All Assets are Overvalued Except Commodities

As many investors realize there are very few places to run from depreciating money given the overall flattish yield curve and historically low interest rates, alternative investments are entering the spotlight. With a persistent inflation rate, money must travel in search of a yield to avoid withering away, yet the present lack of positive real interest rates has made this task near impossible. There is only one asset class that naturally benefits from this environment and this explains why it has outperformed all its competitors. The asset class in reference is precious commodities, and understanding why the competition is weak is key to understanding why rare commodity prices will remain strong and why its the only answer to where money should go at present.

Stocks are Overvalued

Despite very weak inflation adjusted returns over the last decade, stocks still remain a poor investment relative to key metrics. The best and most common measure of a stock’s value is its price to earnings ratio. This breaks down the price of a stock to the earnings one can hopefully expect per share unit, and this provides an objective way of comparing varying stocks or measuring the market as a whole

This means that for every $23 dollars you would need to spend to acquire a stock you’ll receive only $1 dollar in earnings per year. Effectively, the stock would need to keep pace with its current earnings for the next 23 years just to fundamentally justify the base purchase price today, book value aside. If current earnings are likely to decline on an inflation adjusted basis, this situation is much worse.

In many respects, the current p/e ratio indicates stocks are too expensive. For one, the historical mean p/e is 16.41 to 1 and the median ratio is 15.81 to 1. Stocks right now, then, are at least 40% more expensive than their historical average.

In addition, dividends from stocks do not even make up for inflation. The dividend yield of the entire S&P 500 index is 1.94% per year, which is about 1% below the current Consumer Price Index (CPI) annual increase. Therefore, dividends actually are producing negative real returns, destroying the purchasing power of investor’s funds.

This means that for every $23 dollars you would need to spend to acquire a stock you’ll receive only $1 dollar in earnings per year. Effectively, the stock would need to keep pace with its current earnings for the next 23 years just to fundamentally justify the base purchase price today, book value aside. If current earnings are likely to decline on an inflation adjusted basis, this situation is much worse.

In many respects, the current p/e ratio indicates stocks are too expensive. For one, the historical mean p/e is 16.41 to 1 and the median ratio is 15.81 to 1. Stocks right now, then, are at least 40% more expensive than their historical average.

In addition, dividends from stocks do not even make up for inflation. The dividend yield of the entire S&P 500 index is 1.94% per year, which is about 1% below the current Consumer Price Index (CPI) annual increase. Therefore, dividends actually are producing negative real returns, destroying the purchasing power of investor’s funds

Commodities are the Only Answer

Competitive valuation is largely the reason commodities have outperformed all the above asset classes in recent times and given that all other assets remain heavily overvalued, commodities should continue to shine. Real assets have more going for them than just competitive returns as well, and will be sought after for safety, quasi-insurance, and protection in an unusually uncertain economic environment. Commodities are unique in that there is no counter-party risk and the strong liquidity is sought after while economic calamities plague the global financial environment and credit system.

To keep trade competitive, governments around the world are debasing their currencies in an attempt to cheapen their goods on the international market. Instruments that are tied to cash, therefore, are in constant danger of governmental manipulation cheapening their returns. In addition, many assets are presently driven by the credit environment and the sustainability of the credit system has never been in such disarray in modern history. Given these facts its not hard to see why the only assets which have no credit risk, cannot be debased, and have strong liquidity are outperforming the rest.

On a valuation perspective, commodities do not have traditional financial metrics since they do not produce cash flow, but there do exist contexts which provide a means for measurement. For one, on a historical basis, commodity prices still seem attractive, as many agricultural and metal commodities are trading below their nominal highs and almost all are trading below their inflation adjusted highs. Furthermore, gold, one of the most reserved commodities, only makes up less than 1% of global asset allocation which is about at a historical low.

Another major, under-appreciated reason to see commodities as undervalued is the presence of large outstanding naked shorts in the derivatives markets which imply a potential short squeeze effect continuing if price rises persist. All this said, and remaining powerfully true, the real valuation driver for commodities, however, is the deterioration of the currencies they are priced in. With the present intention of central banks to monetize the collapsing credit system, there is no visible end to the potential for commodity price rises then.

The notion that commodities are the only place to run is no longer unique to “gold bugs” like us either. The philosophy is starting to hit the mainstream as money managers find it increasingly difficult to find returns by traditional investment allocations. For example, the lack of real returns in bonds and stocks was recently pointed out by famed bond king Bill Gross in a Bloomberg interview:

In all, the commodity market is far from saturated and the fact remains that there are no other viable alternatives to park cash in at present. So far as this remains true, the commodity bull market will continue to roar forward.

