Gold as a Truly Last Resort 24 comments
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It was, for many investors, confusing not to see gold surge to multiples of its current price. I mean, shouldn’t gold have dramatically surged in this financial tsunami? Most investors, including myself, forgot that gold was a playground to some deep pocket investors from the hedge fund industry that got hit tremendously by redemptions and massive forced deleveraging because of a domino collapse of prime brokers such as Lehman (LEHMQ.PK) or Bear Stearns. The result was a fire sale in COMEX gold futures and paper products with gold as underlying.
The physical market was different, particularly in the third and fourth quarter of 2008. Even though physical demand was very strong and supply reached its upper limits, the price of gold even declined. This was only a short lived market distortion triggered from the paper gold market. In the last couple of weeks, the market already rebalanced the price as gold went from sub $700/oz to roughly $900/oz. The pressure from forced sellers and fund liquidation sales is more or less over and this should pave the road for much higher gold prices in the future.
Another interesting realization was that gold can only move up when the financial system is not faced by a complete meltdown. Is gold truly a reliable hedge against an asset meltdown as it was in the past? Yes, but we have to differentiate. The very important lesson to learn was that gold can only perform if the system itself is not under massive default pressure; at least in the first phase. So is the run now over? It is far from over. Technically, gold is moving up again and the move will very soon be supported by a crash in the currency and particularly bond markets.
Gold: The Truly Last Resort
The pre last resorts in the current financial crisis were the bond markets (particularly the US treasury market) and the US dollar. I’ve explained in previous articles why the US dollar was going up and it also explains why it is going down now. Investors were desperately putting money into the bond market, not because they like bonds, but more because they wanted their money out of equities, commodities and derivatives. Since the US treasury market is the biggest bond market in the world, the huge appetite for US treasury was accompanied by huge appetite for buying the US dollar and selling other currencies in exchange. The bond market (particularly government bonds) is the biggest bubble today and once this bubble bursts then the only asset class that remains will be gold. At this point in time, gold will surge and investors will move huge amounts of money into physical gold and gold stocks because this is truly the last resort.
The Point of No Return: When Gold Will Explode in Value
Gold is the true last resort and this is also a reason why the price of gold has not exploded in the past couple of months. The financial system has not yet reached the stage of last resort but it finally will because the point of no return was passed. Governments and central banks around the globe decided to save the current financial system at all costs. Quantitative easing and aggressive fiscal stimulus will eventually create huge inflation and fundamental changes to our societies and economies. They can’t go back but only forward with faked statistics and money printing to keep the system alive as long as possible to hope for a solution. There is a solution, but it is very unlikely to happen, unfortunately.
Inflation is coming and it is coming back furiously. Quantitative easing accompanied by a zero interest rate policy and massive fiscal stimulus will eventually trigger a hyperinflation environment. Right now, we are in a deflationary market environment with virtually all asset classes losing value. The bond markets have been the only exemptions, but only because investors were putting money into the liquid bond market to park it. The same is true with the US dollar - we are not really in a US $ bull market that is driven by sound fundamentals. I believe that the leading global currencies will eventually crash because the fundamentals are worse than ever. Huge government deficits, huge retirement obligations, unpayable social security systems (in its current status), massive interest burdens on corporate and government debt and demographic changes leading to higher taxes and less income (baby boomer generation will retire and stress the current social security system to its limits). Government bonds particularly in the USA will implode and default in value.
Is it sure that the quantitative easing will trigger inflation? No, not theoretically, but practically. There is a pretty simple formula to explain the function between the amount of money and inflation. The theoretical concept I refer to is the so called: quantity equation: M x V = P x Y, while
V = Velocity of money (frequency with which a unit of money is spent)
P = Price level
The amount of money (M) in the system has exploded and if the velocity of money (V) and real GDP (Y) remains stable then prices (P) must rise. Right now and very likely as always in deflationary environments the velocity of money is slowing (people are starting to save rather to spend) – real GDP is also shrinking. This mechanism allows that the amount of money can rise substantially and is therefore not necessarily triggering inflation. The problem is that once the cure (more money and aggressive fiscal spending) starts to work then the velocity of money is also picking up in speed. When this happens, the only method to avoid huge inflation will be to reduce the amount of money or hope for some spectacular GDP growth that is triggered by huge efficiency gains in the economy (but this is a dream right now).
So, inflation is theoretically not preassigned, but practically inevitable. The people put in charge to avoid a huge surge in inflation are the same as when this mess started: Fed, treasury, government, etc. They had no idea when this crisis began (they are even responsible that it happened!) and they have no idea when it will end and therefore they will never be able to take all this money out of the system and this will ultimately lead to inflation. That’s why I’m sure inflation will come back in the not so distant future.
