Physical gold and silver versus paper

I know this guy who buys physical gold and silver as a form of portfolio insurance and to profit from the bull market in precious metals (which is not over yet). This friend has noticed recently the disconnect between the quoted "price" of gold or silver and the price at which it is easy to actually buy physical metal. No bullshiite, many coin dealers are sold out of silver and/or gold bars and common coins and have been for weeks (and months in some cases). Why would an extremely steep drop off in price cause people to wet themselves and bum rush the nearest coin shop to buy precious metals? What wackos want to hoard a barbarous relic?

Did you know the U.S. Mint ceased minting gold coins (American Eagles first, then American Buffalos, some of the most popular ways to invest in physical gold for U.S. citizens) because of high demand? I've read Orwell. I know, right makes left and up makes down. Let me get this straight. Our government is broke. We borrow money from Asia, the Middle East, and anyone else with a pulse and a checkbook; but God forbid, we keep up with demand for our minted coins and make some of our own money to help pay some of the bills.

No, if demand increases for our coins, we'll simply announce that we will no longer produce the items that people want, no matter what. We won't just get behind and delay shipments of our coin due to increased demand, and we won't just fulfill the order as soon as we can so please be patient while we catch up, we'll just COMPLETELY STOP MAKING THESE COINS BECAUSE PEOPLE WANT THEM. We don't want people to want these coins, for God's sake! No, we make them so people won't like them or buy them and we don't want them to be a success. In fact, we have stopped making these coins indefinitely with no explanation other than “heavy demand.”

People, please think with me for a minute and just stop drinking the Kool-Aid for 2.53 seconds. Do you think our government stopped making gold American Eagle coins because they have your best interests at heart? I mean God forbid the government actually try to please its customers, whether it be via minting gold coins or voting AGAINST a banksta bailout. The physical market has disconnected from the paper market because trust is breaking down. This is part of the nasty bear/social mood cycle down we are in and is part of the reason to be bullish on precious metals, at least as portfolio insurance if nothing else.

Bad money (fiat U.S. dollars) is chasing good money (gold and silver) out of the system. That can only mean one of two things: there are too many paper dollars chasing things of real value and/or the things we used to think were valuable are no longer valued.

Because decreasing land, commodity and stock prices are deflationary and deflation can never be tolerated, inflationary medicine is being poured over our economy liberally. This inflationary government medicine is also know by its street name: "printing money out of thin air." What a treat! Can you imagine being given the privilege to order that money be printed out of thin air? That sounds like a habit I could get used to. The economy is slow? Sprinkle some fairy dust on it and it'll perk up - duh!

The market is in deflation but the government is trying to change it. Markets will win (as always) but governments will push their inflationary medicine so hard that once the markets are done dealing with their deflationary issues (1-3 years?), the United States (and others that seem all too willing to follow our lead lately) could lurch into a highly inflationary drunken fit. Buying gold now gets you in at a reasonable price and ensures protection from the monetary storms that lie dead ahead.

I have seen premiums AT MULTIPLE DEALERS for physical metal products I like ranging from 10-100% over the paper market spot price lately. This compares with 5% or less for the previous five years. Things changed last spring, possibly for awhile. I understood when dealers had sketchy inventory after we cracked $1000/oz gold and $20/oz silver last spring. I mean yo, the fever was on and the bull was raging. Intoxicating gains make a speculative beast tough to tame. But when gold dropped from just over $1000/oz to $750/oz, the shortage remained. Now, the U.S. Mint is too busy to supply customers willing to pay 25% over spot price for their coins. Forget the fact that it is one of the U.S. Mint's mandates to do so.

I bought lots of physical silver at $15-18/oz, not exactly near the bottom. I believe we're going into a brief deflationary period and I know silver doesn't do well in a deflation. The "paper" price of silver is now at $10/oz (i.e. futures price or price seen on a kitco.com price chart). Not a great investment so far, eh? Yet, on Ebay and at multiple dealers in cyberspace and/or a town near you, physical silver in the "real" market sells for $15-22/oz.

You see, actions can have unintended consequences. When bad money is used to chase out and beat down good money, the good money goes into hiding. And it becomes demanded by more and more people who lose faith and trust in the paper promises. It has happened with every fiat currency in history. A worldwide experiment of giving one country the ability to print the reserve currency for the whole planet at its whim is headed toward the same fate. The current fiat currency regime (nightmare?) may be the grandest in terms of scale, but this scheme like all others before it is destined to fail and flame out at horrible economic and societal cost. This is not a conspiracy, this is the expression of human character flaws. Few mortals can resist the temptation to print more money in a time of need once they have had their first taste.

