The Big "What If?"

The Big "What If?"
by Susan C. Walker
The Daily Reckoning
Thursday, May 25, 2006

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• Testing our faith - but not our patience…the biggest spender of all time…

• The frontier between two stages of a bull market…tempests are never welcome…

• Gold: accepted everywhere…our cross-country trekkers feel the blow of $385 loss off a gas station lottery ticket…and more!

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Gold got clobbered yesterday, down $36 for June contracts. It was one of the largest one-day drops in many years. The metal has lost about $100 from its high. Many people already think the bull market is over. The final spike of speculative fever, they say, took gold up to $730. Now, it is downhill from here on. As the price falls further - as it well may - more and more latecomers to the gold market will be discouraged. They will drop out along with the price. Even Daily Reckoning readers will begin to wonder. Maybe the dollar is for real and forever. Maybe the world economic system really is remarkably robust and flexible. Maybe gold really is a relic of the past.

Thus is our faith tested. Not our faith in gold. We know what we think of gold - it is nothing but an inert metal. It says nothing. It performs no tricks or miracles. It never disappoints us. Nor does it ever really do anything to delight or entertain us. It just sits there like a cop in a squad car. He is of no particular use most of the time, but critically important occasionally. No, it is not in the metal that we put our faith; it is in man himself, generally, and central bankers and politicians in particular. We have an abiding faith that when temptation is set before them, they will do what such men have always done - they will go for it.

When George W. Bush moved into the White House you could buy an ounce of gold for only $266. At the time, we thought the man from Texas was a conservative. He said he was. Little did we know he'd become the biggest spender of all time.

Even if Bush had turned out to be a sensible president, gold would still have entered a bull market. These things are cyclical, after all. A 20-year slump is bound, in the course of things, to turn around sooner or later. At the bottom of the slump, gold was a great bargain at $266. But now, with a boom underway, is it still a bargain at $637? That's what we are going to find out. Our guess is, yes and no. Maybe not compared to the price at which you may be able to buy it two months from now, if the correction continues. Maybe so, if the bull market storms ahead as we believe it will.

If the correction follows the pattern of the price correction in the '70s bull market in gold, the price could even fall back to the $500 level. That would wipe out about half gold's rise from the day the neo-cons took over American government to the peak of gold hit two weeks ago, at $720.

Five-hundred-dollar gold would still represent a solid profit for those who bought six years ago - it would double their investment. Our guess is that it would mark the frontier between two stages of a bull market, too. And finally, it would give those whose faith is strong one final opportunity to buy at a bargain price.

You will recall how easy it was. From under $300 an ounce up to $500 an ounce, accumulating gold was simple. We set target prices, raising the hurdle $25 at a time, and buying whenever gold dipped back to hit the target. It was like climbing a set of stairs. But then, when gold rose above $500, it quickly left us behind. We kept waiting for the price to drop back to our target so we could buy more. Instead, it rose even higher. We missed $100 of gain, and then another $100 of gain. We felt like idiots. We had seen it coming, and still missed it. And then, when gold soared above $700, it looked like nothing could stop it. We worried that it would go all the way - all the way to $1,000 or $2,000 without ever giving us another opportunity to buy at a discount. What to do, we wondered in these pages. Close our eyes and buy, counting on the long-term bull market to erase any timing errors? Or, sit on the sidelines and risk missing the best part? We had no answer.

"Buy," was said, with a gulp and a prayer. It is better to be in than out, we reasoned, even if we are not getting in at the best price. Yet, we could not bring ourselves to buy either.

And the price rose…

And then, the financial world shuddered. The frisson originated in Japan, we believe. After 16 years of deflation and slump, the Japanese economy is finally pulling itself together. And Japanese central bankers are now beginning to tighten down on the monetary valves. The money supply in Japan is actually falling. For many years now, speculators - largely hedge funds - have been able to borrow money in Japan at once-in-a-lifetime low rates. This gush of easy money flooded markets all over the world - from India, to Jakarta, to the United States - and most recently, to gold itself. And when, all of a sudden, the cash was not so forthcoming, investors panicked. For the first time in years, storm clouds appeared in the speculators' paradise. Emerging markets dropped last week. The Dow wobbled, too. Commodities - including gold - took a beating.

