One important thing to note is that one of the Canadian Trusts (Harvest Energy) no longer does business by that name. It was purchased by Korean National Oil Corporation (KNOC) at the end of last year. It was perhaps the first casualty of Canada’s ill-fated decision to change the taxing structure for Trusts and it was a big one. Harvest was one of very few vertically integrated Oil & Gas operations, meaning that it owned refinery operations in addition to its exploration and production program. It was viciously attacked by short-sellers during the months leading up to the acquisition and when shareholders were offered a roughly 40% premium over the then $6 and change trading price, they jumped and Harvest was lost.

Trimming your Hedges

The hedging tool used in this particular Portfolio Model was the UltraShort Oil & Gas ETF since it correlated fairly well with the mix of assets represented. However, one of the drawbacks of these ETFs is their propensity to leave gains on the table based on the objectives they pursue. This reality has become somewhat better understood by investors, but let’s go over it again if for no other purpose than to reinforce the point.

From the ProShares website:

“This ETF seeks a return of -200% of the return of an index (target) for a single day. (Emphasis theirs) Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.“

What they’re saying is if you purchase this type of fund and it moves 2X the inverse of the correlated index or security, that if the underlying issue moves down 20%, you would expect the price of the 2X inverse fund to go up 40%. It doesn’t always work that way. Depending on the price action, you could actually end up with a much lower gain, especially if the price action is volatile and choppy.

Again, this is not meant to be an indictment of these types of funds, but rather to point out that no hedge is going to be perfect and you’d better keep your eye on the ball if you want to be successful.

The Sample Portfolio Model

Let’s see how our components have faired over the past 18 months:

For the 18 months ended June 2010, the portfolio model is up substantially not counting dividends. Assuming the purchase of the same 100 shares each and 250 shares of DUG as in the original article, our portfolio on 11/20/2008 would have cost us $31,969. As of 7/8/2010, it would be worth $47,964 for an increase of 50%. During the same time, the portfolio threw off $2,634 in dividends making the effective yield of the portfolio 8.24% and bringing in $146.33/month in dividend/distribution income. $146 doesn’t sound like a lot of money, but when you consider deploying a $100,000 or $200,000 portfolio in this fashion, suddenly you’re talking about some very nice cash flow – certainly in excess of what can be found at the local bank. The performance metrics stated above assumed that the positions were all started on 11/20/2008; a significant market bottom. Waiting until 3/6/2009 to begin them would have resulted in slightly higher gains. We put a few of these positions to work in our newsletter portfolio on 3/13/09 and they have performed in spectacular fashion.

During the same period of time, the Dow Jones Industrials are up just 34%, with well under one-half the yield of this model. The S&P500 is up only 33% with just over one quarter the yield of the model.

Conclusions

One thing that has worked extremely well for me in practice is the strategic placement and removal of hedging devices. I am not talking about trading hedges; that is a completely different animal. What I am talking about is searching for multi-month trends and then placing or removing hedges based on the results of that research. For the average investor who has neither the time nor the inclination to get involved at this level, selecting a solid hedge, putting it in place, and monitoring once a week should suffice.

Still other investors who don’t mind potential wild fluctuations in their core holdings, but are interested merely in yield, will construct a similar portfolio and put 100% of their capital to work earning dividends. We could have pumped the yield of our sample model up considerably by doing that, but decided on a more conservative approach and were willing to leave a point or two of yield on the table in favor of more stable performance.

One thing to note is that many of these components have had their dividends cut since 11/20/2008. Several have been cut significantly. A few were cut, and are now beginning to increase again. One of the lesser-known ramifications of the ongoing credit crisis is that many small and midsize companies have had a difficult time raising capital at reasonable rates. This resulted in a more protective position taken on by management as they’ve sought to preserve cash for operations. This has led to dividend cuts in many cases. Falling share prices in 2008 and 2009 made it easy to do so since they could cut the dividend and still maintain a similar yield for new investors. The argument could certainly made that this is irrelevant since 8% is 8% no matter what the price/distribution levels, but I think it needs to be mentioned to maintain a spirit of objectivity.

