To Taper Or Not To Taper - Go Long Gold Either Way

by: Dave Kranzler

It seems that the biggest topic of debate in the financial media and in the investment community is whether or not the Fed should and will taper QE either at the September meeting, at any of the subsequent meetings this year or whether it will even taper at all. My view is that the economy, regardless of how the Bureau of Labor Statistics chooses to run the numbers, is structurally in a state of economic contraction and the Fed will not taper. I first discussed the QE/taper issue right after Bernanke uttered the word in this article, "To QE Or Not To QE...", in which I suggested that the Fed would not taper. A month later I discussed the consequences of a "taper" and stood firm in my conviction that the Fed would not: Taper/Stock Market Avalanche. At this point there is a small possibility that the Fed will offer up a token amount of taper, but whether the Fed does this or not gold and silver are a table-pounding buy once the decision has been released.

The reason I don't think the Fed will taper yet, if at all, is that it is clear - at least to me - that the economy is in trouble. Just today the monthly durable goods report came in at -7.3% vs. the -4% expected. The previous month's gain was revised lower. While it's true that largest component of the drop was from transportation/aircraft orders, which is always volatile in both directions, ex-transportation the number was still -.6% and non-defense capital goods excluding aircraft orders fell 3.3%. The market seems to like to use copper - euphemistically called Dr. Copper - as its indicator of economic health. This was copper's reaction after today's durables report:

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Clearly the market is nervous about the true strength of the economy.

But there's more. Last week both the Empire State manufacturing index and the Philly Fed index - both for August and thus very current - came in well below expectations and quite a bit below their readings for July. Also, new home sales for July were reported to be 13.4% below June's number, which was revised down from its original reporting by 8.5%. Based on the factory activity and new home sales there can be no question that the economy has been experiencing a dramatic slowdown this summer. The home sales reports are especially troubling because the housing market is supposed to be at its seasonal peak and July is historically always the second or third strongest month for home sales.

Finally, big corporations are stating either outright - in indirectly with poor quarterly results - that the economy is weak. On August 14 Cisco (NASDAQ:CSCO) reported its fiscal fourth quarter in which it lowered its outlook, chopped 4,000 jobs and the CEO stated that the economy is "challenging and inconsistent." Even more troubling, Wal-Mart (NYSE:WMT) a day later reported second quarter results in which it experienced its second straight quarter of negative same-store-sales and also cut its full year profit outlook and earnings guidance. Cisco is one thing, but when you add together the housing market and WMT, it means the economy is likely in a lot of trouble, especially in terms of the consumer. The consumer has been roughly 70% of GDP for close to two decades. I recommend listening to this brief interview with retailing expert Howard Davidowitz: "Walmart Earnings Disaster Exposes a Collapsing Economy".

With that as my context, I still believe that the Fed will hold off on a taper decision until after September. Enough Fed officials have stated recently that they need to see more data, indicating to me that the Fed has willingly built in an "escape hatch" in order to defer the decision without surprising the market. If the Fed does decide to reduce the amount of QE it is injecting into the financial system, it risks the same outcome that occurred in 1929 when the Fed reduced the money supply right before the economy tipped into a depression. A taper now would be the same mistake the Fed made back in 1929. Please recall that it was this mistake by the 1929 Fed that Bernanke pointed to and claimed he knew exactly what to do to in order to avoid a depression and deflation. It seems unlikely that Bernanke wants to go down as the Fed Chairman who triggered the next big economic recession.

Regardless of whether the Fed implements a small taper or not, I think gold will move a lot higher in either case. In fact, if the Fed does announce a token taper, it will actually be bullish for gold. After a likely initial sharp sell-off in the metals in the event of a taper announcement, the market will quickly start to price in the probability that the Fed will have to not only undo the taper, but actually increase QE based on rapidly deteriorating economic data.

Moreover, at some point in the next 45-60 days Congress is going to have to approve a debt ceiling increase, which means the Government will soon be issuing a lot more debt which will need to be funded. The Fed has been funding close 100% of all new Treasury issuance since QE was announced. It will take much higher interest rates in order for the government to issue that debt unless the Fed buys it. It seems hard to imagine that the Fed will tolerate higher interest rates with the economy at risk. The market will therefore price in the likelihood of additional QE to come by taking gold/silver a lot higher very quickly after any taper announcement, if there is one.

If you agree with my view and want to make a play on higher gold prices, I first recommend buying some physical gold and silver bullion coins. My coins of choice are any sovereign-minted 1 oz. coins (American eagles, Canadian maple leafs, Austrian philharmonics, etc). If you want to "index" a move higher in gold, I like GLD or call options on GLD. If you want to make a more aggressive play, Powershares DB Gold Double Long ETN (NYSEARCA:DGP) offers 2x the daily rate of return on gold and VelocityShares 3x Long Gold ETN (NASDAQ:UGLD) offers 3x the daily ROR on gold. Conversely, if you disagree with my view, the best alternatives to express a bearish view are PowerShares DB Double Gold Short ETN (NYSEARCA:DZZ), which is 2x the inverse of the daily rate return on gold or VelocityShares 3x Inverse Gold ETN (NASDAQ:DGLD), which is 3x the inverse of the daily ROR on gold.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. The fund I co-manage and am invested in owns physical gold, silver and mining stocks.