Saturday, December 13, 2008

Paper revulsion means gold profits

Wall street and all the major banks in the United States are essentially bankrupt and being propped up by our government. It is not one or two institutions that are unsound, but our entire financial system. What recession are you aware of in our history where the entire financial system was at risk and asking for government handouts? How about entire states, roughly 40 of them at last count, being in debt up to their eyeballs and pro-active and desperate ones like California already begging at the Federal trough? How about the entire auto industry needing government assistance just to survive another year? How about a real estate crash that has already almost exceeded the decline during the Great Depression I?

We have to be realistic and assess where we are in historical terms to get a feel for how deep and long this recession and stock bear market is going to be to successfully navigate as investors. The bear market is not over and wishing for it to end won't help.

The problem is that we have maxed out on debt and now it is time to cleanse the system of debt so that a new productive cycle can begin. Companies, governments and individuals are all overly burdened by debt. When debt gets to a certain level, it can no longer be serviced (i.e. the interest on the debt can no longer be paid). All it takes is a sneeze in the economy at this point and loans start blowing up left and right. This is what has happened in our system, not just in the U.S., but in the entire developed world.

Think about it on an individual level. People with average jobs and average incomes became leveraged to the hilt with debt via real estate, autos, and credit cards in our order to live beyond their means and worry about paying for it later. At the peak of the housing bubble in 2005-6, many places in California had a median house price of 7-10 times the median income for their area. This is completely insane. To add to the insanity, after many of these people bought these houses they couldn't afford using no money down, they took out home equity lines of credit based on home appreciation, increasing their leverage.

At the corporate level, JP Morgan Chase, which is completely and hopelessly bankrupt (thank God they don't have to play by the rules!), has roughly $100 trillion worth of derivatives on its balance sheet. That isn't just a lot more than the company is worth, it is more than the entire output of the global economy! Financial firms and banks (at least the ones left standing) are so overleveraged that a move in underlying asset prices of a few percent will wipe out entire corporations.

Our government and governments around the world are trying to "pick up the slack" and keep the debt party going by taking on more debt despite being broke and by passing out free money to corporate friends and citizens alike. This is akin to a mother finding out that her child Johnny has maxed out his credit card and is in financial trouble. This mom, who is herself in debt, would then decide to take out a cash advance on her own credit card and give Johnny the money to pay off his credit card.

The debt party is over globally, but especially for the U.S., and this has investment implications that are profound. If ignored, this will result in serious losses to your portfolio. Those waiting for bureaucrats to "save" the debt-based economy are failing to understand the critical point: governments are part of the problem and are not the engines that drive economic growth! Liquidity, a vague term that applies to the availability of money and credit, is drying up. See the chart below for a long-term view of the debt to GDP ratio in the U.S. over the past 90 years (chart stolen from Ned Davis Research):

When liquidity dries up, we are loosely said to be in deflation and certain investing principles apply. The first is that general stocks, most bonds, real estate and most commodities are toast. The second is that cash (and gold as cash extraordinaire) is king. It's that simple. The last time the debt bubble popped, we had the so called Great Depression. Expect a replay of these conditions in financial markets. Perhaps the ready availability of a printing press and a fiat system means we only get the Japanese experience instead, but perhaps not.

A guy by the name of John Exeter created a liquidity pyramid diagram that illustrates what this process looks like and it has already started (diagram stolen from the Long Wave Analyst website and slightly modified):

Toward the very bottom of this inverse pyramid is cash/federal reserve notes/paper money. Having the 90 day Treasury bill at a 0% yield (no, 0% is not a typo), indicates the flight to cash. Next comes the flight to gold once everyone realizes the risk in holding a paper promise backed by nothing with no potential for returns/yield. As liquidity dries up and deflationary forces increase, people gravitate lower and lower into the bottom/apex of the pyramid. Soon, a gold fever will erupt as everyone begins to seek shelter from the storm.

This flight to gold has already started, as requests for deliveries of physical gold bars at the Comex warehouse, the repository for the futures market in gold, are at record levels that could literally deplete the warehouse of gold in a few months if the trend continues. Physical gold coins and bars for retail investors already have an historic premium to the spot gold price attached to them and delays in delivery are now the norm rather than the exception.

Gold stocks will outperform gold over the next few years, but a component of physical gold in your possession is an insurance policy akin to holding cash, which is always reasonable during a bear market. The tide is turning and within 12-18 months, most will see gold as more valuable than cash. By that time, you may not be able to buy physical gold at a reasonable price. And if our silly bureaucrats insist on printing as much money as they can and passing it out willy nilly to any con, crook or sad sack that asks, we may well lurch from deflation into a currency crisis and aggressive inflation. In this case, that gold insurance policy will pay handsomely. If all gold does is hold its value, which is a no-brainer proposition, you've simply missed out on 0.05% returns on your cash.

Buy gold for protection. Buy gold stocks for investment gains. The time for excuses and procrastination is past.

Wikinvest Wire