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Jeffrey Dow Jones is the managing editor for Alpine Advisor. He has previously worked for PaineWebber/UBS and Ford Motor Credit Company, and he spent the last decade co-managing a group of hedge funds. He holds a degree in Business Economics with a specialization in Computer Programming from The... More
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  • Why the Dollar Won't Collapse and Strategies to Play it Either Way
    As the Fed warms up the printing presses on the good ship QE2, a new round of Dollar worries emerge.  Everyone seems to think that Captain Greenback will wind up on the rocks.  

    Is there any chance Ben Bernanke might be able to thread this ocean liner through the narrow canal?

    Rather than panic and drown in a sea of inflationary talking points, we're going to calmly put on our life preserver and build a framework through which we can make sense of this madness.

    It starts with a quick look at why Americans are so touchy about inflation in the first place.

    You see, it wasn't that long ago when we had our own inflationary scare and that's still a recent memory for many people, especially our policy makers and central bankers.  Everybody thinks about their childhood in the 70's and early 80's and remembers the stagflation.  They remember the energy crisis and the gas lines.  They might even recall when Richard Nixon tried to control prices and wages by setting legal limits on each.  A mere decade later the U.S. Dollar was worth half of what it was and people were were mad as hell and were shouting that they weren't going to take it anymore.  Everybody bought gold.

    It's a visceral memory.  Emotions are powerful things.  But there's an academic sensitivity to inflation as well.  There is a collection of sensible, rational people that are highly attuned to the mechanics of inflation and spend a lot of time devising new reasons to be concerned about it.  Most of them wear horn-rimmed glasses and bow ties.

    Let me boil all of their knowledge down for you with one easy chart, one of my favorites from my personal archives:

    Alternatively, that chart could be titled "The Amount of Stuff $100 Used to Buy You".  As you can see, the actual amount of stuff is less and less.

    By most standards I am still considered a "young whippersnapper", but even I remember how much cheaper everything was when I was a kid.  I remember paying less than $1 a gallon when I first got my driver's license.  A date at the movies was like ten bucks.  You could buy a starter home for well under $100k for a few grand extra you could put a new Dodge Neon in the driveway.  Chicken McNuggets, oddly, were the same price, but the concept of a Six Dollar Burger was heresy.

    And I know you old timers totally have me beat.  I'm sure that more than a few of you remember your first job paying $5-$10,000 per year.  Some of you might even remember lusting over Harley Earl styled Cadillacs on the showroom floor.  That was when a couple thousand bucks was a lot of money, enough to purchase a gas-guzzling status symbol.

    Anyway, my point is that there is a very strong, inverse correlation between the value of a dollar and time.  There is a lot of academic evidence to support this conclusion and there are countless personal anecdotes that reinforce the same story.

    Nobody needs much convincing that this is the reality we have always faced and will continue to face.  So let's take a look at why things are this way.

    A slow leak

    Why does it have to be like this?  Why can't we just have dollar that's strong and stable and a proper store of wealth?  We even tried to do this during the adolescence of our nation and fixed the value of a dollar to certain amount of gold.  What happened?  Why does the value have to always go down?

    There are two major reasons, a complicated one and a simple one.

    The complicated one is that we are a debtor nation.  Our country finances a large portion of its budget by borrowing money from its citizens and other countries.  Like any business, the U.S. earns money and then spends it.  It earns money from taxes and then spends that money on things like national defense, public schools, and first class plane tickets for our elected representatives.  Sometimes, it spends the money it makes to bailout failed banks.  (Sorry, that was a cheap shot.)

    But the problem is that the United States spends more money than it earns, and with a policy like that it takes the concept of debt management very seriously.  Countries like China or Japan call up the U.S. and say, "Hey, we will loan you $1 trillion so you guys can buy more stuff.  Pay us back in thirty years and in the meantime give us a little bit of interest."

    The U.S. happily agrees.  They borrow a few trillion dollars that they get to spend right away and as long as they can maintain some positive inflation -- and they're pretty good at this because they also control the printing presses -- the U.S. gets to pay all these people back with Dollars that are less valuable.  It's a sneaky way to get a bigger bang out of each buck that we borrow.

    The other major reason why we have adopted an inflationary policy is that it induces people to spend money.  When somebody spends money, a business somewhere makes a profit.  As businesses make more profits and pay more salaries to their employees, the government gets to keep a piece of that action for themselves in the form of taxes.  The more money businesses and people make, the bigger the government's slice!

    It's a very natural cycle, too.  When people in the U.S. make money they want to spend it because spending money is fun.  But they are also psychologically programmed to believe that if they don't spend it, they won't be able to buy as much with those dollars later on.  They remember how much cheaper gas and houses and Chicken McNuggets were when they were kids and assume that when they get older, those goods will only be more expensive.  An inflationary policy keeps them spending today and not next year.

    Ben Bernanke's single greatest fear is that we all suddenly become Japanese.  That is not to say he's worried we'll develop an unhealthy interest in robots and karaoke, but rather that our psychology turns deflationary.  Deflation and the deflationary mindset that it causes give people a big time incentive to not spend money.  They walk into the Cadillac dealership and decide that while the deal of the month may be a pretty good one, all they have to do is wait a few more months for an even better deal.  The young family out shopping for a house chooses not to buy because prices will probably be cheaper next year.

