Lombardi: Stock Market Commentary & Forecasts, Financial & Economic Analysis Since 1986

Investing in Gold

Readers of Profit Confidential know that we have been bullish on gold for over a decade. And we continue to be.

In 2002, Michael Lombardi’s Profit Confidential famously advised readers to buy gold-related investments when gold bullion traded under $300.00 an ounce. In the December 13, 2012 issue of Profit Confidential, he wrote, “I’ve been pushing gold bullion and gold shares for over a year now. Back in January 2002, I personally started buying gold shares.”

Gold is now in its 13th consecutive year of sequential growth. The recent weakness in gold bullion prices (more like a correction in an ongoing bull market) is a tremendous opportunity for smart investors.

The overarching factors that continue to drive gold prices higher are the global financial crisis, ongoing tensions in the Middle East, devalued currencies, and the potential for faster inflation. As a result, some analysts believe gold will rise above $2,200 an ounce.

At the other end of the spectrum are those bears who think gold is in for a big correction. Faster-than-expected U.S. economic growth, a stronger U.S. dollar (in spite of the Fed’s printing presses running overtime), and the end of the global economic crisis era could cause gold prices to drop as low as $1,200 an ounce.

That logic doesn’t hold with gold-hungry nations like Russia, Brazil, Korea, China, Kazakhstan, and Turkey, each having significantly increased their gold hoard in 2012. Thanks to increasing demand and a serious decrease in supply coupled with ongoing geopolitical tensions and a persistent global economic crisis, the outlook for gold remains strong.

Would You Rather Have $2,000 in Gold or Cash?

Amazingly, some still believe that gold is not a hedge against inflation—that there is no need to hedge against inflation because the central banks will keep everything stable.

To that end, I ask: would you rather have $2,000 in cash or $2,000 in gold? It all comes down to inflation. For millennia, gold has been treasured as a hedge against inflation and a store of value. On the other hand, the U.S greenback, the go-to currency for global economic stability and growth, is imploding.

The roots of America’s financial crisis can be traced back to 2007, when the U.S. housing bubble burst. This sent the dominos tumbling and the United States into an economic meltdown in 2008. In spite of government intervention, the economy has sputtered and slipped in and out of recession.

To stem the economic slide of the U.S. housing collapse that first surfaced in 2005, the Federal Reserve has unveiled three different quantitative easing (QE) efforts. Since 2008, the Federal Reserve has printed trillions of dollars, and it continues to add to that number at a staggering rate each month.

The extra dollars pumped into the economy were supposed to spur growth. But QE also has the reverse effect, shrinking the buying power of each dollar—which is the driving force of inflation. As the U.S. dollar declines in value against other world currencies, goods imported into the U.S. become more expensive.

When the financial crisis began in 2008, the U.S. national debt stood at $9.2 trillion. Based on the White House’s own figures, the national debt will reach $20.0 trillion by the end of this decade—about 140% of our current gross domestic product (GDP).

So, would you rather have $2,000 in cash or gold?

Today, you would have to pay roughly $2,594 to purchase something that cost you $2,000 in 2001, meaning the buying power of the dollar has decreased by 29%.

Over the same time period, had you invested in gold, your $2,000 would now be worth $11,147.80, an increase of 457%.

The Demise of the Gold Standard and the Birth of the Paper Standard

In 1944, fixed exchange rates, based on the U.S. dollar, were redeemable for gold by the U.S. government at $35.00 per ounce. Meaning, the U.S. dollar became the global reserve currency based on the gold standard.

When dealing with the U.S., central banks received a guarantee that they could exchange their currency for gold at a fixed price.

All of that changed on August 15, 1971, when President Richard Nixon defaulted on this promise, thereby abandoning the gold standard for foreign exchange rates; this opened the floodgates to the unrestricted, reckless production of fiat currency.

Backed by nothing, governments on any economic foundation were, from that point forward, allowed to print money at their own leisure—without limit. Four decades later, the paper standard stumbles onward.

Throughout history paper monetary systems have experienced financial instability and economic volatility; resulting in inflation and the devaluation of purchasing power. To rectify the situation, central banks stepped in.

