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Todd Stein & Steven McIntyre (The Texas Hedge Report) submit: Webster’s defines “alchemy” as the “speculative philosophy practiced in the Middle Ages and the Renaissance concerned principally with discovering methods of transmuting base metals into gold.” Webster’s further defines “alchemy” as “any magical power or process of transmuting a common substance, usually of little value, into a substance of great value.”

Alchemy, in a nutshell, is taking something that is abundant and trying to transform it into something that is scarce. While the laws of nature may have prevented medieval scientists from turning lead into gold, we do think a modern-day sort of alchemy has been working and is destined to succeed further.

At Texas Hedge, we realize that what is really overly abundant in today’s world is the supply of U.S. dollars and the accompanying rampant credit creation. Nearly two decades of insatiable consumption in the U.S. has created the precarious position where U.S. citizens now consume roughly 6% to 7% more per annum than they produce. The kindness [read: gullibility] of foreigners as well as reckless financial engineering have enabled the addicts [U.S. consumers] to keep on binging when the mother of all hangovers should have long since sent Americans scurrying to the bathroom in distress.

Sooner or later, whether it’s from exhaustion or a realization of the dangerous imbalances building inside the U.S. financial system, the rest of the world will likely become less enchanted with holding U.S. dollars. We, the U.S., need foreigners to welcome into their arms roughly 2 billion U.S. dollars per day at current U.S. consumption levels. We want foreign TVs, phones, iPods, clothes, cars, etc. and right now foreigners are accepting our dollars without hesitation.

One day in the not-so-distant future, we suspect these foreigners will demand more dollars for the same amount of goods sold to us. With each passing month and year of the U.S. consumption binge, the number of U.S. dollars [both tangible and in electronic form] multiplies rapidly. If the supply of any object, in this case U.S. dollars, increases too rapidly versus demand, the price of that object [USD] will decrease until a new equilibrium is found. A Japanese TV may cost an American 300 U.S. dollars today, but it could cost $350 or $400 for that same TV in a couple of years if the U.S. dollar sees its exchange rate correct in a manner we think is likely.

In a recent Charlie Rose interview, former Fed Chairman Paul Volcker stated the likely outcome for the U.S. dollar would be one of two scenarios:

Scenario 1 – The rest of the world continues to grow rapidly and its consumption of U.S. goods/services expands so rapidly that the large trade and U.S. dollar flow imbalances are grown into. A 6 or 7% trade imbalance moderates to a more palatable level and eventually declines as foreign imports of U.S. goods/services outpace U.S. imports. Texas Hedge considers the preceding scenario to be very unlikely given the hollowing out of America’s manufacturing base.

Scenario 2 – The rest of the world loses their appetite for U.S. dollars sensing our trade imbalance issues and a weakening U.S. dollar becomes a self-fulfilling prophecy. A new radically lower global USD exchange rate is set. The side of effects of scenario 2, the scenario Volcker falls short of forecasting for obvious reasons, would likely be much higher domestic interest rates to shore up the U.S. dollar. This would likely cause the rampant borrowing and previously insatiable consumption in the U.S. to slow precipitously. The combination of all this may prove unsettling to financial markets as luminaries no less than Paul Volcker, Warren Buffett, and John Templeton have pointed out.

This brings us back to alchemy and the concept of turning something abundant into something that is scarce. Total credit market debt outstanding through Q3 2006 is now over $40 trillion according to the Fed’s Z-1 report. We would argue $40 trillion makes fiat money fairly abundant. The rest of the world’s holdings of U.S. financial assets now totals nearly $12 trillion, meaning that their attitude toward owning U.S. assets is of great importance. Our search for something scarce [on a relative basis] has brought us to gold and silver. Best estimates are that 150,000 tonnes of gold have been mined historically and exist above ground. Identifiable silver stockpiles are thought to be roughly 650 million ounces. 150,000 tons of gold and 650 million or so ounces of silver sound like a lot, but one must consider that a good deal of these ounces are held by dollar bears that are unlikely to sell anywhere near current prices. 650 million ounces of silver is only about $9.1 billion – a pittance in terms of $40 trillion in global credit. Even the 150,000 tons of gold is only $3 trillion in USD terms, probably only half of that [$1.5 trillion] is used for investment purposes [according to John Hathaway at Tocqueville Funds], which is again a very small amount in terms of global USD flows.