    That, my friends, is disastrous for an economy.

    Deflation may seem cool because your dollars get more powerful with time, but it's actually really scary because everything in the economy grinds to a halt.  GDP goes down, tax revenue dries up, and the U.S. is forced to borrow even more money to pay for stuff, debts that it has to pay back with more valuable Dollars.  Ugh.  

    So you can see why the Federal Reserve wants to slowly increase the price level over time and why they want the rest of us to be afraid that our paper dollars have nowhere to go but down.

    It's all relative

    The bad news is that the rest of the world is trying to do the same thing.  And in the global currency markets, currencies are priced in terms of other currencies.  Technically, they're just ratios.  There isn't really an absolute standard by which currencies are valued and there is no Cadillac or starter home to use as a universal benchmark.  I know some people like to use an ounce of gold as a historical baseline, but even that has complications.

    Here's a chart of the Dollar Index and it's always gone up and down relative to these other currencies:

    It's clear, however, that the U.S. has done a marginally better job than its peers at debasing its currency.

    Go USA!

    Right now the Dollar is pretty cheap relative to these other countries.  In fact, it's historically cheap.  The Dollar Index is near all-time lows against the currencies of other developed countries.

    The U.S. certainly has its share of problems, but are they as bad as the problems in these other nations?  Are we really in as much trouble as Europe?  Do we have the same massive problems that Japan does?  If it came down to it, would you really rather have a pile of Euros or Yen instead of Dollars?

    The U.S. Dollar might stink, but it's probably the least dirty shirt in the currency closet.

    A better way to evaluate the Dollar

    Consider Purchasing Power Parity (NYSE:PPP), which is a way of pricing currencies against a fixed basket of goods, a more intuitive way for individuals to think of their currencies.  PPP is based on the "theory of one price" which basically says that absent things like tariffs and other barriers to trade, identical goods should have identical prices all around the world.

    The most famous example is The Economist's "Big Mac Index" which measures how much a Big Mac costs in different countries around the world.  Using this global icon as a unit of exchange, you can get a sense of which currencies are strong and which are weak.  Based on their latest highly scientific findings, the Big Mac baseline here in the U.S. is $3.71.  We know that Canada has a strong currency and it costs about $4.18 up north.  That's not too bad, but in Brazil, it costs $5.26 and in Switzerland it costs $6.78!  The average for the whole Euro area is $4.79, which is more than I'm willing to pay for fast food.

    On the cheaper end of the Big Mac spectrum is Russia, where one costs $2.39.  South Korea is interesting at $3.03 per Big Mac, but China is the big winner in terms of having undervalued currency.  Over there it costs $2.18.

    There's a little bit more work and a whole lot of math that goes into the official calculation of Purchasing Power Parity.  But the concept is exactly the same.

    Here's a table of some major countries.  A value above 100 means that the currency is stronger (more expensive) than the U.S. Dollar.  A value under 100 means the currency is weak, and has relatively less global purchasing power than the U.S. Dollar.

    United States 100
    Canada 118
    Mexico 66
    Australia 134
    Japan 145
    South Korea 76
    New Zealand 117
    Czech Republic 79
    Denmark 155
    France 116
    Germany 111
    Greece 103
    Hungary 72
    Ireland 132
    Italy 115
    Norway 156
    Poland 69
    Spain 102
    Sweden 125
    Switzerland 164
    Turkey 85
    United Kingdom 155

    Again, Switzerland appears to have the most overvalued currency.  Not only are Big Macs twice as expensive in Zurich but everything else is too.  It costs 164 US Dollars to buy $100 worth of stuff in Switzerland.

    Noticeably missing from that table is China.  Those PPP figures are all calculated by the OECD (Organization for Economic Co-operation and Development), of which China is not a member.  We've all heard stories about how cheap things are in China, from food to lodging to labor.  A few years back a friend of mine went to China and he said they would buy beer for about $0.40 a bottle and enjoy them on the beach.  So we already know that the RMB is super-weak relative to the rest of the world.  It's pegged to the Dollar at a very low level.

    If you were thinking about shorting the Dollar keep in mind that it's already one of the cheapest currencies in the world on a PPP basis.  On top of that, when you short the Dollar you are in one sense shorting the Chinese RMB, widely agreed to be one of the most undervalued currencies in the history of the world.

    Come on, who really wants to bet against 40 cent beer???

    The perils of universal "truths"

    It ain't what you don't know that gets you into trouble.  It's what you know for sure that just ain't so.
    -Mark Twain

    The thing that should scare people most about shorting the Dollar is that just about everybody agrees it's a good idea.  Remember last year when the entire world  in agreement that the Dollar had nowhere to go but down?  Or how about the apex of universal Euro hatred back in May?

    As soon as everybody piled onto the same side of the seesaw, everything started to move the other way.

    Why do people do this?

