ERICOPOLY

Cows breed.

There is a big difference between cows and gold. Cows have more intrinsic value or utility to them than gold. You can milk them, you can slaughter them for meat and leather goods, and you can use them for labor (e.g., pulling plows). Gold has some utility, but not as much as cows or most other traded commodities. Gold, however, does function very well as an alternative currency, which is driven by the fact that it is a precious metal and has a hold on human imagination that goes back since time immemorial. Furthermore, the absolute supply of gold cannot be influenced/manipulated by central banks, though central banks can affect the dynamics between the supply and demand for gold in the market, as they control most of the gold that exists in the world. This monetary function in the minds of most people in the world makes holding gold a nice insurance policy to have in case of sudden currency devaluations or systemic crisis. I’m not sure that I would ever make the claim that gold has a "stable" value as it is in the end just a currency to be used in exchange for goods and services. The ratio of exchange between gold and useful goods and services can easily fluctuate based on animal spirits and short term supply/demand fundamentals. ----- Here's my theory about what has happened to gold over the last few years and what will happen going forward: -In the late 90s and early 2000s, many central banks -- and the Fed in particular -- came up with an easy money policy where they would inject liquidity into the system to soften every little recession. One of the things that the central banks did when they lowered rates was to lend gold out at very low interest rates, promoting what has been called the "gold carry trade." Gold was leased at these low rates to bullion banks, who subsequently dumped the gold into the market in order to lend out the money or buy fixed income securities such as MBS. This caused the price of gold to be very depressed during this period and the price reached a bottom in the early 2000s. -Between the early 2000s up until the financial crisis happened, the supply and demand in the market for gold began to normalize and so the price of gold began to revert to a more normalized level. On top of this, many smart people began to realize that we were getting to the point where we would finally see the dollar be devalued at a rapid pace and where we could have global systemic crisis due to the casino-like, too big to fail, derivatives-laced financial system that was reaching its apex. These people saw that if a global panic were to ensue, you might want to be in gold because of its insurance value. Reversion to normalized prices plus realization of the potential systemic crisis caused the price of gold to appreciate relative to many sound country currencies over the last five years. -Then the panic happened. It became clear to everyone that the dollar was going to be worth much less going forward, including the Chinese and Japanese central banks who had continued to hold dollar reserves and lend money to us in order to sustain their export sectors. Fearing a sudden devaluation of the dollar and systemic collapse, these central banks, institutional investors, and even retail investors began to pile into gold and useful commodities (such as oil) in order to preserve the wealth they had accumulated. They did this because it was the easiest and quickest way to do so. Gold and commodities spiked versus the dollar and versus other currencies. Gold continues to remain high because supply cannot be ramped up as with useful commodities such as oil, nat gas, and copper, and because demand for gold is not as tied to the real economy as demand for these useful commodities. -Now we see China and Japan, which still have lots of dollars and dollar-denominated fixed income securities in their coffers, chomping at the bit to get rid of their dollars in an orderly manner, i.e. in a manner that won’t destroy their export sectors overnight and cause unrest. Instead of dumping dollars into the currency markets, they are planning on investing in U.S. commercial real estate in the next few years and will probably buy more stakes in U.S. business so that they have claims to real/productive assets instead of dollars in their hands. They will likely also slowly diversify into other currencies such as the Canadian dollar and Australian dollar, which will push these currencies up relative to the dollar over time. Buying gold will no longer be the best way to combat dollar devaluation, and the price of gold will stagnate versus other currencies that are backed by useful commodities, fiscally sound government policies, and strong industrial concerns. The time to buy gold was between 2001 and the financial crisis. Not now. That makes a lot of sense and at least provides a satisfying narrative as to gold vs CDN and AUD, and what I suspect will be their relative outcomes in the future.

I would use gold as a hedge if I could understand the price movements. I don't understand why it makes the Swiss Franc look like it is hyperinflating over the past 5 years. Ditto for gold vs CDN and AUD. I do understand why the USD is falling in value against Swiss Franc, CDN, and AUD. That's pretty clear. It makes sense that it is losing value to gold too. But what doesn't make sense to me is why the CDN/AUD/CHF are quite literally collapsing relative to gold (the past 5 years). There is no theme of rapid devaluation of those currencies, except when held up to gold. So it is a conundrum. Julian Robertson is staying away from gold because he thinks gold is driven by psychology, and he isn't a psychologist. He does believe in the possibility of a USD collapse so he is hedging via derivatives that effectively short US Govt bond market (the curve steepener).

