American Economy: Man The Life-Boats! (Part 1) by Josh Sidman

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by Josh Sidman
Dandelion Salad
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Josh’s Blog Post
Mar. 15, 2008

The announcement today of Bear Stearns’ insolvency was not a small matter. In fact, I believe that when the history books are written, this event may be considered a key sign-post of the beginning-of-the-end. Yes, the Fed can crank up its magical printing presses and pour dollars on the flames, but there is in actuality very little that the monetary authorities can do to fix the problem. In the long-run, the only real effect of the Fed’s actions will be to further decimate the value of the dollar.

In October and November of last year, I advised readers to buy gold and the yen and to sell short the S&P and bank stocks. It was my opinion then (and continues to be now) that after years of economic over-indulgence (the scale of which was made possible only due to the dollar’s unique position as the world’s reserve currency) the wheels were finally falling off the US economy. In times like these, there is little that government or central banks can do to counter the tidal waves that are flowing through the economy. Assurances by President Bush and Fed Chairman Bernanke that we are unlikely to experience a recession are starting to sound tragic-comical. The question isn’t whether we’re in a recession, its whether we are going into a depression.

As I have done previously, I would like to offer a couple of “survival strategies” for those who agree with my analysis and wish to minimize the financial damage in the weeks and months ahead. Unfortunately, it is my belief that the current crisis is of a particularly tricky variety (often described as “stagflation”), which means that virtually all kinds of assets are at risk. In a typical business downturn, one can move money from stocks to bonds and feel relatively secure. Conversely, in an inflationary environment, money can be moved from bonds to stocks and precious metals. However, in a stagflationary environment, there are no safe-havens.

It has become very clear by now that the U.S. financial authorities are willing to throw the dollar to the wolves instead of running the risk of a deflation (i.e. a general fall of prices, which would in this case be led by falling real estate values). In all fairness to those in charge, this is not necessarily a terrible choice at this point. A deflationary scenario would be truly disastrous, given the level of indebtedness of American government, corporations, and individuals. (Keep in mind that deflation increases the burden of existing debts, while inflation reduces them.) And, since the whole world was so willing to enable the U.S. to spend like drunken sailors, maybe it is right and good that they should be made to bear some of the costs by seeing the value of their dollar-denominated investments plummet.

So, how can a person with a nest-egg (large or small) position him/herself so as to not be totally wiped out in the event of a dollar collapse?

Gold is an answer that has become increasingly popular lately. Gold is traditionally considered a last-resort store-of-value. If just a few percent of all of the money currently invested in stocks and bonds was to suddenly be reallocated to gold, it would require all of the gold in the entire world to fill the additional demand.

Of course, there is a risk-factor to investing in gold. The price of gold has risen from under $300/oz. to $1,000/oz. in the last several years. Anything that has risen that far and that fast could be vulnerable to significant corrections. If the “disaster scenario” that I am predicting does not come to pass, gold could potentially get whacked. But, if it does happen, I believe gold could go to $2,000, $3,000, or higher.

In addition, I believe there is a particularly attractive way to bet on gold at this point, due to the fact that the price of gold mining companies have lagged way behind the price of the physical metal. The economics of the gold mining industry are pretty straightforward. A mining company pays for labor, energy, etc. in order to get gold out of the ground and then sells the metal in the marketplace. The difference between the market price and the cost of mining the gold represents the profit (or loss) to the company. So, obviously, if the price of gold rises while the cost of mining doesn’t, the profitability of gold mining companies increases.

In addition, there is another element to the economics of the gold mining industry that is particularly compelling in the event of further appreciation of the metal – i.e. the principle of leverage. Consider the following hypothetical scenario. If it costs a mining company $500/oz. to bring gold to the market and the market price is $600/oz., the company will make a profit of $100/oz. Now, let’s look at what happens if the price of gold rises to $700/oz. This represents a 20% increase in the value of the metal, but look at what happens to the profitability of the mining company. If we assume that the cost structure of the company hasn’t changed, it still costs $500/oz. to bring gold to market, so instead of making a profit of $100/oz., the company will now make $200/oz. So, as a result of a 20% rise in the price of gold, the profitability of the mining company has risen by 100%.

So, while I hesitate to unreservedly recommend that investors buy gold right now, given that it has risen so much already, I do believe that gold mining stocks represent a huge opportunity. Since these stocks have not kept up with the price of the metal, there is both higher potential upside and lower downside in gold mining stocks than there is in the metal itself.

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In the second part of this piece, I will describe another, less conventional strategy for preserving wealth in the event of a dollar collapse. Stay tuned for American Economy: Man The Lifeboats! (Part 2)

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