Tempests are never welcome, but they are most regretted when you are least prepared for them.

Sooner or later, now or in the future, fierce weather is inevitable. Debt begets repayment. Boom begets recession. Bull markets beget bear markets. Stability begets instability. Any day now, China could implode, the housing boom could collapse, foreigners could drop the dollar. Our guess is that all those things will happen. If only we could tell you when!

All we can tell you is how to protect yourself. For that, we turn to no less of an authority than Alan Greenspan himself (we can't think of any less of an authority) who said in 1999: "Gold still represents the ultimate form of payment in the world. Fiat money in extremis is accepted by nobody. Gold is always accepted."

When the wind blows hard - that is to say, in extremis - everything begins to flap, flutter, and fly away. People look for something solid to hold onto.

So far, gold has gone up no more than base metal. Since 2001, gold is up 249%. Lead has risen 240%. This tells us that people have not even looked at the barometer yet. Meanwhile, the Bush administration says it no longer intends to continue the "strong-dollar policy," under which, the dollar lost about half its purchasing power. We can't wait to see what happens under a weak-dollar policy. And all over the world, people have built up huge piles of dollars, yen, euros, and pounds - and staggeringly large claims and counterclaims against them, including a trade in derivatives that is now close to $300 trillion per year. Against all that, the current stock of gold is a mere pittance, a tiny island in a vast sea of paper money. When the winds really begin to howl, our guess is that there will be many people who want a piece of it.

Over to our currency counselor…

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Chuck Butler, reporting from EverBank's world-currency trading desk in St. Louis:

"The New Zealand dollar/kiwi rallied very hard yesterday - all day and all night - after it was reported that their trade deficit had shrunk in April. It now looks now as if it has turned the corner."

For the rest of this story, and for more market insights, see today's issue of

The Daily Pfennig

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And more thoughts from Bill Bonner…

*** Is the commodity boom over? Probably not. In real terms, commodity prices are only about 35% of what they were in the last peak, in the '70s. What we are seeing looks to us like a normal correction in a bull market. "I'm not selling any commodities," says our old friend Jim Rogers, "even if they go down 30% - 40%, because they will be going back up later."

[Ed. Note: That's the stance that our resident commodities expert, Kevin Kerr, always takes. He doesn't see the boom in natural resources ending anytime soon - and that means there are still major profits to be made in this sector. Check out Kevin's latest report to find out why he's earned the nickname "Maniac Trader":

Learn to Play Commodity Options Like a Champ!

*** The glory days for hedge funds are over. The jig is up. The problem with them is that they are not really hedging risk, but adding to it. Typically, they take advantage of cheap liquidity - such as that made available by the Bank of Japan - and place it in more rewarding, but more volatile, places including Dubai, Jakarta, and Bombay…not to mention U.S.-dollar debt. The trick worked well enough for a long enough time to mislead investors. But now, the world's central banks think they are fighting inflation. They saw the boom in commodities and decided to stiffen their backs. It's gotten harder for hedge funds to perform. The Times of London reports:

"Richard Oldfield, chief executive of the fund managers Oldfield Partners, said that investors would gradually become disillusioned by poor returns over the next ten years. 'It will end with a whimper, not a bang,' he said, adding that the target returns of 12, 15 or 17 per cent routinely conjured up by hedge funds were 'totally fanciful.' He said: 'We will look back and realize this was a barmy ," adding that some hedge funds were walking a difficult regulatory line: some were close to acting as concert parties in bid situations and some were coming very close to front-running - the practice of trading ahead of one's clients.

"'My message is that hedge funds are a con,' he said.