I have been seeing sandwich boards out on the highway near my house recently, advertising gold and silver coins. Has anyone else seen these with more frequency as of late?

Viking mentioned the 6.9% book value growth over the past 10 years and law of large numbers in the same post. I was really referring to that. In an parallel world, where KO and similar stocks were dirt cheap 10 years ago and expensive today, then book value growth over past 10 years would have possibly been 15%, but we would not be able to draw any conclusions from that regarding the size of Berkshire and how it impacted performance, only that the market P/E expanded. Lastly, suppose we were talking about KO in isolation and not mentioning Berkshire. Would we even be impressed with measuring KO's book value growth? Doubt it. That's because KO is an operating company and we would be more interested in rate of profit growth. Likewise, Berkshire is increasingly more so every year just a consolidated balance sheet of operating companies and the right way to measure it is earnings growth, not book growth. Fairfax is different because it's operating companies are just shells that hold publicly priced securities, so book value is far more relevant. For example, you don't amortize the cost at which you hold JNJ stock, but if you bought the company outright you would amortize the goodwill. The value of JNJ within Fairfax grows as the earnings at the company grow, this grows book value for Fairfax. Now, if Berkshire took JNJ private the value of JNJ on Berkshire's balance sheet would not grow along with the profits -- you would have instead the amortizing goodwill. Lastly, Fairfax trades them to generate profit in excess of the look-through earnings of those underlying stocks. Berkshire trades to a far lesser extent, largely because of size, but of heavy importance due also to culture (won't trade privately held subsidiaries). On a relative basis Berkshire's results are driven much less by trading. I forgot the year but you don't amortize goodwill anymore, you perform a goodwill impairment test each year but only do a write down if the test is failed. That's an improvement. I should have known this, and I probably read it before and forgot it. This leaves only the problem of a goodwill item that doesn't grow along with the prospects of the company. Oh well, I suppose the Goodwill item serves a purpose as a placeholder so companies like Fairfax don't have a huge immediate drop in book value if they pay a large P/B premium for an acquisition.

Viking mentioned the 6.9% book value growth over the past 10 years and law of large numbers in the same post. I was really referring to that. In an parallel world, where KO and similar stocks were dirt cheap 10 years ago and expensive today, then book value growth over past 10 years would have possibly been 15%, but we would not be able to draw any conclusions from that regarding the size of Berkshire and how it impacted performance, only that the market P/E expanded. Lastly, suppose we were talking about KO in isolation and not mentioning Berkshire. Would we even be impressed with measuring KO's book value growth? Doubt it. That's because KO is an operating company and we would be more interested in rate of profit growth. Likewise, Berkshire is increasingly more so every year just a consolidated balance sheet of operating companies and the right way to measure it is earnings growth, not book growth. Fairfax is different because it's operating companies are just shells that hold publicly priced securities, so book value is far more relevant. For example, you don't amortize the cost at which you hold JNJ stock, but if you bought the company outright you would amortize the goodwill. The value of JNJ within Fairfax grows as the earnings at the company grow, this grows book value for Fairfax. Now, if Berkshire took JNJ private the value of JNJ on Berkshire's balance sheet would not grow along with the profits -- you would have instead the amortizing goodwill. Lastly, Fairfax trades them to generate profit in excess of the look-through earnings of those underlying stocks. Berkshire trades to a far lesser extent, largely because of size, but of heavy importance due also to culture (won't trade privately held subsidiaries). On a relative basis Berkshire's results are driven much less by trading.

I spent quite a while on ShadowStats.com today. I take it the feeling is that the government can hold down CPI calculations to fix budget issues by limiting payments to Social Security. Why then have they rigged it so that FICA taxable income also is pegged to the CPI? I mean, if they keep CPI down sure it limits payouts, but it also limits revenue at the same time. Probably wasn't wise to link taxable income to CPI if they are rigging it. I couldn't find anywhere on ShadowStats where he admits the government is also deliberately holding down their revenue -- not that he would say that given that he is selling his data. My grandmother (Australia) doesn't trust the CPI either. She too thinks the CPI numbers are bunk. I think the CPI has understated inflation, but I think the real rate of inflation is somewhere in between the two. For instance, I don't think a median house is going to be as low as the $112,000 or so that the CPI suggests it would be if houses followed the general trend of consumer prices. Yet I don't think $300k sounds right either.

