We said we were doing some serious thinking this week. Maybe it is the season. But more and more, our thoughts become grayer. Less black. Less white. Less hard. Less soft.

A few years ago, it looked to us as though the world financial system had gone to war. We cheerfully awaited the victory parade. We figured Mr. Market would whup the feds good and hard. It hasn’t happened so far.

On one side, are the forces of a natural market correction… following a long, long period of expansion. The easier money gets, the more people tend to mis-spend and mis-invest it. Then, inevitably, their mistakes must be corrected. That’s what bear markets and recessions are for.

But the feds don’t like bear markets or recessions. And at least since Keynes outlined his general theory back in the early 20 th century, they’ve believed that they don’t have to put up with them. Keynes took a page from the Old Testament. Government should act like an enlightened Egyptian Pharaoh, he didn’t say, but should have. It should run surpluses in the fat years and deficits in the lean years… thus flattening out the pattern of boom and bust.

Pharaoh was no dope. He stored up grain for 7 years, when the harvests were bountiful. Then, when the 7 lean years came, he released the grain to the people. Problem solved.

Keynes believed that modern government could do the same thing. But Pharaoh was not running a democracy. He had no voters to answer to. So, if he wanted to store grain in the fat years, he could do so.

In theory, the US government could do the same. But in fact it never runs significant surpluses. There are too many people who want too much bread and too many circuses. And you don’t win votes by denying the voters what they want. So, in practice, the feds run deficits even in the fat years! Last year, before the downturn really started to bite, the US federal government ran the biggest deficit in history – nearly half a trillion dollars.

Now, let’s imagine how that would work for a bad Pharaoh. He would give out grain in the fat years. This would encourage farmers to produce less grain. Then, when the lean years came, Pharaoh would have no grain to give out… and the farmers would have less grain stored up themselves, since they grew less during the boom years. The famine would be worse than ever.

Then, if we can imagine that Egypt was trading with China at the time, perhaps Pharaoh could borrow grain from the Zhou dynasty to help ease the peoples’ pain. Perhaps he could mortgage the pyramids. Whatever, he – and the Egyptian people – would have been in much better position if he had done as Joseph told him in the first place… lay up stores in good times, draw then down in bad times. How difficult is that?

But Bernanke didn’t see the famine coming. Neither did Geithner. Or Greenspan. Or any of the other savants Pharaoh interpret his dreams . None of them expected hard times. None of them warned the public. None of them encouraged the government to save money for the recession. Nassim Taleb asks why Bernanke was reappointed after he clearly failed the most critical test. But heck… the federal government is an equal opportunity employer. Employees aren’t let go just become they’re incompetent.

Anyway, getting back to our thoughts…

… it looked like a battle to us – between the forces of inflation (the feds)… and the forces of deflation (the market). But battles usually have clear winners. One side is master of the field; the other retreats. One side is victorious; the other is defeated.

Alas, some wars produce no hozannahs of success… and no wailing widows of failure. Some end in draws… or in confusion… or in disgrace and bankruptcy for both sides.

Like the bad Pharaoh, the feds saved nothing. Now, they have to try to work their Keynesian magic on credit. This puts them in a weak position; like a government that wages war on borrowed money. They can continue their campaign only as long as lenders allow them. They can’t wage the war as effectively as they’d like. Then again, maybe they can’t lose it as spectacularly as they might.

For the moment, their credit is still good. The bond market foresees an inflation rate of less than 2%. Bankers, taking money from the government, are happy to lend it back to them.

But the forces of the correction are giving up little ground. While stocks rally, the real economy remains in a funk.

“Sharp drop in start-ups,” is a news headline from yesterday. New business start-ups are a major source of new jobs. Bad omen.

Even glamour publisher Conde Nast is forced to make cut-backs. It has told employees that they may not spend more than $1,000 a night when they are travelling.

A Pimco economist says savings rates are still going up… and may exceed 8%. This represents hundreds of billions of dollars taken out of the consumer economy. Oddly, while it makes the slump worse, it also helps finance the government’s battle against it. Savers buy US debt (albeit indirectly).

So, the battle is still going on… and the outcome is still in doubt.

*** Racehorse prices are in freefall, says a report out yesterday. But collectible cars are still doing well.

Yesterday, we saw someone drive by in a huge, gaudy pink Cadillac from the 1960s. It had magnificent fins and enough chrome to stagger a blind man. In it were a middle-aged man and woman, looking very comfortable and proud. They were travelling in style… in a rolling sculpture.

Old cars are not only holding their values, they’re still going up. But not all old cars. Detroit’s muscle cars have been falling in price for the last three years. Not very green?