"Andrew Clare, Economics Professor at the Cass Business School, said that the industry was hitting capacity constraints. 'There must be a limit to the number of smart guys you can crowd into the same small space,' he said."

*** We received this note from our traveling vagabonds, Joel and Greg:

"Despite its recent volatility, we remain long-term gold bulls. So when a nondescript gas station in the middle of outback Missouri presented us with an opportunity to make a little gold investment, we jumped at the chance.

"One 'Gold Bar' lottery ticket, please, ma'am," we said to a well-fed, mustachioed cashier as we piled the counter high with energy drinks and beef jerky. 'Have you seen any decent returns on gold recently?' we asked.

"'Oh, sure,' came the hoarse but enthusiastic reply. 'The first weekend these gold tickets came out I sold one for $600 and another for $400.'

"'Wow. That's some serious profits on a $5 lottery ticket.'

"As we reached over to choose our lucky penny from the community tray, another, slightly more homely attendant quietly sauntered over. 'We'll tell you what,' we said, 'if we bag anything close to that, the four of us are going to the races.' We shook the penny as if it were dice and held it out for the ladies to blow on. They obliged.

"The first of three rows of numbers yielded nothing. Tension mounted. Second row…nothing. The suspense was palpable as the promised day at the races hung in the balance. We drew our lucky penny across the final row and everyone held their breath, tense with anticipation.

"'Gold bar! Gold bar!' the wobbly ladies were practically leaping out of their floral muumuus. 'That means you get four times the amount shown under the - the gold bar, under the gold bar. Scratch under the gold bar!' We had the feeling this was the most excitement this gas station had seen for a while.

"Four times five makes for a crisp twenty dollar note headed our way. That's a 300% profit in less than ten minutes. Once again, gold comes through with the goods.

"We stashed our winnings in our pocket and bid farewell to our fair ladies. Perhaps if we were ever at this gas station again we'd crack the $600 mark and enjoy that day at the races.

"It wasn't until we arrived at Hayes, our eventual rest stop for the night, that we realized the true cost of our lottery ticket delay. Some sly vagrant had busted into the unattended U-haul cab and fleeced us of a camera and a cell phone for a loss of $400. Less the fifteen dollars in winnings and we were looking at a net loss of $385. Then and there, we decided no more lottery-ticket gambling."

[Short Fuse's Note: I asked our roving Whiskey and Rude fools exactly where this all took place. But, of course, they had managed to lose their map. Let's hope their innocence doesn't join the list of lost possessions if they somehow manage to make it to Colorado. To see where they've been, and what other trouble they've gotten into, click here:

Road-Trippin Across The Empire

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The Daily Reckoning PRESENTS: It happens. Formerly "hot" housing markets eventually lose their sizzle. But does that mean that will simply level off - or take a long tumble down? Elliott Wave's Susan Walker explores…

THE BIG "WHAT IF?"  
by Susan C. Walker

It's long past time to talk about housing markets losing their sizzle. They've already begun to turn down in the most-bubbly markets on the East and West coasts. Now we've arrived at the truly difficult part of any real estate boom-and-bust cycle - the time when prices hang in the balance. Will they go up any more, will they plateau or will they - collective shudder - go down?

This uncertainty particularly worries those who have bought some investment property - say, a second home or condo - and are having trouble selling it. Is it time for them to face their inner fear that they might have to sell their property for less than what they originally paid? Worse yet, what if the property doesn't sell even then?

It happens to the best of families - relatives lose their shirts on real estate. In my own extended family, there's a perfect example. Let's call him Uncle Mike. Back in the early 1970s, he retired and used his nest egg to buy property on Hilton Head Island in South Carolina. One lot for himself and his wife, and four more pieces of land for his kids to build on some day. Easy to see what a great investment that must have been. Hilton Head is such a success story. Wasn't he smart to get in at the very beginning?