    Past performance is NOT indicative of future results

    In the world of psychology there is a concept known as the recency effect.  It's a cognitive bias that describes the disproportionate emphasis humans place on recent events, especially when it comes to forecasting the future.  When we look out to tomorrow, we think of yesterday and assume we'll see it again.

    When it comes to investing, it is the assumption that past performance will indicate future results.  For some reason, nobody takes this ubiquitous disclaimer seriously and the reason is that their brains simply aren't wired to.  That's why there's a disclaimer to protect people from their own natural biases.

    Consider the following recent events:

    1.  A massive rise in commodity prices over the last decade.

    2.  Substantial depreciation against most major currencies over the last decade.

    3.  The Dollar is now one of the cheapest currencies in the world on a purchasing power parity basis.

    So it's no surprise that everybody hates the Dollar.  And because of the recency effect, everybody assumes this trend will continue.

    At this point investors should not be asking if an epic Dollar crash is in front of us.  They should be asking if it's already happened.

    How to play it

    Jens Nordvig, director of currency research at Nomura Securities, was on Bloomberg earlier in the week and the host asked him about his number one trade for the next couple weeks.  He said, "the next couple weeks you want to be long the dollar going into the [FOMC meeting].  I think the dollar is going to surprise you."

    He actually got laughed at!  Though Tom Keene, classy bowtie-wearing guy that he is, followed the laughter up with a compliment for taking such a bold, against-the-grain view.

    It carries risk, but that's one thing you can do.  PowerShares offers a US Dollar Index Bullish Fund (ticker: UUP).  Generally speaking, I'm not a fan of funky ETFs like this that are based on derivative contracts; they are much more effective trading vehicles than investments.  But this is a fund that will make money in a short-term Dollar rally.  And in a risk on / risk off world where everything correlates something like that can be a nice hedge as we figure out exactly what the Fed is going to do.

    Another option is to just hold on to your dollars for the time being.  I know that interest rates are super low right now, but this is one of the best times in history to sit on a large pile of cash.  Your purchasing power has actually increased a little bit in the deflation of the last few years and even with quantitative easing on the horizon, there aren't too many serious threats to your purchasing power.  It takes a lot of discipline and I'll understand if your hunger for yield sends you down another path.

    Commodities are the worst things to own in a Dollar rally.  Things like crude oil (NYSEARCA:USO) and corn and gold (ticker: GLD) gets killed when the Dollar strengthens.  So be careful with that stuff or companies that are direct plays on the commodities boom.  That includes agricultural companies like Potash (ticker: POT) or Monsanto (ticker: MON), oil refiners like Exxon (ticker: XOM) or Royal Dutch Shell (ticker: RDS.A), and miners like BHP Billiton (ticker: BHP) or Rio Tinto (ticker: RTP).  

    Don't panic -- I like those kind of stocks over the long run because we all know:

    1. The Dollar always goes down over the long run against real assets and physical goods.
    2. The world's population and need for resources will keep increasing until about 2050.

    So a Dollar rally can be a good time to pick up stocks like that a little cheaper than they usually trade.  Otherwise, steer clear.

    If the markets still make you nervous and skeptical, the good news is that you don't even have to be an active investor to benefit from all this currency knowledge.  A more fun way to play the Dollar is to use what you know about it to your advantage as a savvy traveler.

    It's hard to believe that a night at this hotel:

    costs basically the same as this one

    for the American traveller.

    This is how big a difference purchasing power can make.  It sounds nuts but you can stay four nights at the Fiesta Americana Grand Los Cabos for $169/night and get a $200 credit for food!  This is the kind of thing that's possible when you take a stronger currency to a country where the local currency is weak.  I can't even wrap my mind around how awesome a deal the average Brit gets in Mexico right now.

    When you're planning your next a vacation, take these factors into consideration.  Grab a PPP table or the latest findings from the Big Mac Index and hit up the countries that are cheaper.  Now's a good time to visit Latin America and the Pacific Rim (ex Japan).  It's not a good time for that Great European Adventure you've always dreamed about.  Don't worry, though, the Euro will have its day in the gutter.  And when it does, I guarantee they'll appreciate your tourist dollar!


    Here's the Big Take-Home Point

    We all know that over the long run the Dollar only gets cheaper against the goods we buy.  We feel this intuitively and see it when we look through our past.  After today, you all know why that trend must continue.  Let's hope that Chief Bernanke is able to kindle a little bit of inflation to get things moving again.  

    Because of this, most investors lack appreciation for the Dollar in the capital markets and don't properly identify opportunities.  From their perspective, their dollars just get cheaper and cheaper over time and they don't understand that every other country is pursuing a similar policy objective.  In order to identify the real opportunities in the currency world, one needs to understand all the different ways to measure value.  Tools like currency cross rates and purchasing power parity will help you spot these opportunities.  They might be big-money macro bets like shorting the Japanese Yen against the Turkish Lira or they might be something simple like helping you enjoy a week of the good life on vacation in a country like Mexico or China.

