tools, and performance when measured with the simple surface approach.
The sources behind our going from an apparent huge gain to losing 81% of our real net worth are that (1) the value of money was destroyed (aka monetary or price inflation); (2) that gold eventually fell in real terms in a regression to the mean to its long term average value (aka asset deflation in purchasing power terms), and (3) that even partially keeping up with monetary inflation created a false income that was taxed by the government (aka inflation taxes). When all three parts work together, we take what on the surface looks to be the best investment decision of our life and we instead lose most of our net worth.
When (1) the Federal Reserve and European Central Bank are creating new money out of the nothingness on a massive basis; when (2) you are buying at the highest gold prices in real terms in almost 30 years; and when (3) your government is effectively bankrupt and highly likely to be raising tax rates in the future, let me suggest that what we just illustrated are three of the most important factors in your life when it comes to determining what your future standard of living will be for both yourself and your family.
We do not have to be helpless victims, however. Right now and the years coming up may indeed be some of the most advantageous times of our lifetimes to create wealth through purchasing gold and silver – but we've got to get there using a little different path than the simplest and most popular strategies.
The Risk Is Not What People Think
Gold investors are well aware that gold is trading at high prices relative to where it has been for most of the last 30 years, and that while we may have strong opinions about where investments are likely to go, we rarely have guarantees. Serious investors know that there is a risk in buying gold at current levels, that gold may return to previous levels, and that they could lose a good deal of money if that does happen.
Now, I happen to agree with the assessment that $1,350 an ounce is not bad at all given what the government is currently doing, in combination with the long term fiscal situation of the US government. It could even be called bargain basement when we consider that the US government is massively monetizing for the first time since the Civil War. And while I don't think $450 an ounce in nominal dollars is at all likely - the possibility can't be dismissed altogether, and indeed, explicitly considering the possibility that an investment will return to a long term average valuation should be one of the scenarios considered as a part of any responsible investment evaluation process. (Taking a good, long look at inflation-adjusted gold prices over the last couple of centuries as shown in the 1791-2009 graph can be quite compelling, when we consider the potential inflation-adjusted price of gold in the long-term future.)
Let's go back to the 2nd quiz question. On the one hand we have gold at $9,000 an ounce, which on an inflation-adjusted basis is equal to $450 an ounce. On the other hand we buy gold at $1,350 an ounce, and we could say that it works out that to everyone's great surprise - Bernanke really is the greatest economic genius in history. The economy does fully recover. The dollar maintains full value. Social security and Medicare pay in full without the value of the dollar falling, just like the politicians have promised us. (Again this is an illustration, not a prediction.) In this scenario, if we purchase gold at $1,350 an ounce and we sell it at $450, we would take a $900 per ounce loss. And let's assume that we generate a tax loss that is usable for us at the current collectibles rate of 30%.
Our $900 loss allows us to reduce our tax payments by $270 ($900 X 30%). If we take the $450 we got in sales proceeds and add the $270 tax loss benefit, we've got $720. This equals 53% of the $1,350 that we originally spent, meaning we took an after-tax and after-inflation loss of 47%.
We previously calculated that with a dollar being worth a nickel and gold going to $9,000 an ounce (which also returns us to the long term average inflation-adjusted value of $450), that we end up with $259 in after-tax and after-inflation terms. Which represented 19% of our original investment. If we compare ending up after-tax and after-inflation with 53% of our net worth intact, to having only 19% of our net worth intact, we see that selling gold at $450 an ounce can indeed leave us with almost 3 times the after-tax and after-inflation net worth that we would have if we sold gold at $9,000 an ounce under the assumptions shown. (Raising the tax rate from 30% to 50% to make the examples uniform would just increase the advantage to $450 gold).