Gold is an alternate currency. It competes with the paper promises of panicked politicians, which throughout history have yielded less than a junk bond and harbored three times the risk. Which investment do you think will hold up better going forward?

Why I'm looking for a bounce and why it's just that

Markets do not travel in straight lines. There is a daily clash between buyers and sellers. Some believe things are going to get better and some believe they will get worse. It is impractical to always be a bull or bear. Investing is about making money, not blindly always cheering for the same directional outcome. Being a bull in the stock market from 1982 through 2000 was a great idea. Since then, not so good.

During the wicked stock market bear market from 1929 thru 1932, the Dow Jones lost 89% of its value. That's right, 89%. If you lose 89% of your investment, you will then need to make over a 900% gain just to get back to even. Translation: don't "suffer" through bear markets because Suze Orman or Ben Stein told you to invest "for the long haul."

This chart below is courtesy (no permission obtained) of http://www.technicalanalysisbook.com/, via the http://www.financialarmageddon.com/ website.

Though the big picture is clear - this is the chart of a bear market over 3 years that wiped out 89% of investors' capital - the short term swings are wild and each contains a year's worth of gains! Bear markets are great for traders because of the wild swings in both directions. Stated another way, bear markets are more volatile than bull markets. In fact, some of the greatest positive gains in daily and weekly percentages are during bear markets, not bull markets. When you see multiple days in a short period of time that show 3-5% gains for the general stock market averages, you are paradoxically much more likely to be in a bear market than a bull.

For those not interested in the day to day drama, moving to cash at the top of the 1929 market meant that you could have bought NINE TIMES the number of stocks just 3 years later by staying out of the market. Additionally, the number of companies that had gone out of business by the end of this wicked bear market meant that the companies left standing were lean, mean, money making machines with a high dividend yield. This leads to wealth creation and this is why staying in cash during a bear market is a great passive strategy. But you have to pay attention to see the bear markets coming. In other words, did Cramer and/or the jag-offs on CNBC warn you a year ago that a bear market was coming and you should sell all your stocks?

Me, I'll stick with attempting to trade the intermediate bear market swings to magnify gains. That's why I'm getting ready to buy gold miners hand over fist, since I anticipate a wicked rally in this sector that will outpace the upcoming general stock market rally. A week ago? I was shorting the market. Now, I'm a bull. I will continue to labor to be neither an uber-bear nor a bulltard, but rather a shrewd investor.

Cash and gold - 1 year returns

Below stolen from the Wall Street journal, via The Big Picture blog.

Gold has outperformed cash over the past year and both have trounced stocks and real estate. This trend will be intact next year as well, but I suspect gold will pull even further ahead of cash. Gold cannot go bankrupt and has been real money for 5000 years, while hundreds of man-made currencies have come and gone. The U.S. dollar will be just a memory at some point, but gold will still have intrinsic value for years after this occurs. Gold can be passed on to children and grandchildren and will always retain its value, while companies come and go (ask ex-Bear Stearns and Enron employees). Gold is the protector of the common man.

If you do not have any gold as part of your investment portfolio, you are ignoring the wisdom of centuries of accumulated knowledge. Most who know what they are talking about recommend 5-15% of your net worth/investments be in gold/precious metals. Though silver has more explosive and volatile potential than gold and can provide outsized returns, it doesn't do well during deflation and is not for the faint of heart (gold is volatile enough).

The Dow to gold ratio closed around 10 for the week and we will get to a 1:1 ratio before this secular bear market finishes. I don't know if that will be at Dow 1,000 or Dow 10,000, but either way, gold will kick the Dow's (and S&P 500's and Nasdaq's) butt for at LEAST 3 more years. Once the ratio returns to 1:1, you can sell your gold and buy stocks "for the long run" and you'll be able to buy a whole lot more stocks than everyone else around you.

I recommend PHYSICAL gold coins and/or bars kept in a safe place where there is no risk of default and do not trust GLD (an ETF that tracks the price of gold) to hold up when the poop really hits the fan. I like Krugerrand 1 oz. gold coins (minted by the South African government) for their recognizability, liquidity and small unit size that allows incremental purchases when funds become available.

Gold miner fundamentals ripe for investing

A few charts to show how good fundamentals are for gold miners. We are within 15-20% of the final low for this gold miner stock correction, which has been wicked in terms of percentage and how fast it has been. The gold mining sector is nothing if not volatile. However, the next leg up will be just as if not more powerful than this current leg down.

First, a gold to $XAU ratio chart, which divides the price of an ounce of gold by the price of a blue chip gold mining index ($XAU). When the ratio is high, gold is favored over mining stocks.