Disclosures: Long PWE, PGH, KMP

Andy spent an hour with Joe Cristiano on Liberty Talk Radio discussing the global financial crisis, the problems in the Eurozone, and some of the different scenarios for our financial markets moving forward. To listen, Click Here

In yet another example of the failure of globalization, or regionalization as it were, the Euro is poised on the precipice of disintegration. Ironically, it will not be the overprinting and resultant hyperinflationary spiral that kills the Euro, but dead weight in the form of various Eurozone welfare states. Germany and some of the other quasi-responsible members simply cannot carry their own burdens and those of Greece, Spain et al. The $1 Trillion rescue fund created in haste this past weekend was intended to inspire confidence in the dying behemoth. Instead, the sheer magnitude of the bailout has done the exact opposite. The Euro-Dollar pair has now sunk below pre-bailout levels and there is a good deal of doubt as to whether rescue recipients will be willing or able to hold up their end of the bargain. I pointed this out in last week’s piece. The temporary euphoria created by a trillion dollars of palliative paper is already gone. This is something that was alluded to in these pages years ago; the law of diminishing returns applies to stimulus and bailouts. As the periods of crisis occur in a more frequent fashion, the effectiveness of Keynesian monetary policy falls commensurately.

That aside, there are several other points that must be addressed as we examine the latest Tower of Babel in the global macroeconomic arena.

National Sovereignty Ceded

While anyone looking at the debt picture could tell that Greece (like so many others) was in trouble almost since its acceptance into the Eurozone, its problems burst into the international media in early 2010. One of the first things that many people noted was the major difference between the Greek government and that of America. Greece was hamstrung in that it did not have its own national bank; it relied on the ECB. While I am not a fan of national or central banks absent a strict Gold standard, this total absence of flexibility accelerated the Greek crisis in months, rather than years. Greece had given up its national identity to join the Club. And for a time it worked. The people of Greece enjoyed lavish social benefits and a carefree lifestyle. As an IMF official recently said, however, and I am paraphrasing: “The party is over”.
Other dominoes are set to fall as well since every other country in the Club has essentially the same problem: they cannot pay their bills, and have no way to wiggle out of it. While in the strictest of terms, this is not a bad thing; it outlines the categorical failure of international trading and currency blocs in the long run. There are always members of any cohort who will try to ride the coattails of someone else. It is human nature and it will not change. From that standpoint, the breakup of the Club was ordained from the day of its inception.

The mere existence of these multinational blocs also fosters a temporary sense of false security, as member nations don’t mind their own fiscal indiscretions because they have the perception that they’ll be picked up by the rest. And they usually are initially, so why change? This is precisely why the Greek people (and now the Spaniards too) are resorting to riots and national strikes. Old habits die hard.

At the bottom of the mess, however, is the loss of national identity. While we look at them as Greeks and Germans, they have in a way come to view themselves as Europeans – citizens of Europe. As Ben Franklin so eloquently put it, new nations come into the world like illegitimate children; half compromised, half improvised. In the case of the EU, we’ve already seen the compromise. Now the improvisation has begun in earnest.

Destruction from Within

Much in the same way the EU is being destroyed by the profligate spending and lackadaisical approach to fiscal matters of a few members, the United States is in a similar position of being devoured from within. This is where it gets very dicey, and I am bound to step on a lot of toes here, but it needs to be said. We know that roughly half of Americans pay nothing in the way of Federal income tax. While I don’t have exact numbers for the 50 states, I cannot imagine that the situation is much different there. This means that, like the EU, America has roughly half of its population riding the coattails of the other half. I am sure that in many cases there are good and noble reasons why this is the case, but I’m trying to address this from a structural macroeconomic standpoint rather than drilling down to specific reasons why people aren’t paying. Frankly, for the purposes of this discussion, it doesn’t even matter. In this way, America is a microcosm of the Eurozone. And we’re not alone. Great Britain is in the same boat. The bills cannot be paid. There is no way to squeeze enough money from the paying 50% to take care of their benefits let alone those of the other 50%.

Much like the EU, America has a central bank, which advocates Keynesian policies such as deficit spending and unfettered monetary creation. Save for one brief stint of interest rate austerity in the early 80’s, America has never wavered. And before we sing the praises of Mr. Volcker, we must consider that his actions most likely were taken to perpetuate the broken system as a whole as opposed to representing some blanket metamorphosis of economic thinking.

The single biggest difference here is that the members of the Club still have the ability to vote others off the island, and/or leave themselves. There is a point certain where the people of Germany, for example will no longer tolerate the abrogation of their economic and financial sovereignty and will either compel Ms. Merkel to take appropriate action or will replace her with someone who will. Hence all the talk of the breakup of the Eurozone. The die was cast on January 1, 1999 when the Euro officially became an international unit of account.

