5 Reasons to avoid the gold rush

Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head. - Warren Buffett

The reasons why one should sell the cat, pawn the mother-in-law, and use the proceeds to buy gold are well known: the Fed is printing money faster than you can read this, which will result in inflation; the government is borrowing like a drunken monkey, so the dollar will be devalued; this will debase all currencies, so the only thing that will save you is the shiny metal.

However, here are some arguments why one should think twice before jumping in bed with gold bugs, or at least remain sober while determining gold’s weight in the portfolio .

1. For investors (not speculators) it is very hard to own gold, because you cannot attach a logical value to it. Unlike stocks or bonds, gold has no cash flow and has a negative cost of carry – it costs you money to hold it. It is only worth what people perceive it to be worth right now. The argument I commonly hear is, “What about all those Enrons, Lehmans, Citigroups, etc. that either went bankrupt or got near it? What was the value of those?” If the lesson learned is not to own stocks but to own gold, it is the wrong lesson. The lesson should be: own companies you can analyze (the aforementioned companies were unanalyzable) and diversify – don’t put your all net worth into one stock.

2. The gold ETF SPDR Gold Shares (GLD) is the seventh largest holder of physical gold in the world. If its holders decide to sell (or are forced to sell; think of hedge-fund liquidations), who will they sell it to? This is extremely important, as the presence of GLD changes the dynamics of the gold price, both to the upside and downside. If gold keeps climbing, the ease of buying will drive gold prices higher than in GLD’s absence. In the event of a significant sell-off, there are not enough natural buyers of physical gold. It is a bit like a roach motel – easy to get in, hard to get out.

3. In the past, gold had a monopoly on the inflation and fear trade. Not anymore. Now you have competition from Treasury Inflation-Protected Securities (TIPS), currency ETFs, short US Treasury ETFs, government guaranteed/insured FDIC checking accounts, etc. TIPS suffer from the flaw of the CPI being measured and reported by the US government, which has an inherent bias to understate inflation; returns of commodity ETFs are skewed by price differentials between financial derivatives and spot prices of underlying commodities; returns of leveraged ETFs diverge significantly over the intermediate and long run from the underlying index; FDIC reserves are being depleted with the every-Friday-night bank bailout (but believe you me, the US government will not let FDIC go bankrupt, even if it means it has to raise taxes and impose draconian fees on the banking sector).

The bottom line here is this: none of these investment vehicles are perfect, in fact many have significant flaws; but despite their flaws they attract money away from gold, thus undermining gold’s monopoly on the fear/inflation/currency debasement trade. (I’ve discussed it in greater detail in my book).

4. If, because of points 2 or 3 above, gold fails to perform as expected, the perception of what gold is worth may change dramatically.

5. Over the last 200 years, gold was really not a good investment. It may have a day in the sun, but it may not. And the cost of being wrong is fairly high.

Though gold bugs make it sound as such, gold is not the only and not the best alternative if the worst fears come to pass. The best way to deal with the risks of dollar devaluation and high inflation – with a much lower cost to being wrong – is, instead, to own stocks of companies that have pricing power of their product. When inflation hits, they will be able to raise prices and thus maintain their profitability. Also, companies that generate a large portion of their sales from outside the US will benefit from the declining dollar.

Gold bugs look at gold as a currency, but it is not one and unlikely to be one in our lifetime. Here is why: there is not enough of it around, so even if world government were to adopt a fractional system (currency in circulation as a multiple of gold reserves), they will never go for it, because central banks and governments will never give up their monetary tools – inflation is a very addictive tool to fight growing monetary obligations.

There is a wild card in the price of gold, though: China (John Burbank made that argument at the Value Investor Congress in Pasadena). If it decides to switch partially from owning US Treasuries to owning gold, the price of gold will skyrocket.

-- Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).

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It’s not if China will act?
China has already acted and pulled the trigger.

By Adrian Douglas
I have a couple of issues with Ted Butler’s comments in his interview this week with Eric King of King World News.

First, I greatly admire Butler’s analytical work in silver, which is well-researched and meticulous. I disagree with his opinions expressed in that interview.

1) Butler speculates that J.P. MorganChase has hedged its silver short position on the Comex via instruments like over-the-counter derivatives and so now may not care if the silver price goes up.

The issue with precious metals short positions is the ability of the shorts to deliver real metal. Any hedging with derivatives will not necessarily result in silver being delivered to MorganChase; such hedging might deliver only dollars.

I agree that MorganChase could hold call-type derivatives that in theory would provide the firm with a neutral dollar-denominated risk on its Comex silver shorts if the silver price rises. This of course would assume that the counterparties are capitalized enough to pay up if silver rose in price significantly. The OTC derivatives market is totally unregulated with no clearinghouse, so the ability of such counterparties to pay is questionable.