This ratio chart shows a current "blow-off" top with an exhaustion gap that should be quickly reversed. Notice the last time this happened in mid-1986. This means we are within a few weeks of the low for gold stocks.

This long-term chart of the $XAU shows what happened in the year after mid-1986, the last time there was a blow-off top in the ratio - a gain of roughly 265% in one year. Not only that, but I am looking at buying stocks that will make more in percentage terms than the $XAU for this next leg up and I am going to buy options (translation: 300-600% gains are possible). If you look at other peaks in the ratio chart through the past two decades, you can see evidence of 100-150% gains following these peaks routinely.

What supports this happening again? Many things. First, people are scared of financial things and are moving toward tangible things that can't evaporate (like 401k plans invested in equity mutual funds). Second, the "real" price of gold is skyrocketing. The concept of the real price of gold is critical to understanding the profitability of mining companies.

Remember that gold miners dig both a commodity and money out of the ground. In a deflationary bear market environment, the commodity function of gold is less important than its monetary role. Cash is king during deflation, because the price of everything else you would want to invest in is going down (real estate, stocks, corporate bonds, unstable government's bonds and all other commodities). In other words, the true price of what the gold miners are digging out of the ground is increasing relative to what it costs to dig it out of the ground. Profitability for miners expands rapidly in such an environment. The best way to display the real price of gold is to compare it to other tangible goods, such as energy (which is a major mining expense).

The gold to general commodities ($CCI as a proxy) ratio chart shows the increased profitability that gold miners are now experiencing.

Bottom line: we are near the psychological (i.e. technical) bottom of this leg and the underpinning profitability environment (i.e. fundamentals) is strong. Within 2-3 weeks gold stocks should bottom and I will start to make some serious money in the gold stocks. I nibbled on a small amount of RGLD and GG today and will starting buying much more on significant price dips over the next 2-3 weeks.

Out of shorts

I sold all my puts today ten minutes before the close near the lows for the day. I am not sure that we are done falling, but we are getting close enough where the obscene profits I made were too good to pass up. I am now all in cash and physical gold.

The next play is a no brainer. I will be BUYING GOLD MINERS. I'm going to start looking for bargains tomorrow if we have a panic in the morning. I am not going to buy all at once, but rather I will average in over several days. I am particularly interested in Goldcorp (GG), Royal Gold (RGLD) and Yamana Gold (AUY) and will be buying 2010 LEAP options with a strike price 30-40% above the stock price at the time I buy. Trust me, it's going to be a worthwhile ride. Worst case scenario will be 50% gain in the underlying stock and with options, we can expect 100-150% gains at a minimum.

We are in the midst of a wicked deflationary bear market and are set to embark on a "recovery" bounce in the general markets that will begin within the next month and last until spring. I plan to ride the gold stocks up into the spring, which will outperform other sectors during the bounce, then cash out and start AGGRESSIVELY shorting the market again in the spring. If you are a traditional buy and hold investor or stock market bull, don't forget this leg down that is almost done. Burn it into your brain. Remember how it made you feel. This winter and spring, when the market makes a bounce recovery, you might start (erroneously) thinking that you should keep holding. You will be wrong. If you continue to hold through next summer you will have more of your portfolio wiped out and it will take a decade or two to recover that money.

Next spring, after the intermediate term bear market rally is over, we will have another DEVASTATING decline in the general markets. I recommend anyone spending their valuable time reading this buy some physical gold coins to keep in their possession as a long term safety play (and a great investment) and some physical cash in their possession to cover at least one month's worth of expenses. Do not think a bank "holiday" can't happen here in the good 'ol U S of A.

Stock markets "see" the future and clearly, what they see ain't pretty. This is not a "temporary, irrational selling spree," though the rapidity and steepness certainly classify it as a "panic" move. However, this is rational panic, NOT irrational panic.

We all need to take off the rose-colored glasses and learn how to protect ourselves and our loved ones from this mess. I promise you, you can't do that by spending your time figuring out whether you want to vote for McCain or Obama - they're both clueless and have no idea what to do. After studying markets, market history and cycles religiously for the past few years, I think I may be able to help mitigate the pain that we are all going to start feeling from the fallout that has unfortunately just started.

The yield curve

The yield curve can give a general signal about whether times are good or bad, much like the Dow to Gold ratio. Without getting into too much economic mumbo jumbo detail, a general assessment of the stock market "weather" can be obtained by the yield (in percentage terms) of a longer dated government bond divided by a shorter term government bond. The chart below is a ratio chart consisting of the yield of the ten year U.S. government bond divided by the yield of the 90 day U.S. government bond (called the "Treasury bill" or "T bill" if you want to sound cool).