Race to Gold – the Endgame of Paper

All the gloom and doom aside, there is an out for those countries and individuals who fear the breakup of the Eurozone, dollar standard default, national bankruptcy, and the types of cataclysmic financial events that our behavior causes us to flirt with. It is shining right now, making new all-time highs as I pen this commentary. It is soaring even as the dollar races higher thanks almost entirely to the fall of the Euro. The mini liquidation last week in global markets was unable to shake it, so unlike the Lehman days in 2008. People around the globe are racing to Gold as the ultimate safe haven. Where the US Dollar is a proxy on the flaws of the Euro, so is Gold the ultimate proxy on the fallacy of stable paper currencies in a Keynesian world. Where paper currencies represent control, Gold represents freedom and a standard weight and measure.

This is probably one area where many here in America fail to understand the connection between our wallets and the first round of the Eurozone bailout. Thanks to our contributions to fund the IMF, and the resumption of various Fed emergency swap programs, the American taxpayer is on the hook for more of the European rescue fund than anyone who seeks to maintain their position in politics or finance is willing to admit. The burdens of lesser paper currencies are shifting to the already compromised US Dollar and the American taxpayer. There is nowhere else to turn except honest money. Truly, the buck will stop there.

One of the biggest ways our premium newsletter has benefitted its subscribers over the past few years is comprehensive analysis of the macroeconomic, monetary, and precious metals environments. In May’s issue, which will be released on 5/15, we cover the conventional wisdom surrounding sovereign debt loads, propose some alternate metrics, and look at the latest jobs figures. For more information, click here.

Click thumbnail to enlarge

Andy Sutton & Chris Wilson from yourcontrarian.com discuss the markets, the broader economy, and where things are headed over the coming weeks and months. Don’t miss this informative session! Listen Here

We have chronicled the damage that Bernanke’s pursuit of QE and near-zero rates have done to savers. Mainly, we’ve focused on short-term implications for those investors who rely on their savings to create income for immediate consumption. But what about the folks who are looking at the pie charts and the promises of over a millions dollars in retirement income? Ah, the powers of compounding. Yes, I have in front of me the literature from 2 national financial service firms that strongly suggest that you too can retire a millionaire for as little as $60/week. Of course there are no guarantees, but the details and assumptions to this rosy scenario on steroids are buried in fine print that you’d need an electron microscope to read.

The obvious conclusion most people draw is that interest rates fluctuate and the phenomenon we’ve witnessed over the past year or so will be transient and eventually higher rates will cycle in and restore the cash flows of fixed income investors. After all, that is what has always happened before, right? Not so fast. There are a couple of reasons to believe this won’t happen anytime soon.

As the graphic below outlines, the Treasury Dept (including debt service) is the third largest line item in the actual FY 2009 budget, at over $700 billion. According to Treasury Direct, the interest paid on the national debt in FY2009 was around $383 Billion. This constitutes an average interest rate of just over 3.1%. Doing a little projecting, if the deficit runs at the estimated $1.5 trillion for FY 2010, the Treasury will need to pay out an additional $431 Billion to service the debt assuming the same 3.1% average interest rate. If early results mean anything though, the amount might be much higher. In the first four months of FY2010, the Treasury has already paid out $164 Billion in debt service, which is setting a pace for nearly $500 Billion. For FY2009, tax revenues were $2.211 Trillion and interest payments on the debt ate up 17% of tax receipts. If the current trend in FY2010 continues, debt service will gobble up around 22% of tax receipts by the time the fiscal year ends next September 30.

While 17% doesn’t sound too bad, think about paying nearly 1/5 of your net income every year to credit card companies. Not a real appetizing thought, but certainly this application of sanity couldn’t apply to the federal government.

The Problem

The problem here lies in the fact that the national debt is forecast to increase dramatically in the next 10 years. Estimates range anywhere from $18 to $23 Trillion depending on whose forecast you’d like to use. Let’s use $18 Trillion as our test case. At this level, assuming an average interest rate of 3.1%, debt service by 2019 will cost around $558 Billion per year. If tax revenues don’t change, debt service will eat up 25% of tax receipts. The conclusions that can be drawn from this simple analysis are pretty clear. If the government intends to provide the same levels of service on entitlement programs and maintain other government spending, the deficit will need to increase each year just to accommodate the additional debt service. This is called a spiral. It is akin to the family taking cash advances on a VISA to pay off Mastercard. I am sure there are many who will disagree with this rationale and call me all sorts of vile names for suggesting that we’re spending beyond our means and that somehow this really isn’t a good thing. Unfortunately, in reality, this situation is actually worse than the above paragraph indicates for a second, less publicized reason.