    A lot of people are afraid about a Dollar crash right now, but they're about ten years late to that party.  The time to worry about a Dollar crash was in 2001 and by any stretch of the imagination, that's exactly what we've had since then.  It's certainly possible that the Dollar isn't done going down, and in fact, it's highly probable that it will keep going down against real assets over the long run.

    But in the meantime, the Dollar will bounce all over the place.  Against the other major currencies, don't be surprised to see it exhibit some relative strength through 2011 and into the coming decade.


    Disclosure: Long XOM, long GLD
    Oct 27 1:52 PM | Link | Comment!
  • Why Gold?

    Gold seems poised to make a new all time high in the next week or so.  Yesterday it briefly traded over $1,260/oz.

    I can hear you asking: is it expensive?  Is it cheap?

    To answer that question we're going to play one of our favorite economist games.  You guys like games, right?  This game is called "Let's Price One Thing in Terms of Another."  Don't laugh!  It's actually much more fun than it sounds.  It's fun because it's a game that can make you money.

    See.  You stopped laughing, didn't you?

    This kind of analysis -- to try and clearly discern gold's relative value -- is really important right now.  It's amazing how divergent analyst views are at present.  The gold bugs have been dancing in streets for what seems like forever and the most aggressive of their forecasts call for gold to get above $2,000 or $3,000 per ounce.  On the other hand, it's easy enough to find guys like MKM's Mike Darda who believe gold should be down around $400-500 per ounce.  How is it possible for two groups of people to have such a wildly different set of predictions?

    It's Draconian custom to look at things form a slightly different perspective, but we'll begin with a relatively straightforward view.

    In our first chart we have 110 years of gold prices.  Any time we take this long a perspective of something, it's imperative to adjust for inflation and we've done so here.

    Pretty cool chart, huh?  It's amazing how such a simple graphic can be so eye-opening.

    There was only one time in history when gold was more expensive than it is right now.  It was during the midst of a speculative bubble.  Is it in a bubble today?  Depends which camp you bunk in.

    Before we get too excited about this chart, know that it carries a gigantic disclaimer.  Prior to 1968 the U.S. was on a gold standard.  That is to say, the relationship between gold and the dollar was fixed.  That's why the line looks funny.

    The greenback has a lot of baggage right now, so let's take Dollars totally out of the picture.  What if we priced gold in another currency like the Japanese Yen and then adjusted for inflation?  In this next chart we have the number of Yen it takes to by one ounce of gold, again adjusted for inflation (Japan's inflation).

    It tells a similar story.  If you are Japanese, you're probably evaluating gold in the same way though you might be a little less worried about a bubble.  Gold has traveled quite a ways off its lows but it clearly hasn't been because of an increase in the general price level.  If it were, the real price would be flat.

    We can do similar charts for other currencies but the story will be basically the same in any language that employs a stable monetary policy.  The price of gold has gone up and it's gone up because of some reason other than a drop in value of the currencies it's priced in.

    This is worth mentioning because gold doesn't grow, earn interest, or pay a dividend.  A dollar on deposit in a bank will be worth a dollar 'n change a year from now.  A share of stock in a company naturally becomes more valuable as the company gets bigger or as the company increases the amount of dividends it pays to its shareholders.  Gold doesn't do anything like this.  Its value, like that of any other currency, is based entirely on supply and demand in the capital markets.  Unlike most commodities, the supply of gold is fairly easy to get a handle on and easy to forecast.  Most of the price movement is thus driven by the demand side.

    So why has the demand for gold gone up?

    I'm sure each one of you has an answer.  I have a few of my own but I'd like to submit that demand for gold might be increasing simply because the price is going up and demand is increasing.  That logic might sound circular because it is!  It's a virtuous circle.  If I know one thing about investors it is that they are slavish performance chasers.  With something like gold, more chasing of the asset by definition translates to better performance for the asset.  Virtuous circles are a lot of fun until they snap.

    Again, I'll chicken out and stop short of calling "bubble" right here.  But know that virtuous circles and positive feedback loops play a major role in inflating bubbles.  In both an economic and psychological sense.

    I tell people over and over that the best way to look at gold is as a neutral currency.  And in this framework, the demand for this neutral currency is driven primarily by a dislike of fiat currencies, particularly the US Dollar.

    If you own gold simply because you hate the Dollar or because you're sold on the hyperinflation meme, why not express that view a different way?

    Seriously, think about it.  Unless you have an intrinsic interest in gold, why not use some other asset to express your dislike of fiat currencies and fear about inflation?

    Why not buy Yen or Euros?  Or the Loonie?  Canada's fundamentals are pretty good.  The New Zealand Dollar even pays you a decent rate of interest!   Why not buy a house?  Or farmland?  If it's the US Dollar that you're really concerned about, why not exchange a few for something like energy stocks?  Or TIPS?

    Why gold?

    I suppose that's less of less of a technical question and more of a philosophical one.

    The tip of your tongue

    Back to that central question that I know everybody wants to have answered.  I've dodged it twice so far.

    Is gold in a bubble?

    You tell me.

    That chart plots gold's current ascent against a few other famous bubbles in history.  Something bubbly may indeed be forming, but if gold completely collapses tomorrow, I'm not convinced that we will label it the bursting of a bubble.  On the other hand, if gold does make a run above $2,000 at some point in the next few years, I will absolutely start throwing around the "b word".

