What It Takes to Be an Objective Scholar

Economics on Trial
April 2000

What It Takes to Be an Objective Scholar
by Mark Skousen

“It was the facts that changed my mind.” -Julian Simon (1)

During the 1990s we watched the Dow Jones Industrial Average increase fourfold and Nasdaq stocks tenfold. Yet there were well-known investment advisers-some of them my friends-who were bearish during the entire period, missing out on the greatest bull market in history. (2)

How is this possible? What kind of prejudices would keep an intelligent analyst from missing an overwhelming trend? In the financial business the key to success is a willingness to change your mind when you’re wrong. Stubbornness can be financially ruinous. When a market goes against you, you should always ask, “What am I missing?”

Over the years, I’ve encountered three kinds of investment analysts: those who are always bullish; those who are always bearish; and those whose outlook depends on market conditions. I’ve found that the third type, the most flexible, are the most successful on Wall Street.

Confessions of a Gold-Bug Technician

A good friend of mine is a technical analyst who searches the movement of prices, volume, and other technical indicators to determine the direction of stocks and commodities. Most financial technicians are free of prejudices and will invest their money wherever they see a positive upward trend, and avoid (or sell short) markets that are seen in a downward trend. But my friend is a gold bug and no matter what the charts show, he somehow interprets them to suggest that gold is ready to reverse its downward trend and head back up. Equally, he always seems to think the stock market has peaked and is headed south. As a result, throughout the entire 1990s he missed out on the great bull market on Wall Street and lost his shirt chasing gold stocks.

I also see this type of prejudice in the academic world. Some analysts are anti-market no matter what. Take, for example, Lester Brown, president of the Worldwatch Institute in Washington, D.C., who puts out the annual State of the World and other alarmist surveys and data. He gathers together all kinds of statistics and graphs showing a decline in our standard of living and the growing threat of population growth, environmental degradation, the spread of the AIDS virus, and so on. For example, despite clear evidence of sharply lower fertility rates in most nations, Brown concludes, “stabilizing population may be the most difficult challenge of all.” (3)

Too bad Julian Simon, the late professor of economics at the University of Maryland, is no longer around to dispute Brown and the environmental doomsdayers. Simon was as optimistic about the world as Brown is pessimistic. Simon’s last survey of world economic conditions, The State of Humanity, was published in 1995. That book, along with his The Ultimate Resource (and its second edition), came to the exact opposite of Brown’s conclusions. “Our species is better off in just about every measurable material way.” (4)

Yet Julian Simon was not simply a Pollyanna optimist. He let the facts affect his thinking. In the 1960s, Simon was deeply worried about population and nuclear war, just like Lester Brown, Paul Ehrlich, and their colleagues. But Simon changed his mind after investigating and discovering that “the available empirical data did not support that theory.” (5)

Scholars Who See the Light

The best scholars are those willing to change their minds after looking at the data or discovering a new principle. They admit their mistakes when they have been proven wrong. You don’t see it happen often, though. Once a scholar has built a reputation around a certain point of view and has published books and articles on his pet theory, it’s almost impossible to recant. This propensity applies to scholars across the political spectrum.

We admire those rare intellectuals who are honest enough to admit that their past views were wrong. For example, when New York historian Richard Gid Powers began his history of the anticommunist movement, his attitude was pejorative. He had previously written a highly negative book on J. Edgar Hoover, Secrecy and Power. Yet after several years of painstaking research, he changed his mind: “Writing this book radically altered my view of American anticommunism. I began with the idea that anticommunism displayed America at its worst, but I came to see in anticommunism America at its best.” (6) That’s my kind of scholar.

1. Julian L. Simon, The Ultimate Resource 2 (Princeton, N.J.: Princeton University Press, 1996), preface.
2. See the revealing article, “Down and Out on Wall Street,” New York Times, Money & Business Section, Sunday, December 26, 1999.
3. Lester R. Brown, Gary Gardner, and Brian Halweil, Beyond Malthus (New York: Norton, 1999), p. 30.
4. Julian L. Simon, The State of Humanity (Cambridge, Mass.: Blackwell, 1995), p. 1.
5. Simon, The Ultimate Resource 2, preface.
6. Richard Gid Powers, Not Without Honor: The History of American Anticommunism (Free Press, 1996), p. 503.

What Are the Bears Missing?