Some people also mentioned the gold standard as a possible solution for a sounder monetary system: I don’t think that this is a solution. The gold standard would be far too restrictive and would prevent economic growth at the upper limit of balanced potential growth. But central banks would do well to change towards a more responsible monetary policy in remembering the gold standard.
Investment Strategy
I recommend investors to be short government bonds and long corporate bonds from leading, reliable and sound companies which are market leaders in their sector. Equities should also perform much better than bonds mainly because of the pending inflation shock. I recommend buying value stocks with low p/e ratios and a strong balance sheet. A core investment should be some heavily battered base metal related stocks such as BHP, Rio Tinto (RTP) or Freeport McMoRan (FCX) and energy/oil related stocks such as ExxonMobil (XOM), ConocoPhillips (COP) and Royal Dutch Shell (RDS.A).
The best investments for the long term will be real assets such as farmland and equities related to agriculture (fertilizer, machine manufacturer, etc.) and commodities. If a rising number of dollar bills are chasing a more or less stable number of real assets then these real assets will go up in price. Besides short government bonds and long corporate bonds and long commodity related equities a must own is physical gold or gold related equities such as Goldcorp (GG), Barrick Gold (ABX) or Newmont Mining (NM). Physical gold is a hedge against the coming financial Armageddon and belongs in every investor’s portfolio.
Disclosure: No positions. The opinions expressed in this article are those solely of the author and do not necessarily agree with the author’s employer.
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This article has 24 comments:
What if the economy does rebound?
The last resort is gold. True, it is also true that in Bear Markets the strongest during the Previous Bull usually go down the most and the leaders of the Next Bull Market are not those of the Past Bull.
Newmont Mining's symbol is NEM. But thanks for NM which I find more interesting anyway.
In the last month Gold has traded in a range of about $60 dollars but never above $900. In the last 3 Months gold has been above $900 and down below $700.
It currently has a double top in place which will be broken if Gold manages to go above $900. Since the dollar is rising, I expect it to drop below $800 at the very least. This is my opinion.
My question to you is: At what point do you cut your losses? Your position is All In Now.
I would not like to take undo losses and do not want to lose anymore money than I have to.
What if your scenario does not play out as you envision.
Do you have a Plan B?
I am not partison. Both parties are equally bad in my opinion. Clearly, no matter who is doing the spending it is far out of control. All the printing presses are running at full speed. Eventually there will be a day of reckoning for the dollar.
I have also been surprised by the strength of the dollar and the weakness of gold, but for the first time in my life I have been actually buying a little gold.
History shows us what can happen: Germany, Mexico, Brazil, Russia. The dollar is considered "safe", but with Helicopter Beranke at the helm, I think its only a matter of time before those greenbacks are not worth the paper they are printed on.
On Jan 12 05:08 AM Ron Mahabir08 wrote:
> Some very relevant points, and overall agree with your analysis.
> Timing, however, is the key here. Your scenario could take a while
> as the whole "old system" is bent on survival. That said, can't be
> too wrong going long physical gold for the long-term (5 years+).
On Jan 12 10:15 AM know nothing wrote:
> Well it looks as though gold will retest it's previous lows,that
> is how it looks today.But at some point gold will establish a low(bottom)
> and confirm that bottom by bouncing off of it and then creating higher
> highs and higher lows.The oppurtunity for large gains in precious
> metels usually comes when we are comming out of a recession, fore
> inflation is a by product of a recession. Therefore the price of
> gold still searching for a bottom,would indicate that we are not
> even half way through the current recession. Thus dollar cost averaging
> should be part of your portfolio strategy ingold,it appears another
> buying opportunity right around the corner. The hurry up and pass
> the next stimulus package is like dejavu, I hope the next adminstration
> can at least tell the american people where their tax dollars are
> being spent. Sooner or later the american people will figure out
> that the current economic model is not one which was designed to
> last for ever and will finally need to be completely overhauled,
> much like the Roman empire failed,the current american consumer model
> will fail as well. The longer we prolong the pain the more it will
> hurt when it finally does fail. Noone seems to understand that you
> can not borrow your way out of debt!!!
When he asked him last year when GC was 1000$ if the guy is going to sell his Gold, he answered of course not, he said I bought it then,placed in the safe box and forgot about it.
I called the guy a piker but here the reasons why:
1.He never bought GC afterwards even when it was 250$.
2.If he would buy any stock in the 1980 probably he would do better today.
3.Then for 80,000$ he could buy a penthouse that today after the crash can be redeemed on the spot for 800,000$.
