The New Case for Gold

(Image: Zen Buddha Silence by Marilyn Barbone.)

November 6, 2016

Given the high debts and deficits of developed world economies, and given that the majorcentral banks have printed trillions of new dollars, what is the best way to protect yourself against the ongoing devaluations of developed world currencies? If the U.S. dollar, the euro, and the yen are all guaranteed to continue to lose value – in an absolute sense, in terms of purchasing power – is there anything that you as an investor should do?

There are many ways for you to protect yourself against the ongoing devaluation of developed world currencies. One of the best ways is to own or have exposure to gold.

James Rickards has written an excellent book, The New Case for Gold (Portfolio Penguin, 2016). Below is a summary of the main points.

The great value investor Michael Burry – the main character in the movie The Big Short – made this comment on the Fed policy of quantitative easing (QE):

we continue to debase our currency...the toxic twins of a fiat currency and an activist Fed remain firmly entrenched – Michael Burry

Click to tweet Burry quote: http://ctt.ec/axdeu

(Link to transcript of Burry's talk "Missteps to Mayhem" at Vanderbilt: https://news.vanderbilt.edu/2011/04/13/michael-burry-transcript/)

ARGUMENTS AGAINST GOLD

Rickards begins his book by examining the arguments against gold. After all, the economics establishment is very firmly against the idea that gold can serve as a stable form of money or currency:

The antigold reflex is intergenerational. Among the older generation are PhDs who came of age in the wake of famous gold bashers such as Milton Friedman. This generation includes Paul Krugman, Barry Eichengreen, Nouriel Roubini, Martin Feldstein, and others who cover the ideological spectrum from left to right. Friedman's other theoretical contributions are mostly obsolete (it turns out that floating exchange rates are supoptimal, and money velocity is not stable), yet that has done nothing to tarnish how his acolytes perceive gold. (page 1)

Rickards lists the arguments against gold:

• Gold is a 'barbarous relic,' according to John Maynard Keynes.
• There is not enough gold to support finance and commerce.
• Gold supply does not grow fast enough to support world growth.
• Gold caused the Great Depression.
• Gold has no yield.
• Gold has no intrinsic value.

Gold is a 'Barbarous Relic,' According to John Maynard Keynes

In July 1914, at the start of World War I, Keynes argued in favor of remaining on the classical gold standard. This would enhance the United Kingdom's credit, allowing it to borrow money for the war. Keynes was right.

In 1924, Keynes said that the gold standard – not gold – was 'already a barbarous relic' because of its flaws.

In 1925, Churchill considered returning the United Kingdom to the gold standard at prewar parity. Keynes was against the gold standard. But Keynes argued that if England was going to have a gold standard, they should set the price much higher. Keynes was right again. But Churchill ignored Keynes' advice, resulting in deflation and depression. Rickards continues:

In July 1944, near the end of his life, Keynes argued at Bretton Woods for a new form of world money he called the bancor, the theoretical predecessor of today's special drawing right (SDR). The bancor would be backed by a commodity basket including gold. It was not a strict gold standard. Still, it did give gold an important place in the monetary system...

In short, Keynes was an advocate for gold early in his career, an astute advisor on gold in mid-career, and an advocate for gold again late in his career. In between, he properly disparaged the operation of a flawed gold exchange standard. Keep Keynes' nuanced view of gold in mind the next time someone throws the phrase 'barbarous relic' at you. (page 5)

There is Not Enough Gold to Support Finance and Commerce

The real issue is not the amount of gold, but what gold price would be needed to establish a gold standard. Rickards clarifies:

The amount of gold in the world is always fixed at a level, subject to an increase through mining. Currently the world has about 170,000 metric tons in total, of which about 35,000 metric tons are official gold held by central banks, finance ministries, and sovereign wealth funds. That gold can support any amount of world finance and commerce under a gold standard at a price. The price can be determined by calculating the simple ratio of physical gold to money supply.

Assumptions are needed to do this calculation. Which currencies will be included in the gold standard? Which money supply (M0, M1, et cetera) should be used for this purpose? What gold-to-money ratio is best? These are legitimate policy questions that central banks have answered differently over time. (page 6)

... When critics say 'there's not enough gold' what they really mean is that there isn't enough gold at current prices. (page 7)

Gold Supply Does Not Grow Fast Enough to Support World Growth

There is widespread misunderstanding about how gold standards work. Rickards explains:

A critic who advances this argument fails to distinguish between stocks of official gold and total gold...