On Auditing the Treasury's Gold

Last week Congressmen Ron Paul held a hearing,, to investigate whether or not the Treasury’s gold stock remains in tact and in US custody and ownership. The Treasury’s Inspector General Eric Thorson and the Government Accountability Office’s Gary Engel were called into be questioned by the House Financial Services Sub-Committee on Monetary Affairs regarding a bill Dr. Paul introduced called the Gold Reserve Transparency Act (HR1495). In short the Gold Transparency Act calls for a full audit and assay of the US government’s gold stock.

To assess the necessity of continuing audit-efforts and pursuing new audit measures of greater scope, I will show a review and history of past audits and expose their apparent deficiencies:

History of Recent Audits

In 1974, after the US closed the gold window, congressional support grew for inquiring into the US gold stock. The Mint and the GAO were sanctioned to audit a portion of the Treasury’s gold. Three out of thirteen compartments at Fort Knox were audited for inventory and samples were assayed and compared to records currently held by the Mint. Following this partial audit the Treasury created the Committee for Continuing Audits of the United States Government-owned Gold in 1975 to annually inspect the accuracy and adequacy of the Mint’s records and internal procedures. These inspections involved auditing about 10% of the US Mint’s gold annually in an attempt to cycle through the whole gold stock. By 1986, the Treasury’s Inspector General managed to halt the audits under the notion that most of the Mint’s gold had already been audited, about 92%, and sealed and no significant issues were yet found. The costs of the procedures were also a stated concern in the halting of continuing audits.

Since then, starting in the 90′s under 31 U.S.C., the audits were mostly indirect efforts as the Mint’s financial statements and Custodial Schedule are annually audited by public accountants at KPMG. There still existed some audit-work that was partially direct up until 2008 by the Treasury OIG as their annual assessments of the mint’s Custodial Schedule statement included direct checks of statistical samples, using a 95% confidence criterion, to verify the number of gold bars in each melt, the melt number for each gold bar, and the fineness stamped on each gold bar.

The above mentioned audits, and in particular present audit-work, are not a review of old audit methods or a new audit of previously reviewed gold, but rather a process of confirmation that joint seals placed on the vaults during their original audits were not compromised. The joint seals, assuming no external breach, can only be compromised by the presence of three individuals; a representative from the gold storage facility, a representative of the Director of the Mint, and a representative of the Treasury OIG. The only aspects of the gold stock that are newly audited, i.e. checked for inventory and fineness, are of gold that was not previously sealed or had a broken seal for whatever reason.

By 2008, the Treasury OIG proclaimed that all 42 of the Mint’s gold compartments, or 100% of the Mint’s gold, were audited and sealed. As a result, all audits since 2008 only involved checking that the joint seals remain intact. None of the audits by KPMG, GAO or the Treasury OIG include an inventory or assay of any of the 5% of the Treasury’s total gold that is stored at the Federal Reserve Bank of New York, or the Treasury’s working stock of gold. The extent to which the US Treasury attempts to verify their gold holdings in the Federal Reserve Bank of New York involves annually requesting a confirmation from the Federal Reserve regarding the status of US gold reserves held by the FRBNY.

Furthermore none of the audits that occurred in the past fully assess the Treasury’s compliance with outstanding legislation with regard to their use of their gold. These cautionary statements are included in all audits by the Treasury and KPMG:

“We limited our tests of compliance to those provisions and we did not test compliance with all laws and regulations applicable to the Mint. We caution that noncompliance may occur and not be detected by those tests and that testing may not be sufficient for other purposes. Providing an opinion on compliance with laws and regulations was not an objective of our audit and, accordingly, we do not express such an opinion.”

KPMG further notes that they simply trust numbers they are given, rather than independently verify quantities relating to gold ownership:

“We did not audit the amounts included in the financial statements related to the gold and silver reserves of the U.S. Government, stated at $10.9 billion as of September 30, 2005 and 2004.” “The gold and silver reserves of the U.S. Government and the financial statements of the IRS as of and for the years ended September 30, 2005 and 2004, were audited by other auditors whose reports have been provided to us and our opinion, insofar as it relates to the amounts included for the gold and silver reserves of the U.S. Government and the IRS’ financial statements, is based solely on the reports of the other auditors.”