    If it's still not clear whether or not gold is being artificially inflated based on speculative demand, let's get back to that question of whether it is expensive or cheap.

    I warned you there would be lots of charts.  Here's one that prices the Dow in ounces of gold.  It measures the number of ounces of gold required to buy one share of the Dow.

    I used the Dow here because it naturally adjusts for dividends, and since it's also denominated in dollars, we can relate it to gold without adjusting for inflation.  The chart covers the years post 1968 as we've been off the gold standard.  It's also log scale, so the rate of change (slope) has meaning.

    Now, we can't just think about this ratio in an absolute sense.  Over the long run and in aggregate, we shouldexpect the Dow to increase at a rate greater than gold because the Dow pays a dividend and participates in growing GDP.  That's why I included a trendline.  That trendline isn't an exact frame of reference, but it will help your brain interpret this chart the way it should be interpreted.  The Dow/Gold ratio oscillates around an ascending trendline, not a flat average.

    You shouldn't use a chart like this to make a buy decision about either asset.  I can't conclude from this if gold or stocks are expensive or cheap on their own.  But I can conclude -- fairly confidently -- that the further that ratio gets below the general trendline, the more stocks I want to own relative to gold.  The further that ratio gets above the trend, the more gold I want to own relative to my stocks.

    It's a rather slow moving chart, but I like to bring it out and dust it off every so often because it does a really good job helping you identify the times when either gold or the stock market is obviously expensive or cheap.  We didn't know it at the time, but 1968 was a great point to own gold and pass on stocks.  By the early 1980's, the smart choice was swapping some of that gold for more stocks.  That was a good strategy for a long time but by 2001 it was time sell those stocks and buy back some gold.  This chart won't time it perfectly, but it's good enough if you have a long horizon.

    If you work in the industry and spend a lot of time thinking about proper asset allocation, this kind of analysis can be particularly helpful.

    Again, it's tough to make the claim that gold is in a bubble right now.  But it's easy to point out that gold is getting expensive here and it's easy to see that another 50-100% increase in the price of gold over the next few years should set off some alarm bells.

    Let me repeat that another way with different emphasis: gold can only be considered cheap at these levels if the market is heading for another bubble or if the U.S. is heading for hyperinflation.  There are clearly safer and possibly more effective ways than gold to hedge the risk of hyperinflation, so ultimately I think the belief that gold keeps going up comes down to a bet on a bubble or at the very least, continued speculative interest.

    My two bits

    As for my personal view, I don't believe that fundamentals are playing much of a role in the day-to-day movement of gold.  In fact, I'm not sure they're playing any role.

    I think most of the action is driven by speculative forces, not unlike what we saw push crude to record highs back in 2008.  I use crude oil circa-2008 as the analogy because in both instances the market was tricking people into believing an incredibly convincing fundamental story.  Back then the majority of the world bought into some variant of the "peak oil hypothesis".  Escalating demand + dwindling global supply painted a pretty clear picture.  It was easy to see and the market tricked itself into thinking that the soaring prices were justified by these fundamentals.

    As for gold, a similar story is being told.  The most popular and convincing argument for owning gold is to protect oneself against future inflation (even if we've shown that it's a rather poor hedge against typical inflation).  Given the current state of the U.S.'s balance sheet, it seems like a no-brainer that inflation will be a problem for our country at some point in the next decade (even if the bond market doesn't hold this view).

    Here's the thing: I think that the crude oil thesis is still good.  I think the long term supply/demand fundamentals point in only one direction for oil prices.  The tough part is that it's going to take longer to play out than we all thought a few years go.  Loading up on crude oil back then was a disastrous investment strategy even if the basic thesis may ultimately prove correct.  And it's the same deal with gold.  Looking ahead into the next few decades it seems hard to avoid a serious bout against inflation.  Isn't that what Reinhart & Rogoff taught us?  That these stories of debt gone awry end in one of two ways:

    1. Default
    2. Inflation (a sneaky way of defaulting)

    For 800 years it has unfolded in the same way.  Heck, even the ancient Romans figured that one out and slowly debased the denarius by minting them with less and less silver.

    Anyway, the thesis for gold appears sound.  But like crude oil a lot can happen between now and then and if I can make one guarantee, I'll guarantee that the story won't play out in the exact sequence that most are expecting.  Always remember: investing doesn't work like a wormhole.  Do not fall victim to The Wormhole Fallacy.  Don't do it!

    If you load up on gold at these levels, strap in for a bumpy ride.  I wouldn't be surprised at all if gold went to $800-900 before going to $2,000.  And if you think that gold can't get back down under $1,000/oz, you haven't studied enough history of the gold market.  The gold market is certifiably insane.  I know Reinhart & Rogoff don't have 800 years of data about gold traders, but I'm pretty sure all of those guys end up the same way:

    1. Going crazy
    Thanks, but...

    We've taken a twisty trail through a foggy forest today.  Where exactly are we now?  What conclusions should we take home with us?