*** And here’s a report we received over the internet, from Aaron Trask:

“Everyone is right to fret about inflation but the “deflation scare” isn’t over yet, says Charles Nenner, founder of the Charles Nenner Research Center.

“Renowned for his cycle work, Nenner sees deflation remaining dominant until year-end and inflation not picking up for another 18 months. But that will be the start of a 30-year (yes, year) upcycle for inflation says Nenner, who spent 12 years as a market-timing consultant for Goldman Sachs.

“The investing implications of this scenario are clear: Nenner is bullish on gold for the long-term and even more bullish on gold mining stocks, which he says are currently cheap relative to bullion. After a secular decline, Treasury yields are set to rise, with Nenner predicting the 10-year yield will reach 5.50% by Spring 2013, a 45% rise from Friday’s close of 3.78%.

“What’s less clear is the timing of this trade. Nenner believes the “deflation trade” is about to reassert itself in the short-term, meaning strength in the dollar and Treasuries, and weakness in commodities and equities, as we’ll discuss in more detail in a forthcoming segment.

“For those who believe the dollar is doomed, Nenner notes “all currencies are bad.” In other words, currency trading will be a game of relative bets vs. a one-way trade against the greenback, as so many expect.”

Until tomorrow,

Bill Bonner

Source: The Battle Continues

There is a buzz in the commodities markets this week. Just about anything that can be pulled from the ground is surging in value. Everything, that is, but natural gas.

Most notably, gold is just about ready to reach over the critical $1,000 level, proving that investors are looking for safety. Even without a hint of inflation, the precious metal has surged by over 5% so far this week.

The quick run means the world’s gold miners are surging in value. The more leverage packed into their balance sheets, the higher their prices are going to go.

So far, Yumana Gold (NYSE:AUY) is up by nearly 20% this week, while AngloGold Ashanti (NYSE:AU) is up by over 15%.

It is a similar situation for the silver industry. As investors search for tangible value, the silver industry is taking its investors on a wild ride.

One of the more popular ways of playing the trend, the iShares Silver Trust ETF (NYSE:SLV) was up by as much as 5%, taking the week’s gains into double-digit territory.

TFN Strategic Trader subscribers love the action. Our call options are worth 66% more this afternoon than they were this morning.

The juicy story

Now, I realize you come to TFN sight looking for more than the usual take on the day’s news. Fortunately, our friends over in Russia are creating more than enough action to feed our appetite for story material.

As if the government-centric action unfolding around the Chinese commodity market was not enough to prove my prediction and profit potential of the “Commodities Carry Trade,” the Russian government is stepping into the ring to create some action on its own.

Unable to secure a firm economic future through normal economic means, Putin is “calling” for the country’s banks to start buying Mechel’s (NYSE:MTL) debt. There are also rumors of strong tax breaks heading towards the large Russian miner.

Not only is this yet another wrinkle in my Commodity Carry Trade theory, it helps prove that the effort truly is becoming a global phenomenon.

With their economies weak and the world’s banking industry even weaker, governments are quickly turning to the commodities market for their financial security.

Why invest in paper backed by a desperate government when you can invest in a commodity the world will need no matter what happens in the coming years?

No questioning the profit potential

While there are lots of facets affecting this trade, one thing that is certain is it will be extremely bullish for the commodities market.

We are seeing a mere glimpse of things to come.

Once demand surpassed production… stand back. Prices will soar.

I have a fantastic way to take advantage of this situation, but I absolutely cannot give it away to a wide audience.

Its value was up by nearly 50% today with a trading volume of just 287 trades. Imagine what would happen if thousands of eager investors suddenly jumped in.

If you want me to email you with the trade to make, just click here.

Finally, just to prove there is an exception to every rule, natural gas prices are hitting yet another new low today, dropping the to a paltry $2.50 per million BTUs.

Could it be that foreign investors want nothing to do with an American-based economy? Or is the bearish action a result of the growing inventory glut across the globe?

Now that some of the world’s most powerful governments are getting in on the action, the commodity trade is not going anywhere anytime soon.

This is exciting stuff that is going to drastically change the commodities industry. The situation has profit opportunity written all over it.

I say we take advantage of it.

Source: Russia’s Maneuvering Boosts the Commodities Market

“FEAR, Mr. Bond, takes gold out of circulation and hoards it against the evil day,” as 007 learns from a Bank of England officer in Ian Fleming’s Goldfinger (1959).

So “in a period of history when every tomorrow may be the evil day, it is fair to say that a fat proportion of the gold dug out of one corner of the earth is at once buried again in another corner.”

