Gold: An Investment for Decades to Come

Jake, Thanks for the newsletter. I am pretty much in sync with this writer's perspectives.

My thoughts on gold have not changed much in several years. I think it is a store of wealth and will do better in times of inflation and dollar devaluation (which mostly run together). Even if gold stays steady and goes no where against other national currencies, as long as the dollar goes down, gold will go up by the same amount, just as other dollar denominated commodities do, like oil.

Additionally, there is the risk premium put on gold for an uncertain world and, probably most importantly, the future demand that will come from Asia. Gold is favored in Asia throughout history, so that is not likely to change soon. As Asians have more disposable income, they will buy more gold, and will increase global demand. Also, the Asian (and Middle Eastern) economies will grow rapidly over the next 20 years (10% a year on average, perhaps) and will probably need 10% more a year of gold reserves to back their currency, and maybe more as they lose confidence in the dollar and shift their reserves towards gold and sell dollar instruments like US Treasuries.

So, for many reasons, I think gold is good for many years. The only reason it did poorly the past 30 years was that the dollar took the role of global reserve currency and the global central banks, especially the US and Europe, sold off their gold reserves adding supply and dropping demand. I don't think the dollar will get that "Reserve Currency" role back anytime soon after all the losses incurred by governments and dollar investors around the world the past couple years.

As you know, I own gold through VGPMX, GGN and best of all, BEARX. Even though BEARX is a bear market fund, it held its own even in the years when stocks were in bull mode because of its gold holdings. It is half shorts and half a gold / precious metals fund, with lots of junior gold producers that will do very well if gold prices continue higher.

Hope this helps.

Problems with Mortgage Bond Insurers

Jake asked me about the problems with mortgage / bond insurers. Here is a good article that briefly explains the problems with the mortgage insurers and the implications for our economy. The big dooms-dayers like David Tice (manager of my BEARX fund) and Robert Prechter have actually outlined the scenario that has begun to unfold, on their website: http://www.prudentbear.com/ in a PPT posted there (see: “The Case for a Secular Bear Market”) that I reviewed in 2003 and shared with you in my annual newsletter that year. Those two have long been leaders in campaigning against the dangers of fiat currencies and the prospect for uncontrolled inflation and dollar devaluation in the United States. The scenario began somewhat like is currently unfolding, with the inability of the insurance companies to back up the banks’ lending hedges, precipitating a financial calamity. This is the reason I own quite a bit of BEARX as a hedge. I figure that Tice will construct that fund to benefit from the disaster scenario he foretold, IF IT HAPPENS.

And that is a very big if. Even Tice has always conceded that the government had the ability, by turning up the printing presses and calling on its trading partners, to forestall or stop his worst-case scenario. But he also warned that if the Fed slipped up and miscalculated, the downward spiral could get away from them and become impossible to stop. Is Bernanke, President Bush and Congress up to the task? That is a very important question. So, just in case, I have a hedge. Ultimately, if Tice is right and as he outlines, even the dollar will become worthless (as has happened in other economies which mismanaged themselves into hyperinflation by overprinting currency, like post WW1 Germany and 70s Argentina). If the worst case occurs, the only safe haven is gold, as the historical store of value. But gold miners and ETFs are no good according to Tice as they are transacted in fiat currencies. If events get bad enough, only physical gold is really safe, as the fund companies sponsoring gold bullion ETFs (like XAU or GLD) can go broke on a cash flow basis have the physical gold reserves in bankruptcy court. My youngest brother buys gold coins because he instinctively does not trust the government. Maybe he will turn out to be right.

I am not paranoid or pessimistic enough to think the worse will happen, so my position is more moderate as mentioned. I think the government will backstop the financial system by guaranteeing the loans / insurance as they did during the S&L crisis when the formed the Resolution Trust Corp to do the same with the S&Ls (and this was a less serious problem to our national economy than the current global banking crisis). But I am monitoring the situation, and if it gets bad enough (say, DOW below 10,000), I will probably use my reserve cash to start buying enough gold bullion to survive an ultimate financial meltdown. But I won’t go all the way and build an underground bunker with food for 3 months, like my brother has.

Here is the article:

Bond-insurer woes may trigger more write-downs, turmoil By Alistair Barr Jan 18, 2008 18:08:00 (ET)

SAN FRANCISCO (MarketWatch) -- Just when you thought it was over, trouble in the $2.3 trillion bond-insurance business could trigger another wave of big write-downs from banks and brokerage firms, experts said Friday.

Leading bond insurers Ambac Financial (ABK, Trade ) and MBIA Inc. (MBI, Trade ) look increasingly likely to lose their AAA ratings. While almost unthinkable just six months ago, such concerns are also causing turmoil in the $2.5 trillion municipal-bond market.

Bond insurers agree to pay principal and interest when due in a timely manner in the event of a default -- a $2.3 trillion business that offers a credit-rating boost to municipalities and other issuers that don't have AAA ratings. Without those top ratings, their business models may be imperiled.

A more worrying consideration is that when a bond insurer is downgraded, all the securities it has guaranteed are, in theory, downgraded as well.

If Ambac and MBIA lose their top ratings, billions of dollars of muni bonds will be downgraded, and the guarantees that have been sold on mortgage-related securities such as collateralized debt obligations, or CDOs, will lose value.

Bond insurers guarantee roughly $1.4 trillion worth of muni bonds and more than $600 billion of structured finance securities, such as mortgage-backed securities and CDOs, according to Standard & Poor's. Ambac alone has guaranteed about $67 billion of CDOs.

"The destruction of the bond insurers would likely bring write-downs at major banks and financial institutions that would put current write-downs to shame," Tamara Kravec, an analyst at Banc of America Securities, wrote in a note Friday.

