Two identical items with vastly different values. How is that possible?
That glass of water on your desk has very little value. You could replace it almost instantly with a similar glass of water at very little cost. You have bottled water in the fridge down the hall, a faucet with essentially unlimited water in the bathroom next door, and a drinking fountain several offices away. The cheap and easy access to close substitutes makes that glass of water on your desk practically worthless.
Take that identical glass of water into the desert, miles from civilization and an eternity from any close substitute, and its value changes.
Same glass of water. Two entirely different values.
A cord of wood might come in handy during a cold Siberian winter, but loses its value entirely in Miami in August. A cup of rice is bland and tasteless at a New York Bistro, but is cherished at a soup kitchen down the street.
The values of some items are just different depending on where and when they exist. The availability of close substitutes is a big driver of that difference.
Such is the case with gold. The value and utility of gold depends on the circumstances surrounding it.
Every person on the planet decides how to store his or her wealth. Some buy real estate. Some buy stocks and bonds. Some keep coins in shoe boxes under their beds. People have alternatives when it comes to storing wealth. They select what they believe is the best alternative. They allocate their wealth accordingly.
When one alternative begins to lose its effectiveness, people naturally change their allocations. They reallocate their wealth to what they believe is a better alternative. That reallocation, importantly, affects prices.
Until recently, most broad-based equity indices had been on a 13-year tear. The S&P 500 was up a staggering 6.2x between the close of the Global Financial Crisis in March of 2009 and its most recent peak in January of 2022. During that period, people and institutions became accustomed to allocating their wealth and savings into the stock market and watching it compound. That decision by millions of people helped drive the S&P 500 Index ever higher. The S&P 500 Index compounded at 16% annually during that 13-year period, far in excess of its long-term average annual growth of about 10%.
Something similar happened in the bond market. The bond market – again until recently – had likewise been in a very long bull market.
Stocks and bonds are financial instruments whose values depend on prevailing interest rates and inflation. Low and declining interest rates and low and declining inflation helped fuel the 13-year bull market run in equities and the 30-year bull market run in bonds. People saw the effectiveness of both bonds and stocks as a store of value and allocated their wealth accordingly. That allocation helped drive the prices of stocks and bonds higher.
The utility of gold in an environment like that is like the glass of water on your desk. Who needs gold as a store of value when the stock market is ripping 16% annually?
Rising interest rates and inflation, however, reduce the value of stocks and bonds. If rising rates cause stocks and bonds to lose their effectiveness as a store of value, people will look for alternatives. They will begin reallocating their wealth to things like gold (and other physical assets) that are more effective at storing value in an inflationary environment. That reallocation of wealth causes hard assets like precious metals to outperform financial assets like stocks and bonds during inflationary periods.
The utility of gold in an environment of rising interest rates and inflation is like that glass of cool water in the desert. Its utility as a store of value rises as effective alternatives begin falling away.
The price of gold compounded at 31% annually during the 1970s. The S&P 500 compounded at just 2%. Bonds were lousy investments then too. That wasn’t a fleeting period, it was an entire decade in which the price of gold seriously outperformed the S&P 500. That was a period when rising inflation and interest rates eroded the value of financial instruments. People took note and reallocated their wealth to other areas that were more effective at preserving purchasing power. Gold received a portion of that reallocation. The reallocation of wealth affected the prices of both financial instruments (lower) and gold (higher).
We believe the world today has some similarities with the early 1970s: a long bull market run in financial assets has just ended, interest rates are low and increasing, and inflation is on the rise. Those are the initial conditions when people begin to rethink where they have their wealth stored. Since the gold market is tiny (very tiny) compared with the size of the global financial markets, even a small reallocation of wealth would have an enormous effect on the price of gold. KP7 is positioned to benefit.