Artificial Interest Rates

Let’s start at the beginning here. Interest rates are payments given to lenders of capital for the privilege of using their money for a period of time. At a very minimum, the interest rate should ensure that the lender’s purchasing power doesn’t diminish due to making the loan. In other words, at the very least, interest rates must equal inflation. Such a situation is generally referred to as ‘free money’ since the lender isn’t actually being compensated for the loan in real terms.

When discussing the federal government and its inclination to spend beyond its means, interest rates are a very important topic at the US Treasury, as they should be. This is one of the reasons why government officials, Fed chairmen, and the absentee press generally try to temper inflationary expectations. If lenders expect inflation, then they’re going to want to see higher interest rates.

I have argued for several years now in this column that inflation in the US is grossly understated, and that it is done for both political expediency and out of absolute necessity, especially in an era of ballooning government debt. John Williams at shadowstats.com estimates (using previous BLS methodologies) that price inflation in the US is currently around 6% per annum. If we had free market interest rates, we would expect the yield curve to start somewhere around 7%, assuming John’s numbers are accurate, and there is no reason to believe that is not the case. It is very easy to see the implications this would have for debt service.

Let’s assume for a moment that under a free market interest rate environment, the US Government could achieve an average borrowing cost of 6.7%, allowing for a similar spread between price inflation and the mean interest rate as what we observe now. Debt service in FY2009 would have been $831 billion and devoured 38% of tax receipts. In 2019, using the same assumptions as previously mentioned, debt service would be $1.2 Trillion and eat up a whopping 55% of tax receipts. I understand there are many assumptions made here, many of which might fluctuate over the period, but the goal of the exercise is to make the simple point that the US cannot afford market interest rates.

It should now be easy to see why inflation is consistently understated, and why the FOMC and its minions are quick to temper inflationary expectations. While that might work to a limited extent when dealing with the general public, does anyone think for a minute that investors around the world don’t know what is going on here? Most of them are doing the exact same thing, albeit to a lesser extent, so you can bet they do.

In Conclusion

Many might look at the above analysis and wonder why it is any big deal. Keep the rates buried at near zero and we can keep getting ‘free money’, right? The problem is that mispriced capital leads to misallocation of the same. The gross misallocation of capital is one of the main ingredients of the ongoing financial crisis. It was willfully done by the Fed previously and it is being done again. These actions will virtually guarantee more misallocation of capital, more bubbles, and more unpleasant results. For savers, the news continues to be bad. We have demonstrated why it is in the government’s interest (a necessity really) to keep rates as low as possible. That means a continuation of the ridiculously low money market, CD and savings account rates. No doubt the pie charts referenced at the top of the essay will need some changing; it seems someone’s taken a few slices away.

This Week in the Markets

US equity markets are getting hammered early this Thursday morning on news that first time jobless claims jumped to 496,000 last week. First time claims have been trending upward over the past few weeks. Yesterday, new home sales put in the worst performance in the history of the data series. This despite the extension of the tax credit program for first-time (and now other) homebuyers. Bad weather was blamed for much of the sour performance. It seems recently the weather is getting blamed for any data point that isn’t in line with the ‘slow but steady recovery’ mantra being put out by the establishment. Oil is back at the $80 mark after being beaten down over the past couple of weeks. On the demand side, petroleum product demand appears to be bottom bouncing; any serious increase in demand will be bad news for consumers at the pump this summer. Forecasts are already in for an average pump price of $3.25-$3.50 this summer.

However the news is not all bad. As I chronicled in the first piece of this series, there are ways to find income – even in this environment. And contrary to the popular investing misinformation you don’t have to take on a boatload of risk to get it. The goal of this essay is to discuss in generic terms some of the methods I’ve used to find income over the past few years and introduce one of the more obscure income vehicles for those investors who might be interested in a little risk. With CD rates still in the basement, and investors in US Government bonds losing 3.5% in 2009, most people are probably looking for some new ideas to make money in our brave new financial reality.

Preferred Stocks – A Well-Kept Secret?

If you’re willing to spend a little time doing research, you will find literally hundreds of preferred stocks from food companies to manufacturers to financial and insurance companies. Many are eligible for 15% tax treatment making their comparative yields even higher. Speaking of yields, they will vary greatly based on both the type of company offering the preferred stock, the rating, and the supply and demand dynamics for the security. The following is not meant to be an inclusive, exhaustive description of all the characteristics of preferred shares, but is intended to provide some basic information about preferred shares to frame the discussion.