I hear you, it sucks to say steak one day and hamburger the next. But once the switch is made, it no longer upsets the differential in CPI for subsequent years. For example, I will have a higher degree of confidence next year when I get the 2010 BLS numbers because I'll at least be satisfied that they are measuring the right thing. If I pay this guy for his shadowstats.com numbers I will get a less useful view of consumer inflation because I will be seeing the price of steak which is a luxury, vs the price of a more widely consumed item. I don't want to continue on the wrong path forever simply for consistency -- consistently inaccurate is not a good thing. If we're supposed to be measuring the most broadly consumed items, then lets do it and quit fucking around with steak which doesn't allow us to arrive at what we're trying to measure in the first place which is the cost of living, not the cost of luxury. The sin as I see it was that they didn't correct the index soon enough, not that they should never correct it at all. I don't care if seniors can't afford steak with their Social Security income -- let them eat hamburger! (that was a joke). Nevertheless, past (hamburger for steak) substitutions in the CPI do not explain why ShadowStats.com suggests that the rate of inflation was approximately 3% higher per annum every single year this decade. You might get a distortion in the very year that a substitution is made (as you describe, $2 steak for $1 hamburger), but this is ridiculous. Every single year! True, homes are not components of the basket, and Shiller knows this. However he argues that homes cannot increase faster than inflation, and he uses the CPI as his measure of inflation. The price to rent ratio was adequate in 1970, rent is a component of CPI, and it's widely accepted that in the long run prices should rise in line with rents. Therefore, although housing prices are not directly a component of the CPI it does actually make a good deal of sense to use rents as a proxy for house prices given that only a bubble should be responsible for a large distortion in the price/rent ratio.

We went through a period where Berkshire held huge positions in stocks like KO that are worth less in price today than they were 10 years ago, even though the earnings power of KO has grown significantly. I think if you look at their look through earnings of today vs 10 years ago it will show that Berkshire's intrinsic value has grown much faster than book value. This law of large numbers isn't what happened to Berkshire the past 10 yrs. Instead, it was the law of compressing equity portfolio valuations.

Book value growth at Berkshire does not matter. What does matter is this: From the 1999 AR Reported operating earnings of Berkshire 1,318 Total look-through earnings of Berkshire $ 1,926

Shadowstats.com has an inflation calculator that give us the "real" rate of inflation (although their data is secret unless you pay them a fee). So I plugged in $17,000 for the median priced home in 1970 to see what it is "really" worth today: http://www.shadowstats.com/inflation_calculator?amount1=17000&y1=1970&m1=1&y2=2009&m2=8&calc=Find+Out CPI is a measure of the cost of a basket of consumer goods and services... and originally used to indicate the impact of price inflation on an "average" consumer. During the Clinton era, the basket of goods and services was changed , like substituting hamburger for steak, which had the effect of understating the rate of CPI inflation. Shadowstat's calculation of CPI uses the prices of the original basket components in order to track the inflation of an unchanged basket, and hence gives a different, higher number. For rates of inflation in USD of housing assets you should refer to the Case Schiller index and for rates of inflation of stocks or other assets, check the appropriate industry price index. Robert J. Shiller is the author of a book titled Irrational Exuberance Second Edition. I have a copy of this book sitting here next to me. He makes a case that house price outpaced their "real" values, as measured by the CPI (as measured by the BLS). Now, if Shiller had instead used the data provided by ShadowStats.com then he would have been forced to conclude that housing was getting cheaper in real terms, as opposed to more expensive. Perhaps then the title would have been Rational Exuberance. Yes, the CPI has been altered. But why do you feel that steak a more reliable measure of inflation than hamburger? Supposing for a minute that there is a real conspiracy by the government to underreport CPI, how would they know ahead of time that hamburger would rise in price at a slower pace than steak? Once the CPI adjustment is made, on a going forward basis the price of hamburger should still increase with inflation right? So shouldn't the price of hamburger be perfectly reasonable to use as a price measure for say, 2005 vs 2004 CPI calculations? Hamburger is consumed in much greater quantity, and steak is really a luxury item. I would say steak is to hamburger as first class seating is to economy seating, and if they CPI were based on first class seating I would think it reasonable to correct the mistake and base it on economy pricing given that it's what's purchased most broadly.