Well, Uncle Mike was smart, but the investment was not. The developers of Hilton Head went bankrupt and took Uncle Mike down with them. He had to sell his home at a loss. He found no buyers for the four lots, and the bank took them over. (Some lucky buyers later scooped them up for a pittance.) Then he and his wife had to move into an apartment that was one-third the size of their previous home. His retirement ended up looking less like "Easy Street" and much more like "Difficult Drive." Once the real estate market shook out, Hilton Head recovered and went on to become the luxurious vacation spot it is, but Uncle Mike never recovered.

Ah, but most people who have bought investment properties recently didn't own in the 1970s. It's hard to be prepared for the history you don't know to repeat itself. In fact, ElliottWave.com points out that people choose to see only one side of the price equation. Even as sales of new homes drop and the number of homes on the market rise, still there is virtually no fear about home values:

A recent national survey of homeowners by the L.A. Times shows 'widespread faith in the real estate market.' The worst possible scenario, that prices would 'stay the same' over the next three years, was selected by just 5% of homeowners. That total was less than the 6% who said they expect to see a rise of 31% or more. No matter how much talk of a bubble there may be, homeowners continue to demonstrate that they have no clue about the ramifications of one. And this is in an environment in which prices actually are falling! The denial runs so deep; it's not even denial anymore. It's some kind of epic disconnect between the reality of a newly falling housing market and an unwritten social contract that says home prices do not fall. [The Elliott Wave Financial Forecast, April 2006]

Yet, you don't have to have lived through a housing bust yourself to appreciate the effects. Just think of someone you know who lived through the bust in the Houston oil patch during the 1980s, or the Northeast condo bust in the late '80s and early '90s, or Atlanta's real estate bust in the 1970s. Most property owners then twisted in the wind, waiting, waiting for prices to turn back up. Many of them couldn't hold onto their property, and the people who picked up the pieces at rock-bottom prices became the next land barons.

That brings us to the big "What if?" What if that investment house or condo you bought doesn't sell? Plan B is usually to rent it, but what if you can't find renters? Do you just hold on and keep paying the mortgage and other carrying costs, or do you throw the towel in and sell at a loss to whomever will buy?

The real problem is that markets can move much slower than we expect, which makes it all the more difficult to decide what to do. For reference, historian John Brooks wrote about how it felt to live during the Great Depression. In one word, it was "surreal." Keep in mind his description of the 1929-1933 experience:

[It] came with a kind of surrealistic slowness … so gradually that, on the one hand, it was possible to live through a good part of it without realizing that it was happening, and, on the other hand, it was possible to believe one had experienced and survived it when in fact it had no more than just begun.

When a market starts to turn, it doesn't have to be quick. It's more likely to be slow and painful - like boiling a frog. (The idea goes that a frog would jump out if it were thrown into a pot of boiling water. But if it's put into a pot of cold water and then the heat is turned on, the frog could not judge the threat.) In fact, economist Gary Shilling wrote in Forbes magazine last September, "History also suggests that a housing boom does not have to end violently. The Federal Deposit Insurance Corp. counted 63 home-price run-ups in various cities over the last 30 years, but so far just nine of these ended in busts, and all of those were regional." He goes on to point out that prices that went up gradually tend to come down gradually over many years. That means slow housing market busts can slowly boil investors who don't have the cash flow to hold onto their properties until the market turns again.

So, will there be more Uncle Mikes in the world next year this time? Thinking about human nature, the answer has to be a resounding 'yes.' There are only a hardy few who can hold on through a protracted bust or who are able to absorb a loss and move on to the next investment. In the meantime, though, many people who own property will suffer from the effects of mental anguish and indecision, not unlike that poor frog who doesn't know if the water is going to keep getting hotter.

Regards,

Susan C. Walker
for The Daily Reckoning

Editor's Note: Susan C. Walker writes for Elliott Wave International, a market forecasting and technical analysis company. She has been an associate editor with Inc. magazine, a newspaper writer and editor, an investor-relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. She is a graduate of Stanford University.

Elliott Wave International

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