If a government wants to increase its official gold supply to support monetary expansion, all it has to do is print money and buy private gold on the open market. New mining output is not a constraint. Official gold supplies could double by acquiring private gold, if that was needed, and it would barely make a dent in the total gold stock in the world. (Official gold is only about 20 percent of the total gold stock, which leaves ample room for governments to acquire gold.)

Printing money to buy gold under a gold standard is just another form of open-market operation. It's no different from printing money to buy bonds, which the Federal Reserve does every day. Of course, it does have market consequences, and discretionary monetary policy can lead to blunders. This is true with or without a gold standard. Ultimately, new mining output does not limit central banks' ability to expand credit under a gold standard. (page 8)

...

There is no reason why a gold standard cannot be combined with discretionary monetary policy. A combination of gold and central bank money was the norm from 1815 to 1971 except during war. Central banks acted as a lender of last resort and expanded or contracted the money supply as they saw fit even under the gold standard. In fact, gold's main purpose was to signal the proper monetary policy based on bullion inflows and outflows. (page 9)

Gold Caused the Great Depression

Rickards pens:

Actually, the Great Depression was caused by incompetent discretionary monetary policy conducted by the U.S. Federal Reserve from 1927 to 1931, a fact documented by a long line of monetary scholars including Anna Schwartz, Milton Friedman, and more recently, Ben Bernanke. (page 10)

... Bernanke's own research shows that at no time during the Great Depression was the money supply ever constrained by the gold supply. The law then allowed the Fed to create money up to 250 percent of the value of gold held by the Fed. The actual money supply never exceeded 100 percent of the value of the gold. This means that the money supply could have more than doubled without gold's acting as a restraint. The problem with money supply growth was not gold; it was the fact that customers did not want to borrow and banks did not want to lend. There was a bank credit and consumer confidence problem, not a problem with gold. (pages 10-11)

Rickards concludes:

Gold did not cause the Great Depression; a politically calculated gold price, and incompetent discretionary monetary policy, did. (page 12)

Gold Has No Yield

Gold has always been viewed as money, and still is:

Gold is money, and money has no yield because it has no risk. Money can be a medium of exchange, a store of value, and a unit of account, but true money is not a risk asset.

To illustrate this simple yet elusive point, just look at the dollar bill. Is it money? Yes. Does it have a yield? No.

Yield comes from putting the dollar in the bank. But then it's not money anymore; it's a bank deposit.

A bank deposit is not money; it's a bank's unsecured liability. The largest banks in the United States would have collapsed in 2008 if not for government bailouts in the form of expanded deposit insurance, guaranteed money market funds, zero interest rates, quantitative easing, foreign central bank swap lines, and other monetary gymnastics. (page 13)

...A gold coin, a dollar bill, and bitcoin are three forms of money. One is metal, one is paper, and one is digital. None of them has a yield. They're not supposed to – they're money. (pages 13-14)

Gold Has No Intrinsic Value

The 'intrinsic value' of gold is 'an obsolete concept,' argues Rickards:

There are many forms of money including gold, dollars, euros, bitcoin, and at certain times and places, feathers, shells, and beads. The value of each form of money varies with the subjective wants and needs of each individual in the economy. At times, dollars may prove highly useful, gold less so, and the dollar price of gold will fall based on this subjective valuation. At other times, confidence in dollars may wane and the dollar price of gold could rise dramatically. (page 16)

Rickards concludes the section answering the arguments against gold by admitting that every monetary standard has problems, even a gold standard:

The creation of a new gold standard, for example, would require extensive technical work on issues of parity with other currencies and maintenance of those parities. Such a task would resemble the eight years of research that went into the convergence of multiple European currencies in the euro between the Maastricht Treaty (1992) and the euro's official launch (1999).

