Next Stop: $2,000 Gold

Last week has to be one of the most stunning in the history of financial markets.

It started with the weekend sale of venerable Bear Stearns (BSC) to JP Morgan (JPM) for the laughably low price of $2 a share, setting the tone for what will be remembered as a prophetic event for the week that followed, and ultimately, for the months that will follow.

The Fed has essentially funded the sale of a distressed asset to avoid the collapse of Bear Stearns, which, if allowed to happen, would put so many other banks into a state of insolvency that the domino effect would ultimately cause more big banking names to fall. The term "capitulation" comes to mind.

So what has happened, is the Fed is exercising its right to print money with renewed abandon, comforted by the short term validation of its strategy afforded by the Dow's responsive surge. Casual observers might be forgiven for interpreting the bear market rally, representative more of short covers and delusional optimists than of relative strength, for signs that the crisis is over, the market has bottomed, and business as usual is imminent.

But hold the phone. Is this the bottom of the well, or merely a ledge hit on the plummet to resume shortly?

Bet on number 2. Though both gold and oil have taken a near 10% hit during the last few sessions, and sure the Dow has piled on 400+ points in two sessions in the last two weeks, there is much, much more to come.

The confidence in the dollar and the Dow expressed in terms of gold, oil and commodities sell-offs is partially a reaction to the swift and decisive actions Ben Bernanke. The general feeling on Wall Street is one of suppressed awe for the utter absence of hesitation the Fed chairman has demonstrated in the face of the crisis. His creativity and resourcefulness during this time is admirable.

The turbulence ahead will no doubt be tempered by such deftness.

But, and this is the big "but", the next 10 to 12 weeks are going to be no less chaotic then we've those we've been enjoying in 2008.

Next up on the Price is Wrong is commercial mortgages and their asset-backed derivatives.

There's no doubt about the fact that the U.S. is suffering a downturn in economic vitality.

New Residential construction numbers announced Tuesday last week indicated a 36.5% drop in building permits issued since last February, and the numbers were down 7.8% for the quarter. Other key economic indicators confirm the slowdown in consumer spending across all areas of the economy. The result: business is slowing down in tandem.

So with business in a contraction mode, all those new office buildings in various degrees of completion add up to an oversupply of office and commercial space inventory, with the accompanying effect of falling prices. Add to that the inability of anywhere from 80% or higher of the commercial paper underwriting the financing of that construction to renew, and you've got a recipe for defaults on a scale that will make the residential mortgage problem tame in comparison.

According to a Wall Street Journal article dated March 22:

The spread on the CMBX Triple-A series 3 index has fallen to around 1.90 percentage points, its lowest level since late February.

That kind of a reading on the triple-A CMBX indexes implies cumulative default rates on the underlying loans of as high as 100%, players say, depending on the assumptions made for recoveries that would follow defaults.

The CMBX Triple A index tracks the cost of protection against default on a series of securities backed by commercial mortgages.

The major difference between commercial mortgage backed securities versus those backed by residential mortgages is exposure. Whereas most residential mortgage-backed securities are represented by hundreds of individual mortgages slices, it's not uncommon for a single commercial mortgage to comprise up to 10% of any individual security. That means the quality of the entire issue can crash if just one mortgage defaults.

This is what Ben Bernanke is facing next, and the only real weapon left in the arsenal is more cash, which is okay for the short term, but the dollar is becoming more and more worthless with every billion dollar bailout.

It was exactly a year ago next week that China began to divest itself of US treasuries for the first time in seven years. With the value of all U.S. denominated foreign holdings free falling in value, other currencies are being sucked into the vortex.

All this means is that gold is going to grow in stature as a perceived store of value as long as the carnage continues.

During the first half of 2007, overall investment in gold was relatively weak; identifiable investment was 22% lower than one year earlier while statistically residual "inferred investment" was substantially negative. In Q3, while inferred investment was close to zero, identifiable investment soared as a result of record quarterly inflows into gold Exchange Traded Funds (ETF). In Q4 identifiable investment was more subdued, as retail investors took profits and ETF inflows steadied, but inferred investment became strongly positive. In dollar terms total net gold investment in Q4 reached just over $8bn – a quarterly record.

The $95 price drop in gold this past week is therefore nothing short of a gift. An unparalleled buying opportunity that will quickly be acted on, and one of a likely good number, as the volatility in the commodities, debt, and equities markets is going to stay high for the foreseeable future.

Next stop: $2,000 gold.

[Editor's Note: We apologize for initially omitting the author's disclosure. Mr. West is long shares of Barrick (ABX), Newmont (NEM) and Goldcorp (GG).]

Comments

[No Moss:]

Gee, I'm sorry, but gold bugs are all the same. Gold does well when there's financial stress. People run to gold when they sniff panic in the air. It's like a herd rampaging.

