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In Parts I and II, I presented readers with examples of obvious asset-bubbles – but in markets which were/are extremely manipulated. Given the obvious risks associated with “shorting” rigged-markets, I postulated that using (gold or silver) bullion as a “proxy” for shorting these asset-classes offered similar correlation to shorting these assets, but minus most of the risk.

That said, any time someone recommends to investors that a single asset-class can be held in lieu of various other investments, then obviously there will be concerns expressed with respect to the concept of “diversification”. Like much market dogma, “diversifying” one’s portfolio is a classic example of an investment “sacred cow” – where financial advisors slavishly adhere to this “principle”, to the point of never even asking themselves why are they diversifying.

In this installment, I will take an explicit look at the concept of diversification, and explain to readers how and why this “Golden Rule” of investing has never been a more dubious investment principle.

To begin with, I will rhetorically ask “why are we supposed to diversify our portfolios?” The answer is simple: no one possesses a “crystal ball”, and thus no market participant can know what will happen in any given market, in the future. This premise is universally accepted without question in the world of investment, and yet I would argue it is strongly contradicted by vast amounts of recent, empirical evidence.

Regular readers will be familiar with the recent boasting by Wall Street Oligarchs that they “made money” every day in their market-trading, for an entire quarter. This data leads to only one of two possible conclusions. Either the most-profitable traders in U.S. markets did not “diversify” their own holdings, or the various asset-classes they held were so highly-correlated that they all performed in a near-identical manner (for an entire quarter).

It would simply be the most-remarkable fluke of luck (equivalent to winning the lottery) if an active-trader like Goldman Sachs could engage in true diversification, and still turn a profit every day. The fact that more than one Oligarch made similar boasts mathematically eliminates the possibility of this being purely a matter of luck.

In reality, as the operators of the rigged-casinos known as “U.S. equity markets”, Wall Street Oligarchs have been able to transform this collection of thousands of individual, corporate listings into a homogeneous force (farce?), where (depending on the slant attached to a particular company/sector) stocks all move up or down together. This has been accomplished through the use (abuse) of trading algorithms.

It was always inevitable that these market abominations would do exactly what they have done (create the near total-correlation of various equity/asset-classes). Despite this obvious reality, even when these destructive devices caused a complete meltdown of U.S. equity markets – in a matter of seconds – all that ever occurred to brain-dead, U.S. regulators was to rig the markets even more extremely, since Wall Street Oligarchs would all rather surrender one of their own testicles, than their precious, market-rigging trading algorithms.

Thus, we have already shattered the myth of “diversification”, with respect to U.S. equity markets. Whether you hold one company, or one thousand (in traditional, “mainstream” investment sectors), there would be little overall difference in portfolio performance – unless the person holding only one company chose an exceptional under/over-achiever.

I would argue, however, that even if we eliminate the “correlation” caused by market-manipulation that we would/should also expect many other asset-classes to be highly correlated – especially when viewed through longer-term analysis.

Prior to the last two decades, the longest/strongest period of global, economic expansion was the enormous economic “boom” which occurred as Europe was rebuilt after World War II. The massive need for new infrastructure, combined with a “retooling” of global industry from primarily armaments to consumer-goods produced the largest global economic expansion in history.

What made this episode especially impressive from an economic standpoint is that this global growth was driven (almost completely) by the economic performance of Western economies – which, collectively account for only roughly 10% of the global population.

If such a massive, global expansion can be fueled by the economic activity of only 10% of the global population, what are we to conclude about the industrialization of Asian economies, along with many “developing” economies from other continents?

Rather than representing a paltry, 10% of global population, the new “economic tigers” of the 21st century collectively represent at least 50% of the global population, and as much as 75% of the global population – depending on how inclusive or exclusive we choose to be in defining these “high-growth” economies.

While there have been no global wars necessitating the massive rebuilding of infrastructure, the current process of “urbanization” involves billions of people who previously lived as rural, peasant populations. This is creating the need for (first) infrastructure and (second) consumer-goods, as these populations industrialize and urbanize, which (in turn) is creating a potential for growth (and a demand for raw materials) which dwarfs anything ever seen since the Industrial Revolution.

Absent other economic factors, the obvious question is “why would any investor want/need to diversify?” Investors in Asia can invest in their own developing markets/economies. Investors in commodity-producing nations (like Canada) can load-up on commodity producers (to provide the necessary raw materials), and even “old” economies like those of the United States and Europe can capitalize on expansion of their established corporations into these “virgin” markets.

Of course there are other “economic factors” which muddy the waters. As I (and other precious metals commentators) point out on a daily basis, many of these “old” economies appear to be dying rather than merely aging. The cause of these imminent fatalities is obvious: the accumulation of far too much debt, and the printing-up of far too much worthless, paper currencies – courtesy of the Western bankers who have been permitted to hijack our economies for their own selfish purposes.

This presents investors (especially Western investors) with a dichotomy never before seen in the modern history of markets. There are two, ultra-powerful (but contradictory) long-term economic trends simultaneously at play: the Century of Growth for the world’s developing economies, and the self-annihilation of many/most of the “Old Guard” economies of Europe and North America.

As this century progresses, it is a certainty that “Asian growth” will be the more significant trend than Western, economic devolution – for the reasons previously mentioned. However, over the medium-term, it is a “toss-up” as to which of these economic forces will prove to be dominant over the next few years.

Given this context, diversification would imply putting half of one’s money into the “Asian growth” equation, and the other half betting against the crumbling, Western economies. And mathematically, the predicted result of such diversification is to have one half of one’s investments simply cancel out the other half – resulting in little to no long-term appreciation of one’s investment portfolio.

This leaves investors with three, possible alternatives. They can slavishly adhere to the mantra of “diversification”, despite the fact that it will tend to eliminate not “maximize” investment profits. Secondly, we can favor one “equation” or the other – and bet heavily for Asian growth, or against Western economies (and accept significant risks if we bet on the wrong “horse”). Lastly, we can look for an asset-class which (hopefully) can thrive irrespective of which of the two, identified trends dominates.

I will now remind readers that in the first sentence of Part I, I told readers I intended to focus upon the “versatility” of precious metals. While I did not define what I meant with that statement, when I expressed it at the time, such versatility should now be self-evident to knowledgeable precious metals investors. Gold and silver are assets which we should expect to thrive in either an “Asian growth” or “Western devolution” scenario. In fact, I have written extensively as to how and why precious metals should be a superior asset-class as a positive investment (in a high growth/high inflation world), or as a “defensive” investment – against the nightmares of debt-default which await the U.S. and UK economies (and perhaps some of Europe’s “PIGS”).

This should serve as a classic example to investors of the need to put common sense above market dogma, and simply “old habits”. More specifically, it alerts investors to the need to put “versatility” ahead of “diversification” – as we seek to cope with economic parameters totally unlike anything seen in history.

Disclosure: No position in Goldman Sachs or any stocks mentioned

Source: Bullion as an Alternative to Shorting, Part III