As competitive currency devaluation looms, the USD may gain on a relative basis. The black swan remains the possibility of a loss of confidence in the U.S dollar.

Continued Artificial USD Strength

Human beings have the bad habit of valuing things on a relative basis. Absolute value is very hard to comprehend. The recent USD strength has been a factor of weakness in foreign currencies and NOT strong fundamentals for the USD. This was highlighted Tuesday when both Gold and the USD rallied on the back of Euro weakness. Allow me to highlight several fundamentals that are developing:

For the past few weeks, I have spent a lot of time thinking about the valuation of gold. I have been struggling to figure out a metric for calculating how much demand the price of gold is discounting. Before I get into the details of this fairly simplistic approach, let me first explain this method in relation to equities.

When valuing an equity, it is fairly easy to see the relative demand for the security based on how much someone is willing to pay today for the security, relative to known earnings. Of course I am talking about the P/E ratio. While I see strategies of targeting purchases based on P/E ratios as being of little value, the underlying idea remains true. That is that a low P/E stock relative to comparable companies is cheap, while a high P/E is expensive. There is one discrepancy to clear up and that is that by using historical earnings, new information may distort P/Es. For example, a company reports earnings of $1 per share and then a few weeks later lands a deal that will double earnings for the foreseeable future. The price and the P/E ratio would advance significantly even though the security may still be cheap relative to future earnings.

Gold has staged a spectacular rally over the past few days and there are a few important things to note:

1. The precious metal bounced after dipping below $700
2. On Thursday gold strengthened alongside the dollar. Friday then saw a massive jump with follow through buying today.
3. Gold's role has reversed from safehaven focus to dollar focus - it has been rallying along with the market.

Role Reversal

As the crisis unfolded, it was common to see gold strengthening alongside weakening equities - now we are seeing the opposite. Why? Well simply because we are not rallying on fundamentals but rather the prospect of government bailouts. In other words, the markets are only being supported through inflation. Another inflationary development over the weekend saw several OPEC members calling for massive production cuts to support the price of oil - another positive for gold. All of this has led to a massive rally in gold.

Like most things, treasuries are not functioning in this environment as you would expect. There are external fundamentals at play that are distorting the prices we are seeing and are making the simplest of investing decisions more complex.

Take the steepness of the yield curve. People use different durations to make these observations. Some look at the 2-10 spreads, others the 30-day-10-year spread. I am using the 2-20 spread.

When talking about value, for many investors it all comes back to gold. How many ounces of gold does it take to purchase an asset, whether it be real estate, equities or anything else? Please note that the following charts use monthly prices with the last data being that of September 2008.

This week saw a fundamental shift in Paulson's approach to restoring the proper functioning of the credit markets. I have been arguing for some time that the credit being pumped into the market is not finding its way into the system. The way that this plays out has direct implications for the price of gold.

I hope that all the gold bugs are preparing for the next leg down. Although risk does exist on both sides, the path of least resistance is down.

Then and Now

When researching gold prices, it is common practice to use historical quotes to give some indication of where prices may go. In my opinion that is a very bad strategy. 'Inflation adjusted highs' is simply a fancy way of saying that the price was here, we multiplied by some factor and so the inflation adjusted high is X. Therefore with more inflation the price MUST take out that previous high. That's like saying that Yahoo shares traded for $100 in the past and since earnings have expanded since then, we must ultimately breach that price - ignoring the P/E ratio buyers are willing to pay and by that I mean demand.

A year ago there was general worry amongst the investment community that the Fed was keeping rates too low. Inflation expectations were high, commodities were soaring and the stock market was performing well - capital was easily accessible. The Fed and other central banks insisted that their main goal was price stability, they were concerned about inflation, but maintained that risks existed to both sides.

Then 2008 came around and within a few months the Fed was criticized for not cutting fast enough as housing prices started to collapse. At that point, the Fed was criticized from both sides for all the wrong reasons. Raise rates to fight inflation! Cut rates to save the housing market! While the second may seem more accurate in hindsight, those calls were largely made by those who benefit from lower rates, not people who saw credit violently contracting. The Fed ultimately started to cut, under extreme criticism from the dollar bears. It also experienced criticism from the market bears who wanted to see more action.

Let me start off by saying that the following article is both speculation on my part and addresses other speculation that I have seen circulating online. Bretton Woods II is a term being used by the media to address the calls by international leaders to revisit the Bretton Woods System. This has led to speculation, in my opinion incorrect speculation, that world leaders want to return to a Bretton Woods System in its classical architecture.