Preferred stocks are really a hybrid of common stock and bonds. Preferred stockholders generally don’t get voting rights in company matters, but are first in line for dividend payments. Some are cumulative some are non-cumulative. Cumulative preferred shares accumulate dividends in the event payments are suspended for any reason. In the event payments are reinstated, preferred shareholders are paid first and they’re paid for any dividends accumulated during the payout stoppage. The preferred stocks of major companies are generally listed on exchanges, but there are also many that are available Over-the-Counter (OTC).

Preferreds are like bonds in that their stated yield is based on the face value of the stock. For example, a preferred that pays $1.00/year and has an face value of $25.00/share would have a yield of 4% and be designated as such. If you discover this stock a year later at $26.00/share and buy it, your yield based on the purchase price would be a bit lower at 3.85%. Conversely, if you buy in at $24.00/share, your yield would be higher at 4.17%.

Two ‘Preferred’ Model Portfolios

Let’s look at two ‘model’ portfolios. These have been constructed over the past few years when it became obvious that we were heading into a period of near-zero rates due to the Fed’s propensity for putting the liquidity hammer to the floor.

The first consists of just 4 issues – all preferred stocks of utility companies in equal proportions:

Due to the fact that one of the components was only issued less than 2 years ago, we only have that period of time to compare the model to the benchmark S&P500 and Dow Jones Industrials. From a risk and volatility perspective, the model comes in with a standard deviation of 12.82% while both the Dow and S&P comes in at nearly twice that with the S&P at 23.87% and the Dow at 24.32%. In terms of return, the Dow and S&P both lost around 7.5% annually for the period while the model gained nearly 9% annually during the same time. So to frame the comparison, the model beat the indexes by roughly 33% with about half the volatility during the worst financial crisis in recent memory. The chart below graphically displays the returns:

Admittedly, during the ongoing bear market rally, the indexes have beaten the model soundly, but remember the purpose of the model – income. The model yields just over 6%. The charts above show that the model did an excellent job of protecting capital while providing stable income. And it was done with very little in the way of volatility except for a 2-month period in late 2008 when the globe’s financial system stood on the precipice. It must be noted that many investors have chosen to use this type of investing strategy for growth as well, opting to use their cash distributions to purchase more shares. Compounding at 6% sure won’t win many awards on CNBC, but in the real world where people are trying hard to protect their savings, it is a valid construct to consider.

Let’s now take a look at a second model: one that has a bit more history behind it. It consists of 2 utility company preferred stocks, a telecom preferred, a no-load special purpose mutual fund, and a preferred stock ETF – in equal proportions. As a general rule I don’t favor mutual funds because of excessive fees, confusing sales charge structures, black-box management, and high expense ratios, but there are a couple of funds that exist for a single purpose, don’t have the other detriments listed above, and as such are suitable for inclusion in portfolios.

Much like the first model, this one has a much lower volatility than the benchmark S&P/Dow. Annualized Std Deviation is 9.44% compared to 22.01% for the S&P and 22.57% for the Dow. On the return side of the ledger, the model provided an annualized return of 7.02% while the Dow and S&P were both around -9%. The data on this model goes back to August 2007 – before the market’s top. The chart below graphically illustrates the comparison between the model and the benchmarks.

The cumulative return for the model was 16.94% over the 2.3-year period as compared to a loss of 20.44% for the S&P and a loss of 19.74% for the Dow. The model beat the benchmarks by 36% on average yet sported less than half the volatility of those benchmarks.

There are countless other combinations that can be explored. These two models were focused on utilities. Truth told, we construct similar models across a variety of industries that would perform similarly, and in fact do so on a regular basis to provide effective portfolio diversification.

ELKS – Hidden Income or High Risk?

A rather obscure income vehicle that generates high levels of income, but unfortunately, also carries significant risk is the ELK or Equity Linked Security.

ELKS are derivatives of the first degree in that their performance is directly linked to that of an underlying security – usually a stock. The main selling point of ELKS is that they generally sport much higher distributions than the underlying shares and mature in a year.

So what’s the catch? Terms will vary depending on the particular issue, so you will want to be sure to read and thoroughly understand the prospectus before clicking the ‘Buy’ button. The size and nature of the principal repayment for an ELK is linked to the share’s performance during the time period before the ELK matures.

