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Markets: Time For A Little Bling!
New York: April 02, 2007
By John R. Stephenson

Somehow, gold lost its investment luster. Then things changed and now gold is hot again. Between 1980 and 2001, gold was just about the worst performing asset class out there. Now it is red hot. The reason? Worries about the strength of the U.S. dollar and consumption demand around the world.

Ground zero for gold consumption is India. Gold jewelry is big business in India (the biggest gold consuming nation in the world). With more and more Indians becoming moderately wealthy, they are converting their rupees into gold. Indian gold consumption has become a big deal of late with its purchasing power rivaling that of central bank gold sales in terms of impact on the price of the commodity.

Gold has always been considered a symbol of wealth, but increasingly, it has become more commonplace in even the most remote villages of India. While it is still considered an important component of a woman's dowry, it is starting to become attractive to the rising Indian middle class as a market investment. In a country where inflation is running at 6 percent a year, gold, a long-standing hedge against inflation, is gaining traction. Not only that, but in India, the banking system (particularly outside the major urban centers) is dominated by small, local deposit institutions of varying financial stability. For many newly wealthy, the thought of investing their life savings in bank deposits at near-zero or even negative real interest rates is completely unappealing.

More than mere flights of consumer fancy are behind gold's recent rise in popularity and value. Concerns over U.S. dollar weakness have helped send the price of gold ever higher. Over long periods of time, investment research has shown that the price of gold is 90 percent negatively correlated with the U.S. dollar. When the dollar swoons, gold tends to soar.

Lately, concerns over rising levels of consumer debt (a negative savings rate in the U.S.) and huge government indebtedness have made investors ponder — does the emperor have any clothes? For many investors, the answer is "no". Add to this the concerns over the rising off-balance sheet liabilities of the government (Social Security, Medicare and Medicaid) which dwarf the on-balance sheet debts (by a 5 to 1 ratio), not to mention a war in Iraq that has lasted longer than the American commitment in the Second World War and a worrisome picture emerges.

As well, America's love affair with consumption has continued to result in a rising trade imbalance with the rest of the world. China bears most of the brunt of economically illiterate outbursts from Senator Schumer (Democrat - New York) whose tirades and proposed tariffs on China would only serve to set the clock back from an economic perspective. Nevertheless, the growing current account deficit (exports minus imports) is now in excess of 7 percent of GDP and is the highest imbalance that any country in the history of the world has sustained. How long this situation can persist is anyone's guess.

If American indebtedness continues to rise or if the economy slows, the ability to fund the debt and keep creditors at bay looks more and more suspect. Like an individual who abuses his credit card, currencies can also suffer when countries start to run up the tab and try to skip town without paying the bill. If this happens, look for gold to continue to march ever higher as it fulfills a special role in the universe of investment alternatives since gold was once a currency itself.

Figure 1: The Historic Relationship Between Gold and the U.S. Dollar

Gold has proven to be an excellent hedge when shocks to the financial system occur. One possible catalyst for a shock to the financial system could be the implosion of one of the highly levered behemoths littering the American investment landscape.

Just as Americans have become addicted to junk food, lately we seem to have become addicted to junk bonds. With interest rates relatively low, a bull market in debt has occurred. According to the Financial Times of London, global debt issuance in 2006 was $6.4 trillion, up more than double from five years ago and an eight-fold differential with the amount of equity issued. Companies such as KKR (a New York based leveraged buyout firm) have been on an acquisition binge and cheap and available debt is the weapon of choice.

So much debt is sloshing around and so many companies have taken on massive amounts of debt to ward off potential acquisition that there is real worry building that perhaps the debts will become unmanageable. According to Standard and Poors, a credit rating agency, 71% of the industrial companies that they rate are carrying debt ratings that are classified as junk or below. Look for the next financial crisis that materializes because a major American firm chokes on an explosive cocktail of too much debt, too little earnings or both.

For many, gold is the antidote for much of what ails the world. For our money, it is not a panacea, but rather a smart defensive move if things fall out of bed with the U.S. economy. While we have never been gold bugs, we do think that gold is an important component in an overall investment portfolio. Gold, whose value is uncorrelated with the U.S. dollar, will be the beneficiary if things start to stumble here at home. As well, gold will benefit from a rising trend toward global prosperity and the human desire to put your best foot forward.

Investors looking to profit from gold should consider buying gold exchange traded funds such as the GLD (NYSE) which offers direct exposure to the commodity with the ease associated with purchasing a stock.

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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