A FOUR-LETTER INVESTMENT

Gold has been irrelevant for so long that most investors
ignore it completely.

That’s unfortunate.

The precious metal’s three-year advance from $265 an ounce
to $470 is no accident. The price of gold is rising because
its main competition, the U.S. dollar, is proving to be a
very poor store of value.

In other words, the gold bull market is just beginning.
According to the conventional wisdom, there are only a few
ways for the bull market in gold to play out. Option #1:
The yellow metal’s dollar price will violently launch into
orbit at some point, arc into a near vertical crescendo and
ultimately burn itself out supernova style; Option #2: The
gold price will grind higher over the next few years,
punctuated by sharp rallies and swift sell offs (just to
keep us on our toes). But in either case, the gains will
not endure. The gold price will eventually return to
earth…where it belongs.

Gold will return to normalcy, which in gold’s case equates
to dormancy. After all, what goes up must come down. Right?
It’s only logical. That is what everyone expects. Yet what
if, this time, the future doesn’t look like the past? What
if gold were to climb to new highs, breaking the $1,000-an-
ounce barrier, and never return from whence it came?
Now that would be something…

To understand the bullish outlook for gold, we must first
examine the bearish influences operating against the U.S.
dollar.

The greenback still reigns supreme, of course, holding sway
over all other paper currencies. In spite of all the
pessimism and diversification talk of recent years, IMF
figures show that dollars still make up roughly two-thirds
of the world’s foreign exchange holdings.

So why is the dollar so popular? What gives America free
rein to settle debts in its own currency, print more of it
at will and impose its fiscal whims on the rest of the
world?

The first critical element is security, provided in the
form of military and economic dominance. Charles and Louis-
Vincent Gave, of research house GaveKal, theorize that the
world’s reserve currency is primarily held as a form of
insurance in the event of crisis. Based on this theory,
GaveKal has come up with four key requirements, as follows:

Attribute #1: “The issuing country must be dominant
militarily. And here the logic is simple: One holds a
reserve currency for random crisis events. Wars are random
crisis events. One wants to ensure that, in case of a war,
one is able to buy the best possible weapons… and be sure
that the weapons will be delivered.”

Attribute #2: “The issuing country must be dominant
technologically (see above).”

Attribute #3: “The issuing country must be dominant
agriculturally so that in case of a random crisis, reserves
can be morphed into food to feed local populations.”

Attribute #4: “The issuing country must be mature
financially (i.e., have developed financial markets) so
that in a random crisis, the afflicted country has the
ability to raise money in the financial markets.”

By this reckoning, the dollar is more than just a paper
liability of the U.S. government; it is backed by the best-
in-class physical strength of the U.S. military and the
best-in-class financial strength of the U.S. economy. This
provides a sense of security to smaller countries facing
greater exposure to the dangers of political unrest,
military conflict or economic shock. When the local unit of
exchange is being buffeted this way and that like a dinghy
in a hurricane, it is good to have a stash of dollars on
hand.

Another significant element propping up king dollar’s
throne is plain old inertia. When things have been done the
same way for a very long time, it is hard to introduce
change. But even inertia yields to change eventually.
So how might the dollar be toppled? There is precious
little to work with in terms of past example. The Economist
observes the last regime change:
 
“The pound was king during the era of the gold standard.
But in the years after 1914, Britain switched from net
creditor to net debtor, and by the 1920s, the dollar was
the only currency convertible to gold (although the pound
returned to gold in 1925). Two costly wars and two episodes
of currency devaluation in Britain later, the dollar was
unchallenged as the world’s chief reserve currency.”

It arguably took two world wars and a global depression to
dislodge the pound. That is a fairly tall order; no wonder
the consensus belief is that king dollar will maintain his
throne. But for all the elements working in its favor, the
reign of America’s world-beating currency has a large
strike against it: The profligate policies of America
itself. While it took a series of extraordinary events over
the space of decades to dislodge the pound, Britain never
spent others’ money with the wild abandon America has
shown.

