Why you should buy Gold.

Posted on 1st April 2010 by Trevor Reynolds in Finance in Focus

Fundamental Reasons Gold Will Soar

You Can’t Ignore Inflation: The 2008 stock market panic sent stock and commodity prices – including the price of oil – into a tailspin. And that launched the big debate about whether inflation or deflation would ultimately carry the day. Keep in mind that since 2001 – under benign price inflation of roughly 2.5% – gold has managed to rise about 400%. Meanwhile, the U.S. Federal Reserve is widely expected to keep short-term rates near zero through this year, leaving the door open for inflation. In addition worldwide, central banks have rolled out an unprecedented $12 trillion worth of stimulus programs, with some of the money still to be spent.  Inflation is coming just don’t know when . . .

Inflation explained: When the economy goes down, people save more. When that happens, circulating M2 (money) also goes down because less people are spending. That would make the economy even worse, so what the government does, is it borrows money from the Fed, which makes money out of absolutely nothing, and then lends it to the government at interest.  Then this new money sort of replaces the saved money, and the recession should hopefully not get worse. 

Then, once things are better, this new money which eventually floats around is deposited at banks. Banks then use this as high powered money to create more money from thin air. About 90%, so, you deposit, $10,000, the bank can lend $9000. This isn’t YOUR $9000, it is brand new money. Your $10,000 is still there, this process doesn’t end there. Now there is $9000 of new money in the economy. That then gets deposited at another bank. Now that bank can lend $8100, and so on until about $90,000 is effectively created out of thin air!

That’s why the bailout of $700B will eventually reach about $7 Trillion. (This will expand the money supply around 30% to 50 %.) The money hasn’t been “unlocked” yet (banks are not lending).  So, once the economy picks up again, and it’s going to need employment for the money to be unlocked, we could see a lot of inflation; maybe even 10% a year for a few years.

Investment Demand is out there: Large institutional investors – hedge funds and pension funds – are making large allocations to gold, as are individual investors.  The proliferation of gold-focused exchange-traded funds (ETFs) bears this out. The SPDR Gold Trust (NYSE: GLD), the world’s largest physically backed ETF with 1,100 tons of the lustrous metal, is the sixth-largest holder of gold bullion. Individual investors have never had an easier avenue for owning gold. (However maybe this is not the best way as it is not 100% backed)

Asia, with a population that exceeds 2.5 billion inhabitants and a long-standing cultural affinity for gold, is stoking global demand in a big way. China is encouraging its citizens to buy gold and silver.

Central Banks are Becoming Net Buyers: India’s recent purchase of 200 tons of International Monetary Fund (IMF) gold was the likely impetus that pushed gold up over the $1,200 level in December. But more important is the sea change that has seen central banks change from net sellers into net buyers of gold. BlackRock Inc. one of the world’s largest investment managers, said that 2009 was that turning point. If that was the case, it will have been the first time in 20 years, as central banks have been net sellers of gold since 1988.

A Currency Crisis is Looming: The “PIGS” – Portugal, Italy, Greece and Spain (or “PIIGS,” if you want to include Ireland) – aren’t in very good fiscal shape. And they aren’t alone. Iceland has already gone over the edge. The United States, the United Kingdom, and countless other economies are struggling. And that reality has ignited a crisis of confidence about fiat currencies in the minds of many investors. Money is nothing more than paper and ink, backed by the full faith and credit of the issuer. When investors find that their faith in the issuer is shaken, the value of that currency erodes. Additional sovereign-debt downgrades from ratings agencies are but one potential trigger of a currency crisis. Under such conditions, gold – the ultimate store of value, and the oldest existing form of money on earth – will soar as investors seek to protect their purchasing power.

We’ve Yet to Reach the Mania Stage: the gold bubble that takes prices to all-time-record levels will inflate in three distinct stages. This process will start with currency devaluations in Stage One, will be fueled by growing investment demand in Stage Two and will experience its stratospheric ascent in Stage Three, the mania phase of this evolution.  Keep in mind, the entire gold industry has an aggregate market capitalization (value) below that of Wal-Mart Stores Inc. (NYSE: WMT) alone (currently about $210 billion). So as the crowd piles in, the “big money” to be made will lie with gold explorers and producers, where 1,000% returns will not be uncommon, even from today’s prices.

All these fundamentals underscore that gold prices have plenty of room to run from here.   All the physical gold in existence is worth somewhat more than $1 trillion US dollars while the value of all the publicly traded gold companies in the world is less than $100 billion US dollars. When the fundamentals ultimately encourage a strong flow of capital towards gold and gold equities, the trillions upon trillions worth of paper money could propel both to unfathomably high levels.

It’s Time to Make Your Move

Everyone needs some exposure to gold in their portfolios, no matter their age or risk tolerance. Owning some physical coins or bars makes sense.

