Weekly Musings 4-24-11 from oftwominds.com
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For those who are new to the Musings: they are basically a glimpse into my notebook, the unfiltered swamp where I organize future themes, sort through the dozens of stories and links submitted by readers, refine my own research and start connecting dots which appear later in the blog or in my books.
Speculation/Preservation of Capital Warning!
Just as a reminder: all "investments" are speculations; the only difference is the time-frame (short, medium or long-term). One reader opined that I was a danger to my readers in recommending a "Contrarian Trade" in the U.S. dollar. Please note I highlight topics and trades as "food for thought," not as investment recommendations.
If anyone followed me into UUP, please set stops (either trade stops or mental stops) which will exit the trade if the DXY (dollar index) breaks its 40-year support level at 71. It seems suicidal for the Fed to push the dollar into uncharted territory where the risks of a destabilization increase enormously, but they might well do so. As individual investors, we are assessing the probabilities and making bets in in favor of what appear to be the most likely outcomes. But there are no guarantees, and the dollar could depreciate rapidly and decisively below 71, so we have to protect our capital if a trade goes south.
"Expert" opinion vs. actions of the "public"
In the conventional view, the "herd" always gets it wrong: the investing public buy stocks at the top and start speculating in real estate just as the "smart money" is selling. there is cdertainly some truth to this cycle of manias and bubbles.
But there are also examples of "the public" being more accurate (so-called "crowdsourcing") than the "experts." One of the most remarkable trends of the past decade is the steady rise of the classic hedges against inflation and disorder: gold and silver.
Readers tell me their local coin shops are out of silver coinage; the public has been buying with a vengeance. (Silver has long been called "the poor man's gold.") While the Federal government and a veritable army of conventional economists have repeatedly assured us over the past 10 years that the economy and the dollar are both sound, gold has quintupled from under $300 an ounce to over $1,500 an ounce.
Given that official inflation is pegged at 26% for the decade 2001 - 2011, then clearly the public isn't "buying" the "sound dollar, sound economy" story. They're also not buying the "the New Bull market--you can't afford not to own stocks" story: the public has sold some $350 billion of domestic mutual funds. These are unmistakable signs that the public has lost faith in the government's account of the dollar and the economy.
Gold as a Hedge ("insurance")
The basic idea of a hedge to protect oneself from a low-probability devastating event. A hedge shares some characteristics with insurance, but it's not identical. Insurance works on an actuarial, statistical model of loss over a great number of people and events. It is reasonably reliable and consistently profitable for insurers.
A hedge is "insurance" against events which cannot be statistically anticipated. In this sense, a hedge can share aspects of redundancy. For example, owning a push lawn mower provides "backup" or redundancy in case your power mower fails. the push mower is a sort of hedge against the loss of the power mower.
In "Survival+", I asked frequent contributor Harun I. to explain how buying a futures contract for gasoline could be used as a hedge against the possibility of a sharp rise in gasoline.
The futures contract is not free, of course. If gasoline drops then the contract loses its value. But in the contract timespan, then a $1,000 contract offered "insurance" against dramatic increases in the cost of gasoline. A $1,000 contract could rise to $5,000, for example, giving the owner $4,000 in profit to pay the higher costs.
A simple hedge aginst rising costs for rice and beans is a stockpile of rice and beans purchased at lower prices.
Let's conduct a thought experiment:
Let's assume there is a chance that the global fiat currency regime collapses as people lose faith in paper currencies (what many refer to as hyperinflation).
Question: how much gold would we need to own to hedge ourselves and our current capital against such a destabilization?
Here's how I would "solve" this calculation.
I would take all current financial net worth (assets minus liabilities) in the U.S. which according to the
Fed Flow of Funds is about $35 trillion. (Fixed assets such as real estate are about $10 trillion)
Total financial assets are $47 trillion, but these include corporate equities and non-corporate business assets which include plant, factories, production facilities, etc. owned by the corporate and non-corporate enterprises.
The U.S. has about 25% of the world's wealth, so let's multiply the $35 trillion in purely financial capital by 4: the global economy has about $140 trillion in purely financial wealth (pension funds, blue-sky value in stocks, bonds, etc.)
There are about 5.3 billion ounces of gold "above ground,"
roughly 160,000 tons. At the current price of $1,500 an ounce, all the available gold is worth about $8 trillion. About half is in jewelry, 10% in industrial uses and 40% as central bank reserves and investment.
Let's say that by the end of the global loss of faith in paper currencies, gold took the place of fiat currencies as "money."
Gold would have rise to about $140 trillion in value: a price in today's dollars about 18 times its current price. So $1,500 X 18 = $27,000 an ounce.
Let's round that off to $25,000 an ounce.
To hedge $250,000 in financial wealth (productive real estate, factories, etc. would still retain their productive utility value after hyperinflation), you would then need 10 ounces of gold, or $15,000 worth at today's prices.
Though we cannot be sure of much in the world, we can be fairly certain that gold will not go to zero value. Thus owning gold is not like owning a futures contract which expires.
Worst-case scenario is the hyperinflation never occurs, and instead gold sinks in dollar-denominated value. Let's say it falls in half to $750/ounce.
Then the hedge against complete destruction of paper money would have cost $7,500. That's a relatively modest price for "insurance" or a hedge that doesn't expire.
Interestingly, at $25,000 per ounce, the 256 million ounces of gold (8,000 tons) in Fort Knox would be worth about $6.4 trillion, probably enough to back a "hard" currency like "the new dollar."
From Left Field
"Facebook asks what I’m thinking. Twitter asks what I’m doing. Foursquare asks where I am. The internet has turned into a crazy girlfriend."
ImTracyMorgan
Thanks for reading--
charles
.