Forecasts & Strategies
Personal Snapshots
January 2000

What Are the Bears Missing?
By Mark Skousen

“He has been wrong about the stock market for a decade, he said, because he is a contrarian.” — The New York Times, December 26, 1999

The 1990s has turned out to be the best-performing decade of the 20th century in terms of stock market performance. Several new factors palyed a role: Unexpected low commodity and consumer inflation, fiscal restraint, increased productivity, globalization and the collapse of the Soviet communism and the socialist model of central planning.

And yet, an incredible number of bright people missed the entire bull market. Year after year, they predicted the imminent collapse in stocks, yet the Dow increased three fold and the NASDAQ 10-fold. The New York Times named names: James Grant, Marc Faber, and more recently Barton Biggs. All Ivy League graduates. Many of my gold bug friends missed the bull market, too.

How is this possible? What kind of prejudices would keep an intelligent analyst from issing an overwhlming trend?

Confessions of a Gold Bug Technician

A good friend of mine is a technical analyst who searches the movement of prices, volume, and other technical indicators to determine the direction of stocks and commodities. Most financial technicians are free of prejudices and will invest their money wherever they see a positive upward trend and avoid or sell short markets that are seen in a downward trend. But my friend is a gold bug and no matter what the charts show, he somehow interprest these charts to suggest that ogld is ready to reverse its down ward trend and head back up. Equally, he always seems to think the stock market has peaked and is headed south. As a result, throughout the entire 1990s, he missed out on the great bull market on Wall Street and lost his shirt chasing gold stocks.

Another friend uses an old-style Dow theory that requres both the Dow Industrials and the Dow Transports to hit new highs before a bull is declared. Durring the 1990s, this Dow theorist had the bear in the box more than the bull.

Over the years, I’ve encountered three kinds of investment analysts: Those who are always bullish, those who are always bearish, and those whose outlook depends on market conditions. I’ve found that the third types, the most flexible, are the most successful on Wall Street.

“What Am I Missing?”

In the financial business, the key to success is a willingness to chage your mind when you’re wrong. Stubbornness can be financially ruinous. When a market goes against you, you should always ask, “What am I missing?”

Sound “Austrian” economics has taught me two principles that can be applied to this situations. First, marginal changes in the political or economic landscape can make big differences in the markets. Economists always talk about marginal analysis. Thus, marginal tax cuts, reducing the size of government, and minimizing trade barriers can turn a bear market into a roaring bull market.

Second, beware historical data. History does not repeat itself in every cycle. It does make a difference who is president, or what the new technology is.

“The bears are transfixed by historical data,” reports The New York Times. Indeed, in bull versus bear debates over the past 10 years, the bears have always brought up the fact that stocks are vastly overvalued “on an historical basis.” No argument there! But does that mean we must be bearish? Again, we must ask ourselves the all important question, “What am I missing?” The markets have been overvalued for years — but they keep going up because of new net benefits to the economy. This is data that is not part of the past.

A Golden Comeback, Part III

Economics on Trial THE FREEMAN NOVEMBER 1998

by Mark Skousen

“A free gold market … reflects and measures the extent of the lack of confidence in the domestic currency.”

In the past two columns, I’ve highlighted the uses and misuses of gold. Despite occasional calls for a return to a gold standard, the Midas metal has largely lost out to hard currencies as a preferred monetary unit and monetary reserve. Most central banks are selling gold.

Gold has also done poorly as a crisis hedge lately. It has not rallied much during recent wars and international incidents. U.S. Treasury securities and hard currencies such as the German mark and Swiss franc have become the investments of choice in a flight to safety.

Nor has gold functioned well as an inflation hedge over the past two decades. The cost of living continues to increase around the world, yet the price of gold has fallen from $800 an ounce in 1980 to under $300 today.

What’s left for the yellow metal? I see two essential functions for gold: first, a profitable investment when general prices accelerate and, second, an important barometer of future price inflation and interest rates.

Gold as a Profitable Investment

Since the United States went off the gold standard in 1971, gold bullion and gold mining shares have become well-known cyclical investments. The first graph demonstrates the volatile nature of gold and mining stocks, with mining shares tending to fluctuate more than gold itself. The gold industry can provide superior profits during an uptrend, and heavy losses during a downtrend.