Let’s say for example you purchased an ELK that was linked to Company ABC’s stock. Let’s say the ELK was issued when the price of the shares was $20/share. The ELK might be structured that you will receive back 100% of your principal (plus the distributions, which are received regardless) if the price of ABC’s stock is at all times at least 90% of what it was when the ELK was issued. In this case, you will want ABC’s stock to stay above $18/share. If this condition is not met and the stock drops below $18 (even before maturity), you will receive a pre-determined number of shares of ABC stock for each ELK you own as opposed to your principal in cash.

Sounds like a rip-off doesn’t it? Not necessarily. Let’s say you really wanted some shares of ABC stock because they pay a solid dividend. You buy the ELK, collect the enhanced dividends for a year, and if the stock does drop below the threshold, you have your shares. If not, you have your cash and a stellar return and can go share hunting later or buy another ELK. If this is your intention, then make sure you’ll be adequately compensated in shares in the even you don’t get your principal back in cash.

There certainly are drawbacks. First, ELKS are issues of Citigroup Funding, Inc. and as such you are dependent on Citigroup’s solvency for your payments. Right now no one seems to be concerned about bank liquidity, but that is likely to change moving forward. Secondly, due to the structure of the ELKS, there is an incentive for Citigroup to issue ELKS for those shares it holds in its various dealer accounts that it wants to unload and has a belief will go down during the time the ELK is active. This may not be true in every case or even at all, but it needs to be mentioned regardless. That is why, as a general rule, I don’t consider ELKS unless I’m interested in owning the underlying shares because ending up with them is a very real possibility. Another drawback is that if the price of the underlying shares skyrockets, you don’t get to participate fully in the move. You just collect your distributions, and then your principal at maturity. Obviously, if the underlying shares tank, as can happen, you could theoretically end up with shares that are worth much less than your initial payment for the ELK – even with the distributions included.

From a taxation perspective, ELKS are often subject to favorable tax treatment. First, part of the distribution payments are considered as option premium payments and as such don’t need to be declared until the ELKS mature. So you get deferred tax status on a portion of your distributions, which is nice. Secondly, if the price threshold is broken and you receive shares instead of your principal at maturity, then the portion of the payment associated with the distribution (treated as an option premium) reduces the stock basis and isn’t counted as income.

In conclusion, it is possible to find income in this environment without taking on inordinate amounts of risk. Granted, preferred stocks and ELKS carry more risk than a bank CD, but given the graphs shown above, the two models registered little more than a slight bump during the worst crisis in 100 years yet outgained CD’s by several fold. ELKS are a bit more complicated and carry some additional risks, but the potential rewards are commensurate with those risks. Investors should always seek a thorough understanding of the nature of any investment and consult with a qualified adviser before making any investment decisions.

Gulf petro-powers to launch currency in latest threat to dollar hegemony

For the past 9 years now, students of history and common sense have been literally shouting from the rooftops that Gold was the place to be as the monetary tradewinds shifted back in 2000 and the fiat inflationary cycle began to go parabolic. While the multi-trillion dollar deficits might be a surprise to many, for those who understand how these things work, it is just a mundane repetition of history and yet another confirmation that man cannot alter the laws of economics or his own intrinsic predilection to ignore events past.

From 2000 up until recently, there was a constant battle going on. Central banks and the IMF would sell off their physical Gold to suppress the price. Between 1999 and 2002, Gordon Brown, then England’s Chancellor of the Exchequer made the extremely wise decision to sell a good chunk of Mother England’s Gold (395 tonnes) in the $275-$300/oz area. The people were so enthralled by this obvious economic genius that they made him the Prime Minister. All sarcasm aside, this was only one prong of the tactic to suppress Gold prices.

The second prong consisted of large New York and London banks mercilessly shorting Gold in the paper futures markets. For most of the last nine years, the bulk of these futures contracts were rolled over or settled in cash; taking delivery wasn’t really en vogue. There have been many people such as Jim Sinclair working hard in the trenches to educate people on the merits of taking delivery and fighting the cartel by taking their playing chips off the table. Gold in your possession cannot be leased out by a central bank to various third parties, nor can it have futures contracts written against it.

Despite even these herculean suppression efforts, the price of Gold made the journey from $275 to $940 in fairly short order. Surely, there were many gut checks in there; days when the metal lost 5% and the pundits would scream the bubble had burst and it was all over, now please buy some mortgage backed securities. There were some epic struggles like the Battle for $700 shown below.

