DECEMBER 28, 2009
Why Gold Will be the Greatest Trade Ever
BY PETER KRAUTH, Contributing Editor, Money Morning
Forget about all the forecasts being made for 2010. Here's my prediction for 2015: An entirely new name - John A. Paulson - will grace the coveted top of the annual Forbes billionaires list.
And the gap between Paulson and the runner-up billionaire will be huge.
Everyone knows that Bill Gates and Warren Buffet are America's - and the world's - two richest men. But the financial crisis of 2008 and 2009 was not kind to either of them, eradicating $17 billion of their combined net worth.
On that famed list, at No. 33, is where you'll find Paulson today. The hedge-fund manager's financial acumen led to what is now being called the "the greatest trade ever." By shorting the subprime mortgage market, Paulson & Co. Inc. generated a $15 billion gain.
Paulson's personal net worth of $6 billion is impressive in its own right. But over the next several years, I believe that Paulson's trading savvy will vault him into the top spot.
And the vehicle that will take him there is gold.
Going For the Gold
Paulson's latest foray says a lot about how he intends to further multiply his own net worth, as well as that of his clients.
That foray will focus on gold, he said during an address to the Japan Society in New York earlier this month.
"As an investor, I became very concerned about having my assets denominated in U.S. dollars," Paulson told his audience. "So I looked for another currency in which to denominate my assets in. I feel that gold is the best currency."
As of June 30, gold and gold-related assets accounted for 46% of the Paulson firm's total holdings - a colossal position that flies in the face of traditional portfolio-diversification theory and position sizing. Yet I expect this will help him generate a brand new "greatest trade ever."
It's also worth noting that Paulson recently announced his firm's plan for a Jan. 1 launch of a dedicated gold fund. The fund will invest in gold stocks and gold derivatives in a way that will enable it to outperform the price of gold. Paulson is committing $250 million of his own capital to this new investment vehicle.
This all adds up to one enormous wager on gold. But Paulson's track record and reputation for research diligence make it impossible to ignore.
The story behind the killing that Paulson's company made on the subprime-mortgage crash - and the lengths that Paulson and star analyst Paolo Pellegrini went to create the profit opportunity - is as gripping as any detective story.
Although it's now referred to as the "greatest trade" ever, it certainly wasn't the easiest position to take. Paulson and his cohorts watched from the sidelines as the housing industry zoomed through four years of unprecedented growth. When Paulson bet against the bubble, and continued to increase his position even as housing continued its surge, he found that many longstanding customers that had profited nicely from Paulson & Co. refused to go along.
Paulson, they felt, was flat out wrong.
Is that happening again? After all, there's a long list of pundits who are right now saying that gold is in a bubble that could burst at any time. Ignore them. This array of "talking heads" will inflict irreparable damage on your portfolio.
Besides, Paulson isn't alone in his investment thesis.
In a recent interview, author and global-investing guru Jim Rogers said that "during the course of the bull market [gold] is going to go much higher, it is certainly not a bubble yet." To underscore his point, Rogers said that "I don't think this is the top," and said that "I'm not selling under any circumstances."
Also in this camp is Victor "Trader Vic" Sperandeo, whose 40 years of market experience has included stints with George Soros and Leon Cooperman.
"Well, I'm on record across the world as saying that gold is the best investment in the world for the next two to three years," Sperandeo said. "If you go back to its lows, and you compound where [gold] is today, it's about 6.5% compounded. That isn't a bubble."
Where Does Gold Go Next?
More recently, however, gold has experienced an unprecedented run. At one point, for example, it sprinted from $1,050 to $1,218 in under 30 days flat.
That's an impressive 16% gain. Between late October and early December, the precious yellow metal saw 14 record closes in 17 days. So its recent pullback is not only unsurprising, it's healthy.
Don't forget that gold's clocked a positive gain every year since 2001. Yet gold's run is far from over; rather, it's just getting warmed up...
My research tells me we're currently in what I've labeled as "Stage Two" of the current bull market in gold. Stage Two begins when gold decouples from the dominant currency (something that's clearly already taking place against the U.S. dollar). The yellow metal then rises against most other currencies, as investment demand kicks in.
As they attempt to forecast gold's next move, market observers often rely on the U.S. dollar as their chief barometer.
That's a futile game.
While the greenback does have an impact on the price of gold, it's more correlated to shorter-term price movements. Comparing the U.S. dollar's exchange rate to other currencies is only mildly helpful. The reason: Because America is such a big consumer of global goods, other nations will move to devalue their currencies to make sure that their exports remain competitive.
The best barometer, then, is the price of gold versus all "fiat" currencies, since gold is "real" money and those other currencies aren't. A good proxy here is the U.S. Dollar Index, which is composed of euros, Japanese yen, British pounds, Canadian dollars, Swedish kronas, and Swiss francs.
Gold easily surpassed its previous 2008 high against this basket of currencies. We are clearly on a path of competitive fiat money devaluation. Only two years ago, one ounce of gold bought just eight units of the U.S. Dollar index. In early 2008, that ratio had spiked to 14 units. After recently peaking at 16, an ounce of gold still buys 15 units. Look for the upward trajectory to continue - and to do so for the long haul.
There's only one possible conclusion here: Gold's value is rising against all major fiat currencies.
The Growing Global Demand for Gold
Another hallmark of Stage Two in a gold bull market is when sophisticated investors take positions of their own.
Investors in Asia, Europe and many other global investors have a much stronger affinity for gold, and understand its ability to preserve wealth. Experienced and professional investors alike make their portfolio allocations at this point in the cycle, and Paulson's just one of several institutional investors who exemplify this out point of view.
The purchase of 200 tons of International Monetary Fund (IMF) gold by India's central bank in late October helped propel gold to its recent record highs. Given that this was the single largest purchase of gold by a central bank in the past 30 years, its dramatic effect is justified.
But two aspects of this landmark transaction are especially noteworthy. First of all, India was comfortable enough with gold at $1,045 to part with $6.5 billion - no small outlay, even for a central bank. And second, India chose gold over unbacked fiat currencies.
Other growing global economies have also been hoarding physical bullion, says the World Gold Council, which forecasts that 2009 will see a new trend asserted: Central banks will become net gold buyers for years to come.
Also Fueling the Gold Bull...
I've already made a strong case for gold. But those aren't the only catalysts pushing gold higher. In fact, here are a few more:
Since its 1980 peak, gold's only up 65%, while inflation is up 175% and stocks have gained 900%: there's plenty of ground to make up.
Scores of junior gold explorers and miners still trade below book value; many are still too cheap.
Gold production peaked in 2001 and has been falling since that time, meaning that the supply-and-demand dynamic points to much higher prices for gold.
Sovereign-debt defaults are a growing risk, against which gold is the best insurance (see Greece, Ireland, Spain and other recent ratings downgrades)
There's growing interest in gold. But the masses have yet to join in; when the typical investor and consumer starts to view gold as an essential holding, the price of gold will begin a near-vertical ascent - a near-mania/near-bubble scenario that could cause gold to more than double from current prices.
I said at the beginning of this piece that Paulson was headed for the No. 1 spot on the Forbes billionaires list.
Now you know how he's going to get there.