One of the reasons for the high volatility of mining shares is their distance from final consumption. Mining represents the earliest stage of production and is extremely capital intensive and responsive to changes in interest rates.1

Gold as a Forecaster

Gold also has the amazingly accurate ability to forecast the direction of the general price level and interest rates. In an earlier Freeman column (February 1997), I referred to an econometric model I ran with the assistance of John List, economist at the University of Central Florida. We tested three commodity indexes (Dow Jones Commodity Spot Index, crude oil, and gold) to determine which one best anticipated changes in the Consumer Price Index (CPI) since 1970. It turned out that gold proved to be the best indicator of future inflation as measured by the CPI. The lag period is about one year. That is, gold does a good job of predicting the direction of the CPI a year in advance. (All three indexes did a poor job of predicting changes in the CPI on a monthly basis.)

Richard M. Salsman, economist at H. C. Wainwright & Co. in Boston, has also done some important work linking the price of gold with interest rates. As the second graph demonstrates, the price of gold often anticipates changes in interest rates in the United States. As Salsman states, “A rising gold price presages higher bond yields; a falling price signals lower yields. … Gold predicts yields well precisely because I~ it’s a top-down measure. It is bought and sold based purely on inflationdeflation expectations; thus it’s the purest barometer of changes in the value of the dollar generally.”2

In sum, if you want to know the future of inflation and interest rates, watch the gold traders at the New York Mere. If gold enters a sustained rise, watch out: higher inflation and interest rates may be on the way.

1. For further discussion regarding the inherent volatility of the mining industry, see my work The Structure of Production (New York: New York University Press, 1990), pp. 290-94.

2. Richard M. Salsman, “Looking for Inflation in All the Wrong Places,” The Capitalist Perspective (Boston: H. C. Wainwright & Co. Economics),October 15, 1997. For information on his services,call (800)655-4020.

A Golden Comeback, Part II

Economics on Trial THE FREEMAN OCTOBER 1998

by Mark Skousen

“Gold maintains its purchasing power over long periods of time, for example, half-century intervals.”
Rou JASTRAM, The Golden Constant1

In last month’s column, I focused on gold’s inherent stability as a monetary numeraire. Historically, the monetary base under gold has neither declined nor increased too rapidly. In short, it has operated very closely to a monetarist rule.

What about gold as an inflation hedge? In this column, I discuss the work of Roy Jastram and others who have demonstrated the relative stability of gold in terms of its purchasing power–its ability to maintain value and purchasing power over goods and services over the long run. But the emphasis must be placed on the “long run.” In the short run, gold’s value depends a great deal on the rate of inflation and therefore often fails to live up to its reputation as an inflation hedge.

The classic study on the purchasing power of gold is The Golden Constant: The English and American Experience, 1560-1976, by Roy W. Jastram, late professor of business at the University of California, Berkeley. The book, now out of print, examines gold as an inflation and deflation hedge over a span of 400 years.

Two Amazing Graphs

The accompanying two charts are from Jastram’s book and updated through 1997 by the American Institute for Economic Research in Great Barrington, Massachusetts. They tell a powerful story:

First, gold always returns to its full purchasing power, although it may take a long time to do so; and

Second, the price of gold became more volatile as the world moved to a fiat money standard beginning in the 1930s. Note how gold has moved up and down sharply as the pound and the dollar have lost purchasing power since going off the gold standard.

In my economics classes and at investment conferences, I demonstrate the long-term value of gold by holding up a $20 St. Gaudens double-eagle gold coin. Prior to 1933, Americans carried this coin in their pockets as money. Back then, they could buy a tailormade suit for one double eagle, or $20. Today this same coin–which is worth between $400 and $600, depending on its rarity and condition-could buy the same tailor-made suit. Of course, the double-eagle coin has numismatic, or rarity, value. A one-ounce gold-bullion coin, without numismatic value, is worth only around $300 today. Gold has risen substantially in dollar terms but has not done as well as numismatic U.S. coins.

Gold as an Inflation Hedge

The price of gold bullion was over $800 an ounce in 1980 and has steadily declined in value for nearly two decades. Does that mean it’s not a good inflation hedge? Indeed, the record shows that when the inflation rate is steady or declining, gold has been a poor hedge. The yellow metal (and mining shares) typically responds best to accelerating inflation. Over the long run, the Midas metal has held its own, but should not be deemed an ideal or perfect hedge. In fact, U.S. stocks have proven to be much profitable than gold as an investment.

The work of Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, has demonstrated that U.S. stocks have far outperformed gold over the past two centuries. Like Jastram, Siegel confirms gold’s long-term stability. Yet gold can’t hold a candle to the stock market’s performance. As the chart, taken from his book, Stocks for the Long Term, shows, stocks have far outperformed bonds, T-bills, and gold. Why? Because stocks represent higher economic growth and productivity over the long run. Stocks have risen sharply in the twentieth century because of a dramatic rise in the standard of living and America’s free-enterprise system.

