The Great Game, Gold Arbitrage & Three Little Pigs
By Daniel R. Amerman, CFA
Below is the 2nd half of this article, and it begins where the 1st half which is carried on other websites left off. If you would prefer to read (or link) the article in single page form, a one page version can be found here:
THE GREAT IRONY
Gold did excel during the inflationary 1970s and 1980s, as it may again if another round of major inflation befalls us. This performance is well known. The irony, however, is that gold is not where most households made their money. As documented in my book, The Secret Power Within Your Mortgage, when we track exact national averages from 1972 to 1982, the average homeowner saw their real equity grow from 25% of their mortgage amount to 500% of their mortgage amount as a direct result of being effectively short the dollar during a sustained period of relatively high inflation – even while real estate prices were slightly declining on an inflation-adjusted basis.
This extraordinary growth is far from theoretical. The inflation-driven destruction of most of the value of the outstanding mortgages was what nearly destroyed the Savings & Loan industry back in the 1980s, and I spent years as a young investment banker trying to help financial institutions survive the massive damage. Indeed, this event constituted one of the largest transfers of wealth from institutions to individuals in American history.
You likely know someone who held onto their house for decades over this era and became “house rich” as a result, enjoying the benefits of a huge equity in their home even as they made little $50 or $100 monthly payments long after the national average mortgage payments had moved to over $500, and then to over $1,000. Yet, to the extent people think about it at all, they often mistakenly believe this increase in personal wealth was a result of the run up in home values (which merely more or less kept pace with inflation), rather than inflation effectively forgiving most of their largest debt and making most of their payments.
CHECKING THE BACK DOOR
Sometimes if the front door is locked, you need to check the back door. If direct asset purchases are problematic, and your net worth is equal to your assets less your liabilities – liability management becomes your back door. This back door is standing wide open - at interest rates that have been manipulated by the Federal Reserve to be far below free market rates - and constitutes a highly effective way of shorting the value of the dollar in a long-term and tax-advantaged manner.
It is this back door that created enormous amounts of homeowner wealth the last time inflation went out of control in the United States. It is creating the back door within investment strategies that is key to the Great Game as it is being played right now, for when the Game finally ends – the back door of inflation shredding the value of the debts is what will allow many of the people who created the problem to walk away wealthier than ever. In some cases this will be accidental (as it was for most homeowners in the 1970s), but for the more astute investors this is quite deliberate. As it needs to be for you, if you are to enjoy the same protections and profit potential.
When you put a “back door” on your long-term wealth preservation and creation strategy, then you have a 1-2 combination with both assets and liabilities. The assets you lead with are then a matter of choice, and the effectiveness and costs of this strategy will vary widely with that choice. Gold, the choice for Jim illustrated here, has powerful advantages for near term and major inflation – but is also quite expensive in terms of cost of carry, as you won’t have interest, dividends or rental income to offset the mortgage payments. There are pros and cons to gold as there are with a diverse range of alternative investments.
A Puzzle For Turning Inflation Into Wealth Mini-Course Readers
Let’s take a minute and go back over the results achieved by Jim when he owned a home, borrowed with a mortgage, and bought gold. By purchasing gold during a time of economic turmoil, and by buying at $62 an ounce and selling at $315, he made a 407% return during a decade when the stock and bond markets were being pummeled. Even after discounting for a dollar only being worth 43 cents by the end of that decade, Jim still made a (pre-tax) real return of 120% on his investment.
Results of this type, from the last time stagflation punished the United States, are exactly what many investors are currently seeking through investing in gold. It is also interesting to note that these superior results were achieved during a decade when real estate values were (on average) falling in real terms.
So what would have happened if Jim had skipped the money-losing real estate investment, and put everything he had into gold, during a decade of outstanding gold performance?
If Jim had sold the house, taken his entire $18,000 and bought gold at $62 per ounce in June of 1972, then he would have owned 290 ounces of gold. His $18,000 would have become worth $91,000 by June of 1972, for a monetary gain of $73,000, which would have equaled a percentage gain of 407%. His investment would have become worth a little more than $39,000 in inflation-adjusted terms, for a real gain of 120%.
In other words, by skipping the money-losing real estate investment with 80% mortgage financing, and putting everything into gold during a time when gold excelled as an investment – Jim would have earned $7,000 less in real (after-inflation) terms, and dropped his simple total return from 155% down to 120%. Remember, Jim only started with $18,000 between cash and house equity - so $7,000 in additional real profits is a tremendous boost.
This is of course on a pre-tax basis, with a very simple analysis. When we fully include the inflation tax benefits and the value of having a place to live for ten years, then Jim’s multiple asset strategy outperforms a gold-only strategy by a much wider margin, even after we have fully incorporated the effects of making mortgage payments over the ten years. Indeed, as we saw in our earlier reading, "Creating Wealth With An Inflation 'Tax Shelter'", when we add the benefits of the inflation tax shelter, then the real estate / mortgage combination alone would have produced after-tax and after-inflation benefits equivalent to a conventional investment earning about 22% per year.
Rephrased then, if we could travel back in time with what we know now, the correct answer to gold versus real estate in 1972 was neither gold nor real estate – but both. This is true even when we assume a foreknowledge that gold would have a stellar performance, and that real estate would not quite keep up with inflation.
Multiple-Asset Turning Inflation Into Wealth Strategies
What we just saw was an example of making more money in inflation-adjusted terms by putting 56% of your assets into an asset that loses money in real terms, instead of 100% into an asset that more than doubles your investment in real terms. How and why this works is beyond the knowledge of most people. Indeed, it might seem counter-intuitive - if not impossible - to most individual investors, and that might have included you before you started this course.
The remainder of the analysis is contained in the subscriber version. Subscription for The Turning Inflation Into Wealth Mini-Course is free.