Through the past nine years the game was played under the rules of central banks and the IMF. In the past two months, countries, large players, and even Gold producers have turned the game on its head. Suddenly everyone wants physical metal, not paper promises. And don’t give us the 90% bars either; we want the good stuff. Suddenly, there are instant buyers for IMF sales that were previously guaranteed to suppress prices. Suddenly an IMF sale sparks a rally to a new all-time high. China tells NY and London banks to take a long stroll off a short pier by issuing a directive to its state banks to walk away from commodity derivatives contracts. And, even more telling, central bank selling has been dropping steadily over the past few years and has been nearly nonexistent in 2009.

And finally, Barrick is closing its infamous hedge book. What was once a 20 million ounce boat anchor on the price of Gold has become a multibillion dollar boat anchor around Barrick’s neck and they’ve finally had enough. The book, now around 3 million ounces will be closed by next year according to Barrick boss Aaron Regent.

Oddly enough, it is not the collapsing US Dollar that is driving this decision, but rather a realization that Gold production likely peaked in 2001 and that even a tripling in exploration budgets across the mining sector has yielded precious little in the way of new discoveries. During this entire time period, demand for Gold has been rising consistently, thanks in no small part to the continual abuse of paper currencies by governments around the globe. The existence of serious supply-demand dislocations immediately rules out the prospect of a speculative bubble. Granted, there are plenty of smaller players who are dabbling in Gold without the slightest bit of understanding as to why they’re doing it. The next correction will undoubtedly send many of them running back to mainstream newsletter writers demanding a refund. After all, they were supposed to be living on the beach in 6 months; the advertisement said so!

The shattering of the old paradigm as it relates to Gold is very similar to a paradigm that was shattered with regard to stock investing nearly a decade ago. In that case, the conventional logic was that the market always went up in the long run. And for 18 years, that had absolutely been the case. Even the crash of 1987 hadn’t done much to derail the bull market. However, when we crossed into the new century, the paper paradigm changed with the major indices going NOWHERE in the past 9 years and change. Yet many conventional financial professionals are still investing as if it were 1995 then blaming the markets for client losses when they should be blaming their own inability to see that our world has changed dramatically.

Unfortunately, another of the very negative sides of the attack on Gold have been the ad hominim attacks on proponents of Gold-backed currencies and those who promote the reality that Gold is in fact real money. The attackers use the term ‘Gold Bug’ to paint a picture of little men sitting in fallout shelters wearing tinfoil hats with stashes of food, water, and enough weapons to make the debate about Iran seem pretty foolish. That just isn’t the way it is. Simply put, a Gold bug is someone who understands Gold’s historical role as money and seeks to educate others in this regard while protecting their own assets from the abuses heaped on paper currencies by their custodians.

So today I, an admitted Gold bug, ask: Now… do we finally have your attention?

]]> http://www.sutton-associates.net/blog/2009/11/12/gold-do-we-finally-have-your-attention/feed/ 0 http://www.sutton-associates.net/blog/2009/10/02/another-october-surprise/ http://www.sutton-associates.net/blog/2009/10/02/another-october-surprise/#comments Fri, 02 Oct 2009 18:40:38 +0000 TwoCentsEditor http://www.sutton-associates.net/blog/?p=306 I have been asked countless times in the past month why it is that share markets seem to have a difficult time navigating the autumn months. Obviously, there is a healthy amount of fear regarding the next 29 days, as the memories of last year are still firmly intact. Yesterday’s 203-point drop in the Dow Jones Industrials Average has done nothing more than rekindle those sour memories. While the question ‘Why October?’ is largely rhetorical in nature, we can certainly take a look at history for some potential causes for the blowups.

Not helping our prospects for avoiding another October surprise is the fact that almost nothing has been done to rectify the underlying problems facing the US economy. Plenty has been spent to bailout various enterprises, but until a healthy, unsubsidized demand for goods and services exists at the consumer level, we will continue to spin our wheels. A fantastic example is the cash for clunkers program. The massive infusion of subsidies did manage to increase auto sales, but now that the program has ended, we’re heading right back to where we were before. This is evidenced by Ford’s US auto sales immediately dropping 5.1% after C4C was terminated.

The Panic of 1819

The panic of 1819 was the first stoic example of the boom-bust cycle in the nascent United States. Oddly enough, this panic, and the crisis in which we are currently embroiled have striking similarities even though they occurred nearly 200 years apart. For starters, the panic of 1819 was a direct result of internal factors rather than external ones. Occasionally, a crisis in a nation can happen because of someone else’s doing. This one was mainly due to the rampant spread of private bank notes of varying quality and value thanks to runaway inflation caused by borrowing for the War of 1812. Oddly enough, the panic of 1819 resulted in many of the same things we are seeing today: foreclosures, unemployment, bank failures, and significant slowdowns in both agriculture and manufacturing activity. This crisis is important because it is the country’s first example of a homegrown crisis and really determined the anatomy of many subsequent events. Essentially what happened was a boom of sorts, which resulted in malinvestment, financial and economic dislocations, and the decay of underlying fundamentals followed by a severe correction of the imbalances to restore economic and financial order.