When will gold really take off? I think it will take a few years. But with bubbles, or speculative frenzies, one never knows. Just this week, in fact, Robert R. McEwen, the chairman and chief executive officer of U.S Gold Corp. (AMEX: UXG), predicted that gold could more than quadruple to hit the $5,000 level by 2012. Some experts have labeled this expected move as a looming “super spike.”

Despite the mania stage (we think) is still several years away, the wise investor recognizes both the importance and the potential of investing in gold.

I have no doubt that today’s $1,100 gold price level will eventually, in hindsight, look like an outrageous bargain.

WAYS TO OWN GOLD

There are many ways to own gold. The best way is to buy a few one-ounce gold coins, preferably American eagles if you’re in the United States, or Canadian maple leaf coins if you’re in Canada. With one-ounce coins, you pay the lowest commission.  The trouble with gold coins is also their advantage: they are in your possession. They can be lost or stolen. They must be mailed back to a coin dealer to sell them for money. There are commissions to pay. But, in a time of national crisis, coins are the best way to hold gold for the small investor.

You can buy gold shares – a very good idea. This is the standard approach of most investors an easy way would be with GDX or GDXJ – exchange traded funds.  There are gold miner shares on almost every exchange.

There is a Fund which invests 60% of its assets into physical gold the other 40% is invested in Managed futures which since 1990 has achieved returns of over 17% pa.

There is a fund, the Central Fund of Canada, that holds mostly gold and some silver bullion. The prices of the two metals move in tandem most of the time. Owning shares of this fund is a surrogate for owning physical gold. This is far better than GLD as there you are buying paper and not all the gold is actually there!

Always remember: if there is no proof of physical possession of gold, and if there are no storage charges for gold held in reserve, then you may be trading a futures contract, which is a promise to pay gold on demand. Promises to pay are never as reliable as gold in hand. Third-party verification of gold held against receipts issued for gold becomes important.

You should ask yourself what you are hedging against. Answers include the above fundamental reasons in the report, plus these more specific ones:

  • Dollar inflation/depreciation
  • Terrorist attack on the U.S.
  • Crisis in the bank payments system (cascading defaults)
  • Speculation: Asians may start buying gold

WHAT IS THE DOWNSIDE RISK?

The standard ones are these:

  • Net central bank sales of gold to public
  • Recession reduces price inflation
  • Recession reduces demand for commodities
  • Asians turn out to love paper money more than gold
  • Governments outlaws gold  
  • Gold-owning people actually obey the governments

The political pressure is very strong to keep a higher price of gold from identifying reduced confidence in the dollar. We have seen the government take steps to push down gold’s price. But the government also sells gold coins. It maintains the official position that gold is not relevant for monetary affairs. To outlaw gold would be to admit that gold is relevant. This might turn into a gold-buying panic. Because people can easily buy and sell gold on the Web, there are ways for people to evade the law.

A worldwide recession is possible if China suffers a major recession. China at some point will have to go through a recession because of today’s inflationary policies. But the question is: When? Gold may fall 30% from $1,100 an ounce if it does buy some more. If you have no gold, it’s not wise to bet the farm on a fall in price. Besides, if gold falls, you’ll probably think, “It’s going to fall even more. I had better wait.”  The Greece situation is the next thing to happen will they or will they not be bailed out, but really the bigger situation is who is next as Greece is about as relevant to the European economy as say Utah is to the USA.  Now what happens when California needs a bailout it is the 8th largest economy in the world on its own. Then longer down the line there is Japan the third largest economy . . . and in the end the USA.

CONCLUSION

People postpone doing what they don’t really want to do. They don’t want to take action that implies that the present system is shaky, that the government is following policies that will debase the currency, and that there is no way for the government to preserve the purchasing power of the dollar by anything other than ceasing all monetary expansion, which the Federal Reserve System never does.

2 Comments
  1. Steve says:

    It is a troubling situation when the US banks are printing money like there is no tomorrow. But, tomorrow will come. It is just a matter of when. I think that physical gold is the only way to own gold. Holding shares in the GDX or something similar in itself poses risk since it is tied to the broader market. Personally, I hold shares in gold funds.

    1st April 2010 at 6:25 am

  2. Enquirica says:

    Ultimately, the question is not how high gold can go, its how low fiat currency can go. While the debate about whether gold is in a bubble or whether we are in a deflationary or inflation environment continues, the monetary authorities in the developed world have embarked on a well-publicized campaign of currency devaluation via low interest rates. Central banks can control interest rates or exchange rates – not both – and they are opting for record low interest rates with little concern for the debasing consequences. There should be no debate on this matter – central banks have a perfect track record in one area and that alarmingly is in currency devaluation. The US and Canadian currencies have suffered a greater than 95% loss in purchasing power since the inception of their respective central banks.

    1st April 2010 at 3:56 am

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