Then the dust settles. Calm returns. When it does, gold doesn't look so good anymore. It doesn't return anything. It doesn't move, or if it does it moves down.

At the end of the stampede, there are the dedicated gold bugs who just can't accept that gold has served its purpose.

My prediction? Gold won't hold $800 in the next month. There is virtually no upside for gold short of war. I have no idea where gold will settle in the long run, but I'm pretty sure that by the time T-bills creep back over 2% (a sign of a return to financial normalcy) gold will have lost its luster yet again.

2008 Mar 24 08:41 PM

[Hieronymus:]

As to the cloying comments above I would ask: where was the chaos in 05, 06 and midway of 07? This period had gold in a solid but undiscernable (to most) upturn, lacking only the chaos mentioned above. While there are plenty of wildeyed goldbugs to be found in just about any market, sometimes they are right. Commodity markets, and, concommitant with them, financial system duress and dysfunction have a long and clear market cycle. I think we are in the top of the 4th inning.

2008 Mar 24 08:55 PM

[aurora703:]

Gold is making a minor, and well deserved correction. The dollar has further to fall, oil will remain high, and the geo-political landscape will remain dicey, to say the least. Wall Street historically underestimates the action of gold and now is no exception. IMO gold will see $1,200-1,500 by year end and "possibly" $2,000 within 12 months.

2008 Mar 24 09:37 PM

[cachaca:]

"Gee, I'm sorry, but gold bugs are all the same"

Well, I will tell you that I am a "regular" investor who happens to have been born and raised in a 3rd world country. I had been fully vested in "regular" stocks up till just a few months ago.

GOLD holds its value through monetary correction...nuff said
I think that we are seeing a flood of dollars as the fed prints and the foreign powers dump greenbacks.

I do not know how high GOLD will go, but I know that the dollar has not hit bottom yet...and that is enough for me.

Once the market is a tad less volatile, I will be a "regular" investor again. Till then, I will be wearing GOLD slippers to bed.

2008 Mar 24 10:23 PM

[GKM:]

Should there not be DISCLOSURE if the author is long gold in some way shape or form?

That being said and hopefully done: I hate to burst your gold bubble but it will likely correct even further so I wouldn't be hopping on the shiny metal train again just yet. For disclosure, I am not short gold yet but plan to be once it retraces to around $960.

2008 Mar 24 11:22 PM

[mkreisel:]

Gold is strong buy at 800.

2008 Mar 24 11:24 PM

[User 167623:]

Gold is in the beginning of the second phase of a three stage bull market that will end in a classic stage 3 mania....the top of the mania will exceed even the predominant bullish predictions.

2008 Mar 25 01:30 AM

[mkreisel:]

Everyone can make outrageous predictions. It doesn't even matter if your prediction turns out to be true. What matters are how much confidence you have in your prediction, how much you are willing to bet on your prediction, and how much you stand to lose if your prediction is wrong.

2008 Mar 25 02:36 AM

[Skynrd:]

Guy's, The Dollar is only a piece of paper that can and will go to zero. It's only a matter of when, just look at history. Gold has never seen zero, and never will. It's not about making money right now, It's about trying to keep what you have. Take cover or beware!

2008 Mar 25 05:24 PM

[Indeendent:]

Whether one is a "gold bug" or an ignorant optimist does not matter. There is no single solution to investing, including the "by-and-hold" approach invented for the largely uneducated majority. There is little doubt that the US is in the midst of a financial crisis with a quickly deflating currency. Gold, inter alia, is one of the means to hedge against such a storm. But, eventually, it is not the tool what matters, it is the skill of those who use it. However, "the long-term value of any paper currency is zero." The same cannot be said about gold.

2008 Mar 25 09:07 PM

[mkreisel:]

If Dollar goes to zero, your gold will be worthless too. That would be the end of the civilization and you would need to resort to cannibalism to survive.

2008 Mar 26 12:37 AM

[User 168171:]

After billions dollar of speculators away from commodity, the gold still stands above $900. Then true buyer came in. Now gold is about $940. When speculators come in, the gold will be above records, my calculation is about $1070. And if they're playing the price, with reason the fed will cut the rate again, the gold will be $1100

2008 Mar 26 12:51 AM

[Kage:]

I don't know about gold but vitriol/invective must be going pretty cheap ! I'll keep my shiny insurance in a safe place, and buy some more on the dips.

2008 Mar 26 02:39 AM

[Frodo:]

Investment advisor Harry Browne eventually came to the conclusion that strategy was more important than forecasting. Consider that thought carefully.

He wrote a book called Failsafe Investing, and also was an advisor to the Permanent Portfolio Family of Funds. The point was to use a higher than normal amount of precious metals combined with the usual stocks, bonds, and cash. When something goes crazy, like gold has done, the Permanent Portfolio re-levels the portfolio by selling some of, in this case, the gold. This formula has soared recently, and has never sustained a continuous losing streak of any concern.

