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7 Trillion Reasons to Own Gold

Thu, Oct 9 2008, 10:32 GMT
by Sean Brodrick

Money and Markets

In just a few short weeks, America has gone from looking at a potential economic downturn to staring into an economic abyss.

In a matter of days, confidence in the Federal Reserve's ability to unfreeze our nation's credit markets has nearly vanished.

And now, to add insult to injury, the Fed has decided to start financing business corporations directly.

No wonder investors are looking for an escape from this madness! And no wonder gold is performing far better than virtually any other commodity!

Here's how this crisis has unfolded and where it could be headed ...

Wall Street's Vote of No Confidence

The market has shown how ineffective it thought the $700 billion bailout would be on Friday when stocks cratered ... again on Monday ... and still a third time with yesterday's 508-point plunge in the Dow.

It's about time Washington gets the message that they're bailouts, handouts and special lending programs are not working!

The real problem is that, despite all the bailouts all the Fed's wacky lending programs, the corporate credit markets remain frozen up.

Buying up some toxic debt won't do much to fix that because banks simply won't lend to each other for fear that other banks may follow IndyMac and Washington Mutual down the road to insolvency.

Result: A breakdown in the interbank system — no bank is lending to anyone else. Respected economist Nouriel Roubini says that we face the risk of a total systemic financial meltdown where ...

• The next step of this panic could become the mother of all bank runs, a run on the trillion-dollar-plus ... short-term interbank liabilities of the U.S. banking and financial system.

Roubini adds that "a silent cross-border bank run has already started."

The Federal Reserve realizes that the problem remains in the credit market, and just yesterday announced the creation of a Commercial Paper Funding Facility (CPFF) to help provide liquidity to the credit markets by purchasing commercial paper from issuers.

But the jury is still out on the CPFF as well.

So, again, do I think it's a good time to own gold? Buddy, I think it's a GREAT time to own gold ...

Gold Is the Ultimate Safety Play!

Traditionally, portfolio theory suggests putting 5% or 10% of your assets in gold as "portfolio insurance" — to guard against a crisis in paper investment vehicles triggered by war, political instability, severe inflation, or financial panic.

In other words, gold is a good investment for a rainy day, because, unlike many paper assets, gold's value has never gone to zero.

And while I'm not saying that the major markets are going to zero, they have had a very tough year.

The S&P 500 has lost nearly a third of its value in the last 12 months. The Chinese market, as measured by the FXI, is doing even worse — cut in half.

Meanwhile, gold, despite its ups and downs, is UP 12.49% in the 12 months ended last Friday.

And paper assets are looking worse all the time ...

The 7-Trillion Dollar Question

The first $700-billion bailout is already perceived as a failure. At some point, Uncle Sam will have to mount ANOTHER bailout to recapitalize the banks or risk the entire system falling apart.

That second (or third ... or fourth ... ) bailout is probably going to be very expensive. The question is, how much.

Part of last week's bailout package included a provision to raise U.S. Federal Insurance Deposit Corporation insurance to $250,000 per individual per bank.

This means the FDIC is now insuring about $5.2 trillion in deposits ... but it only has $45 billion in its insurance fund.

And while $250,000 may seem like a lot, nearly a third of small-business accounts still won't be entirely covered!

If Mr. Roubini is right — and I'm pretty sure he is — then the U.S. may follow the lead of central banks in Ireland and Greece and guarantee ALL deposits in ALL banks while it sorts out the good banks from the bad banks and recapitalizes the good ones.

That is enormously expensive and potentially very inflationary.

Remember, there is about $7 TRILLION deposited in U.S. banks.

Even if the U.S. doesn't have to pay up on all or even most of that money, providing blanket coverage would send the potential debt of the U.S. soaring.

That, along with recapitalizing the banks deemed worthy enough to save, could send U.S. printing presses into overdrive.

And a lot more dollars in the system should drive up the price of gold.

By the way, you know that debt clock in New York's Time Square — the one that logs how deep in the hole American taxpayers are? It ran out of spaces to display the $10 TRILLION in red ink that the government hit last week with the cost of the bailout!