GOLD AND THE FED

Is the Federal Reserve System insolvent? Rickards explains that (at the time of his writing) the total assets on the Fed's balance sheet are approximately $4.49 trillion, while total liabilities are approximately $4.45 trillion, and total capital is $40 billion. Based on these values, the Fed is not insolvent. But being levered 114 to 1 seems precarious. A 1 percent loss on the Fed's assets would wipe out its capital.

Of course, central banks don't technically need capital. Still, one can wonder whether confidence in the Fed can be maintained.

Rickards spoke with an array of experts about the issue. Finally, a friend told him to look again at the balance sheet. Rickards did, and he saw on the first line 'gold certificate account.' It was listed as $11 billion, but that's a historical cost. The gold certificates were last marked to market in 1971 at a price of $42.2222 per ounce. If you adjust the value to reflect gold at $1,200 (today gold is closer to$1,300 per ounce), then the entry would show $315 billion in gold. Using this value for gold, the Fed is only levered 13 to 1.

This hidden asset is more than enough to absorb the mark-to-market losses on the bond portfolio when they arise. (page 26)

But the establishment is quite united in its opinion that gold no longer matters. Rickards is not so sure:

Even a passing reference to the importance of gold to the Fed's solvency could start a debate on gold-to-money ratios and related topics the Fed left behind in the 1970s. Nevertheless, gold still matters in the international monetary system. This is why central banks and governments keep gold in their vaults despite their public disparagement of its role. (page 27)

GOLD IS MONEY

There have been many kinds of money.

A classic definition of money has three parts: medium of exchange, store of value, and unit of account. If all three of those criteria are met, you have money of a sort. (page 28)

Economists believe that only fiat currencies qualify as money. They view gold as 'shiny metal' rather than money. But gold has several unique properties that make it an ideal form of money.

First, gold is an element in the periodic table. There is no other periodic element that has the properties of gold. Only gold and silver are rare, but not impossibly rare. But silver tarnishes, whereas gold does not. In sum, writes Rickards:

Our ancestors did not use gold just because it was shiny or beautiful as modern critics suggest. Gold is the only element that has all the requisite physical characteristics – scarcity, malleability, inertness, durability, and uniformity – to serve as a reliable and practical physical store of value. Wiser societies than ours knew what they were doing.

Of course, this list of virtues does not mean that gold has to be money. Today's money exists mostly in digital form. Electrons that store the digits don't rust either. Then again, they're not the least bit scarce.

Just because money is 'digital' doesn't mean it's not part of the physical world. There is no escape from the periodic table of the elements. Digital money exists as charged subatomic particles stored on silicon (Si) chips. Those charges can be hacked and erased. Gold atoms (atomic number 79) are stable and cannot be erased by Chinese and Russian cyberbrigades. Even in the cyber age, gold still stands out as money nonpareil. (page 32-33)

Furthermore, gold is not really a commodity because its industrial uses are very few. Gold is not even an investment, says Rickards, at least in the following sense: gold has no maturity risk, has no issuer risk, and it's not anyone else's liability if you own it. And unlike commodities that can degrade, gold is durable and uniform.

The main reason gold is not a commodity is that gold is money. For instance, from 1929 to 1933, commodity prices plummeted along with industrial production, but gold did not deflate because it served as money, explains Rickards. Gold serves as money whether there is deflation or inflation.

Paper contracts that offer exposure to gold – like the ETF with ticker GLD – are not at all the same thing as physical gold. If a large number of customers asked for delivery of physical gold, many would not get physical gold. They would instead get a cash payment (or nothing if the bank fails). Rickards' point is that if there is a demand shock or buying panic for gold, paper gold is not at all guaranteed to perform as well as physical gold.

The History of Monetary Collapse

Rickards notes that there have been many times when the international monetary system collapsed, including 1914, 1939, and 1971. It could happen again:

Because today's international monetary system is largely based on the U.S. dollar, a new collapse will be triggered by a collapse of confidence in the dollar and its role as a store of value. It may be surprising. Still, such collapses do happen every thirty years or so. Based on the monetary history of the past century, we're probably at the end of the useful life of the current international monetary system and fast approaching a new one.

