Thursday, May 06, 2010

Finding the Right Safe Haven For This Crisis

"Is it safe?"

That question still brings shivers up my spine as I recall the 1976 movie, Marathon Man, starring Dustin Hoffman, Roy Scheider, and Laurence Olivier. If you haven't seen the film, here's the scene in question on YouTube.


That question, no doubt, is running through the mind of many an investor at the moment as they search for a safe haven. Like Dustin Hoffman's character in the movie, many financial advisors may well be telling clients this or that investment is "very safe, so safe you wouldn't believe it." Also like Hoffman's character, they may not know what they're talking about because, I suspect, experience isn't much of a guide these days.

You don't know if I do either, so I'll just lay out my arguments and you can decide if they make sense.

I believe the world is in the final stages of what has been the longest unanchored credit expansion (by which I mean a period of undefined monetary units) in modern history. Previous credit expansions ended, after a manic phase, with prices quickly finding some equilibrium in relation to the monetary anchor's price. In modern history that anchor has been gold and/or silver.

"Oh no," you might be thinking, "it's another lecture from a gold bug."

Yes and no.

I think the past 39 years has demonstrated the potential for an unanchored monetary system. In "The Fed Vs. Gold" I charted the US$/Gold price for each of the post 70s crisis Fed Chairmen, and prior to Mr. Bernanke's tenure (and the end of Greenspan's), even though the US$ was not convertible to gold at a fixed rate, the price behaved, more or less, as if it was.

The point being, convertibility isn't the key, rather, however one measures monetary stability, Central Bankers need to shoot at a target and the market needs to have some sense of what that target is.  No commodity or inflation target, no bond vigilantes.

The target now, apparently, is to ensure that the world's big banks don't go bust, ergo the size and direction (to the banks and not the people, infrastructure projects, etc.) of "rescue" flows each time the increasingly frequent crises erupts. 

The effect of this policy was readily apparent today, as it was during the last few months of 2008- nobody knows what anything is really worth. Traders, on their own or, more often, guided by computer models, act on "asset" price cues and sling around huge volume orders in markets suddenly thinned of price makers. 

I sometimes wonder if, in part, the substantial increase in computer driven trading has kept this game going far longer than it otherwise would.  After a while, you'd think, humans would begin to wonder what things are actually worth, instead of simply reacting to price cues.  Of course, the answers to those questions might not be favorable to the big banks, or governments.

It's not safe.

Over the past few years the number of safe havens have been shrinking, and, in one key respect shifting. For the first time in many years, gold rose as traders looked to shed risk. This, to me, is a most interesting development. Historically, gold has been the premier safe haven, the ultimate store of value in times of financial confusion. I expect this to continue.

As I noted a few days ago (the timing was more fortuitous than a result of expertise), credit conditions are tightening and should continue to tighten. The authorities, most likely, will try to inflate their way out of the tightness.  The Fed, as the supplier of global reserve currency liquidity will have to act as lender of last resort at a time when Fed Funds are already near zero.

They key, in my view, the last peg to the US$ standard, is the US bond market. Had bond prices fallen sharply today I would have qualified today as the terminal stage of the credit expansion, but prices rose.  Prior to the 1987 crash, a substantial equity market decline would have, as today, led to thoughts of more liquidity and, unlike today, higher inflation.

If the argument laid out above is correct, at some point in the not too distant future, US bond prices will fall sharply along with equity markets, major currencies will slide against key industrial commodities, and gold will rally sharply. 

When people don't know what money is worth, and have no faith in its stability, how can they know what anything else is worth in terms thereof?

At times when nobody knows what anything is really worth there is one answer historically to the question, "is it safe?"

It's safe, if it's gold.

An interesting observation:  I spent the day playing golf and none of the televisions in the club house were tuned in to CNBC.  That would not have been the case in 2000.

Full Disclosure: Long lots of Gold (thank you, Morgan Stanley, for those 1998 Golden Eagles at $275)