Kravec cut her rating on Ambac and MBIA on Friday because she thinks that ratings downgrades are "highly probable" now.

Indeed, Fitch Ratings cut Ambac's AAA rating to AA on Friday, becoming the first major agency to take that step. Fitch downgraded 137,390 muni bond issues and 114 other securities guaranteed by Ambac soon after.

Merrill Lynch & Co. (MER, Trade ) took a $3.1 billion write-down on Thursday related to the firm's CDO hedges. Merrill had bought CDO guarantees from bond insurers including ACA Capital, a smaller player that's now struggling to survive. Most of the write-downs were related to ACA.

CIBC (CM, Trade ) and French banking giant Credit Agricole unveiled similar write-downs in December, related to guarantees they bought from ACA.
But ACA is much smaller than Ambac and MBIA. If the two larger bond insurers are downgraded, banks and brokers that have bought guarantees from them may have to write-down their exposures further.

Merrill has net CDO exposure of $4.8 billion. But that includes a lot of hedging, mainly through guarantees bought from bond insurers. Excluding those hedges, the brokerage firm still has a "whopping" $30.4 billion of CDOs on its balance sheet, Brad Hintz, an analyst at Bernstein Research, noted on Friday.

"We remain very uncomfortable with Merrill's CDO balance sheet exposure," the analyst wrote in a note to investors. "If the counterparties are downgraded, and they cannot post additional collateral, we would expect that Merrill Lynch would have to take a valuation reserve against that specific exposure."

Citigroup (C, Trade ) set aside $900 million during the fourth quarter to cover heightened credit risks related to counterparties it uses to hedge CDO risks.
The impact on the muni-bond market may be just as big, experts said Friday.
There are $2.5 trillion to $3 trillion of muni bonds. Roughly half of those are insured by bond, or "monoline," insurers like Ambac and MBIA.

So more than $1 trillion of muni bonds are now in danger of being downgraded. That could trigger losses for muni-bond investors.

"Assuming the "monoline" insurers lose their triple-A ratings, underlying insured muni bonds could be susceptible to downgrades and downward repricing, leading to losses for muni-bond mutual funds," Michael Kim, an analyst at Sandler O'Neill, told investors in a note Friday.

Shares of big muni-bond fund managers, including Franklin Resources (BEN, Trade ) and Eaton Vance (EV, Trade ) have already been hit by such concerns, Kim said.

Franklin stock has slumped 22% so far this year; Eaton Vance is off 27%.
Most muni bonds insured by Ambac and MBIA are now trading as if there isn't any insurance, Richard Larkin, a municipal-trading desk analyst at JB Hanauer & Co., commented Friday.

"The market has lost all faith in bond insurance and the ratings agencies," he said. "Prices are being discounted because people wonder whether there is any value to the insurance."

That's a big problem, because there are no official ratings for many of the underlying issuers of muni bonds, such as cities, school districts and utilities, he added.

When municipalities sold debt, they asked agencies like S&P and Moody's to evaluate the securities with bond insurance attached.

If the insurance on this debt becomes less valuable, muni bond investors have few ways of checking the new creditworthiness of the issuer, Larkin said.
That's creating an "information vacuum" because the rating agencies aren't going to re-evaluate muni bond issuers unless the municipalities request and pay for new analysis, he said.

"The lack of public underlying ratings on insured debt is a big problem, and if more bond insurers are downgraded, the rating agencies are not likely to fill the vacuum and publish underlying ratings unless they are paid additional fees to do so," Larkin explained.

"Trades are being made based on people's best guesses of the creditworthiness of issuers," he added. "And if these downgrades happen, that will be the environment going forward. Not a good one."

DOW 12000 Looks Like the Target

Today brings an even worse market. But it is really thin (very low volume on all the majore index ETFs like SPY or DIA), so just means all the potential buyers are taking the day off. Market closes at 1pm EST today, I think.

Based on the big sell-off in Asia last night and the weak USA market today, I think this downward direction could continue a while, until someone announces how they plan to stablize the financial markets (the Fed? a consortium of global central banks?) The whole world's financial system is exposed to our credit markets. The European, Asian and oil exporter countries have been big buyers of the credit that is now so junky (CDOs, subprime securities, etc). China has been an especially big player. So, the whole world has a stake in how this turns out and the global markets will move accordingly.

I am thinking that 12,000 target on the DOW is looking like a pretty sure bet now. We will see if the market holds there. In the meantime, I am definitely overweight what I had planned for this occassion (too many financials...it is killing me). So, you can have the right idea, and still have poor execution. I will try to learn from this and figure out where I went wrong (mostly, I got myself exposed to high yield that I thought was safe (like Citi), but wasn't. High yield = financials).

None of this market trouble changes my thinking on the the weak dollar - strong hard asset story (oil, gold, mining, metals). That should be a theme for many years. By extension, the Asian economies and currencies will be strong for many years, since that is where the growth is. This means good things for EWY, EWT, EWH (Hong Kong), FXI (China), IFN (India) and even Japan (EWJ) which saw a big strengthening of the yen the last couple days. Japan is the financier and infrastructure engineer for China. I predict that Japan and China will eventually become very friendly to each other, like the British and Americans (they share culture, language, religion, some foods).

So, I will wait a while, but pull the trigger on these type trades once the dust settles. I will use the funds from some of my money in BEARX, which is a bear market mutual fund (wish there was a tradeable ETF for it, but there isn't). David Tice is the manager. He is a famous goldbug and long term bear. Everything he has written about the dollar and our economy over the past 10 years is coming to pass. You can see his site at: www.prudentbear.com. It can get a little scary. He is a real pessimist on the dollar.