In "good" times, the ratio of the longer term rate divided by the shorter term rate declines, while it rises during a contraction (i.e. the "bad" times). When the bull market gets a little overzealous and everyone starts to speculate too much, the phenomenon of yield curve "inversion" can occur, which is when the short term rate goes higher than the long-term rate, which causes a ratio of less than one on the chart above. Once the yield curve inverts, the bull market top should occur within about a year or so, giving longer-term horizon investors plenty of warning that the good times and the current bull market of the day will be coming to an end. This time around was no different.

Are we there yet?

While I don't mean to discourage those hopeless optimists out there, it is important to look at where we are and where we're headed in the "bigger picture." We don't want to get swung around in circles by the latest Cramer rant or by the hopelessly clueless Ben Stein.

Long-term cycles do exist and the reason they continue to exist is because people haven't changed all that much when it comes to fear and greed. Every other generation has to re-learn the same old mistakes. You know the old quote about the history thing and being doomed to repeat it? While every cycle is a little different, the waves of prosperity, excess, and subsequent "cleansing" of the excesses built into the system during the "good" times continue to help us map out the macro-environment. The Dow-to-Gold ratio (see prior post on this topic for chart) is an easy way to play/see this cycle and allows you to ignore the question of inflation versus deflation.

But most of us like to watch and play in the general markets and would be bored to death hoarding a barbarous relic for 20 years. So, where are we in this wicked bear market and where are we going? To the charts, to the charts, I say. First, a long-term chart of bull and bear market periods in the Dow Jones over the past 100 years or so (Note: another cyberspace chart theft and I can't remember where I stole it from).

If we want to be optimists, we would say the secular bear began in 2000 and will end in 15 years (instead of 20). Thinking it will be shorter means you are thinking wrong. Thinking Bernanke will try to save your 401k means you are wrong, naive, and probably high. Next up, an INFLATION-ADJUSTED chart of the Dow over 200 years (from Stephen Williams).

This was last updated in 2003 and I can assure you that we have been heading down from the peak of the top channel line drawn on the chart since. Note that this chart exposes the ravages of inflation when comparing the 1966 to 1982 periods between these two charts. In other words, the only difference between the 1930s and 1970s in terms of REAL, inflation-adjusted returns is... ummmm..... not much.

Now for more recent events:

All major trend lines have not just been broken, they've been shattered. We shan't regain these trend lines again anytime soon. Minor support at 1000 and major support at 800 when looking at this chart from a longer-term perspective. Anyone hoping for a resumption of the bull market in general equities is related to Cramer and missing out on big opportunities to profit (and remember that stepping aside and moving to cash is actually VERY profitable in deflationary times because cash is king). Stay with the major, undisputable trend. The trend is your friend and it be down, yo...

I believe the S&P 500 will re-test (i.e. last seen in 2002-3) the 800 level within the next 1-2 years and it may come quicker than most of us can fathom. Are you prepared? From a more intermediate term basis, this leg down should be over by the end of the month. Notice the deeply oversold RSI indicator on the weekly chart. I don't think we're done with this leg quite yet, but 1-3 more weeks should do it. I got rid of my $SPX puts today at around the 1040 level, but may buy some back if we have a decent bounce for the next day or two. Could have just as easily held for another week or two, but the whole "pigs get slaughtered" theme kept popping into my mind this morning.

Bonds - another indicator of deflation

I have been impatiently waiting for the long bond to break down and signal higher rates for the future. The fact that it just isn't happening solidifies my belief that we will have a deflationary-type period for at least 1-3 years. The long-term chart below demonstrates the current 30 year bond rate cycle versus the last one in the U.S.

I stole this chart but I don't remember where from so I can't give proper credit.



Remember, the bond market is larger than the stock market and is supposed to have more "sophisticated" investors. The 90-day T-bill has been under 1% for a while now, which is suggesting anything BUT inflation.

Commercial real estate - a dream short?

Below is a chart of the Down Jones U.S. Commercial real estate index ($DJUSRE) with a superimposed plot of the Dow Jones U.S. Homebuilder's index ($DJUSHB):



These charts so far look nearly identical with a phase shift. The homebuilder stocks peaked in 2005 and have tanked since (down as much as 75-80)%, while commercial real estate didn't peak until 2007. I circled the "dream" segment of a leg down in the homebuilder's index, which lost over 50% in less than 6 months. When shorting, remember that a 50% move down is similar to a 100% up move for those only used to thinking in the bull camp.