Prior monetary collapses have not meant the end of the world. People did not go into caves and start eating canned goods. Monetary collapse meant that the financial and trading powers of the time sat down around a table and rewrote what they called the 'rules of the game,' which is a shorthand expression for the operation of the international monetary system. (page 41)

1971 to 1980 was fairly chaotic as the world moved towards floating exchange rates. The dollar price of gold went from $35 to $800 an ounce as inflation took off. The dollar's value was cut in half, says Rickards. Starting in 1981, Paul Volcker and Ronald Reagen rescued the dollar. (On several occasions, Reagen wantedto go back to a gold standard, but was repeatedly discouraged from doing so by his advisors.)

In effect, the United States told the world that even in the absence of a gold standard, the dollar would be a reliable store of value. This meant ending dollar inflation and making the United States an attractive destination for dollar investments. Volcker's monetary policy and Reagen's tax and regulatory policies accomplished these goals.

...

For thirty years, from 1980 to 2010, the world did not have a gold standard. We had a dollar standard instead. Now we have no standard and no anchors whatsoever in the international monetary system. It should come as no surprise that since 2007 we have been living with confusion, volatility, and supoptimal performance in the markets and the economy. (page 42)

Rickards observes that central banks, despite their rhetoric, have never really abandoned gold.

If gold is so worthless, why does the United States have more than eight thousand tons? Why do Germany and the IMF keep approximately three thousand tons each? Why is China acquiring thousands of tons through stealth and Russia acquiring more than one hundred tons a year? Why is there such a scramble for gold if it has no role in the system?

It's highly convenient for central bankers to convince people that money is unconnected to gold because that empowers them to print all the money they want... Still, gold is the foundation, the real underpinning, of the international monetary system. (page 44)

Rickards believes that, in effect, there is already a shadow gold standard. The IMF is the third largest gold holder after the United States and Germany. However, China is probably the second largest gold holder. China is keeping its true gold holdings a secret because it is still trying to acquire enough gold to protect against a decline in value in its large holdings of U.S. dollar-denominated reserves.

The IMF does issue notes, but they're denominated in special drawing rights (SDRs), worth about $1.38 recently. The IMF issued 182.7 million SDRs in 2009, and each country could withdraw a specific amount based on a quota allocation.

In the next liquidity crisis, notes Rickards, major central banks may be constrained in their ability to print money because they've already printed so much. In that case, the world may turn to the IMF's ability to issue SDRs. Of course, a huge SDR issuance would be very inflationary in dollar terms. At some point, gold will offer vital protection against inflation. That's why major powers such as Russia and China continue to buy large amounts of gold. Rickards observes:

If SDRs work, it will be in part because so few people understand them. Still, if people do understand, they are likely to lose confidence. In that scenario, the only recourse is gold. (page 52)

The shadow gold standard refers to the fact that the major powers continue to acquire or hold massive amounts of gold to protect against inflation and to prepare for a possible reset of the international monetary system. Rickards concludes:

Academic economists don't seem to care about gold. It is mostly ignored, and never studied in a monetary context. Still, gold has never completely gone away. It still matters behind the scenes. Gold is still poised in the reserves of the international monetary system and will be even more important in the years to come. (pages 55-56)

GOLD IS INSURANCE

Rickards explains how gold is insurance:

As discussed in the last chapter, gold is not an investment, it's not a commodity, it's not a paper contract, and it's not digital. Gold is simple, an element, atomic number 79; it is the opposite of complex. It is robust in the face of international monetary collapse and financial market complexity. Owning gold is insurance against the current economic climate and unstable monetary system. (page 57)

Rickards introduces complexity theory:

Complexity is a branch of physics that explores the impact of recursive functions in densely connected networks. It is the science of how nodes are interconnected and how they interact. The interaction leads to changed behavior, also called adaptive behavior, which can produce completely unexpected outcomes. The Federal Reserve, however, uses stochastic equilibrium models, which are not a good representation of how the real world works. (page 57-58)

Economics adopted the notion of equilibrium from physics. The only problem, in Rickards' view, is that the economy is a complex system, not an equilibrium model. In a complex system, cataclysmic outcomes can result from small, sometimes imperceptible changes in initial conditions. It's similar to a very unstable pile of snow. At some point, a random snowflake will cause an avalanche.