Here in the United States, the Federal Reserve, thanks to its very own printing presses, has been keeping interest rates artificially low and propping up the entire U.S. economy by buying the majority of government debt issued by the U.S. Department of the Treasury. As a result, the U.S. government has become dependent on borrowing to finance itself. (Source: Crawshaw, J. and Jones, F., “WSJ: Fed Buying 61 Percent of US Debt,” Moneynews March 28, 2012, last accessed February 27, 2013.)

Where does the U.S. government get the money to buy the bonds? It borrows from the Federal Reserve…which creates money out of thin air.

The trillions and trillions of dollars pumped into the American economy at the hands of the Federal Reserve was supposed to increase lending, create more jobs, and lower the unemployment rate. Instead, banks are sitting on a pile of cash and remain tight-fisted, fewer jobs have been created, and the unemployment rate remains high.

This is a dangerous, unsustainable trend that cannot continue. And it’s one Ponzi scheme that will eventually come to a crashing end. The U.S. cannot continue to issue government debt only to have more money printed to pay off that debt.

Increased Demand and a Diminishing Supply

Paper money can be destroyed. Gold, however, cannot. But neither can the will of the people who want to own gold bullion. And the right to own gold is a relatively new phenomenon in America.

In 1933, Franklin D. Roosevelt, signed into effect “Executive Order 6102,” making it a criminal offence for U.S. citizens to own or trade gold anywhere in the world. In 1964, the law was relaxed so that collectors could own gold certificates, but they still could not own actual gold bullion.

That changed in 1974, when President Gerald Ford signed a bill permitting American citizens to purchase, hold, sell, or deal with gold in the U.S. and abroad. (Source: “Public Law 93-373,” U.S. Government Printing Office web site, August 14, 1974, last accessed February 27, 2013.)

That doesn’t mean there is a huge supply of gold gathering dust, waiting for buyers. The fact of the matter is that gold mining companies are having difficulty filling demand. And they are looking everywhere to avoid a production shortage—or rather to shore up the production shortage.

Simply put, the supply has not kept up with the rising price of gold; and worse, production is declining in mature areas.

Since 1997, the gold mining industry has made 99 significant gold discoveries, but those are expected to replace just 56% of the gold mined during the same period. It’s even worse for supergiant discoveries (more than 20 million ounces). During the 1980s and 1990s, there were 25 supergiant discoveries. Over the last three years, there has been just one discovery of this size. During the first decade of 2000, there were five—a 76% decline in supergiant discoveries.

It’s not for lack of trying, though. In 2011, a record $8.0 billion was spent on gold mining exploration. Even if gold prices were to soar past $2,000 an ounce, investors wouldn’t see production run in step. (Source: “Gold Mining Discovery Rate Falls Despite Record Exploration Spend – 13 November 2012,” BullionVault, November 13, 2012, last accessed February 27, 2013.)

Gold is in short supply; so too is the quality. Ore grades have tanked from an average of 12 grams per tonne in 1950 to roughly three grams per tonne in Australia, Canada, and the U.S. In some cases, grades have dropped to one gram per tonne. (Source: “The looming gold ‘production cliff,’” Mining.com, February 1, 2013.)

In a nutshell, supergiants are rare, mine maturity is up, discovery costs are up, development time is up, technical risk is up, and discovery rates are down.

A New Era for Gold Bulls

After three rounds of QE, U.S. economic growth is anemic. The International Monetary Fund (IMF) lowered its growth estimate for the global economy to 3.6% for 2013 and warned that future revisions would likely be lower.

Economic instability, political deadlock, the business community’s mistrust of the government, concerns over the government’s fiscal health, deterioration in the development of U.S. financial markets, and a weak American dollar has cut into corporate America’s bottom line.

These lower margins, in turn, could lead to further layoffs, sending millions into unemployment. To rectify the situation, the government increased and expanded taxes to generate capital.

We are still waiting to see the results.

America’s future economic growth will depend on its ability to innovate, create, and reinvent the way we do business. And it will also need to meet the growing and evolving untapped demands of an increasingly challenging global environment.

The actions taken by the Federal Reserve and the U.S. government since 2008 have put the country’s economic future into serious doubt.

If investors are looking to find a hard asset that will keep its value against a devalued currency that is spiraling into irrelevancy, gold is the only place to turn.

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