Wrap Your Head Around Gold

Long overlooked and seldom understood, gold is now the 800-pound gorilla in the room that the world has been forced to acknowledge.

Reaching another new all-time high nominal price above $1,150 per ounce Wednesday, the metal's rise continues to astound its silenced detractors and reward investors who sought timely protection from fundamental weakness in the U.S. dollar.

It's all about the dollar
At its core, gold's ascent is about a crisis of confidence in the greenback, and by association other impaired fiat currencies like the British pound (not so sterling anymore). At the risk of repeating myself, Fools may wish to reflect once more upon former Fed chairman Alan Greenspan's own characterization of gold's rise as "an indication of a very early stage of an endeavor to move away from paper currencies."

The fundamental outlook for the U.S. dollar is comprised of some daunting challenges, including:

  • Enormous government deficits projecting many years into the future.
  • A resulting irreplaceable reliance upon foreign willingness to support those deficits by buying U.S. debt.
  • The forestalled de-leveraging of hundreds of trillions of dollars in USD-denominated derivatives.
  • The political expediency of further economic stimulus measures like the recently enacted homebuyer credit extension and potential job-creation initiatives.
  • Persistent economic headwinds domestically that leave the Fed still married to zero-bound interest rates for the time being.

As students of the first Great Depression will recall, it is often the unforeseen consequences of government interventions designed to stave off a de-leveraging event that prove more damaging than the problems they sought to address. I maintain that this is precisely the case with the multitrillion-dollar collective response to the jarring events of 2008, and that the greatest danger to financial markets remains the unforeseen consequences of the response strategies employed.

One of these consequences is coming clearly into view as we speak. As a direct result of prolonged zero-bound interest rates, the dollar is replacing the Japanese yen as the currency of choice for investors engaged in carry trades. A carry trade is used as a means of boosting investment capital by swapping low-yielding currencies for higher-yielding alternatives, and leveraging the difference to fund investment activity. If the yen carry trade raised concerns with respect to setting the conditions for potential asset bubbles, the potential impacts of a dollar carry trade are greater in scale. China is concerned about the nascent dollar carry trade, and made note of it during President Obama's visit to China this week.

It's not just about the dollar
Did I just say it was all about the dollar? Silly me ... there's much more to it than that.

Stepping away from currencies for a moment, Fools are reminded to keep a close eye on the supply environment for gold. Last week, we discussed Barrick Gold (NYSE: ABX  ) CEO Aaron Regent's proclamation that the world has passed the peak gold stage, citing a decade-long trend of declining global output in the face of increasing demand and increasing capital expenditures. This week, a research report from South Africa challenged widely held assumptions about the quantity of gold remaining in South African reserves. According to this report, South Africa may hold less than 3,000 tons in remaining reserves, which is less than half the quantity reported by the U.S. Geological Survey. Supply remains tight even as demand reaches new heights, and Fools know exactly what that could mean for prices.

Where and how to invest
Pulling the trigger on gold equity purchases at these unprecedented levels is a bit like traveling to Spain for the "running of the bulls" -- it is not for the faint of heart. Ultimately, a pause in gold's ascent would seem inevitable before it marches significantly higher -- just as many anticipate a short-term rally in the U.S. dollar before that currency retests its all-time low -- but I have argued consistently that the fundamental conditions to support higher long-term gold prices are already in place.

To reduce the potential risk of a near-term pullback, Fools are encouraged to maintain a disciplined approach to the precious-metals sector. Mark Johnson of the USAA Precious Metals & Minerals Fund (USAGX) employs such an approach, emphasizing "low-cost producers with strong management and good balance sheets that have growth profiles and also relatively reasonable valuations." Among his favorites (and mine) are Agnico-Eagle Mines (NYSE: AEM  ) and Royal Gold (Nasdaq: RGLD  ) .