4.His cost in todays $ is 2000$ per ounce with inflation adjustment.
5.He lost on his GC investment with the US$ buying power 70% and he is happy about it.
Oil stocks would seem to be sensible because many products are made from petroleum, and the shippers will need fuel to power their ships or trains.
I also think this should be a good indicator as to when the bear market is ending and a bull market starting. There might be rallies, even significant rallies, but until enough confidence in the economy is indicated by manfacturers increasing their inventories of raw materials, base metals, intermediate rallies will not have the 'legs' needed for a sustained bull market.
However, I have one concern: do you fear the eventual confiscation of gold as our government did in the 1940s? That could certainly blow a hole in ones net worth and plans for financial survival.
Any thoughts on this subject would be greatly appreciated (silver coins and gold coins).
Meanwhile, as an investment that produces no income while holding it, it is inferior to other commodity type investments like oil, coal, agriculture, non precious metals, etc. If a person is totally hooked on precious metals, I would think platinum is the better buy right now.
Gold was valuable when people equated it to money. Gold was money for most of recorded history. That hasn't been the case for a while now and people are a lot more sophisticated than they used to be. The psychological link lingered for a while and some still hold a flame, but essentially the show is over.
Gold of course is an interesting curio and will always have its place in the jewelers shop, but to go back to a fully gold based system in the modern World you would need a lump about the size of Cuba.
Philosophize all you want, but the bottom line is Gold has not moved as some might expect because most intelligent people have come to realize that there is no return from a lump of metal that just sits there. Indeed, maintaining a Gold hoard is quite an expensive business, unless you decide to do it on the cheap and bury it at the bottom of the garden. As for persuading the banking system to return to Gold, you surely have to be kidding. How many of them want to surrender their right to issue money against debt and being able to store their value in virtually reality to go back to the old days when they were constantly getting blown up with Dynamite?
I have been studying the past performance of the options market that occurred throughout 2008 and I believe shorting banking stocks and other financials may be a place where big money will be able to made once more.
There will be a second round of failures, maybe as large as the previous to come in the next couple months. Alot of people with 3 year arms have not been able to refinance and these loans will be adjusting between spring and summer and the next wave of defaults and bailouts are just around the corner. Deflation seems more likely in the short term (2009) then inflation. Hopefully I am incorrect but the finger is pointing in this direction more each day.
Good luck to all and if anyone has an opinion on my statements please feel free to comment.
Deleveraging will continue, Gold was part of the leveraging process. Why should there be a disconnect?
The Gold Bear started in, I believe, March of 2008. The Fact that it did not break above $1000 again even though oil approached $150, 3 months later, should have made gold investors suspicious.
Ever since that high, gold has had lower high and lows.
That Trend is intact. A new Low would take out $700.
For many months, Gold stock pundits have been saying that Gold shares were trading as if gold was at $600.
I have taken that as my target.
Gold will be above a Thousand again but not this year.
Besides, a move from the new lows to $800 would give me my needed correction and set the stage for $1300-$1500 gold sometime next year.
I am very, very bullish on both gold and the S&P. And I do believe the USD will get reamed eventually.
But I also believe the Pain will continue. I do not expect a new sustained move up in the S&P this October. IMO
On Jan 12 01:00 PM johninmontana wrote:
> I know the arguments for owning physical gold (eg coins), and these
> arguments certainly make sense.
> However, I have one concern: do you fear the eventual confiscation
> of gold as our government did in the 1940s? That could certainly
> blow a hole in ones net worth and plans for financial survival.
>
> Any thoughts on this subject would be greatly appreciated (silver
> coins and gold coins).
On Jan 12 04:21 AM Nikola wrote:
> Daniel, not to berate on the point, but what else might you be forgetting?
>
>
> What if the economy does rebound?
The biggest difference between then and now and the Equation that would lead to a similar collapse in the USD is that All other countries are devaluating their own currencies in a similar manner.
Currently, the USD IS stronger than anyone else's excepting the Yen whose country has gone through this once before. In the 1920's, Germany was an Island onto itself. Today, the World is in it together.
Meanwhile, Gold as priced in Dollars, seems to be tracking the Euro. As the Euro drops against the USD so does gold in terms of $s.
Mind you, I'm haven't looked at this Graphically yet. It just struck me as I was posting this comment.
So, if anyone can easily do so, Please take a look if there really is a coorelation. Thanks.
Dave W, you're right; people are a lot more sophisticated today. Many of them found employment at Countrywide, Bear Stearns, Lehman, WaMu, AIG, Merrill, Citi, Moodys, the Fed, Treasury, etc. With all of that incredible intellect running around loose, I think I'll hold onto my gold. It may just become money again.