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A Golden Opportunity?
New York: November 09, 2009
By John Stephenson

Gold has rallied strongly in the last few weeks, and now sits poised to break through the $1,100 per ounce barrier. When it was disclosed last week that India 's central bank had bought some $6.7 billion or 200 tonnes of gold from the International Monetary Fund (IMF), prices for the precious metal surged. With an economy that will grow by more than six percent this year, India decided that now was the time for it to hold more gold—a very bullish call on the long-term price of gold.

And that helped ignite a fire under gold prices as investors bet that India and other emerging economic powers in Asia will need to buy more gold in the future to diversify their foreign-exchange reserves and to protect against an ever-weakening greenback.

Less than two decades ago, India found itself in a totally different predicament. A crushing financial crisis left the country with no other option but to physically ship its gold reserves to London as collateral for a bailout loan from the IMF.

For years, Western central banks have hoarded gold as part of their foreign reserves. In many European countries, gold makes up about 15 percent of foreign reserves. And while central bankers in the West have been content to store gold, India is the world's largest consumer of the precious metal, accounting for 20 percent of global demand. India imports almost 800 tonnes of gold every year for the country's enormous jewelry demand.

But today, the tables have turned and India and China are both looking to increase the percentage of gold that they hold in their central bank reserves. Gold now accounts for about 6 percent of India 's $285.5 billion in foreign-exchange reserves. China , whose $2.2 trillion of foreign reserves, the world's largest, was widely expected to snap up most of the 403.3 tonnes that the IMF had for sale. With gold making up just 1.7 percent of China 's foreign reserves, it could be next to add a little bling to its central bank holdings.

Back in the U.S. , the Great Recession clocked in another grim milestone, as the unemployment rate climbed to 10.2 percent, a rate not seen since 1983. Since the recession began in 2007, more than 7.3 million Americans have lost their jobs.

But because of the way that the data is tracked, the Bureau of Labor and Statistics doesn't count you as part of the ranks of the unemployed if you've not been looking for work during the last four weeks. When you toss in those who would like to work full-time, or are “self employed” in a marginal venture, a truer number of unemployed Americans emerges. By some estimates, the ranks of the unemployed could be closer to somewhere between 16 and 20 percent—a staggering number.

Even the most bullish of economists is hard pressed to forecast a significant drop in the ranks of the unemployed, once America begins to grow again. And this is creating a possible nightmare scenario for Ben Bernanke and other central bankers in the West.

As Asia continues to grow at a torrid clip, the very real possibility exists that inflation could once again rear its ugly head. Already, gold and oil are beginning to respond to anticipated improvements in the fundamentals of these commodities.

During the 1970s, investors began to expect that prices would rise. With expectations ratcheting up for ever-higher future prices, deep pocketed firms and investors began to stockpile inventories of commodities in the anticipation that future prices would be higher than current prices. That set off a chain reaction, which led to much higher levels of prices throughout the general economy, if for no other reason than that was what was expected. To finally reign in inflation, Paul Volcker the then-chairman of The Federal Reserve, raised interest rates sharply before the actual official inflation rate was disclosed to help crush speculation over rising levels of inflation.

During the 1970s, investors began to expect that prices would rise. With expectations ratcheting up for ever-higher future prices, deep pocketed firms and investors began to stockpile inventories of commodities in the anticipation that future prices would be higher than current prices. That set off a chain reaction, which led to much higher levels of prices throughout the general economy, if for no other reason than that was what was expected. To finally reign in inflation, Paul Volcker the then-chairman of The Federal Reserve, raised interest rates sharply before the actual official inflation rate was disclosed to help crush speculation over rising levels of inflation.

And that potent combination of a slack labor market and industrial base at the same time that the general level of prices is rising in the economy could leave central banks with no choice but to raise interest rates to tame inflation. If inflation and interest rates were to rise sharply, the nescient recovery could fly off the rails and we would find ourselves back in a recessionary environment.

Investors, looking to profit from a surge in gold or other commodity prices should consider an investment in one of the senior commodity producing stocks. While index funds linked to the commodity can make sense, many of these funds will underperform the commodities and the equities themselves because of the way they are structured.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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