"You should buy Lubrizol. It's in my Hedge Fund Trader....."

The Skousen Hedge Fund Trader (www.markskousen.com) may now hold the world’s record for best return in one day:  9,100%!  When Warren Buffett announced Monday morning that Berkshire Hathaway bought out chemical company Lubrizol (LZ) for $135 a share, our March $120 call options went from 15 cents to $13.80 almost immediately.
If you annualize it, the calculator can’t handle it; it says the return is “infinite”!

Here’s the full story:  We recommended Lubrizol last October, and were underwater on both the stock and the call options.  The stock was down 7%, and the March $120 calls had lost 97% of their value when Buffett bailed us out.  Subscribers who initially bought back in October made 20% on the stock, and 150% on the calls.  Not bad.

I don’t know if any subscribers bought the March calls (which were due to expire this Friday!) for 15 cents a week before, but if they did, they made 9,100% in one day!

Cheers, AEIOU,
MSkousen

Economics on Trial
IDEAS ON LIBERTY
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.

WHO IS THE GREATEST ECONOMIST OF THE 20TH CENTURY?

“But half a century later, it is Keynes who has been toppled and (_________________), the fierce advocate of free markets, who is preeminent.” –Daniel Yergin and Joseph Stanislaw, The Commanding Heights, p. 15.

Who deserves to be the greatest economist of the 20th century? This question was debated at my session of the annual American Economic Association meetings in New York City last month. We polled the audience of about 150 economists, and John Maynard Keynes won. Keynes revolutionized the economics profession by contending that the free-market economy is inherently unstable and requires government intervention (through deficit spending, progressive taxation and monetary inflation) to keep it on the path of full employment.

Of course, the audience may have been biased since the topic of the session was on Keynes’s most famous proponent, Paul A. Samuelson. Still, Keynesian economics–the economics of government interventionism at the macro level–is very much alive, and therefore, Keynes must be regarded as the most influential economist of the 20th century.

FRIEDMAN’S COUNTERREVOLUTION

However, influence is not the same as greatness. Milton Friedman came in second in the informal poll and in terms of greatness, he exceeds Keynes. Time magazine’s editor-in-chief, Norman Pearlstine, gives the nod to Friedman as the “economist of the century” (Time, December 7, 1998). And in a recent study of living economists most frequently cited in college textbooks, Milton Friedman came in #1 by a landslide. He was cited in all the textbooks. (Paul Samuelson came in a distant #12.) Friedman’s contributions are many: He demonstrated that government, not free enterprise, caused the Great Depression (through a disastrous monetary policy); he showed that monetary policy was more powerful than fiscal policy; he made the case against progressive taxation, deficit spending and monetary inflation. He won the Nobel Prize in 1976 for these efforts. His best books are Capitalism and Freedom and Free to Choose (both still in print, available through Laissez Faire Books, 800/326-0996).

Sharing the Prize

Milton Friedman should also share the prize of greatest economist with Friedrich A. Hayek, the Austrian who studied under Ludwig von Mises. As Yergin notes in The Commanding Heights (quoted above), Hayek made a convincing case against socialist central planning in The Road to Serfdom and other anti-socialist works. He developed a powerful tool for explaining business cycles, known as Austrian capital theory. His theory of knowledge and entrepreneurship is vital in today’s global economy. He rightly won the Nobel Prize in 1974.

So my vote goes to both Friedman and Hayek.

WHO DO YOU CONSIDER THE GREATEST INVESTOR?

As we approach the end of the 20th century, scholars are compiling lists of the greatest writers, politicians, entrepreneurs and scientists of this remarkable century.

I know who gets my vote for greatest investor: Warren Buffett. Not only has he consistently beaten the market, but his optimism about America has paid off handsomely. Too bad he doesn’t own any Internet stocks. He could have been the world’s first trillionaire!

R.I.P., THE SUPERBOWL INDICATOR

I bid a fond farewell to the Superbowl Indicator. Every so often, market players get caught up in an irrational indicator that allegedly makes it easy to predict the markets. In the 1970s it was the soybean-silver ratio. In the 1980s it was the Kondratieff Cycle. And in the 1990s it was the Superbowl Indicator. Supposedly, if the National Football Conference (NFC) won the Superbowl, stocks would rise; if the American Football Conference (AFC) won, stocks would fall. Amazingly, this indicator worked for decades. Throughout the 1990s, the NFC team won and the stock market rose. Then last year the Denver Broncos of the AFC won, and many stock market pundits exited the market or sold short. Big mistake–the S&P 500 rose 28% in 1998! And thus ended once and for all the Superbowl Indicator. Good riddance, and may it be replaced by sound strategies based on free-market economics!

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.”
– LUDWIG VON MISES

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.

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.

Economics on Trial THE FREEMAN SEPTEMBER 1998

by Mark Skousen

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

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.