Rickards asks: If the system collapses, whom do we blame? The true cause of the collapse would be the instability of the system. As long as the Federal Reserve relies too much on equilibrium models, it is likely to miss bubbles and to underestimate systemic risk. If your model is not very good, high IQ's and PhD's will not necessarily save you, writes Rickards.

Although I don't agree with Rickards on every point, I do think the following: the Fed encouraged an enormous stock bubble in 1999-2000; the Fed also was partly responsible for the housing and stocks bubbles in 2005-2007; and the S&P 500 Index over 2100 is likely fairly close to bubble territory. It seems that the Fed keeps inflating asset bubbles with the goal of causing more spending. But each asset bubble necessarily collapses at some point, by definition. Now, it's possible the S&P 500 Index will not suffer an outright collapse. It may just go nowhere for 5-10 years until economic growth catches up with valuations. But if the alternatives are either a sharp bear market or zero returns for 10 years, then as an investor, you should think about investments such as gold that can increase in value while the S&P 500 Index does not (for 5-10 years).

To be clear, if there is a sharp bear market coming, no one can say precisely when. But if many U.S. stocks are overvalued, you don't have to be able to time the next bear market in order to create an asset allocation that has a chance to do OK in a variety of environments. Some individual sectors and stocks may be undervalued. And having some exposure to gold makes sense. (The Boole Microcap Fund that I manage has been able to find a handful of individually undervalued micro-cap stocks overlooked and ignored by larger investors.)

Rickards elaborates:

The amount of dry wood in a forest or the amount of snow on a mountainside are examples of scaling metrics in complex systems. In capital markets, we have scaling metrics as well. These include measures such as gross size of derivatives, asset concentration in the banking system, and total assets of the largest banks. These are the financial equivalents of unstable snowpacks and dry forests. Just as forest rangers and ski patrols descale the systems they manage , so regulators should regularly descale the banking system. (page 69)

Rickards argues that the financial sector has become quite bloated:

At the time of the crisis in 2008, the financial sector of the U.S. economy represented about 17 percent of stock market capitalization and 17 percent of GDP. That's an enormous percentage for a facilitation activity. Why should the banking sector be 17 percent of GDP? It should be perhaps 5 percent, which is closer to its historic share. Now finance has become an end in itself, driven by greed and the bankers' ability to devise arcane ways to extract wealth from this complex society. The difficulty is that the means bankers use to extract wealth add to complexity without adding value. Extreme financialization almost destroyed the global economy in 2008. (page 71)

...

Finance does not create wealth; it extracts wealth from other sectors of the economy using inside information and government subsidies to do so. It's a parasitic or so-called rentier activity. Finance needs to be contained before it triggers the next crash. This involves breaking up the big banks, banning most derivatives, and constraining the money supply. (page 72)

The Fed wants negative real rates:

Why does the Federal Reserve want negative real rates? Because it is a powerful inducement to borrow money. Negative real rates are better than zero interest rate because you can pay back less than you borrowed in real terms because the money's not worth as much due to inflation. In a world of negative real rates, almost every project makes sense and the 'animal spirits' (in Keynes's famous phrase) of entrepreneurs are aroused. If you borrow money at 2.5 percent and inflation is 3.5 percent, the real rate is negative 1 percent; you get to pay the bank back in cheaper dollars. That's the power of negative real rates. (pages 79-80)

The key to negative real rates, observes Rickards, is inflation. Today there is an ongoing tension between deflation and inflation:

Deflation is the natural consequence of the debt binge that home buyers and credit card shoppers went on between 2002 and 2007... Such deflation is amplified by deleveraging, asset sales, reducing balance sheets, and other factors.

Inflation is facilitated by central bank policy, mostly money printing, and catalyzed by changes in expectations that lead to increased turnover or velocity of money.

In fact, price indices are showing little change: about 1 percent per year. This is because the forces of inflation and deflation are pushing against each other to some extent, canceling each other out.

... In addition to fighting deflation, the Federal Reserve must cause inflation so the United States does not go broke. The national debt is more than $18 trillion as of this writing... The test of sustainable debt is if the economy is growing faster in nominal terms than the debt and interest. Real growth is fine, but real growth is not needed to sustain debt. What is needed is nominal growth, which is real growth plus inflation... Of course, inflation is bad for savers and retirees because their fixed incomes and bank accounts are worth less. Still, inflation is great for debtor countries like the United States because the debt is worth less also. Inflation is the key to making debt affordable. (pages 82-83)

Who do you think will win, the forces of deflation or the Fed?