    For one, do not try and short gold at these levels.  The trends in gold are immensely powerful right now and I'm not one to step in front of freight trains.  If you want to ride the trend, go for it.  Just understand what can happen if the Gold Train derails.

    If you've owned gold, good for you.  *HIGHFIVE*  If more than 10% of your investment portfolio is gold, now is a good time to think about bringing that back in line with a more appropriate weighting.  But my guess is that if more than 10% of your portfolio is in gold you're either a gold bug, John Paulson, or someone who really knows what they're doing.  In the event that you are actually John Paulson, please contact me at so I can tell you about our awesome investment products!

    If less than 5% of your portfolio is in gold, you're probably better served just hanging out for a pullback.  Don't worry, gold always pulls back.  I think that 5-10% is a good weighting for the average investor to have in gold.  Bullion is best.  Coins are cool.  And the GLD ETF is fine.

    I think everybody needs to own gold at all times but not because I expect it to always perform well.  I like gold for one reason and one reason only: it's different.

    I like things that are different and things that are different can be incredibly powerful tools when it comes to constructing a robust investment portfolio.  Over the long-run, gold has exhibited little correlation with any other asset class.  That is immensely desirable for professional asset managers like us.

    My lovely wife, Mrs. Draconian, swears that gold has other "utility" but this is a debate that is still unfolding in our household.  Her birthday is approaching.  Currently, she has the upper hand in the argument.  Perhaps some of you other men out there understand what a troublesome confluence of events this represents.

    Yet again, the conclusion seems inevitable.

    The Box

    I feel like I've fallen a little short this week.  Informative, perhaps.  But this week I think I missed the mark on usefulness by raising more questions than I answered.  So I'll close with a personal story that I was reminded of as I wrote all this business about gold.  If I can't be useful then I'll at least try to be entertaining.

    I'll never forget my first experience with gold.

    You see, I am the son of a gold bug.  Before founding an investment firm and launching his own fund, my dad was a local coin dealer.  I'm sure that was a great business in the late 70's when gold was going up, but now I see why he gave it up in the early 80's and pursued a different line of work.  I doubt people were buying much gold as the bubble was deflating.

    Despite that, he was a guy with an undying love of precious metals.  He wrote a newsletter about gold .  He kept bags of silver in a vault downtown.  He was a man that buried bags of pure-copper pennies in the backyard.  I was told repeatedly as a youth to some day dig them up when the price of copper was higher than that of the penny.  Are pennies even still made of copper?  We had an honest-to-God treasure map for their location.

    One day he came home and set a small box -- maybe half the size of a shoe box -- down on the kitchen counter.  I picked it up.  It was very heavy.  Inside was a dozen or so plastic cylinders.  They were sealed tightly and he would not permit me to open any of them.  He did uncork one tube, however, and emptied out a single, radiant coin.

    "Daddy," I said.  "What's that?"

    "It's your college education."

    There were probably two or three hundred one-ounce Canadian Gold Maple Leafs in the box.

    It might have been $100,000 of gold sitting right there on the kitchen counter, where later that night I would eat my mac 'n cheese.  I wonder how much of his entire net worth was sitting there in front of us.  My little mind couldn't fathom that, of course.  But the enormity of it left an impression nonetheless.

    Who knows why we recall the specific experiences that we do from childhood.  Whatever the reason, this one would impact me me in several profound ways through the rest of my life.

    As a boy I remember being utterly transfixed by those coins, if not on the surface then subconsciously so.  I wonder if there's something deeper that attracts us to gold, something woven into our genetic code, something baked into the marrow of our bones.  I think this might be why the history of the gold market is one of madness; it's a corollary to our own history as humans.  That knowledge and that feeling follows me everywhere.

    By the time I went to college, those coins were worth half of what he paid.  He always hoped I'd go to Stanford but I wound up at UCLA.  Tuition was probably cheaper than what he originally budgeted, but I doubt that box of gold coins would have paid for all four years.  When I graduated, I thought of those coins.

    After graduation my first job was as a commodities broker.  (Remind me to tell you that story sometime, the story of my first day at work -- it was September 10th, 2001.)  Gold was trading in the mid-$200's.  It had gone down for almost twenty straight years and was sitting at a generational low.  Every single person I talked to about gold hated it.  Everyone.  No rational individual considered it a worthwhile investment.  Even most of the old skool gold bugs had given up that ghost.  I'm astonished at how dramatically sentiment has changed in just the last ten years.  Don't be surprised at how dramatically sentiment can change from here.

    Today as I reflect on that box, I realize what he really was doing was making an investment in me.  Even if that box wasn't literally for my college education.  There was something large and weighty sitting on the counter, and that put the hopes and expectations for me into perspective.  Today that much gold might be worth close to half a million dollars.  That's a lot of money that was invested in me.

    There's not a day that goes by that I don't wonder if that investment was worth it.

    I can only speculate.

    Disclosure: Long GLD, Long TIP
    Sep 09 11:09 AM | Link | Comment!
  • Six Things Most People Don't Know About Gold (Part 3)
    Click to read parts one and two.

