Option Investor
Educational Article


Printer friendly version

Wake me from a dead sleep, and through the grogginess, I'll still extol the virtues of this timeless metal like a salesman possessed. A gold bug, I am not, just as I was not a technology, micro-cap, or Internet stock freak in the late '90's. I'm a bull market freak (when I find them). And that's what I see in gold.

Throughout history, there have always been central bankers. Throughout history, there has always been gold. Throughout history, they have always done battle. . .with central bankers winning many battles with fiat currency using the implicit message of "Trust me". But gold always wins the war because it is the only true and trusted currency when fiat currency spins out of control, as it has done at the hands of the world's central bankers.

So For me, it's about preserving wealth in a world rife with central bankers. But it's also about fundamentals and technicals - buying low on an emerging bullish trend and selling high when others see the value - plain old buying low, selling high. If that coincides with your investment and/or trading strategy, you can't afford not absorb the content of today's article.

Let me be clear here. I am not "recommending" gold as the be-all, end-all investment for the next 5-20 years. However, many readers over the last year have noted my references to building a financial "ark" in which I hope to preserve as much of my capital as possible. Remember, in a bear market, he/she who loses the least wins. And like Warren Buffet, I hate losing capital. So job one for me is preserving it, over and above making a profit, though I seek that too. A big part of my financial ark is gold.

(This isn't new. You can go to this link for some additional background.)

Why is that? Let's review quickly. In the last four articles, we've spent time dissecting inflation and deflation, real estate, and stocks. Within that context we've discussed high personal debt burden, China's exportation of deflation, competitive currency devaluations, exchange rates, the mortgage debt bubble, consumer spending, the Fed's printing press, and the state of the U.S. economy, along with the corporate profit picture.

In a nutshell, none of these conditions are particularly conducive to the appreciation of financial assets. Tangible assets are what I would rather own for this period of the economic cycle. (Check out my earlier article on that concept here:)

Of course, as one of the remaining holdouts who still thinks 2003 will be a down year for equity markets - the 4th in a row, shattering all statistical dogma that says I will be wrong - you'd expect that from me, Fundamentals Guy. Hey, at least I'm consistent!

The worst possible outcome in owning gold is that we have a financially indestructible insurance policy that never relies on the brand name or credit rating of the issuer - a put option against the financially unthinkable that never expires. It may lose immediate value in the world of a successful central banker. But how long does that last? We can never truly label them "successful" because every central bank engaged in making fiat currency - every one - eventually fails. In the end, the central bankers' track record is zero for roughly 400 currencies that have tried it dating back to the Roman Empire. Mere coincidence? Nope. It is a statistical certainty. It is only a matter of when. Gold will always be there and always have a value (though it will fluctuate, but hasn't any investment always done that?) no matter how many economists and bankers tell us it is a relic of the past.

Does that spell the end of the world? No way. Can the Fed and other currency printers in the modern world pull a rabbit out of their hat again? Sure, just like they have for the last 90 years. But eventually, the world demands real currency, not "print at will" Monopoly money. Central banks eventually run out of gimmicks and manipulative power just as a magician must eventually run out of rabbits.

People obviously live through monetary upheavals; otherwise we wouldn't be here now. Perhaps we are doing so now, as others have in past centuries. Since WWI or WWII is a pretty short gauge of history to be so certain that gold is irrelevant. So what better time, as a prudent investor, and a prudent provider for your family to consider the case for gold now, if for nothing more than an insurance policy?

Of course, the best outcome is that we become fabulously wealthy by recognizing and taking advantage of the beginning stages of a new bull market in gold! We really only need one chart for this. Shall we take a peek?

Don't get me wrong. This chart does not tell us to drop everything we are doing and run to our nearest gold coin dealer. I don't suggest that ever. What I do suggest with the chart above is that gold has entered a bull market. We can see that in the simultaneously rising 200-dma and 50-dma. We can also see the breakout from a long period that kept the candlesticks in a neutral wedge.

But in my opinion, gold is momentarily overextended. I would not be surprised to see it fall back to a more supportive level, say in the $350-$360 range. Just like in the late '90's, dip buying works in any bull market. I'm betting that for traders, it will work here too.

Aside from this technical aspect, let me pull together the fundamentals starting with the inflation/deflation argument. "So wait a minute, Buzz. You said that gold could do well in inflation OR deflation? How could it be?"

Here's a simple explanation: Those who believe that Fed-generated inflation will devalue the Dollar are obvious candidates for gold purchases. Each marginal Dollar printed that can't be borrowed, used, or spent adds to the once-considered-limited supply. By definition, if they aren't worth the paper they are printed on, their value diminishes compared to real money, aka gold.