One final note: Stocks tend to do poorly and gold shines when price inflation accelerates. As Siegel states, “Stocks turn out to be great long-term hedges against inflation even though they are often poor short-term hedges.”2 Price inflation is the key indicator: When the rate of inflation moves back up, watch out. Stocks could flounder and gold will come back to life. In my next column, I’ll discuss the ability of gold to predict inflation and interest rates.

1. Roy W. Jastram, The Golden Constant: The English and American Experience, 1560-1976 (New York: Wiley & Sons, 1977), p. 132.

2. Jeremy J. Siegel, Stocks for the Long Run: A Guide to Selecting Markets for Long-Term Growth (Burr Ridge, Ill.: Irwin, 1994), pp. 11-12.

A Golden Comeback, Part I

Economics on Trial THE FREEMAN SEPTEMBER 1998

by Mark Skousen

“A more timeless measure is needed; gold fits the bill perfectly.”

When speaking of the Midas metal, I’m reminded of Mark Twain’s refrain, “The reports of my death are greatly exaggerated.” After years of central-bank selling and a bear market in precious metals, the Financial Times recently declared the “Death of Gold.” But is it dead?

Following the Asian financial crisis last year, Mark Mobius, the famed Templeton manager of emerging markets, advocated the creation of a new regional currency, the asian, convertible to gold, including the issuance of Asian gold coins. “All their M1 money supply and foreign reserves would be converted into asians at the current price of gold. Henceforth asians would be issued only upon deposits of gold or foreign-currency equivalents of gold.” Mobius castigated the central banks of Southeast Asia for recklessly depreciating their currencies. As a result, “many businesses and banks throughout the region have become bankrupt, billions of dollars have been lost, and economic development has been threatened.” Why gold? “Because gold has always been a store of value in Asia and is respected as the last resort in times of crisis. Asia’s history is strewn with fallen currencies. … The beauty of gold is that it limits a country’s ability to spend to the amount it can earn in addition to its gold holdings.”

Not Just Another Commodity

Recent studies give support to Mobius’s new monetary proposal. According to these studies, gold has three unique features: First, gold provides a stable numeraire for the world’s monetary system, one that closely matches the “monetarist rule.” Second, gold has had an amazing capacity to maintain its purchasing power throughout history, what the late Roy Jastram called “The Golden Constant.” And third, the yellow metal has a curious ability to predict future inflation and interest rates.

Let’s start with gold as a stable monetary system. With most commodities, such as wheat or oil, the “carryover” stocks vary significantly with annual production. Not so with gold. Historical data confirm that the aggregate gold stockpile held by individuals and central banks always increases and never declines.2 Moreover, the annual increase in the world gold stock typically varies between 1.5 and 3 percent, and seldom exceeds 3 percent. In short, the gradual increase in the stock of gold closely resembles the “monetary rule” cherished by Milton Friedman and the monetarists, where the money stock rises at a steady rate (see Chart I).

Compare the stability of the gold supply with the annual changes in the paper money supply held by central banks. As Chart II indicates, the G-7 money-supply index rose as much as 17 percent in the early 1970s and as little as 3 percent in the 1990s. (Why has monetary growth slowed even under a fiat money standard? The financial markets, especially the bondholders, have demanded fiscal restraint of their governments.) Moreover, the central banks’ monetary policies were far more volatile than the gold supply. On a worldwide basis, gold proved to be more stable and less inflationary than a fiat money system.

Critics agree that gold is inherently a “hard” currency, but complain that new gold production can’t keep up with economic growth. In other words, gold is too much of a hard currency. As noted the world gold stock rises at a miserly annual growth rate of less than 3 percent and oftentimes under 2 percent, while 70% GDP growth usually exceeds 3 or 4 percent and sometimes 7 or 8 percent in developing nations. The result? Price deflation is inevitable under a pure gold standard. My response: Critics are right that gold-supply growth is not likely to keep up with real GDP growth. Only during major gold discoveries, such as in California and Australia in the 1850s or South Africa in the 1890s, did world gold supplies grow faster than 4 percent a year.3

Prices Must Be Flexible

Consequently, an economy working under a pure gold standard will suffer gradual deflation; the price level will probably decline 1 to 3 percent a year, depending on gold production and economic growth. But price deflation isn’t such a bad thing as long as it is gradual and not excessive. There have been periods of strong economic growth accompanying a general price deflation, such as the 1890s, 1920s, and 1950s. But price and wage flexibility is essential to make it work.