Shadowstats.com has an inflation calculator that give us the "real" rate of inflation (although their data is secret unless you pay them a fee). So I plugged in $17,000 for the median priced home in 1970 to see what it is "really" worth today: http://www.shadowstats.com/inflation_calculator?amount1=17000&y1=1970&m1=1&y2=2009&m2=8&calc=Find+Out It turns out that the official BLS data suggests it is worth $113,258, and (while they won't give out the exact number for free), the ShadowStats data suggests that home is worth nearly $300,000 today. The height of their block 2.5x to 3x the height of the CPI-U block (suggesting at least 2.5x to 3x the price of $113,258). Hmmm.... is that really the inflation adjusted price? It feels to me like the BLS number is closer, but that's because I doubt the real price of the median 1970 house is anywhere close to $300k.

Those returns don't look cheery, and can you imagine how bad it looks on an after tax basis? Especially if you were in the top marginal tax rate (as high as 94%): http://www.truthandpolitics.org/top-rates.php It's hard to belive that in my lifetime, tax rates were as high as 70%. Everyone should convert their IRAs to RothIRAs next year when there are no income limits. Get out while you can. (that's my fear mongering for the day)

The bond market looked similar in the 1940s, but I don't think it was a good time to buy long term bonds.

A quarter of them are $125 and $140 strike Jan 2010. Then I have 2011 calls with strikes of $200 and $210. There are no 2012 available. My 25% cash position is there for taking delivery, or buying more calls if I need to (I will need to if it gets really cheap again). I don't want to bet against inflation, don't want to bet against a market pullback. So I have 50% hedged for inflation and 50% hedged for a market pullback. At $23 WFC is only 1.27x book -- that's quite silly if we can put the $7.80 market bottom out of our minds.

50% notional deep-in-the-money FFH calls (ties up 25% of my cash) 50% TIPS (10 yr Treasury Inflation Protected Securities maturing July 2019) 50% WFC naked puts, 2011 $30 strike 25% cash The TIPS are great -- my principle rises with inflation, can't go below the original issue principle with deflation, and need barely any margin backing. And there is a little interest income that ought to defray the tax due on the CPI adjustment gains. 1) I am hedged against a pullback to $23 in WFC 2) I don't need the WFC price to rise more than like 5% in order to grab 30% gain 3) I have a decent upside potential with FFH calls 4) I am 50% hedged against inflation with the TIPS (hopefully HWIC will one day hedge the other half via FFH).

I doubt too many of them have fixed incomes of any meaningful size outside of Social Security, which is indexed to the CPI-U.

I don't think people will feel comfortable buying stocks on margin if the earnings yield is lower than their margin interest rate, and with higher interest rates I would think it would put the brakes on earnings for levered companies. But one never knows :)

I'm curious about these "goldbugs", apparently they are withholding part of the narrative, and its now time to wonder why. Who are they? What part of the narrative are they withholding? are they nefarious? are there motives impure? Are they to blame for the short run on the USD? Should they be suppressed? "They" are the people who do not look critically at the magnitude of the movements. They seem to be intellectually satisfied that the price of gold is rising in USD terms, that the US dollar is declining based on Fed monetary policies and huge deficits far out in the future, and therefore they leave it at that. "They" forget to say that "well, that being said, the price of gold is soaring in terms of ALL world currencies", and they forget to then wonder what will happen if the price of gold adjusts to the extent that it has overshot these other relatively more sound currencies. The guy in this article is such a character -- taking a relatively short time period (8 years) and explaining how much "Pricing U.S. homes in gold reveals that housing has fallen by two-thirds from its 2005 peak. ". It takes only a small amount of critical thinking to realize that most things, houses, Swiss/Austrlian/Canadian currencies for example, have fallen from their 2005 levels if you compare them to gold. For some reason he was perfectly happy in drawing such a conclusion -- maybe looking for disconfirming evidence is not interesting to him. Or perhaps for sensational effect he just wanted to find something that has risen wildly in price and use it to price houses. I personally don't see what value he gets from doing this -- you ask if his motives are impure, and who really knows. Maybe he just wanted to sensationalize the housing crash in order to draw in more readers, see how many hits he can get. They do this on the evening news -- often seeming to exaggerate a story for dramatic effect. What drives them? I can't imagine.