    5) Sorry, Tea Party.  We’re not going back to a gold standard.

    And take away Obama, Bernanke, Geithner & Co.’s ability to keep printing more dollars on demand?  puh-lease!

    They might be fighting a noble fight, attempting to combat the effects of a nasty recession, but know that each dollar that gets printed or pumped into the system via quantitative easing runs the risk of decreasing the relative value of all the other dollars in the system.  It’s simple supply and demand.

    There’s been substantial easing already, but we haven’t seen many signs of price inflation.  One of the big reasons why is frequently overlooked: there has been a total collapse in monetary velocity.

    The velocity of money is just the average frequency with which a dollar is spent within an economy.  For example, if I have $1 and use it to buy a cup of coffee from you, and you then take that $1 and use it to buy a donut from me, we’ve created $2 of Gross Domestic Product for the little economy that exists between you and me.  Our $1 of total money supply has turned over twice. With this, we can actually rewrite GDP another way:

    GDP = M (the money supply) * V (the velocity of money)

    So when the velocity of money in a big economy like the US drops because people slow down their spending, The Fed needs to increase the money supply to prevent a subsequent drop in GDP.  It typically does this by purchasing government bonds out in the market which increases the reserves at banks which means they can turn around and loan more money to people.

    Here’s a monetary velocity chart for M2, which consists of things like paper currency, bank checking deposits, traveler’s checks, savings & time deposits, and money market funds:


    The big reason for that sharp drop in velocity has been banks’ unwillingness to lend out money because of shakier capital foundations and stricter lending standards.  There’s a reason the banking system in particular has been so aggressively targeted with stimulative efforts.  Imagine a giant network of gears – the banking system is the big gear in the middle that turns a whole bunch of smaller gears around it and so The Fed has spent the majority of its efforts getting that central gear turning again.

    This is all relevant for gold because, as you can see, we’ve needed to aggressively grow the money supply lest that collapse in velocity seriously impact GDP.  But the great economist Milton Friedman warned we shouldn’t ever increase it by too much.   Increase the money supply by too much and you do get inflation.  It’s a tight rope act.  And like any tight rope act, it’s incredibly captivating because so much is at stake – the life of the rope walker or the fate of our currency.

    There’s a very common false argument out there that simply “printing money” (via quantitative easing) will destroy the dollar, create inflation, and therefore drive the price of gold sky high.   This isn’t always the case.  Thereare times when good old fashioned money printing is what’s called for, especially when we want to make a nasty recession a little less nasty.  A gold standard would throw a monkey wrench in The Fed’s ability to do that.  It also would make it much more difficult for the US to pay back its creditors, but that’s a whole ‘nother can of worms.  We’ll explore that rabbit hole in another letter.

    The US paper dollar has value because we can always use these dollars to settle our debt with the government (aka income taxes).  So long as everybody needs to pay taxes then paper dollars will have some sort of value.  I know that if I offer my services in exchange for your dollars, I will accept your dollars because I can use those to settle my tax bill next April.

    That being said, the track record of fiat currencies throughout history is very poor.  Many have involved spectacular collapses from the late Romans to John Law’s 18th Century France to Weimar Germany to more recent collapses in the Mexican Peso, Thai Baht, and Russian Ruble.  There has never been a major fiat currency that has lasted very long.  I’d like to think our track record will be better here, but really bad things have happened in the US before and really bad things will happen again.

    A currency crisis could be one.

    Which brings me to…

    6) Every investor needs to own gold.

    If you have an investment portfolio of significant size, some of that portfolio needs to be allocated to gold.

    If you've ever met with a financial advisor, you've surely heard something about building a “balanced portfolio”, something like 60/40 or 70/30 stocks and bonds depending on your age.  Target Date funds are very popular now with mutual fund companies; these are funds that start out aggressively with allocations to riskier equities and then slowly get more conservative and add more fixed income as they move towards a “target date” at which one will presumably retire.  They’d be a neat idea if that was the way investors actually invested.

    But how many financial advisors have seriously urged you to add gold to your portfolio?  Where's the 40/40/20 portfolio? Or where’s the “six dimensional portfolio” that allocates across cash, equities, bonds, gold, real estate, and alternative funds?  That’s real diversification for you.

    Anyway, let me be clear: own gold.

    The reasons for owning gold are numerous, but only one reason matters.  The only reason that should ever matter when adding any new investment to your portfolio.  Gold is different and it moves in totally different ways.

    And I've got good news.  It's a lot easier to add gold to your portfolio than you might think.

    The easiest way to get it is through a gold ETF.  There are several gold ETF's (exchange traded funds), but GLD is what I use.  You can learn about The SPDR Gold Trust here, but the key thing to know is that it holds physical bullion.  A lot of commodity ETFs – you might be familiar with UNG (natural gas) or USO (crude oil) – just hold or trade the futures contracts which is problematic because futures contracts expire and before they do, new ones need to be purchased.

    Without getting too technical and dropping crazy terms like "backwardation" and "contango" (two of my all time favorite words) you simply need to be aware that the values of these ETFs won't perfectly track the underlying commodity.  Sometimes they'll go up more than the underlying commodity, but because of the nature of commodity markets, they usually underperform.