Next month. Update on Jastram’s study The Golden Constant, and gold’s amazing ability to maintain its purchasing power over the past 400 years.

1. Mark Mobius, “Asia Needs a Single Currency,” Wall Street Journal, February 19, 1998,p. A22.
2. See the chart on page 84 of my Economics of a Pure Gold Standard, 3rd ed. (1997), available from FEE. Note how the world monetary stock of gold never has declined between 1810 and 1933.
3. Ibid., p X6.

You Be the Banker

September 7, 1998

You Be The Banker
by Mark Skousen

If credit risk bothers you less than interest rate risk, consider owning a prime rate fund.

Two rules of thumb on buying closed-end funds, elucidated elsewhere in this survey, have to do with the cost of ownership. One is that you should almost never pay a premium over net asset value to get a closed-end. The other is that you should be wary of a fund that has a higher than normal expense ratio. The story on page 230 sets out the reasoning for these rules.

I’d like to make a case for breaking both rules for a fund category that complements your bond portfolio. I’m talking about so-called prime rate funds. These are portfolios of bank loans, held by closed-end funds.

First, why diversify into this class of funds? Since 1994 bonds have been on a tear. But there’s a downside. Yields on 30-year Treasurys have slid to a measly 5.6%. That’s not bad in relation to recent inflation rates, but it’s a somewhat lopsided bet. It’s pretty unlikely that rates would move down another two points, handing you a fat capital gain, but it is quite possible that between now and 2028 rates could move back up two points, to where they were just a few years ago.

How, then, to get a decent yield without taking on long-term interest rate risk? Prime rate funds invest in variable-rate senior loans to corporations at interest rates tied to the so-called prime rate. Currently this benchmark at most banks is 8 1/2%. That is several percentage points higher than the yield on Treasurys, mortgage paper or money market instruments like certificates of deposit.

Even after charging stiff fees of 1.4% or more, funds holding these loans are yielding at least 7%. Although the net asset value of the funds is not completely unchanging, like that of money market funds, the fluctuations to date have been minuscule.

There’s a reason why you should be willing to stomach those high expense ratios: Your fund, to a degree, is acting more like a bank than a bond fund. It has to appraise borrowers’ credit quality and take a chance on an investment that is not traded every day and is not liquid. There’s a lot more work involved than there is in taking positions in five Treasury notes and sitting on them.

What happens when interest rates shoot up and bond prices fall? Conventional bond funds get hammered, but the prime rate funds, whose interest income floats up with the prime rate, have been remarkably stable. In 1994, when investors suffered terrible capital losses on longterm bonds, Pilgrim America Prime Rate Trust enjoyed a stable net asset value and delivered more than 7.5% total return for the year.

What’s the downside? For one, declining interest income if the prime rate declines. Next, credit quality. The senior loans are collateralized and go to respectable borrowers, but there are no government guarantees. Third, liquidity. Two funds trade publicly, but the rest are redeemable only quarterly.

Among the funds I like are Van Kampen Prime Rate Trust B shares, currently yielding 7%. Unlike the Pilgrim fund, it doesn’t use leverage. You buy at net asset value. The fund offers shareholders the ability to tender shares quarterly, receiving net asset value less a redemption charge starting at 3% the first year and then declining 1/2% per year. A brand-new sister fund, Van Kampen Senior Income Fund, will use leverage and deliver a slightly better yield. Senior Income trades publicly as a closed-end and is currently at a slight premium.

Pilgrim America Prime Rate Trust, the oldest of the breed (trading since 1992), sports an 8% yield, goosed up by some leverage. Caution: Pilgrim can play tough. In 1995 shareholders were dismayed by a rights issue that forced them to either add to their holdings or risk dilution. At a recent $10.16, Pilgrim goes for a slight premium. Try to get it for less than $10.

Emerging Markets Floating Rate Fund is for the brave. This one invests in floating-rate loans to governments in Latin America, eastern Europe, Asia and Africa. With emerging markets out of favor, the shares have dropped from $17.75 in June 1997 to a recent $12.88, close to net asset value. The yield is 12%, but that figure makes no allowance for loan losses–and you just might see a default on some of these loans someday.

Forbes · September 7, 1998