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Dodge the Dollar With a Silver Bullet?

It's getting harder to write about the state of the economy without sounding like Saturday Night Live's Debbie Downer (cue up sound effects). For Foolish investors with some exposure to gold and silver, though, there can be great comfort in the safety of hard assets and the prospects for continued growth in what has been a seven-year-long bull market for them.

What exactly is driving gold and silver higher?
Gold and silver are coveted for industrial applications, for jewelry, and for their intrinsic value as two of the world's most ancient and resilient forms of money. The renewed interest in them is driven by the whole macroeconomic landscape, which itself is dominated by the U.S. dollar. Because of the dollar's near-universal use as a reserve currency, and its importance for trading critical commodities such as oil, the dollar is king.

The king, though, is not well: The dollar's value has been cascading. Since 2002, its value has fallen 39% to new historic lows against a basket of foreign currencies. Meanwhile, the Bush administration is gunning for a $3 trillion budget, there is the continued meltdown of the U.S. housing market, and there are the systemic failures in the credit and derivatives markets that led to the collapse of you-know-who. While Ben Bernanke is trying to slay the mortgage meltdown dragon with reams of freshly printed dollars, a more fearsome beast lurks in the shadows: inflation.

The annual rate of inflation tracks the falling purchasing power of the dollar at home the way the dollar index tracks the currency's performance abroad. Inflation -- currently around 4% -- certainly will not be slowed by the kind of action the Fed took recently with its $200 billion credit swap. As the dollar continues to fall, some foreign countries will be less willing to finance our massive debt, raising the likelihood that more new money will be "printed" to service that debt. This is a recipe for stagflation, and a potentially vicious cycle.

Have investment banks been "on the money"?
The investment banks have been woefully inadequate at forecasting the scale and duration of this precious metals bull market. Though many of the major financial firms are just now warming up to gold, their price forecasts remain laughable, at best. Goldman Sachs (NYSE: GS  ) missed the boat entirely. In November 2007, with gold near $800 per ounce, it directed investors to short gold in 2008 as one of its top 10 tips for 2008. Thanks, but no thanks.

One month earlier, Credit Suisse (NYSE: CS  ) targeted gold at $838 per ounce in 2008, $950 for 2009, and $1,050 for 2010. Similarly, both Citigroup and Merrill Lynch issued extremely bullish statements last month about the underlying fundamentals for gold, though neither firm would commit to a price target above $1,000 for 2008.

What are industry insiders and others telling us?
Industry insiders, including Gold Fields (NYSE: GFI  ) CEO Ian Cockerill, remain strongly bullish on the metal. So does commodity uber-bull Jim Rogers, who recently forecast $3,500 for gold, and Jim Cramer, with his $1,600 forecast.

Like these guys, I'm also strongly bullish on gold, but I'm even more bullish on silver. Industry watchers frequently point to a long-term price relationship of gold to silver being at a ratio of 20 to 1. The gold/silver price ratio has been much higher in recent years, however. In fact, right now the relationship is more like 50 to 1. If you're bullish on gold and assume that silver prices will shift back closer to their historical price relationship with gold, that would suggest that silver -- currently near $20 per ounce -- is significantly undervalued.

The Foolish bottom line
I can understand investors' concerns about getting into gold at what looks like a high price, but I believe the greater risk is in not diversifying your portfolio into precious metals, including gold.

Consider some bullion exposure through exchange-traded funds like the streetTRACKS Gold Trust (NYSE: GLD  ) , but also focus on mining companies, which will enjoy greater leverage to increases in the price of gold. Look for companies that are producing at low costs-per-ounce in politically stable regions. (Hint: There are also 84 rated gold stocks in the investor-intelligence database that is Motley Fool CAPS).

Be brave, Fools. There will be corrections along the way -- some of them substantial. Investing in this sector requires strength and conviction, and short-term movements are nothing but noise within the broader trend.

Further Foolishness:

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 29, 2009, at 2:06 PM, Cashcow247b wrote:

    you are living in a time warp.

    ..."Meanwhile, the Bush administration is gunning for a $3 trillion budget,"

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