Here is an interesting article on a website which documents your "narrative fantasy". If gold was the ultimate sound money then this analysis documents the actual rise and fall of the US housing bubble: http://www.oftwominds.com/blogsept09/housing-gold09-09.html Cheers Fun and games with an oscillating value. The key points in the article are "For the past eight years. " Never mind the entire data set, let's just keep the conversation focused on the periods when gold has risen against the dollar. Of course, this also showcases not just housing was overvalued, but Candian dollars, Australian dollars, Swiss francs... everything that fell steeply against gold over the past 8 years. Since 1970 though, housing has become cheaper in gold. Therefore, housing must have been in a bubble in 1970 too, using the same logic in that article. The fact is that housing was in a bubble this decade -- that's not under dispute. But a narrative can be developed that gold is only rising because the USD is being debased... and that accounts for part of the rise no doubt... however when gold makes even the Swiss franc look like it's under rapid devaluation, then it's time to wonder what part of the narrative is not being told by the goldbugs.

I have been reading the book this week... apparently Davis used the maximum margin the SEC allowed, which the book describes as "the maximum the SEC allowed--slightly more than 50 percent". He owned a seat on the NYSE, so his firm had access to cheap margin rates and looser margin restrictions.

The P/E is higher than PG or JNJ. Why?

Mostly I'm worried about a rise in price level -- after all, I don't want to see my net worth being drawn down at an ever growing rate by a rising cost of living. A dropping dollar will eventually translate to a rising CPI. One strategy I thought of a short while ago is to buy TIPS in a margin account. Being a government security, the margin requirements are very little so I can leverage 2:1 without worrying about a margin call. Idea: 1) start with 100% cash in a margin account 2) deploy the cash 100% into TIPS 3) write far out-of-the-money naked puts on companies that you would normally love to own, and make it such that you can buy 100% if you get assigned from your initial cash balance This accomplishes: 1) capital gains in line with a rising CPI from the TIPS 2) income from volatility decay on the naked puts 3) protection from a falling market P/E if inflation rises and market crashes (if you get assigned the shares, the high earnings yield will give you some good earning power protection from inflation) negatives: 1) You can't achieve 100% CPI protection from the TIPS because you get taxed each year on the gains from the CPI adjustment 2) Writing out of the money puts you pay capital gains taxes, whereas if you just owned shares you get tax-deferred compounding. 3) CPI might not keep pace with the costs that matter the most to you, or government might lie in the CPI computation, etc... Anyhow, it's yet another strategy.

Actually the 1970 official price of gold (35.00 USD) was indeed manipulated.. by the US Federal Reserve.. it had for some time been over creating US dollars and unable to redeem all its dollars for gold at the fixed rate. By closing the gold window, Nixon was in fact stiffing all foreign holders of US dollars and shifting the burden of government debt to foreigners. There was a small free market for gold in Macau at that time which operated outside of the USD world... gold was traded freely then at about 75.00 per oz, and indeed within a year of the depegging, the price in the international market rose to the Macau price. When gold rose to its 1980 high of about 800 bucks, it did so in response to the fear that the US buck would implode because of dillution. There was a speculative frenzy which lasted a very short time, shorter than last year's speculative frenzy in oil. Quoting 800.00 USD as a peg price in 1980 is as accurate as pegging the price of oil at 150.00/bbl in 2008. In inflation adjusted terms (even using "official" CPI numbers which understate USD inflation), the price of gold has remained relatively stable since the initial adjustment after depegging. Mr Market set the Macau price in 1970 at $75, and Mr Market is setting the price today at $970, which is a rise of 12.93x. The 1970 median housing price of $17,000 priced in gold by Mr Market, is worth $209,100. So housing prices have actually fallen in real terms. Amazing how everyone can be so easily misled to believe that housing prices rose faster than inflation, right? Well, no. The problem is that the current price of gold is set by (as we all know) the immensely rational Mr. Market, the same level headed person that set the price in 1970, and of course also set the price under $300 earlier this decade. There are narratives to fit the prices, but beware of narrative fallacies.

Mungerville, I picked 1970 because gold was still pegged to the dollar and I knew the price of gold off the top of my head without having to look it up. In 1980 gold wasn't pegged to the dollar, it was driven by speculative/investment demand, and I don't want to use such a period as a terminal point for that reason. Instead, 1970 is a good terminal point because gold/usd wasn't manipulated by speculators. Today (similar to 1980) USD is not pegged to gold and so... are we driven by fundamentals now or investors/speculators? This is the unknown I fear, so I look to how gold is rising vs other more stable currencies (like AUD and CDN) as clues to whether gold is merely rising in USD terms, or rising absolutely against a whole basket of currencies that most of us deem fairly safe alternatives to the USD. It turns out that gold is a ballistic missile relative to those currencies.