However, there was another interesting twist in many of these early panics, and it had to do with our money itself. One of the characteristics of early banks in the US was to offer paper bills that were redeemable for specie (metallic) money. Redeemability was a huge factor in the confidence in the paper bills. Unfortunately, analogous to today’s Fed, these early banks had the propensity to print and circulate bills far in excess of the amount of specie they had on deposit making them susceptible to bank runs. Many of the early panics in the new United States were caused because banks got greedy and overstepped their boundaries. Sound familiar? The more things change, the more they stay the same. Unfortunately, when these bank runs occurred, the banks would merely run to the government who made the rather foolish decision to suspend specie payments on bank notes, effectively ripping off the holders of the bank notes. Incidentally, as a result of the panic of 1819, unemployment in Philadelphia, for example, reached near 90% and almost 2000 workers were put into debtors prisons. In addition, displaced and unemployed workers lived in tents outside the city. I am sure this irony is not lost on anyone who has seen some of the tent cities around America as a result of runaway foreclosures.

The important point underlying many of the panics of the 19th century was the fact that they were rooted in the monetary system and/or the economy in general. This paradigm shifted with the advent of share markets and the panics oftentimes transitioned from monetary and economic panics to stock market crashes and then to a hybrid situation from 1929 through the start of World War II.

The Crash of 1929 – October 24-29, 1929

I am not going to rewrite the chronology and factors surrounding the Great Depression. For anyone who is interested, they can Click Here to read an article entitled ‘Anatomy of a Disaster’ from last fall. This crash was the first well-defined example of a stock market crash and a significant economic contraction happening simultaneously. Not surprisingly, this is where the history books usually get it wrong. They oftentimes assert that the market crash caused the Great Depression. Nothing could be further from the truth. The economic boom of the roaring 1920’s had run its course leaving (as in prior examples) financial and economic dislocations, overleveraged consumers, and a general feeling the boom would last forever. The mountain started shaking in the summer of 1929 and by autumn, panic gripped the markets resulting in a 2-day 23% sell-off in the DJIA. By the middle of November 1929, the DJIA had lost 40% of its value. What happened next is crucial to understanding what is happening right now. The market then made a valiant attempt to rally, bringing back many investors from the sidelines as the Dow mounted a furious charge into 1930. However, the rally didn’t stick, conditions worsened, and by the time 1932 rolled around, the venerable index had lost 89% of its value. It would take 25 years for the Dow to recover that lost value in nominal terms. If you think this cannot happen again, then you are incredibly naïve.

The Crash of 1987 – October 14th – 19th, 1987

In financial folklore, the crash of 1987 is one of those events that cannot generally be explained since there were no obvious dislocations. P/E ratios were high, but not extreme, investors were not grossly overleveraged, and the economy was comparatively healthy. There have been many theories about financial raiders cashing in on the sudden decline, and given what we’ve seen recently, the idea of someone triggering a crash for their own benefit doesn’t seem too far out of the realm of possibility. The interesting thing about the 1987 event was the recovery time. On a percentage basis, the loss was massive – 31% in 5 days for the DJIA. Yet it took just a tad under two years for the index to fully recover in nominal terms.

What was rather poignant about the ’87 crash was the response. This was the event that gave rise to the shadowy President’s Group on Working Markets, lovingly referred to as the Plunge Protection Team. In addition, various circuit breakers were placed in the markets to halt trading if certain conditions were met:

After the invocation of trading curbs and the President’s Working Group, investors seemed to be lulled into a sense that the markets could never again drop significantly. That has certainly not been the case, and in case anyone is counting, the events are becoming larger and closer together. In 1997 and 1998 we had the Asian crisis and the Russian default, followed by Long Term Capital Management. The new century was ushered in by a vicious bear market thanks largely to overvalued Internet stocks. That bear market ended in 2003 and was followed by a steep nominal recovery in share prices only to see markets fall apart once again after the late 2007 top.

In summation, given everything we know about the underlying economic fundamentals, and the nature of bear market rallies; it certainly won’t be much of a surprise if we have another horrendous October. And if the first day is any indication, it could be a long month.