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Gold: Where Have We Been And Where Are We Going?


...the ultimate store of value throughout recorded history has been gold, which outperformed just about every asset class in the stagflationary 1970s.


One has to know where we've come from in order to understand where we are potentially going in gold.

First, gold is the only precious metal that is recognized as a central bank reserve asset, which means it is "money".

After peaking at around $850 in 1980 as Fed Chairman Volcker's "tough love" of high interest rates finally killed the 1970s inflation, gold went into a 20-year bear market. Gold emerged from that bear market when it began to rally in 2000 and has since posted its highest spot monthly close in history.

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The Dollar's Demise?

That brings us to what appears to be a secular downtrend in the dollar, which for obvious reasons tends to be inflationary. While people like to concentrate on the U.S. dollar index, this is mostly a euro proxy. See what I've written about such topic here.

The trade-weighted dollar, which is what "matters" as far as import prices and the willingness of foreigners to finance the US' trade deficit are concerned, continues to make new multi-year lows on virtually a daily basis now.

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The Fed's Major Currency Dollar Index, which consists of major foreign currencies that have a wide circulation outside their country of origin, has already made new all-time lows.

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What precipitated this decline in the dollar? Like all things, the cause is debatable, but the various global imbalances that are now feeding its decline have been building for years. One of the reasons the imbalances, like the U.S. trade deficit, could get as large as they did was due to the dollar's status as the world's sole reserve currency, which gave the Fed a great deal of flexibility in how it could respond to various financial and economic problems. However, that may now be changing as more and more foreign central banks begin to diversify their reserves.

The catalyst that kicked off the current decline in the dollar appeared to be the Fed's massive money printing operation that began in 2001 after the U.S. stock bubble began to come apart. That "inflating away" of the stock bubble has brought us to where we are today, where massive amounts of dollar "liquidity" is sloshing around the globe and looking for a home. And that home is increasingly being found outside of U.S. financial assets, like stocks and bonds.

Stock bulls like to say that they're bullish on U.S. stocks because there is a massive amount of "liquidity" sloshing around, and on this point I agree wholeheartedly. The difference between myself and most stock bulls is our perception of what "liquidity" is. Liquidity stemming from too many pieces of confetti looking for something to chase before the value of that confetti drops even more (i.e. fear of losing purchasing power, other wise known as "fear of inflation") is not bullish for financial assets that are denominated in that particular piece of confetti. And in this case, the primary piece of confetti is the dollar.

Now, that liquidity mass is already avoiding certain markets in the U.S., like its credit markets. Next comes a liquidity preference away from the U.S. stock market, as more and more "liquidity" moves into "bad stuff" like gold and other hard assets, even residential real estate again eventually. But long before it gets back into residential real estate again, people should finally begin to see this "liquidity" for what it actually is: a massive inflation. And like all inflation, they are only seen for what they are long after the events that actually precipitated them and sowed the seeds of the inflation.

In this case, the inflationary wave began six years ago when Uncle Al began slashing interest rates and effectively monetized the biggest stock bubble in the history of the world. And that inflation continues to feed through to the real world today. We saw that inflation first occur in U.S. residential real estate prices, and we continue to see it today in the continued rise in commodity price inflation and the collapsing dollar. Unfortunately, the Fed can't (and won't) do a thing about it because of the housing bust's drag on the fragile US economy.

Speaking of inflation, what exactly is the rate of inflation in the U.S.? Well, if we look at the pre-Clinton administration's formula for the CPI, for example, the headline rate of inflation is running at above 6%. If we use the CPI version that was in place back in 1980, headline inflation is running at over 10%. And keep in mind that this is occurring even as the US economy slows due to the drag from the housing bust.

What sort of asset performs the best in such an environment of slow growth and rising inflation (i.e. stagflationary) historically?

Answer: "stores of value".

And the ultimate store of value throughout recorded history has been gold, which outperformed just about every asset class in the stagflationary 1970s.

Stocks are still benefiting from this inflationary phenomenon too for now, thanks to the stronger global economy even though the U.S. economy remains weak, but eventually that won't be the case if inflation and long-term interest rates (which rise as a consequence of inflation) rise enough to eventually compress equity valuations.

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.

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 potentially causes problems in the financial system and U.S. economy, the Fed may even be eventually 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. New Zealand is already moving in this direction and is the first G10 country to begin to intervene in order to halt the appreciation of its currency.

So, 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 500 tonnes of gold 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 (GLD), 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:

  • Gold Fields (GFI)
  • Harmony Gold (HMY)
  • ASA (ASA)

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 HMY 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 (40% or so is AngloGold Ashanti (AU), GFI and HMY) 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.

  • Golden Star (GSS)
  • Metallica Resources (MRB)
  • Nevsun Resources (NSU)
  • Minefinders (MFN)

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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Position in gold shares, ASA, UXG, NSU, MRB, MFN, GSS, GDX, NEM

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