    So if you buy GLD, you're technically buying shares of a trust that holds a whole lot of physical bullion.  GLD will move in almost perfect lockstep with the actual price of gold.

    Owning gold through a trust is cool, but owning physical gold is really cool.  Show someone a 1oz gold coin and watch how they react.  It's a great party gimmick and is guaranteed to impress your friends.  You can buy gold coins through the US Mint or through a local coin dealer or an online dealer like Monex.  You can even buy gold coins on eBay.  There are all sorts of places to get it, but the most important thing here is that you should alwaysexpect to pay a premium for physical gold.  When you see the price of gold on the news expect to pay a bit more than that for some coins or bars.

    Another way to own physical gold is by buying jewelry.  No joke!  It's definitely not the most efficient way to get it, and it's probably one of the least liquid forms of gold, but it does happen to be the most fun.  Your wife will thank you for it, too.   And surely that's worth the extra cost?   Wives, if you're the one reading this – kudos, by the way – have your husband study this newsletter top to bottom and tell him it's a good way to diversify your investment portfolio.  Really!

    Just make sure the jewelry is of good quality – as an investment, more pure gold is better, but my mother-in-law has informed me that 24 carat gold (99.9% pure) doesn't make for the best jewelry. So the two of you will need to compromise.  But hey, that’s marriage.


    If you're looking for a little more kick, try picking up some stocks of companies that mine gold.

    These are familiar names here in Nevada.   Most of you, especially those of you between Lovelock and Elko, are familiar with the Newmont (NEM), Barrick (ABX), and Coeur d’Alene (CDE).   You can also check out Randgold (GOLD), AngloGold Ashanti (AU), Agnico-Eagle Mines (AEM), Goldcorp (GG), or Kinross (KGC).

    Traditionally, these have been a more “leveraged” way to invest in gold; these gold stocks typically go up more than gold if gold's rising, and fall farther than gold if gold's going down.  They don't typically move with the broader market to the extent that other economically-dependent stocks do, so if you're building a simple portfolio of stocks, gold miners are a great way to get equity diversification.  I'm not a mutual fund manager, but if I were, I would absolutely own gold stocks in my fund.  You can buy a straight basket of all the gold miners in one easy purchase with GDX, an ETF that mirrors the NYSE Arca Gold Miners Index.

    If you don't mind the extra layer of fees, you can also pick up a gold mutual find like Tocqueville (TGLDX) or Gabelli Gold (GOLDX).  They'll hold a mix of actual gold and gold stocks and sometimes some related positions.  Sometimes it can be worth it to have a professional fund manager’s expertise.

    I feel as though I need to make one final thing clear.  It's subtle distinction, but when I say that every investor needs to own some gold, I'm not saying that I think that gold is necessarily going up in price.

    I do think that a decade from now it will be higher than it is today, but I'm a lot less sure about where it's headed over the short run.  Unfortunately, that's a call you'll need to make on your own.  But if you've made it this far in this article, you're certainly equipped to do so, and with confidence.

    Caveat Emptor

    Dwarf Miner

    As you’ve listened to me pontificate about gold, you need to understand who I am in order to put my comments into proper context. As with any advice you hear dispensed from any fountain of so-called expertise, you need to develop an understanding of the source before blinding accepting its ideas as your own. You need to be aware of my biases and predilections.

    I am a second generation native Nevadan. I was born here, raised here, then ventured out into the world only to return here. I love living in Nevada, and not only that, feel spiritually bound to the region. As a kid I spent many a summer vacation in the South and would later live and work for 6 years in Los Angeles. So I understand powerful local cultures, to be both a part of them and exist within them as an outsider.

    Nevada is who I am, and Nevada itself is a composite of others like me, individuals from present and past.

    Gold is a key part of our state and our history.

    Nevada produces a whopping 80% of all the gold mined in the United States. Those of you readers from other states or outside the country might not understand how proud we are of our mining heritage. The discovery of the massive Comstock Lode underneath Virginia City was one of the most influential factors in Nevada being admitted as an official Union territory. Abraham Lincoln saw the opportunity and welcomed us to the Union, ensuring that our silver riches would assist their cause and not the Confederate's.

    As a state of no-frills pragmatists, Nevadans understand mineral wealth. To us these metals are not “bling”. They’re not a fad, nor are they for speculatin’. These metals are practical, useful. Necessary, even. They are hard assets.

    What kind of person holds gold through a 40-year rollercoaster from $100 to $850 back to $250 and onward above $1000?

    Nevadans do.

    Like Tolkien’s Dwarves of Moria, we are transfixed by gold’s eternal, timeless worth. We are the ones who work so hard to pull it up from deep in the earth only to re-bury it in our vaults for subsequent generations.

    Perhaps we do have an innate understanding of gold that others don’t. But we couldn’t possibly be considered objective – which isn’t to say you should regard this aspect of our regional culture with complete skepticism.

    All I’ve really given you thus far has been facts.

    Disclosure: Long GLD
    Jul 13 3:00 PM | Link | Comment!
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