That’s Nice And All, But What Do We Do About It?
So, assuming you’re not asleep yet after that long setup, let’s get to the question that people are actually interested in: What are we supposed to do about this?
“Stores of value” perform best in an environment of slow growth and rising inflation (i.e. - stagflation), and the ultimate store of value throughout recorded history has been gold, which outperformed just about every asset class in the stagflationary 1970s. There’s also another way to look at this, which I like to call the “smart guy trade”.
What Are the “Smart Guys” Doing?
Since 1998, the “smart guys” have asked not how can I attack this bubble that is popping (in 1998, that financial bubble was embodied by failed hedge fund 'Long Term Capital Management'), but instead how will the “powers that be” respond to the bubble popping and what asset will benefit the most from that response?
In the case of 1998, the massive amounts of liquidity that were injected into the system by the Fed to avert a financial meltdown following LTCM’s collapse resulted in the tech and equity bubble of 1999-2000. So, the “smart guys” bought Internet and technology stocks in 1998.
In 2000, when the tech bubble popped, it became apparent that the Fed would once again respond by printing money. What did the “smart guys” do? They bought real estate and housing stocks in anticipation that the Fed’s actions would create a bubble in housing.
Fast forward to today…the housing bubble has now unquestionably popped. How will the Fed respond? The answer is obvious. They will ease and ease massively.
The housing bust is already preventing the Fed from fighting the current rise in inflation or from defending the dollar, which is why the Fed hasn’t moved to raise interest rates in over a year despite the rest of the world continuing to tighten due to what they seem to perceive as an inflation problem (even though these foreign central banks have had the anti-inflationary benefit of having a strong currency vs. the dollar). As the housing bust worsens and causes problems in the financial system and U.S. economy, the Fed will eventually be forced to rev up the printing presses again, just like it always does in response to problems, except this time there are no more asset bubbles left to blow.
Instead, all you are left with is an eventual collapse in the dollar. But since the dollar is also the world’s reserve currency, other paper currencies also derive their “value” from the purchasing power of the dollar. So, the world's currency system is essentially based on the dollar. The result is that foreign central banks will intervene eventually to support the dollar in order to keep the system together. Thus, all currencies will suffer some of the dollar’s pain to a certain extent.
As a result, the dollar may not necessarily “collapse” against foreign currencies, although it will most certainly depreciate. The true “collapse” will be in the dollar’s purchasing power and the purchasing power of other global currencies that hold dollars as their primary reserve asset and import dollar-based inflation through intervention to support the dollar, and the biggest collapse of all will likely be in the dollar's value against a “store of value” like gold.
Thus at the end of the day, a “store of value”, like gold, may become the chief beneficiary of the official sector’s response to the housing bust.
So, perhaps the “smart guys” are now buying gold?
Thus far, the StreetTRACKS Gold Trust ETF (GLD) has inhaled nearly 30 tonnes of gold over the last two days and over 500 tonnes since its inception, making it the 10th largest holder of gold in the world behind the Chinese central bank (more on this ETF below).
Is China One of the “Smart Guys”?
The fact that China was going to eventually be forced to diversify its massive Forex reserves is not news, but as is often the case, the conditions may now be such that the market is going to react a little more violently to what appears to be an inevitability, even though the exact timing of that event remains somewhat elusive.
But can China diversify a large portion of its $1 trillion in Forex reserves into the euro for example? Practically, no, China cannot. A massive exchange of dollars for euros would drive up the euro vs. the currencies of the rest of the world, straining trade relations and causing mass financial chaos (not to mention crush Europe’s economy).
The logical choice for China to diversify its dollar reserves into is the only other widely recognized reserve asset held by central banks around the world and the only reserve asset held in any size by the U.S. Federal Reserve, gold.
So, Who Are the “Smart Guys” this Time?
One never truly knows the answer to that question until after the fact, but I think a good case can be made that the “smart guy” position currently is to be long gold as well as the shares of gold miners.
To buy gold, the easiest way is to simply buy the StreetTRACKS Gold Trust, which is an ETF that holds gold bullion.
Alternatively, if one wishes a little more leverage to an upside move in gold, there are the gold mining companies, where there is also an ETF that tracks the GDM Gold Mining Index, which trades under the symbol GDX.
Or specific gold miners can be purchased, although one should never own just one mining name. If one chooses to go the route of specific miners, no less than four or five gold mining names should be owned at a minimum given the highly volatile nature of the mining business. See the list below for a handful of some of the gold names that I like (and own in most cases) at present:
The South African rand is an even bigger piece of confetti than the dollar, and it should continue to weaken against the dollar going forward providing South African producers AU and GFI (who's costs are obviously in rand, as opposed to their revenues, which are in dollars) with greater leverage to gold than their non-South African counterparts.
ASA is a closed end fund of mostly gold shares (30% or so is AngloGold Ashanti (AU), and GFI) that is trading at a large discount to NAV, which makes it even more attractive, and is probably the one case where one could buy just one stock within the gold mining universe since this closed end fund is obviously already a basket of gold shares.
All four of these junior names above are takeover bait and trading well below their NAVs based on $700 gold.
- Newmont Mining (NEM) - It's dirt cheap (nearly 40% below NAV based on $700 gold) and universally hated. It’ a value play at this point, not to mention its enormous land package which could yield exploration success at any time. Its new CEO also appears to be willing to do the necessary things in order to turn the company’s stock around.
- US Gold (UXG) -This one is not for widows and orphans. It’s a gold explorer (not a junior) that has a large land package in the gold-rich region of Nevada called the Cortez Trend. The key characteristics of the company are its $50 million cash position (which is being used for the exploration of its properties), the gold-rich history of the area where its properties are located, and the fact that Goldcorp’s (GG) former famed CEO, Rob McEwen, is not only the head of the company but also owns about 13% of it. All of that adds up to what I like to call “high imagination value” during a bull market in gold, and has the potential to be much more than that if the company is successful in finding gold deposits on its properties. But unlike the gold names above, it has no proven and probable reserves. So, it should only be considered as a highly speculative addition to a gold portfolio and not a “core” holding.
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