Gold Still Looks Good; Japan Still Doesn't

By LESLIE P. NORTON | MORE ARTICLES BY AUTHOR

The editor of Grant's Interest Rate Observer on gold, gold stocks, the gold standard and why he's stopped investing in Japan.

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When Jim Grant left Barron's in 1983, after inaugurating the Current Yield column, bonds already had ended their long bear market and begun the great ascent that put 10-year yields around 2% last week. Grant founded Grant's Interest Rate Observer, and in nearly 30 years of publication, his beautifully written musings on the markets have become de rigueur reading among cognoscenti who appreciate big doses of financial history served up with compelling investment ideas. Among Grant's greatest calls: The eye-catching bull market in gold. We caught up with him last week, as gold was fetching $1,800-plus, European banks wobbled, and central banks pumped dollars into the system to avert the crisis.

Barron's: Is gold in bubbly territory?

Grant: A bubble is a bull market in which the user of the word "bubble" has not fully participated. You can think of gold as a stock that went from 2⅝ to 18 in a dozen years. I'm not sure that's a bubble. It is the nature of gold that its valuation must forever be a mystery. It earns nothing. It pays no dividend. No conference call, no management to call up and complain to. What I do think is gold is simply the reciprocal of the world's faith in the institution of managed currencies. It is one divided by T, where T stands for trust. And trust is a shrinking number and will continue to shrink. Therefore, I am still bullish on gold.

If a bubble connotes absurdity, what is absurd are the monetary conditions that supported this gold bull market. Gold is an expression of the world's justifiable distrust of the way our central bankers conduct their affairs. The poetry of it is that it can't be quantified. The central banks are unworthy opponents. The Fed has pledged 0% money-market rates for the next two years, so that's not much competition. And the governments of the world are taking under advisement this notion called financial repression—short-circuiting market mechanisms, capital controls, punitive taxes or intrusive taxes and the like.

"You can think of gold as a stock that went from 2⅝ to 18 in a dozen years. I'm not sure that's a bubble. " -- Jim Grant

And I thought you were introducing a Freudian concept.

This is economist talk, made not on the couch, but in the pits. Gold is a desirable asset for people who wish to get out of the way of the fire of financial repression, which is more a threat at the moment than a promise. Governments certainly have it in their capacity to interrupt capital flows and make life difficult for people with wealth.

The gold standard, which you've championed, is now getting its due.

I'm talking about the classical gold standard that ended with the guns of August 1914, not the successors. Indeed, some of the variations are not much better than the present-day paper-money system. One of its essential features is that there is no reserve currency. Markets are distorted by the huge outpouring of paper currencies. With the gold standard, nobody gets a special credit card, everyone gets a debit card, and deficits and surpluses are settled promptly in cash. The essential feature of the current monetary system is procrastination. It's "Oh, we'll get to that, we'll balance accounts later." But it turns out we don't.

What are the Fed's other errors?

Both Alan Greenspan and Bernanke in 2001 to 2003 were on a campaign to anticipate a deflationary threat. They said that we had to act lest we tumble down the stairs that Japan did in the 1990s. But never once did they define this phantom that they held out to be a clear and present danger. Most Americans spend some part of the weekend hunting down everyday lower and lower prices. And in a world blessed with digital technology and with the introduction of great new swathes of territory in which something like market economics are practiced, and with the inclusion of hundreds of millions of willing new hands into the world's labor force over the past 15 years or so, wouldn't you expect a tendency toward falling prices? That is called progress.

Deflation to me is trouble with debt, a symptom of which is falling prices. In a debt crisis, companies can't finance, they have to liquidate inventory, sell stuff at a loss—that's deflation. But Bernanke and his predecessor never distinguished between everyday lower prices and deflation. Having made their error, they suppressed the funds rate for more than a year at 1%. If there had been a sensible discussion about this, much of the distress of the past 10 years could have been avoided.

You once had high hopes for a recovery that doesn't seem to be materializing.

We observed in 2009 that, if an economy goes down hard, the first year of the recovery tends to be very strong. It was a bad call. As for the economy now, I don't know. We always look from the bottom up for valuations and mispriced securities and markets, rather than make calls based on some expectation for the macro economy.

How does Europe's mess end?

The dollar will become the beneficiary of this mess. The euro is Confederate money. It is the emission of a confederation of states. It's an indictment of the dollar that it for so long was trading at 1.40 euros, rather than 1.15 or 1.05. The centrifugal forces in Europe are strengthening, and they are beyond the capacity of governments to deal with. The euro will break up. At the margin, Europeans with money will seek a haven in this country.

What about inflation?

The Fed has achieved something unique in this cycle. It has given us symptoms both of inflation and deflation. The Fed has overdone it with quantitative easing and rate reductions; the symptoms of that are the dollar exchange rate, the price of gold in dollars, commodity markets generally and a lot of speculative assets. The measured rate of rise in consumer prices is not minus 3.6%, year over year, it's 3.6%. We have too much debt, and a consequence of that is a tendency for some prices to fall. We have too much money, a symptom of which is that some prices rise. What an interesting world we live in.