In the end, inflation is going to win the tug-of-war because the Fed's tolerance for deflation is so low and the consequences of deflation are so devastating. The Fed must have inflation and will do 'whatever it takes,' in Mario Draghi's words, to achieve it. Inflation may take time and more rounds of money printing, and forward guidance. Still, it will happen eventually. That inflation will be the catalyst for negative real interest rates and a significant increase in the dollar price of gold. (page 84)

Rickards ends by pointing out that gold works as insurance both against potential deflation and against potential inflation. Inflation is more likely because the major central banks will do 'whatever it takes' – negative interest rates and/or ever more money-printing – in order to achieve it.

GOLD IS CONSTANT

Gold should be thought of as a constant unit of measurement, says Rickards. So if the dollar price of gold goes up, that doesn't mean gold went up, but that the dollar lost value.

If you think deficits, debt, negative or zero rates, and massive money-printing will lead to inflation – or the continued devaluation of the major currencies – then you should have exposure to gold. Gold is a form of money that will preserve value during inflation. Rickards:

When you're worried about deflation, and you've cut interest rates to zero, printed trillions of dollars, and done everything else possible, the only way left to get inflation into your economy (which the Fed wants) is to cheapen the currency. Given the corner the Fed has painted itself into, my expectation is that the Fed will have to reverse course and again pursue monetary ease in the form of either more quantitative easing or a cheaper currency. Both paths are bullish for the dollar price of gold. (page 97-98)

The Fed wants a weaker dollar, thus it does not mind the gold price going higher over time as long as there is no panic buying:

There is a condition on any long-run policy of higher gold prices. It must be orderly, not disorderly in the Fed's perspective. Slow, steady increases in the dollar price of gold are not a problem for the Fed. What the Fed fears are huge, disorderly moves of $100 per ounce per day that seem to gather upward momentum. When that happens, the Fed will immediately take steps to rein in the upward price momentum. Whether those steps will succeed or not remains to be seen. (page 110)

China is continuing to buy massive amounts of gold. It still probably does not have enough to protect against a potential devaluation of its U.S. dollar-denominated reserves. Thus, says Rickards, China has an incentive to try to keep the price of gold as low as it can for as long as it is still building up its gold stockpiles.

Rickards notes that it is in the interests of the United States to allow China to acquire massive amounts of gold. The U.S. can more readily continue its policy of dollar devaluation once China has fully insured its dollar reserves with gold. Rickards:

The price has to be kept down until China has enough gold. When it's done buying, when it has approximately eight thousand tons, the United States and China can shake hands and both say they're protected. At that point, a dollar devaluation by a rise in the dollar price of gold can commence. (page 115)

GOLD IS RESILIENT

Rickards writes that gold is resilient:

Gold has maintained its resilience through monetary collapses in the past, and it will do so in the future collapses. (page 116)

Rickards explains that gold is not digital and cannot be hacked, which gives gold a further dimension of resilience – resilience against the risk of cyberfinancial war.

Much of the world is interested in establishing a new reserve currency in place of the U.S. dollar:

In the 1970s, during the Nixon and Ford administrations, the United States and Saudi Arabia agreed on the petrodollar deal. The United States would ensure Saudi Arabia's national security, and in exchange Saudi Arabia would require that oil be priced in dollars. Once oil was priced in dollars, the entire world would need dollars because everyone needs oil. The petrodollar agreement created a strong foundation for keeping the dollar as the global reserve currency.