But if we are going to postulate that MorganChase has dollar hedging of its silver shorts, I don’t think we have to invoke the questionable OTC derivatives market. For MorganChase has the ultimate dollar hedging because the firm is essentially the Federal Reserve and the Fed has a “technology called the printing press,” as Fed Chairman Ben Bernanke famously bragged.

We know that MorganChase and the Fed are essentially the same entity because MorganChase was selected by the Fed to take over Bear Stearns for $2 per share with no due diligence and apparently no competitive tender between rival banks. When Bear Stearns shareholders protested the $2 per share offer, it was arbitrarily increased to $10 per share. What normal enterprise could suddenly increase a takeover bid by 400 percent without batting an eye in times of great financial stress?

But if you have a money-printing press, who cares what you pay for Bear Stearns?

If MorganChase has access to unlimited dollars, then the firm can roll its Comex futures indefinitely and never have to deliver and never have to cover. But this does not imply that the firm does not care about the silver price rising. The firm’s whole raison d’etre as the big short in Comex silver is to cap the price. I think MorganChase does care if the price of silver rises because the Fed doesn’t want that.

The silver price manipulation will end when there is a silver shortage, but it won’t be MorganChase that defaults, because the firm will continue to roll contracts and cover its dollar losses.

The physical silver market is under growing stress. China’s encouraging its citizens to own silver could be the straw that breaks the camel’s back. China was the last country to be on a silver standard. The word for “bank” in Chinese means “silver movement.” The Chinese associate silver with money just as Mexicans do, because the Mexican peso used to be denominated in silver. There appears to be a cultural affinity for silver, so this is explosive for a nation that, like China, earns so many intrinsically worthless dollars.

2) Butler also has commented favorably on the U.S. Commodity Futures Trading Commission’s withdrawal of exemptions from speculative position limits for Deutsche Bank Commodity Services LLC. Butler extrapolates that the CFTC is doing what it promised in re-imposing position limits and figures that the agency eventually must reduce the concentrated short position in silver.

I don’t draw the same conclusion. Deutsche Bank is a hedge fund that is long commodities. The withdrawal of its exemption fits into my view of the new CFTC chairman, Gary Gensler — that, like his predecessors, he wants commodity prices to be low, as that is thought to be good for the United States. So the CFTC continues to attack investors in commodities. The CFTC is convinced that long-side speculators caused the boom in commodity prices in 2008 and does not see the real problem, which is the unlimited creation of dollars, whose depreciation has to be hedged.

The suppression of prices by allowing short-side speculators unfettered freedom exacerbates the problem, choking off investment in commodity production.

I wonder if this singling out of the Deutsche Bank hedge fund could be related to speculation that Germany has asked to have its national gold reserve returned from storage in the United States. Now that Switzerland won’t sell any more gold, its leading bank, UBS, is threatened with criminal action by the U.S. government for helping U.S. citizens evade taxes. Are these really just innocent coincidences?

If Gensler is the knight in shining armor who is going to clean up the Comex, then why hasn’t the CFTC’s Enforcement Division issued a report and criminal indictments in its almost year-long investigation of the gold and silver markets? How long does it take to recognize massive concentration of the short positions there? How could the CFTC possibly be contemplating a solution to manipulation, such as the imposition of strict position limits, without first even acknowledging that there is a problem?

Gensler used to be adamantly opposed to regulation of derivatives, a detail that seriously delayed his confirmation as CFTC chairman. He is a former officer of Goldman Sachs, a company that thrives only by manipulation and front-running markets.

Has Gensler had an epiphany? Did he see the burning bush? Has he suddenly become a man of the people mounting a crusade against manipulation and corruption committed by his former employer and cronies?

I do not give the benefit of the doubt to people with such a past. Given Gensler’s past, he is guilty until proven innocent, and his clamping down on long-side investors in grains at Deutsche Bank Commodity Services only compounds my fears.

I think the gold and silver cartel will be defeated only by the physical market. The precious metals will not suddenly be liberated from price suppression because MorganChase has a fiat dollar hedge or because a cartel stooge at the CTFC supposedly gets a conscience and pretends he is Eliot Ness.

I have a lot of respect for Butler’s work but I’ll take the opposite side of the trade here.

Adrian Douglas is a commodity market analyst, publisher of the Market Force Analysis letter (http://www.MarketForceAnalysis.com), and a member of GATA’s Board of Directors.

Courtesy: www.gata.org

China is in play.

Gold is a Currency You Can Rely On

By Adam Brochert Sep 8 2009 10:45AM goldversuspaper.blogspot.com

I get comments and questions from people who don't understand why Gold is money and don't understand why it has any value other than as jewelry. The two most important functions of money in my opinion is that is function as a unit of exchange and a store of value. Money should also be durable, portable, divisible, acceptable, uniform and in limited supply to function effectively.

Gold meets all of these characteristics with the exception of acceptability. It is true that you cannot use pieces of Gold to buy things in most modern settings. This is because most governments around the world have made Gold illegal for daily transactions because they do not want competition for their fiat (i.e. "by decree") paper currency. However, Gold can be exchanged for local currency almost everywhere in the world, so in a sense, it does have a limited form of widespread acceptability.