What does this mean for bonds?

We are living in the mirror image of the excesses of 25 and 30 years ago. Then there seemed no hope for interest rates ever coming down. The bond market had been going down since 1946, with mainly rising rates by 1980. People called these bonds "equity-like returns without equity risk," or "certificates of confiscation." Today, yields are no longer 15%. They are 3% and 4% and, after five years, if you have no magnifying glass, you have to squint because they're so small. But people have come to see that bonds appreciate in price as yields fall. But it is remarkable that people are flying for safety into a class of security denominated in the very paper money that others are flying from. The great gold bull market is driven by people in flight from paper currencies. Somebody has not gotten the memo.

Are we in a Japan scenario?

I don't think so. I invested in Japanese value stocks, and had occasions to note over and over the reluctance of the Japanese to admit error and reprice. Companies that deserved bankruptcy would often not be allowed to meet their just deserts, but were carried on the back of banks that themselves had no true claim to solvency but were supported by the government. Capitalism is not just about success—that's the easy part. It's also about failure, recognizing it, dealing with it, liquidating it, properly pricing it. The Japanese have been unable to do that, and this characteristic was on display in the 1920s as well, so I take this to be a salient Japanese trait.

Grant's Picks...

		Recent
Company	Ticker	Price
Agnico-Eagle	AEM	$68.08
Bank of NY Mellon	BK	21.19
CVS Caremark	CVS	36.90
Exxon Mobil	XOM	74.01
Microsoft	MSFT	26.99
Newmont Mining	NEM	64.29
Tocqueville Gold Fund	TGLDX	88.97
Yamana Gold	AUY	15.82
...And a Pan
China Coal Energy	1898.HK	9.68 HKD
Source: Bloomberg

Now America has perhaps too forgiving a system of bankruptcy. We are pretty good at acknowledging enterprises that don't work and going on to the thing that does. In 1920-1921, we had a very steep, painful depression, with wholesale prices down 30% to 40%, unemployment at perhaps 12%. But it ended, despite the Treasury's running a surplus and the Fed raising interest rates over the course of the downturn. Markets tend to clear. To the extent that we allow markets to clear, we'll be on our way. I'm not a believer in the Japanese and parallels with Japan.

You were a great believer in Japanese equities. What happened?

With my friend Alex Porter, I was a general partner in Nippon Partners from 1998 through the end of 2010. We invested in Japanese value stocks. We closed it in December of 2010, because we weren't making money, and it was immensely frustrating. Japanese corporate managers, by and large, don't own equity. They have a platonic interest in the stock price. In the absence of a lively market for corporate control, there is no check on management doing nothing. In 1998, we began investing in companies whose shares were trading well below their pro-rata share of net cash on the balance sheets. In this country, in 1974, 1975, there were a lot of companies like that and they did rather well in the 1970s and the 1980s. But in Japan, many [companies like these] remained at these compelling valuations for year upon year upon year. You get tired. The last straw was when one of our companies was selling at a huge discount to everything, and announced that it would undertake a capital investment larger than its stock-market capitalization.

You just published Mr. Speaker!, a biography of the great House Speaker Thomas B. Reed. What did you learn?

He was that rarest of creatures, an intelligent, principled and, not least, funny politician, who transformed Congress through his parliamentary skill and wit. In Reed's day, the final quarter of the 19th century, the wingnuts, the eccentrics, were those who argued for a paper currency uncollateralized by gold. Today, the eccentrics are the gold people. The establishmentarians are teaching at Princeton and running the central bank. I learned that cycles forever change and that wingnuts and establishmentarians change places, even before you know it.

Let's have some investment ideas.

We've been looking more and more at blue chips, such as Microsoft [ticker: MSFT], Bank of New York Mellon [BK], CVS Caremark [CVS] and ExxonMobil [XOM]. These big, world-dominating U.S. companies are well-financed and adaptive, they have thrived in different monetary environments. ExxonMobil, in the five years through 2010, had an average return on capital employed of 27%. It has boosted its dividend 5.7% annually since 1983, about double the rate of rise in the CPI since then.

Gold will go up a lot, and that's as finely calibrated as I can get. I like some individual gold stocks, like Yamana Gold [AUY], Agnico-Eagle [AEM] and [ Newmont Mining [NEM]. They are very cheap. But a mutual fund like Tocqueville Gold [TGLDX], which John Hathaway manages, can be a better bet; John has been at this since the late 1990s and done much better than the S&P and the XAU [gold index].

What do you dislike?

China, and China Coal Energy [1898.HongKong], the No. 2 miner in China. Weak margins, spotty disclosure, a convoluted organizational table and burgeoning accounts receivable are just some of the problems.

Thanks, Jim.