Here is an up-to-date version of the same effective statement by the only independent auditing party, KPMG:

“We did not audit the amounts included in the financial statements related to the gold and silver reserves of the U.S. Government or the financial statements of the Internal Revenue Service (IRS), a component entity of the Department. The gold and silver reserves of the U.S. Government and the financial statements of the IRS were audited by other auditors whose reports have been provided to us. Our opinion, insofar as it relates to the amounts included for the gold and silver reserves of the U.S. Government and the IRS’ financial statements, is based solely on the reports of the other auditors.“

Outstanding Reported Gold Discrepancies

There are at least a couple mismatches between financial statements of the Treasury and the reported finances of the Federal Reserve that are worth noting. An obvious example found is in 2004 and 2005, Federal Reserve owned gold certificates are stated at a level that is greater than a necessarily equivalent liability from the Treasury. The Treasury only adds a liability of $10,924 million for issuance to the Fed while the Fed reports a gold certificate holding of over $11,036 million for the same period.

Iran Says “Gold Is Money”

Economic crises signal that the current system isn’t working as expected and needs improvement. When it comes to monetary systems, questioning their fundamentals can lead to doubts about whether the preferred medium of exchange will continue to be preferred for long. The large-scale whirlwind of economic trouble around the globe has pushed some to rethink the role of gold in the economy – and to actually move toward bringing it back.

A month ago, a rumor that India is going to pay in gold for oil imported from sanction-struck Iran sent shockwaves through the markets. It was no small deal, both in principle and volume: India is one of Iran’s largest oil buyers, responsible for about 22 percent of total exports and worth about US$12 billion per year. China is next with 13 percent, and Japan is third with about ten. All of them are having a hard time dealing with Iranian oil imports, as the country is under sanctions caused by Western fears regarding its nuclear program.

Then an Israeli news site claimed exclusive knowledge of a possible workaround between India and Iran: settling the purchases in gold. Indian government officials refused to comment, which added to the speculation.

On the surface, the arrangement looked like a great way to settle the purchases via a stable medium: Iranian currency, the rial, is not widely used outside its border, and gold’s inherent anonymity would have provided a perfect way to avoid unnecessary attention from the global community. Ironically, it was precisely the fact that the settlement was planned in gold that attracted so much attention.

It proved to be nothing but a rumor, however: the sides decided to arrange the deal in a more tactical manner. India will partly cover the purchases with its own currency, and Iran will later use those funds to acquire imports.

But gold is not out of the equation yet. The US-initiated sanctions were effective, at least in the sense of making international institutions avoid the pariah nation. Reuters reported that Iran has failed to organize imports of even basic food staples for its population of 74 million. Prices on local markets rose sharply; and as the country neared parliamentary elections on March 2, the government was taking radical steps to provide citizens with basic necessities. One of those unconventional solutions was offering gold as barter for food.

“Grain deals are being paid for in gold bullion and barter deals are being offered,” one European grains trader said, speaking on condition of anonymity while discussing commercial deals. “Some of the major trading houses are involved.”

Another trader said: “As the shipments of grain are so large, barter or gold payments are the quickest option.”

Trading in gold rather than a fiat currency is “cashless.” That may sound as if there’s no medium of exchange, but that is of course a misconception: gold is history’s longest-standing medium of exchange.

As long as the sanctions remain in force and the Iranian government has limited access to international currency markets, gold will remain an obvious way to settle transactions. Decreasing oil imports to Japan, the world’s third-largest importer, will impact the Iranian economy further, draining foreign currency inflows. Lacking foreign currency may push the country to continue using its foreign exchange reserves, or gold, to cover its international liabilities. Oil looks like a viable, though less convenient, alternative as well.

The Iranian economy is in a state of crisis, and due to the lack of trust in its currency, leaders are increasingly resorting to extraordinary offers to trading partners. The situation would clearly worsen if the country enters a state of war. While that’s still speculation, imagine what would happen to the price of gold if a part of Iran’s 29-million-ounce gold reserve becomes a medium – not an object – of exchange in international trade.

That reduction in potential supply could be a game-changer, not only because of crisis-struck Iran, but because it could open the door for other countries to follow suit. The price of gold would likely respond very positively.

This scenario, while possible, may not happen very soon: large-scale trading in gold has occurred only rarely in recent years. Traces of deals are difficult to track down due to the anonymity of the yellow metal. This re-emphasizes our point regarding gold as money in extremis: when economic push comes to shove, gold will outlast any other medium of exchange in existence. As the evidence from Iran shows, even governments – the masters of the central banks – will resort to mankind’s oldest form of money when pressed.

Which brings us to this evergreen conclusion: Gold is one of the best assets to own in both good times and bad. It can rise with inflation in a surging economy, and it can be practical for exchange when times are bad.

Gold isn’t just a hedge; it’s money.