U.S. dollars are abundant and, while the dollar has declined 30-40% over the last 5 years, the decline has been measured. The overwhelming abundance of USD claims and the likelihood of a panicky Fed printing more dollars in any sign of financial distress are not yet fully understood by most market participants. Given the sorry state of most other fiat currencies, we think the true star performers in the next couple of years will be gold and silver. Mine production for both precious metals is relatively stagnant and most, if not nearly all, of the above ground ounces of gold and silver are spoken for at around current prices.

In fact, judging from the performance of the major U.S. gold [(GLD), (IAU)] and silver [(SLV)] ETFs [GLD just a hit a new record of 14.344 million gold ounces, IAU has now collected 1.365 million gold ounces, and SLV which just hit a new record of 110.677 million silver ounces], there seems to be a growing individual and institutional investor appetite for hedging out U.S. dollar risk via the precious metals.

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Despite gold and silver having seen their likely highs for the year in May [$720 & $15 respectively], nearly each day GLD and SLV, physical gold and silver, whether prices rise or fall, have been gathering new assets. It appears the only ones selling the precious metals these days are government bureaucrats continuing to liquidate government holdings and technically momentum driven commodity funds that sell from time to time if gold and silver aren’t acting well according to trading patterns or charts.

Step 1 in our modern day alchemist manual involves trading small rectangular government issued pieces of green paper with little functional utility except as a medium of exchange for yellow and gray chunks of metal that admittedly have only slightly better utility [silver more so] except as a medium of exchange. However, these yellow and gray metals have a finite supply which will keep them scarce as fiat currencies inflate away. Until the trade and debt imbalances in the U.S. are corrected, we think the U.S. dollar, the world’s reserve currency, is very vulnerable. Today’s alchemists who turn their green paper into precious metals should prosper. Gold and silver have been money for thousands of years and with Helicopter Ben at the helm, that stands little to no chance of changing. The risk/reward of gold and silver is not as good as when they were trading at 250 and 4 bucks, but we still find them very compelling as the U.S. dollar’s fundamentals have only gotten worse.

Step 2 in our modern day version of alchemy will occur in the coming years. Again, we want to take things that are abundant and move them into things that are scarce. If the U.S. dollar is put into the penalty box until our consumers can learn to behave themselves, we envision gold and silver rising a not insignificant amount from here. At that point we imagine that gold and silver bulls will be a plenty [think early 80s]. Likewise, we suspect a period of revulsion towards U.S. stocks [and bonds] may ensue. If the U.S. dollar has serious problems it will not bode well for mainstream financial assets across the board in the U.S. While we are fans of gold and silver in the intermediate term, we do realize their limitations in the very long run. A basket of high quality equities is likely to outperform gold and silver over the next 40 years, but in the next 5 or 10 years gold and silver could do quite well. A multi-year to a decade allocation to gold and silver is as close to market timing as one should ever get. Well run operating businesses can compound earnings by growing volumes and raising prices over time. The miracle of compounding works to equity holders’ advantage in a very tax and commission efficient manner. On the other hand, gold and silver bear no interest and have annual storage and insurance costs.

The problem with owning stocks and bonds in the U.S. these days is that they are too expensive. Across the board, stocks trade at 18x to 40x earnings no matter what corner of the world you look at. That is a 3% to 6% static earnings yield, which is not compelling. Treasuries all the way through junk in the bond market offer 4.5% to 7.5% yields - again nothing to get too excited about as our table below depicts:

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stocks and bonds

Ownership of high quality equities can deliver 10-15% returns per annum over the long run if they are purchased at truly attractive prices on an absolute and not just a relative basis. But one must be very careful about the price paid. Pay too much and the returns will suffer. The math simply dictates so. The ultimate alchemy in our books is to take grossly overvalued U.S. dollars and convert them to gold and silver. Gold and silver could deliver solid returns over the coming years as the dollar and traditional financial assets adjust downwards. Then, when stocks and bonds become cheap, convert back [the now more valuable] gold and silver to U.S. dollars to purchase a select few truly cheap stocks and bonds.

Gold and silver are not wonderful multi-decade investments but, in a span of 5 to 10 years like in the 1970s, allocating a portion of one’s assets to the precious metals makes a great deal of sense.

Source: One Is Silver and the Other Gold: Modern Day Alchemy of the US Dollar