Today China, Russia, and Saudi Arabia, all powerful nations that export oil, natural gas, and manufactured goods, have a shared interest in ending dollar hegemony in the international monetary system. (pages 123-124)

Russia and China continue to acquire huge amounts of gold. There also have been financial transactions that used to be done in U.S. dollars but now are not:

China has access to Swiss francs, a highly desirable hard currency. Iran is selling oil to Russia, which Russia can resell to China. China can pay Russia in Swiss francs that Russia can intermediate through the new BRICS bank. What's missing in this chain of commerce? The dollar's missing – it's not involved. (page 126)

Chaos and Collapse

Rickards explains his view:

We are getting closer to a collapse of the international monetary system. That doesn't mean tomorrow morning necessarily, but it does mean that it will happen sooner rather than later. It's not a ten-year forecast. Could it be five years? Maybe. Could it be one year? Yes. (page 130)

Rickards acknowledges that the end of the current international monetary system does not necessarily mean a return to some form of a gold standard, although that is a strong possibility. Rickards also is quick to point out that no one is rooting for a collapse of the current monetary system:

The most likely outcome from the dollar's fall is chaos or collapse emerging from the complexity of the global financial system. It's not what anybody wants. I don't think there's any team out there rooting for chaos and collapse.

...

If you're an investor, or a portfolio manager, or you're just trying to make sense of it all, I don't think it serves you well to make categorical predictions about the timing and catalyst for a collapse. What I try to do instead is identify what I call indications and warnings (we do this in intelligence analysis). (page 132)

Rickards observes that it is likely we'll see either gold or SDRs as central to the next international monetary system:

After a collapse you might end up on a gold standard or a modified gold-backed SDR. Gold or SDRs are the two most likely outcomes, and perhaps a gold-backed SDR is the best of all possible worlds. (page 133)

GOLD MINING STOCKS

Rickards writes about gold mining stocks:

Gold mining stocks follow gold to a great extent, but they're more volatile. Traditionally, gold mining stocks have been described as a leveraged bet on the physical metal. There are technical reasons for this, having to do with the difference between fixed costs and variable costs, but basically, when gold goes up, mining stocks go up even more. When gold goes down, mining stocks may underperform and fall faster than the metal itself. (page 159)

... Of course, what sets gold mining stocks apart as an asset class is that they're completely idiosyncratic. In other words, miners are never generic like futures or indices. Mining companies will each have unique characteristics related to the ore quality, the competence of management, corporate finance, and other one-of-a-kind factors. (pages 159-160)

From a value investing point of view, you should look for gold mining companies that are not only undervalued, but that also have low or no debt. This will allow them to weather the ups and downs of the gold price.

STOCKS AND GOLD

Stocks and gold have various correlations depending on which scenario is unfolding. If the economy is strong, stocks may go up while gold goes down. If inflation is in its early stages, stocks and gold may both go up at the same time. During panics or if inflation is in its later stages, gold will go up while stocks go down.

One could see, for example, the economy getting stronger in nominal terms with inflation picking up. In that scenario, stocks and gold go up together because stock investors would see higher revenues due to inflation and gold investors would hedge with gold in the expectation that inflation will get worse.

On the other hand, if inflation gets out of control and the Fed gets behind the curve, then inflation begins to destroy capital formation and most forms of wealth. This could lead to stagflation, where we don't have real growth but we do have inflation. This would be similar to 1975-1979. In that world, we would see gold going up for fundamental reasons. (pages 161-162)

The bottom line is that you should have both stocks and some exposure to gold in your portfolio because no one can predict which scenario will unfold or when.

Rickards also points out that other hard assets can offer protection against inflation. Warren Buffett has made large investments in railroad, oil, and natural gas assets.

CONCLUSION

Given the deficits, debts, zero or negative interest rates, and massive money-printing by major central banks, as an investor you should expect the continued devaluation of developed world currencies. In an inflationary environment, gold is an excellent way to help preserve the value of your portfolio. Gold also would likely work well in a deflationary scenario, or during any type of reset of the current international monetary system.

Since many U.S. stocks appear to be overvalued, it makes sense to look for those areas where you can uncover undervalued stocks. Micro-cap stocks are a good place to look, since most large investors never look there. Also, certain sectors, such as oil-related companies or gold miners, appear to have some undervalued stocks.

• Some offshore oil drillers, like Atwood Oceanics (NYSE: ATW), look particularly cheap. (The Boole Microcap Fund has invested in the company.) But focus on the offshore drillers with high cash and low debt, since it may take longer than expected before oil returns to a long-term market clearing price of approximately $60-70.

Moreover, oil-related stocks and gold miners are likely to do well in an inflationary environment. As a value investor, make sure the companies you invest in have low or no debt, since things often take longer than you expect.

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees.

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.