When the government's paper debts are getting too big to measure, it's time to think about gold, the ultimate currency.

The yellow metal has been used as money throughout history, and has some great things going for it ...

Permanence: Gold does not tarnish and is immune to the ravages of water and even most acids. Unlike paper money, it will not decay, shred, break or be eaten by mice in the basement.

Convenience: Can you carry a little over eight pounds in a bag? Then you can walk around with $100,000 of gold. Not that you would want to do that, but it shows how handy gold is. Try walking around with $100,000 worth of real estate in your pocket.

Real wealth: Most importantly, the Good-Time Charlies in Washington can't print gold!

An Important Question:

Can Gold Go Up If We Have a Recession?

The short answer: YES.

Just look at this chart ...

I've charted the year-over-year change in inflation with gray areas showing U.S. recessions. On top of that, I've added the U.S. gold price.

You can see that in the 1970s, the U.S. went into recession, yet inflation kept going higher, and so did the price of gold.

Today, America is paying for a war that is ruinously expensive in both blood and money. In many ways, it's a repeat of what we had in the 1970s. Inflation has been red-hot, and gold is going higher — and we aren't even officially in recession yet.

So, yes, I think that gold is going to continue higher longer-term. However, recessionary forces ... even deflation ... could push gold prices down in the short term.

If so, this should give us a great set-up for new positions, because Ben Bernanke will not sit by and watch deflation strangle America.

Bernanke, the chairman of the Federal Reserve, is well aware of how bad deflation and economic depression are. He's an expert on the Great Depression. In fact, you can read a paper he wrote in 1990, which is posted online: "The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison"

After last week's bailout bill was passed, Bloomberg News quoted Bernanke as saying:

"We will continue to use all of the powers at our disposal to mitigate credit-market disruptions and to foster a strong, vibrant economy."

That sounds like a guy who's willing to pump up the money supply. Damn the inflationary risks — printing presses full steam ahead!

Three More Reasons Why I Like Gold Right Now

#1. Central banks are holding on to their gold. According to the World Gold Council, just over 357 metric tonnes of gold were sold by European Central Banks in the year through September.

Under the terms of the Central Bank Gold agreement, which limits gold sales, the banks could have sold A LOT more — 500 tonnes.

Germany — holder of the second-largest gold reserves in the world after the U.S. Federal Reserve — said on Tuesday it would make no gold sales over the next 12 months.

Switzerland, another big holder of gold, also said it has no plans for future sales.

If central banks thought gold prices were going down, wouldn't they be selling?

Maybe they realize that with all their paper assets wilting, they had better hold on to the gold they've got!

Plus, other central banks — China and Japan for example — are holding a lot less gold as a percentage of their foreign reserves than they should.

If they start to stock up, as some of their critics have suggested, that could really light a fire under gold.

#2. There's still a gap between physical and paper gold prices. I talked about this in depth last week, and it's only gotten worse. Gold closed Friday at $833. If you wanted to buy a 1-ounce American Gold Eagle, it would cost you $876, and you'd have to wait two to eight weeks for delivery.

How can the price of paper gold be less than for the actual metal? Obviously, the demand for physical metal is bordering on frantic — and it has become disconnected from the paper price.

That disconnect will have to be corrected — either the paper price of gold will go up or the price of real, physical coins will have to go down.

And with the financial crisis careening from calamity to full-blown catastrophe, my money is on paper prices going up.

#3. Gold ETFs are loading up. Assets in the SPDR Gold Share ETF, which held $17.4 billion in its coffers at the end of August, surged in September to above $21 billion.

In fact, the three highest-volume days in SPDR Gold's history were all logged in the past month!

As the banks melt down ... and other investments turn to dust ... investors will likely turn more and more to gold. And the GLD, XAU and other gold ETFs and funds make buying gold easier than ever.

Bottom line: This is one of those times when you might want to have some physical gold on hand. I'm not saying a lot ... but I keep some just in case, and it lets me sleep at night.

And I think the SPDR Gold shares (GLD) or one of the other gold ETFs is a good way to get an additional gold stake in your portfolio.

Published on  Thu, Oct 9 2008, 10:41 GMT