Just for the record, for every ounce of gold added to the supply since Alan Greenspan became the Fed Chief, the G-Man has created $6250 in new paper Dollars.

For those who believe that deflation is the monetary condition of the next decade, and that excess debt is the Black Plague of a deflationary economy (it is), gold is still the safest place to be since deflating Dollars will buy us progressively less gold. Deflationary Theory buyers are protecting their buying power against erosion.

The case for buying gold can thus be made by both inflationists and deflationists.

Either way, here is the case fundamentally spelled out by Richard Russell of the Dow Theory Letters. The guy is a Dow Theorist and grizzled veteran of markets for over the last 50+ years. A friend of mine, knowing my interest in gold, sends me these snippets on occasion, which I'll reprint here with all credit to Mr. Russell.

Russell notes, "Each year there is less production of gold, meaning the actual supply/demand equation is favorable for gold."

"China and Asia are exporting deflation, while the Fed is fighting deflation by inflating the US money supply."

One of my favorite outside-the-box thinkers, James Grant (true research analyst and Forbes columnist) sheds detail: "Each of the three principal currency blocks - dollar, euro, yen - would welcome a falling exchange rate...Of course, the top currencies can't all simultaneously become cheaper against each other. They can only become cheaper against an alternative. Such are the times that few governments welcome a rising alternative. What would that alternative be? Constant readers may close their eyes, because they have read the answer here before. It is gold, an asset with the virtue of being mute. It never complains and never explains, and it has no central bank...It does not object if its price appreciates..." Amen, I couldn't have said it better.

Russell continues:

"The US trade deficit is going through the roof. This is putting increasing pressure on the dollar."

Here's another voice from Felix Zulauf, Zulauf Asset Management of Zug, Switzerland: "Other central banks will at some point then try to support the dollar, because if it declines too much, it hurts their exports. They will be forced to adopt the same policy as the U.S. central bank, and you will have the whole world creating more fiat currencies. That's when gold will really run."

Zulauf goes on: "How far? In 2000, the ratio of an ounce of gold compared to the Dow stocks was 45 to 1. It took 45 ounces of gold to buy the Dow. Now, the ratio is down to 25 to 1."

My comment: Remember in the late 1970's when gold topped out $878 per share about the time the Dow traded around 850 - a 1:1 ratio. That isn't a weird occurrence. We've all lived through that; some of us, many times. Probability, given the severity of the bull market, and the likelihood of an equally severe correction in equities (Newton's Law) says that it could happen again. It isn't as far-fetched as it seems now. However, I'm not predicting the Dow Industrial's parity with gold at $2000. There' a long way to go before we see that, and maybe it never happens.

Anyway, back to Russell:

"The Bush administration will be generating massive deficits as far as the eye can see, at least $1trillion over the next five years."

"The existence of terrorism will mean that the US is on the path of endless spending for security."

"The dollar is in a bear market that promises to take the dollar vastly lower over a period, not of months, but of years."

"US citizens, cities, counties, states, and the federal government are up to their eyeballs in debt. The only financial item around that has no debt against it is gold, the only real money."

[I feel compelled here to add a comment by Bill Bonner, Publisher of the Daily Reckoning. "The whole world is getting worried; it counts on the American consumer like a liquor store depends on alcoholics. There are better customers, maybe, but none more reliable." At least that use to be the case until cirrhosis set in.]

Back to Russell again:

"Third world nations are not honoring their debts, thus faith in debt and paper money is declining rapidly."

"All the above point to an almost unique situation in favor of real money -- gold."

I can't add much other than to close with a quote from Warren Buffett's father. . . yes, his FATHER, a congressman from Nebraska. He delivered this line in a speech over 54 years ago in 1948 before Warren even possessed a driver's license.

Buffet Sr. warned, "The paper money disease has been a pleasant habit thus far and will not be dropped voluntarily, any more than a dope user will without a struggle give up narcotics...I find no evidence to support a hope that our fiat paper money venture will fare better ultimately than such experiments in other lands....

Well said, but we've had to wait 54 years for those words to possibly ring true, and still, our Fed prevents the failure. It will happen, but when is anyone's guess. Rather than fret the day in worry with eyes cast low, I simply buy gold and sleep well.

If that is of interest to fellow readers, and enough drop me line (put the word "gold" in the subject line), I'll be glad to do a follow-up on the different vehicles in which to make that investment or trade.

Until next week, keep your hands in your pockets for a better entry into the yellow metal!


Options 101 Archives