If what you want is to preserve and reliably grow your nest egg, have a look at the Permanent Portfolio, or read a downloadable version of Failsafe Investing (used hard-copies available via Amazon). The suggested strategy will not keep up with a jubilant stock market. But when the market suddenly loses 1/3 all at once - as we have recently witnessed - you'll be smiling, as PP investors have been in recent years, enjoying 12 to 14% annual returns while everyone else is being skewered.

It's all about peace of mind and the knowledge that you will prosper in all conditions - even to the point of thriving in the rare instance of a complete financial meltdown or runaway inflation.

And if you don't know who Harry Browne was, please look at HarryBrowne.org, and then curse the media for not covering his presidential campaigns in 1996 and 2000. He was on the ballot in all 50 states in '96 and 49 states in 2000. He was also one of the most brilliant and gentlemanly humans I have ever observed.

2008 Mar 26 01:42 PM

[agneaux:]

Harry Brown is one of my personal heroes, along with Thomas Jefferson. I recently rolled over an old 401k (from a previous employer) into a self-directed IRA, and placed 1/4 in GLD & IAU, 1/4 in SLV and the rest in energy, oil, and mining stocks. So far I've been way up, way down (last week) and now am slightly down but looking up again. My intention is to hang on to what I've saved since 1983 (I lost half of it in the 2001 downturn but made it back), and if I make some more, alll the better. Somewhere I read that if you divide the current long-term national debt by the available gold, it comes out to something like $36,000 per ounce. I don't see how gold can keep from going up in the long term. Silver will do well, too, as the traditional ratio of Gold to Silver value is 16:1 but it's now more like 50:1. Bernanke should be raising rates like Volcker did in the 70's. What will happen when the rates reach zero but things still get worse? When the SHTF, the paper dollar will be worthless, but silver will still buy you some groceries. My advice: invest half in precious metals but also buy some actual gold/silver rounds to hold in your home safe for emergencies, and have a gun and plenty of ammo to defend it. No, I'm not kidding. People will try to take it away from you then.

2008 Mar 26 02:38 PM

[Freetruth:]

mkreisel said "If Dollar goes to zero, your gold will be worthless too. That would be the end of the civilization and you would need to resort to cannibalism to survive."

Why? If worthless paper is revealed to be what it truly is then real money also becomes worthless? What about the Euro and other currencies? End of civilization? Wow, that is an indoctrinated world view that totally discounts society as an entity elavating bureaucratic controllers to the status of saviours. When the "full faith and credit of the U.S. government" goes to zero value this great society will be released from the biggest chains ever put on productive people. Thus we will not only survive, but thrive. The whole bunch of political junkies aren't worth saving, its time to take our lumps for being duped and move on. Let free-markets rule, not fools.

2008 Mar 26 04:55 PM

[Palehorse:]

Isn't remarkable about the FED doing the Financing so that Bear Sterns could be sold to J P Morgan, since J P Morgan is a major Player and so called owner in the Federal Reserve System, it didn't even cost JP Morgan a single farthing, but it cost the<USA Corporate citizen> more blood, sweat, and many tears.

2008 Mar 26 10:35 PM

[mkreisel:]

If the US currency collapses, it means world-wide economic chaos on a unprecedented scale.

During economic chaos, where can you exchange your gold for food?

If a hungry mob knows you have the gold, do you think you can get away easily?

2008 Mar 27 05:33 PM

[User 169240:]

sounds like a bunch of doom sayers----invest wisely----GOLD

2008 Mar 27 10:10 PM

[Dan Schmeidler:]

Gold is scarcity. If gold was not gold, we would be building buildings out of it. It happens to be a solid and effective metal that is also scarce. But the many "myths" surrounding it probably make it at times uninvestable. Just be careful with it.

2008 Mar 28 12:26 AM

[Dan Schmeidler:]

Just to add. One might want to add or substitute for the gold miners to your gold investments. Following the equity side of this play will add more clarity as far as growth potential is concerned (with respect to earnings, for example). But, I guess, it would just depend on what kind of investor you are.

2008 Mar 28 12:37 AM

[geralvon:]

If you wish to have an idea of where gold will probably go, imagine you have x number of currency units in savings in your safety deposit box. Then imagine that your country's paper currency is gradually losing its purchasing power and that a loaf of bread costs more and more currency units as time goes on. Then ask yourself what you should do to preserve the value of your savings, such that when you need to years hence, you will still be able to buy the same number of loaves of bread than when you started out. Finally imagine what other people are going to do about their savings. Remember that the value of anything depends upon how much other people wish to obtain it. If loaves of bread could be easily preserved and safely stored for future consumption, then I would convert my savings into loaves of bread.

2008 Mar 29 05:11 AM