The Problems We Are Facing

The original Bretton Woods laid the groundwork for institutions such as the World Bank and the IMF. Now the feeling is that these institutions are not doing a good job in terms of forecasting risk and should be more active in terms of managing global imbalances. 

The U.S. ISM Report that was released yesterday paints a very bleak picture - factory activity is the lowest since 1982 (see TradetheNews). Here is a summary of the numbers released today.

OCT ISM MANUFACTURING INDEX: 38.9 V 41E

As the Volatility Index ((VIX)) surges to a new record high of 89.53, investors and traders are running for the hills, but where are they running to? There are many ways to either protect your portfolio or to seek safety, but that protection comes at a cost, especially when you are late to the party. High volatility makes options expensive and reduces your flexibility, but also produces certain strategic alternatives. As this is an important topic to investors at the present time, I will try to be as extensive as possible in the following analysis.

First I will focus on a few strategies to protect your portfolio. Following that I will look at several safe havens, their performance and outlook.

Some people may be wondering why the dollar has strengthened so much lately as the Fed has been flooding the system with dollars. Here is a quick list of possible explanations:

1) Margin Calls

Most of my posts over the past few weeks have been centered around the idea of this public credit finding its way to market and the implications for inflation, borrowing costs, and the stock market. I have tried to think about how the money will move out of the financial institutions and into the hands of consumers and corporations. One of the commentators on CNBC spoke about a tidal wave of credit that is coming in the next 6-18 months, but will it arrive?

Now I am trying to turn the picture around in order to answer this question. Let's assume that the banks stabilize and trust returns for the most part - we finally reach the point where banks are willing to start lending. Here are some of my thoughts.

Just a quick follow up from my article yesterday on gold and real estate.

In the same way that short term treasuries have been bid up beyond their true intrinsic value due to the flight to safety, so to has that lent support to gold prices. Take a look at the following chart (click to enlarge):

When I think of gold today, and I try to convince myself to be a bull, I feel a sense of greed more so than the feeling that I've arrived at a logical conclusion. Everywhere I look prices are dropping, yet gold hovers roughly 20% below its all time high. At the same time, the dollar is about 15% off of its lows and oil is about 45% off of its highs… don't get me started on housing.

Yet for some reason, I have this itch to buy gold. I feel like a soon to be loser would've felt at the height of the tech bubble - I just don't want to miss out while other people make money. Take a look at the following chart.

When Milton Friedman said that inflation is purely a monetary phenomenon, he was 100% correct. Yet, the general public's understanding of the term inflation leads to some confusion.

Over the past 12 months I have read an exhaustive amount of articles and commentaries on the CPI's inability to truly track inflation. This has never sat well with me. Although I agree that the Fed shouldn't be using CPI to gauge inflation, I don't believe it has anything to do with hedonic regression or conspiracies about the Treasury not wanting to increase payment on TIPS. Instead, I have always believed that the main component that moves consumer prices is consumer demand and producer supply. The level of money creation and the debasement of the currency is in no way represented in the CPI figures - or is at most a small component.

Here is an interesting George Soros Interview from October 10, 2008.

George Soros discusses what he calls Free-Market Fundamentalism. He argues that unfettered free markets have an inherent agent-principle problem that can arise due to encouraging everyone to look out for their own self interest above all else. This came about in the mortgage industry where the mortgage issuer's interest lay in reselling the mortgages that they had approved, thereby having no interest in the home owner being able to actually pay off the loan.

Several people expressed confusion over my gold article yesterday so I wanted to take this opportunity to elaborate.

Why is the short term gold outlook uncertain?

As speculators, we are often very quick to impose our theories on the market - we think we know better. Yet sometimes it is important to take a breath, look at the market, and see what it is telling us. Remember that the market prices in our expectations, not reality. Therefore, the best trades have already been discounted and at the current time it is usually a sucker's bet. That is likely where we sit with respect to gold.

Ask a random Joe on the street if gold is a good bet right now - his answer is likely YES, followed by a list of economics 101 arguments which in theory hold true. Yet there's a reason why those commercials you see about quitting your job and working for 5 hours a week are nonsense. To be a good trader, you need to be ahead of the market. You need to be aware of what's going on in both the market and reality. You need to watch how the market moves when a particular piece of news is released and understand why - not just look at the quotes at the end of the day when all is said and done.

Google (GOOG) is the undeniable king of internet advertising, but can it be successful in other mediums? My answer is YES! Here's why.

To understand how effective Google's systems are, you simply have to look at the Yahoo (YHOO) deal. Under how many circumstances would the second largest player in an industry subcontract the largest player in its direct line of business? The proof is in Yahoo's willingness to do this deal, which Yahoo projects will add significantly to its bottom line. Why? Liquidity!