To put it bluntly, the United States has taken a jackhammer
to its financial credibility. The U.S. consumer is happily
in hock up to his eyeballs, betting on further housing
appreciation to bail him out, while the accelerating pace
of U.S. government spending boggles the mind.

Consider this: President Bush has already beat out Lyndon
Johnson as the biggest spender of all time. The Cato
Institute reports:

“The increase in discretionary spending — that is, all non-
entitlement programs — in Bush’s first term was 48.5% in
nominal terms. That’s more than twice as large as the
increase in discretionary spending during Clinton’s entire
two terms (21.6%), and just higher than Lyndon Johnson’s
entire discretionary spending spree (48.3%).”

What we have is an extraordinary situation. The status quo
is not sustainable, but no one is clear as to what will
happen next. Here is where things get interesting. If no
fiat currency can stand up to king dollar, perhaps a
precious metal can. Bloomberg columnist Matthew Lynn makes
the case:

“Whatever the financial Jeremiahs may think, the gold rally
isn’t telling us that the global economy is about to
descend into hyperinflation. Nor is it saying paper money
is worthless, and people are hoarding something more
reliable. It just tells us there is too much cheap money
floating around.”

Gold is rising higher on a sea change in perception. The
yellow metal has benefited not just from commodity price
pressures, but also from a sharp upturn in expectation for
future inflation. The United States government appears to
be fiscally out of control in the wake of Katrina and Rita;
persistently high energy prices have convinced many that
the pain of high energy prices is no longer a temporary
concern; and there is real concern that America has no true
long-term solution to its deficit spending woes other than
devaluing the dollar and monetizing its debt. Last but not
least, the ‘safe hand’ at the helm of the Federal Reserve
will be retiring at a most inconvenient time, to be
replaced with a successor of unknown caliber…

Against this backdrop, gold’s strength is no accident. Its
rising price, in dollars, reflects the severity of
America’s fiscal imbalances. The dollar remains the world’s
reserve currency…but only to a point, and only for so
long.

Did You Notice?
By Steve Sjuggerud

It was “perhaps the most important speech on monetary
policy in twenty years,” Dennis Gartman said today. He was
referring to the speech by Ben Bernanke a few years ago
about the Fed’s ability to defeat deflation by “simply
dropping money from helicopters.”

And so the One-Way Bet is on…

Ben Bernanke is the next Alan Greenspan. And as the head-
to-be of the Federal Reserve, he has explained that the
“helicopters” – his ability to “print” money – is one tool
at his disposal to ward off deflation. Ben Bernanke is
committed to avoiding a Japan-style deflation a la the
1990s, where stock prices and home prices crashed, causing
a long lasting recession. Japan’s bad times have gone on
for 15 years now… and are only starting to end.

Bernanke is convinced that if the Japanese authorities had
just printed more money, they could have avoided this
situation. With Bernanke’s promise to prevent deflation by
printing money, the one-way bet is simple… Bernanke’s in,
so buy gold. Let me explain…

The concern a few years ago was deflation… falling
prices. China was producing things cheaper every year.
This, somehow, is a bad thing, and must be stopped (go
figure). It causes guys like Bernanke to get nervous and
print money – to create inflation to offset the deflation.
(Again, go figure.)

In short, in deflation, the price of gold rises as Bernanke
prints dollars. These days, with the rising price of oil
and other commodities, the concern is not deflation, but
inflation. The funny thing is…

Gold (a commodity) also soars during times of big inflation
fears, as people look for a store of value as the
purchasing power of their dollars is eroded.

So the price of gold goes up during the risk of deflation.
And it goes up during the risk of inflation. So when
exactly does gold NOT go up? Gold didn’t do much in the 90s
because nobody worried about inflation or deflation.

Right now, it’s a one-way bet…Bernanke’s in, so buy gold.

And the Markets…