Caesar Bryan of Gamco Gold Fund (GLDAX) is more focused on a combination of overall reserves and strong cash flows, selecting quality names like Gold Fields (NYSE: GFI  ) , Goldcorp (NYSE: GG  ) and Kinross Gold (NYSE: KGC  ) in anticipation of substantial dividends that may be initiated down the road. To these fine suggestions, I would add the recently launched Market Vectors Junior Gold Miners ETF (NYSE: GDXJ  ) as an attractive vehicle for exposure to precious-metals price appreciation, but this one could drop like a stone if we do see a major correction sooner rather than later.

Rather than attempting to time this market, I believe Fools with no precious metal plays in their portfolio should think about gaining some degree of exposure, perhaps keeping some dry powder on the sidelines to increase that stake on any big pullback. Now that you know my thoughts on the matter, I'd like to hear yours through your vote in our Motley Poll and your comments below.

Gold is a hot topic on the blogs at Motley Fool CAPS. Join the free service today and see just how many Fools are taking the long view when it comes to investing in gold. The "Gold" tag at CAPS lists 47 potential investments, and you'll find Christopher's comments on most of them.

Fool contributor Christopher Barker carries a silver coin which reads: "Honest value never fails." He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns shares of Agnico-Eagle Mines, Kinross Gold, and Royal Gold. The Motley Fool's disclosure policy is 0.999 pure.


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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 November 19, 2009, at 8:33 AM, sept2749 wrote:

    I have seen gold go up and down and the same goes for the dollar. I have never bought gold -except for my wife! When times get tough I stay with the top long term players like JNJ, PG etc... and I have always did fine. That's not to say I don't believe a complete disaster may occur and I'd get clobbered. However, I believe that gold is HIGH right now and if I had better forsight I would have bought some last year. Oh well, at least I bought some good stuff "cheap". If gold really soars like some say it will I guess I missed the boat. However, according to history things should rebound in a year or so and we'll be OK unless of course we keep printing "monopoly" money and continue to increase our debt. I feel sorry for the next generation as they will be paying this debt off for a very long time!

  • Report this Comment On November 19, 2009, at 12:06 PM, rfaramir wrote:

    Sorry, but there is no "according to history" this time. The Federal Reserve has not increased total reserves by 17X in one year (August 08 - August 09, see http://www.federalreserve.gov/Releases/h3/20090813/) ever before. With the "multiplier effect" of about 10-to-1, we have potential inflation of 170 times.

    Not that we'll necessarily get it, for two related reasons: 1) the banks are scared to lend against their new reserves, not when they can make a safe profit 'lending back to the government' by buying Treasuries with it, instead of lending to wealth producers, and 2) much of the new reserves are just covering losses the banks incurred in the past, which is to say they already inflated, leveraged, gambled, and lost and would be out of business if not for socializing their losses with this taxpayer-backed infusion.

    If you knew how much of the new stuff was just covering losses, then you could calculate the inflation the rest would cause.

    To get a 'proper' price of gold, you could just divide the total money supply (M2?) by total ounces of gold in the Treasury, assuming that the best case would be if we went back on the gold standard. Someone said (in the summer) that that number is about $35,000 per ounce; I have no idea if that is accurate anymore. But this administration is not likely to go back to such a conservative standard, nor will they stop inflating, so the sky's the limit to the price because zero is the limit to the value of a paper/electronic FRN.

    The low end for the price of gold would be total paper currency (actually printed dollars, is that M1?) divided by total government gold ounces. But that assumes that all fictitious "checking account" money and fractional-reserve multiplied money just disappeared, by say all banks going under and fractional reserve banking outlawed and the dollar becoming gold-backed again. A dream scenario for proponents of sound money. Unlikely, but again, it's just to establish a lower bound on the price of gold. Anyone know that number?

  • Report this Comment On November 21, 2009, at 1:28 AM, thisislabor wrote:

    so what do you do to get the statistical likelihood of us going to a gold back dollar again? divide the current price by that $35,000 dollar number? about a 1 in 33 chance?

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