Paper money, we all know, is a terrible store of value. The U.S. Dollar has been losing value rapidly ever since we severed our link to a true Gold standard. Let me give you an example of the difference between Gold and paper money over the long haul. Let's say you had $100 worth of U.S. paper Dollars in 1930 and $100 worth of Gold at 1930 prices (Gold was fixed at $20.67/ounce back then by the government). Today, you would still have $100 in nominal U.S. Dollars, but it would buy much, much less in actual goods than it did in 1930. The Gold, however, could be traded in for slightly more than $4800 U.S. Dollars today (as of Friday's closing spot price for Gold).

But Gold hasn't changed over the years, hasn't grown, hasn't paid dividends and hasn't increased in its intrinsic value. Gold essentially has not become more valuable, paper fiat Dollars have become less valuable. Those who think steady inflation year after year is healthy are either bankers, politicians, or brainwashed by modern economic theories espoused by jokers like Paul Krugman. Up is down, right is left, and increasing debt and punishing savers is healthy!

People wonder why money can't be backed by oil or rocks or food. With rocks, the problem is the same as with paper only rocks are less portable, namely that rocks aren't scarce enough and thus inflation would be rampant under such a system. With oil, portability is also a problem. Who wants to carry around a cup of oil in their pocket? Food spoils, so durability is a problem.

Why is scarcity an important quality for money? If you don't know the answer to this question, look at what the U.S. Government and their non-federal, private, for-profit federal reserve corporation are doing. "Stimulating" the economy by printing new money and debt requires no more effort than a keystroke on their part! This leads to excessive monetary expansion, excessive debt, and rolling bubbles and collapses in asset prices.

Under a Gold standard, if the government expands its promises too far, people simply exchange their paper notes for actual Gold and deplete the government of its resources. In other words, those who hold paper exchange notes can act as a "check" on government power by redeeming them for Gold. Spendthrift governments have their Gold stores depleted, which eliminates their economic power and prevents them from pursuing their harebrained schemes. This is why Nixon had to suspend even the quasi-Gold standard in 1971 - we couldn't afford all of our social programs and our war and the rest of the world knew it!

The other issue with Gold is a long-standing history as a form of money extending on and off over thousands of years. This cannot be ignored. America as a country is so young relative to much of the world. Gold is steeped in the tradition of certain countries like India. When the shit hits the fan, Gold has always functioned as a medium of exchange and store of value. So a strong reason for its continued role as a "currency of last resort" is that it has always worked in the past.

I am not saying a Gold standard is without problems and I am not saying it is the solution to all our problems. Even if we returned to one some day, a government would come along during a crisis and just suspend it again. But keep in mind that both the United States and Britain enjoyed their greatest years of growth and steady prosperity on a Gold standard and both began to decline shortly after abandoning the Gold standard. This is not a coincidence!

Give politicians (who are trying to get elected by winning a popularity contest) a nearly unlimited ability to make promises with other people's money and they are going to continue to make promises until they destroy the system. This is how it has worked with every fiat system in history and how it will continue to work as long as human beings are in charge. What politician can resist such power? Who can resist taking the easy way out, whether citizen or politician? Who as a citizen can resist asking for more free stuff when every wish seems to be granted and seems to have no cost?

In essence, Gold meets all the criteria needed for a successful form of money except where governments have stepped in and suspended reality under threat of force (they have used this force before and will again). But when things get bad, the smarter citizens of the world will ignore their apparatchiks as they have throughout history and turn to what actually works. Economic self preservation overrides concerns over following the mandates or whims of some elected bureaucrat trying to lead his or her flock to an economic slaughter. The global fiat system we have currently is on its last legs. That doesn't mean it can't last a few more years and that doesn't mean we won't jump from one fiat system to another new one, but it does mean that every country involved in international trade is at risk for massive currency fluctuations throughout this process. When the change comes for whatever countries are involved (many are at risk), it won't be announced in advance and you won't be given time to prepare.

The United States has the most to lose if the fiat currency regime is altered, as the new system will certainly be more equitable to other nations. Though I believe the U.S. Dollar is set to rise on an intermediate-term basis while another vicious leg of asset and debt liquidation creates a bid for Dollars, I also believe Gold has a much brighter outlook as a form of money and store of value over the longer term than the U.S. Dollar. Since I believe we are in deflation and a Kondratieff Winter has begun, I prefer cash to stocks, commodities, corporate bonds and real estate.

For those who are not nimble traders and when ignoring the short-term swings, Gold will remain the best form of cash for the foreseeable future. Maybe the Dollar and Yen are better over the next few months, then the Euro may rally again, then the Aussie Dollar may run, etc. But the entire global fiat system is in a bear market relative to Gold and that bear market in paper has a ways to go.

Adam Brochert

Visit Adam Brochert’s blog: http://goldversuspaper.blogspot.com

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