The Fed's Powder Keg Is Locked And Loaded - Gold Armor Is The Best Defense

Includes: ABX, GBG, GDX, GG, GLD, NEM, UUP
by: Alberto Savrieno

For those of us who have been following the gold market for the last decade, it's nothing new to note that the price of gold and the dollar index tend to be inversely proportional. Here's a one year chart of the GLD gold ETF versus the UUP dollar ETF.

We hear very often that Bernanke is "printing money," engaging in quantitative easing, QE-infinity and the like. In a way this is true. But when Bernanke "prints money," you don't exactly see your checking account balance going up. If everyone's checking account increased in proportion to the amount of money Bernanke was pumping into the economy, there would be an immediate increase in the money supply and consequent immediate price inflation that would have everyone freak out and dump dollars for gold and silver in a hyperinflationary spiral. That wouldn't work.

So instead, Bernanke does something rather unwise. He credits huge banks with excess cash reserves every time he does QE, and the cash is dormant. The money is not in circulation, so it doesn't affect prices immediately. It's more like a huge pile of explosives, dormant until somebody lights a match by loaning it out for use. Look at the chart below and be amazed.

This is the amount of cash in reserves at banks throughout the county - not in checking or savings accounts, but in reserve for use in future lending. It has been basically zero since 1959. Now it has jumped to over $1 trillion, and that didn't even take a year. The explosives are still there. Excess reserves have not gone down substantially since 2009 when the massive bailouts started.

If and when this cash starts being lent out - either due to an uptick in economic activity or by force from government in an attempt to grease the economy, then the match will be lit. The money supply will explode as has never been seen before in history, and two things will happen. The price of a dollar will collapse, and the price of gold and silver will go up fast.

I don't know when the match will be lit. All I know is that the explosives are set. To take advantage of this explosion, you can either buy physical gold and bury it in your backyard (I'd stay away from safety deposit boxes in case owning gold becomes illegal again as it was from 1933 to 1975), or you can invest in the companies that produce it.

Precious metals miners are in a unique position to be protected from the explosion. On the one hand, the cost of mining gold will go up as the money supply expands, but so will revenues as the price of gold goes up with it. The basic bet for miners investors is what will go up faster? The cost of mining or the price of gold? There is a balancing negative feedback loop here in that if the price of mining goes up too fast, then companies stop mining, supply stagnates, demand goes up, and the price of gold catches up to equilibrium.

The easiest and safest route is the gold mining ETF, GDX. This eliminates company-specific risk and the decay from fees is very low. Here you can find its full list of holdings. This fund is severely undervalued at a p/e ratio of 16. It could become even more so in the short term due to the heavy rise in the cost of mining and recent earnings misses by some big players, but if you have the patience to wait for the big Fed-induced money supply explosion, the reward will be much worth the wait.

If you'd rather invest in straight stocks, then the big three in terms of market cap are Barrick Gold (ABX), Goldcorp (GG) and Newmont Mining (NEM). ABX is the best bet short term in my opinion due to its suffering a huge drop in an earnings miss at the beginning of the month, its 10-day RSI skirting 30, and P/E an anemic 10.76. All this could set it up for a big pop once the market stops fretting over the past and starts looking toward the future. GG is less attractive short term but just as tantalizing long term. It is not nearly as oversold as Barrick and its P/E is a healthy 23.5. Newmont is something in between, being that it has also been beaten down with an earnings miss, which presents a buying opportunity, but it's P/E is in the stratosphere at over 120, which is cause for concern. None of these timing considerations, however, will be important once that match is in fact lit.

One of the most interesting, may I say daredevil, options in the sector is Great Basin Gold (GBG). Surprisingly, GBG is also a component of the GDX fund, be it a tiny one. This company has been absolutely fleeced due to mismanagement, debt, and serious problems at its mines. Its market cap has shriveled from over $1.6B down to a micro cap level of $48M. But there are two things it does have: $715M in hard assets and mining property that they can't develop for lack of cash. Trading is currently suspended for GBG at just under 9 cents a share, but if there was ever a time for someone to take over this company and get it going again, the Fed's cash powder keg suggests that there's little time to waste.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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