MLR - The case for the continued long term ownership of gold and silver

Published : March 13 2011 at 21:55 ET

The case for the continued long term ownership of gold and silver

SLV had another pocket pivot on Friday. This would be a good place to initiate or add to existing positions. Silver correlates with gold quite well, though is more volatile than gold, thus even though silver offers more potential upside than gold, it also has larger drawdowns than gold. Odds favor that these precious metals will continue their multi-year bull run for technical and fundamental reasons.

Silver has been viewed in recent decades more as an "industrial metal," while gold has always been valued primarily for its use in jewelry and as "money." Recently, however, in a world awash in fiat currencies, awareness of the need for "alternative currencies" in precious metals has refocused attention on silver's historic role as "money." One of the first, widely accepted "mediums" of exchange in The New World was the Spanish Real, also known as the "piece of eight." Stock traders know that this was also the basis for why stocks originally traded in halves, quarters, and eighths. This was a silver coin. As well, China has a long and deep cultural history of considering silver as "money."

During historical periods where gold and silver were both viewed as "money," the ratio of the gold price to the silver price has been approximately 16 to 1. Currently that ratio is somewhere in the high 40's, so increased awareness of silver's "monetary properties" as "the poor man's gold" as this ratio potentially "catches up" should cause silver to continue to outperform gold. Of course, this does not preclude gold from going up a lot higher from here. At current levels the crowd appears more concerned that these precious metals have gone "too far too fast," when it may be that they haven't gone far enough fast enough at all. But that will only be proven in hindsight - for now the trend in both silver and gold remains to the upside.

Quantitative easing (QE) has pushed the markets higher since March 2009. Corrections have generally been contained to within -10% with the exception of May 2010 when QE ended. There is talk of extending QE2 and starting up QE3. This will only serve to fuel demand for "hard currencies" like silver and gold as well as other "hard assets."

Here are the ramifications of a continued program of quantitative easing:

1) Bernanke believes that QE potentially prevents deflation and thus averts a Great Depression 2. In the meantime, he is trying to achieve a soft landing where a gentle transition is made between quantitative easing and new growth in the economy, but this is easier said than done. At some point, QE will have to be removed, and this financial headwind as well as headwinds from inflation brought on by the devalued dollar may prolong any economic recovery for years to come. Bonds are currently on the verge of entering a prolonged bear market.

2) QE poses a potential problem with runaway inflation. QE devalues the dollar, bond yields start a relentless rise, and the cost of real goods, ie, commodities such as food, oil, gasoline, and energy, continue to rise. The US Dollar lost nearly 40% of its value against a basket of major world currencies from 2002-2007. Gold has been on a 10-year bull run. The upside is that a devalued dollar means the U.S. can repay its debt burden, being the greatest debtor nation on the planet, with cheaper dollars. The downside is that it may lose its status as the world's reserve currency. The U.S. has enjoyed relatively cheaper oil vs. the rest of the world thanks to the Dollar's status as the world's reserve currency. Since oil trades in dollar, one must purchase dollars first, which serves to pad dollar demand. Should this change, the price of oil would likely skyrocket in dollar-terms, having deleterious economic effects. 


A policy of easy money is likely to continue through QE and other means, and emerging nations should continue their torrid growth rates, thus hard assets/stocks/commodities should continue their rise. Here are some facts:

1) Output in emerging countries is huge compared to debtor nations which is running flat to negative.
2) Inflation in emerging countries is currently running higher than in debtor nations.
3) Interest rates in emerging countries is running low compared to debtor nations because some emerging countries' currencies are linked to the dollar.

What does this all mean?

The Chinese will continue their commodity buying spree while shifting their exposure away from U.S. treasuries. With all the debt the U.S. is taking on board, China does not want to be exposed to U.S. bonds. China's inflation rate is running at around 5 1/2% with a 10% economic growth rate, so their GDP is nominally growing at about 15% a year. With this kind of growth rate, China wants to borrow as much as possible, buying things with a higher return, while saving as little as possible. China's economy, with its torrid pace of growth, is in danger of overheating but they cannot tighten monetary policy because their currency is linked to the dollar. Eventually, inflation in China will become a problem and China will have to let the yuan float free, unlinking it from the U.S. dollar. When this occurs, a huge shift in currency valuation will take place. This will also occur in other emerging creditor nations that will eventually have to decouple from the U.S. dollar. Meanwhile, debtor nations that can print money will continue to print money, further devaluing their currencies. The bonds issued by debtor countries will continue to be unattractive investments. Creditor countries will continue to buy commodities which are considered safe havens.

Ultimately, the U.S. is destined to lose its reserve currency status in the years to come. The British pound lost its reserve currency status, a status it had enjoyed through the 18th and 19th centuries, after World War II, when the Bretton Woods breakup ended convertibility of the dollar to gold in 1971, unlinking monetary and exchange-rates. The exchange-rate system was established and the International Monetary Fund oversaw it. Under that system, the U.S. dollar became the reserve currency, backed by nothing but the promise of the federal government, because the United States was the world's economic leader while the U.K. was mired in inflationary spirals and economic hardship.

Hard assets [stocks, real estate, precious metals, commodities] should continue their rise, with the occasional correction, due to the following factors: QE, commodity supply shortages, and demand exerted from emerging creditor countries such as China and India. China should continue to increase its gold and silver reserves since they assume that debtor nations will continue to depreciate their currency. As always, we will continue to provide specific investment ideas in stocks and ETFs in real-time to members.

The devaluation of currencies of debtor nations will continue, so one should avoid currencies of debtor nations especially the U.S. and U.K./Europe. One should also avoid government bonds of debtor nations. Hard assets make a good hedge against a falling dollar.

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