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    Precious Metals Have Performed Quite Nicely, Thank You

    People often ask me why I invest in gold and silver when they have no return. Some call it return-free risk when compared with bonds or stocks, especially those that pay regular dividends. And on its surface, that argument seems to hold water. That is until we examine it under even the most lightly powered microscope.

    Gold does provide a return through leasing, which is when gold is ‘lent out’ to a third party in exchange for a periodic payment. Think of it as renting the metal, in which the full allocation of metal will be due back at the end of the lease term. Here are the recent lease rates for gold on the COMEX.

     

     

    Lease rates are higher than returns on cash or bank accounts and somewhat less than general interest rates, though that was not always the case. Only recently did the Fed raise their interest rate above the lease rate of gold. For gold holders that leased their gold for the past 15 years, they performed as well as many assets whose prices relied upon the Fed funds rate or other low-interest rate indexes.

    While gold is not leased often by individuals, gold leasing is a popular method of obtaining a risk premium for lending out the metal. Central banks have leased metal for decades and typically do well during periods when gold is not rising. The reason for this is that buyers would sell the leased metal and simply replace it later on with expectations of a lower price, essentially shorting the metal and profiting by the lease returns and any fall in the gold price over the lease term.

     

     

    Per the picture above, one can see that gold lease rates rise during times of market stress when gold’s price is likely to rise more due to demand. The point is that gold does have a return that rises and falls with perceived economic risk, where returns could be said to be inversely correlated to the general return of other risk assets such as stocks.

    Gold and Silver Best the Stocks

    When discussing precious metals, I often point out that the last two decades have been great for metals in terms of overall return. Looking at a 20-year chart comparing the metals to the stock market illustrates the point quite nicely.

     

     

    Gold and silver have even out returned the Wilshire 5000 index with reinvested dividends, and this is on price alone. I am not including the aforementioned lease rates as part of the return. So, when comparing apples to apples, the precious metals come out in a much more positive light over the last couple of decades when compared with the stock market.

    One may wonder why this phenomenon occurs, and the answer is not at all that difficult. Gold’s price, for much of its history, has been fixed at a set rate to the dominant currency. For much of the past century, gold was pegged to the dollar. The Federal Reserve explains how it worked:

    The international monetary system after World War II was dubbed the Bretton Woods system after the meeting of forty-four countries in Bretton Woods, New Hampshire, in 1944. The countries agreed to keep their currencies fixed (but adjustable in exceptional situations) to the dollar, and the dollar was fixed to gold. Since 1958, when the Bretton Woods system became operational, countries settled their international balances in dollars, and U.S. dollars were convertible to gold at a fixed exchange rate of $35 an ounce. The United States had the responsibility of keeping the dollar price of gold fixed and had to adjust the supply of dollars to maintain confidence in future gold convertibility.

    However, in 1971 President Richard Nixon opted to remove the convertibility of dollars into gold. In the 1960s, the share of US export output decreased and so did the need for foreign countries to hold dollars. And they had an incentive to dump them as more dollars had been printed by the US than gold had been added to reserves, causing a potential arbitrage play for countries wanting to dump declining dollar purchasing power for the natural stability of gold. Naturally, other countries converted excess dollars to gold, draining much of the country’s stash and forcing Nixon to end the convertibility to avoid all of the U.S. gold being claimed by foreign parties.

    Gold and Silver Reflecting Rising Risk

    I believe that two reasons exist for gold and silver outperforming the stock market for the last two decades. First, the metals are allowed to trade in various currencies without a strict peg. As the world’s central banks have increased monetary printing, that increased money supply has found its way to the precious metals markets.

    Secondly, overall sovereign debt issuance has been rising since 2000 as seen in the following chart from The Fed.

     

     

    Investors know that increased sovereign debt, as a percentage of GDP, raises the chances of a debt default. While many market pundits would laugh at the possibility of a US debt default, the history of debt above 90% of annual GDP tells another story.

     

    As researchers Rogoff and Reinhart have documented in their research, the risk of both high inflation and debt default/restructuring rises significantly at 90% of debt to GDP level, the so-called ‘point of no return’. Right now, the US sits at over 120% of debt to GDP and was recently as high as nearly 140%.

     

     

    We are already experiencing a period of higher inflation rates which do not appear to be decreasing in the near future when the costs of commodities are taken into consideration. Consumers should rightly expect higher prices as the new norm for the foreseeable future, at least until the government can get inflation under control. To do this, The Fed will have to continue to tighten by raising rates and actually selling some of its debt into the bond market without crashing it in the process. They are walking quite the tightrope of tightening into what many consider is a US recession, as defined by two consecutive quarters of negative GDP growth.

    Final Thoughts

    The reason for the article is to provide a more realistic view of precious metals when compared to the broader stock markets. Most brokers are not going to recommend gold because they don’t make money from it; there is no commission typically on vaulted gold. The gold vault will charge for the security of the metals they are holding, but those fees don’t typically pass to brokerage houses. Therefore, the benefits of holding gold and silver in one’s portfolio are often not discussed in the financial industry. Therefore, most investors are simply unaware of how well the metals have performed over the last two decades.

    Will gold and silver’s performance continue? Many are skeptical considering the last few months, and in particular since March when precious metals have sold off just like most of the paper investment markets. Those price declines this year cannot be ignored.

    However as I pointed out in a recent article, the physical gold and silver markets are absolutely booming. Investors, along with industrial users and central banks, have an obvious affinity for precious metals. I would consider silver to be in a medium-risk state for availability due to the last 18-month run-off of the metal in the two major western exchanges.

    The increased pressure on the silver price, due to steadily decreasing inventories of finished metal, should give investors hope that prices for metals derivatives will eventually reflect the dwindling physical metal inventories and cause spot prices for silver to rise.

    For gold, I expect continued economic and geopolitical concerns to place a floor under the price of gold where it is right now. And further, I expect gold to continue to climb the wall of worry as it has been steadily doing for the past two decades. Nothing has changed from a fundamental economic perspective here, and therefore gold should continue to steadily march higher over time.

    Disclaimer: All Market Updates are provided as a third party analysis and do not necessarily reflect the explicit views of JM Bullion Inc. and should not be construed as financial advice.

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