During the current cycle, peak prices for residential real estate/homes began before commercial real estate prices peaked, matching the stock cycles. I believe the charts will continue to show significant symmetry and so I positioned myself to profit in what I hope will be the strongest leg down for the commercial real estate bear market.

I bought January 2009 call options on an ETF (SRS) that is designed to try to provide the double inverse return of the Index in the chart above. In other words, if the $DJUSRE goes down 10%, SRS is supposed to go up 20%, although its tracking is far from perfect. Plus, I bought options on the ETF, making this a very leveraged play with plenty of risk if I am wrong. Friday, the $DJUSRE broke below its "head and shoulders" set up pattern and if I made the right call, the fireworks/"dream" leg down has begun.

The next play - gold stocks

Once we get the end of this intermediate bear market leg down that's causing everything except U.S. Treasuries and cash to go down, we will have a "recovery" bounce in just about everything. Currently, I have all my money in cash, gold and market shorts (shorting Bank of America (BAC), KB Homes (KBH), S&P 500, and commerical real estate via the SRS ETF).

I expect to cover my shorts (which are actually put options) before October is over and potentially as early as this week if the market has another big panic move down. Once I do that, I am going to use the proceeds to go long the gold mining sector.

I believe blue chip miners will go up 50-70% in a 6-7 month time frame once the general stock market intermediate term bottom occurs. Catching the exact bottom is impossible except through luck, and I'm not very lucky, but I only need to catch 70% of this coming move to make a bundle.

There are some charts and fundamentals that justify my belief in a coming big rally in the gold stocks. The first is that a deflationary environment actually benefits gold miners because the "real" price of gold generally rises, even if it's nominal price remains flat or even slightly declines. In other words, the schizophrenic nature of gold becomes exposed. Though gold is a commodity and an inflation hedge, it is also the oldest form of money, and cash is king in a deflationary environment. If you think of gold as money instead of as a commodity, think about what a boon deflation is for gold miners. Other commodities (like energy) and labor costs go down in a deflationary environment, so the cost of digging money out of the ground decreases and money becomes the world's most valuable investment during a deflation.

To get a proxy sense of the "real" price of gold, we can use a ratio chart that divides the price of gold by the price of a basket of commodities (the $CCI).

Notice the breakout to new highs, which I believe is the beginning of a powerful new leg up in this ratio, increasing miner profitability. Next, I want to show you a ratio chart of the price of a gold mining index (the $HUI or gold bugs' index of un-hedged miners) divided by the price of gold. When the chart is going up, gold miners are considered to be more highly valued than gold and vise versa.



As you can see, gold miners strongly outperformed gold itself in the first 3 years of the gold stock bull market, but have lagged the price of gold for the last 4 years. This situation is about to reverse. I have given my estimate of Elliott wave count for this chart, which must be a pretty clean chart for me to even attempt it. Bottom line if you're not into Elliott theory, the "correction" for miners relative to the price of gold is nearly over (i.e. the "C" wave is almost done) and the next leg up should be powerful and roughly 2-3 years. Looking at a gold mining index chart, such as the GDX/$GDM, it is clear that we are undergoing a major (rather than a minor) correction that I believe will complete before the end of November. Since I don't know exactly when the bottom is in, I am going to buy gold stocks once general stocks (i.e. S&P 500)are done tanking, as a severe stock market decline (which we are in now) often takes everything with it.

Below is a chart I found on www.gold-eagle.com (a great gold site), which shows how Homestake Mining, a major gold miner at the time, did during the greatest deflationary bear market of the last 100 years.



A few things are clear here. First, gold stocks did go down during the initial panic in 1929 and second, the most spectacular gains occurred after the final stock market bottom in 1932. However, the chart doesn't have a log scale and a trader could have bought Homestake in late 1930 for a roughly 30% gain over a few months, in early 1931 for a roughly 75% gain over six months, and then in mid-1932 for a 300% gain in 1 year. Because this will be the "first" leg up in the next wave of the gold stock bull market, we don't know exactly how big the move will be, but such is trading. If you're not into trading, you can simply buy the GDX, GG or AUY this fall and hold for 3 years to make lots of money while everyone around you is losing their shirt. Me, I'm going to lever up and go for the gold, selling at what I think is the end of this leg up so I can switch to shorting the market again next spring.

I plan to play this coming leg up by buying 2010 LEAP call options on a few blue chip miners including Goldcorp (GG) and Yamana Gold (AUY), as well as a smaller gold company called Royal Gold (RGLD). For those not as familar with the sector, I would recommend GDX, an ETF that holds a basket of mining companies (LEAP options can be purchased to leverage gains and risk and the basket eliminates the risk of picking the wrong company in the sector).