Evil-day gold buying really motored since the credit collapse began in August 2007. Soaking up investment dollars worldwide, in fact, new allocations to the metal – whether trust fund or owned outright – swelled by 38% during the first quarter of 2009 compared with total demand between Jan. and March 2008, according to marketing-group the World Gold Council (WGC).

Within that figure, what the GFMS consultancy (who supply the WGC with its data) calls “identifiable investment” leapt 248% compared to Q1 ‘08. And gold ETFs made the headlines once more, sucking in “another quarterly record” as new inflows required 465 tonnes of metal to back them, thus dwarfing the previous record of 149 tonnes set in the third quarter of last year.

That doesn’t mean the world’s investors are now all in, however. According to the World Gold Council’s Marcus Grubb last month (using we-don’t-know-which data), current gold investment allocation stands at less than 0.6% of total global wealth.

It makes a nice pie chart, and it offers a useful snapshot of different asset classes vs. each other. But we also think the idea’s worth refining. Because this estimate both over-states liquid assets in toto and under-estimates the stock of gold available to investment flows – whether retail or wholesale.

First, note the scope for double-counting between pension, mutual and insurance funds. I’m not saying the WGC’s data trips up on that error, but you can see how likely it seems given the end-allocation categories applied. For instance, “hedge funds” are stripped out separately (as are REITs and private-equity), even though institutional allocations via funds-of-funds will be counted elsewhere under the broader “funds” title.

Similarly, but more pertinent, the outstanding quantity of “gold – investment stocks” underplays the true volume of metal held as a store of wealth. Simply counting the “investment” volume excludes fully 84% of the above-ground supply, as another chart from the WGC’s presentation shows.

Why not also include “official sector” gold hoards? Sovereign wealth funds and FX reserves were included on the other side of the ledger, after all.

More crucially still, why not include jewelry? Trying to split out the volume of trinkets held for aesthetics alone might feel easy enough to a Western analyst just back from window-shopping at Mappin & Webb. But across south-east Asia, and most particularly in India – typically the world’s No.1 destination for physical gold each year – large, chunky necklaces and bracelets make for “investment jewelry”, acting as a store of wealth in the absence of any formal banking network.

Still, the point is well made, we believe. Gold remains but a slither of investable wealth – albeit a fast-growing slither as the value of other assets has dropped.

“Gold [has] been deprecated and reduced as a financial asset,” as Jeffrey Christian of the CPM consultancy put it earlier this year. “In 1968 gold may have represented 4.5% to 5.0% of the world’s wealth…By the 1990s it was down to 0.2% of the world’s wealth. Not that gold was falling in value so much as the other wealth – stocks, bonds, paper assets, government bonds, corporate bonds, bank deposits – were exploding once the tie to gold was severed.

“In 2006 gold represented 0.2% of world wealth. At the end of 2007, it was about 0.4%. Depending on what you think about wealth destruction in 2008, it may have been 0.6%.”

That figure just about matches the WGC’s estimate of 0.7% (perhaps they used the same inputs and excluded the same volumes of central-bank and jewelry gold?). It also contrasts with our own Estimate of Gold as a Proportion of Investable Wealth at nearer 2.7% by the close of 2008.

Either way, gold is fast-attracting attention – both from nay-sayers, retail investors and new die-hard bulls amongst the professional institutions. Regulatory filings show legendary hedge-fund manager John Paulson took his position in the SPDR Gold ETF (NYSE:GLD) to 30% of his portfolio during the first quarter of 2009. Paulson & Co. now owns 8.7% of that paper – as well as significant chunks of the Gold Miners ETF (NYSE:GDX), Kinross Gold (NYSE:KGC), Gold Fields (NYSE:GFI) and AngloGold Ashanti (NYSE:AU) – if not any actual bullion itself.

Does that in itself make gold a buy? Of course not. But compared to the evil days of 1930s depression – or the fearful inflationary panic of the late 1970s – the world’s wealth remains very under-invested in metal right now.

Regards,
Adrian Ash

Source: The World Gold Council Wrong About Gold

This from Money Morning:

The consensus estimate of earnings for the Standard and Poor’s 500 Index for 2009 is currently about $83. The index itself is currently standing at about 904. That means the market is trading on only 10.6 times next year’s forecast earnings, far below the historical average multiple.

So it is a screaming buy, right?

Not so fast.

“Consensus” estimates of earnings lag reality substantially. Because they include an average of all earnings forecasts over a considerable period, forecasts made in late September would still be included in today’s consensus estimate. But in a period such as the present, when reality has changed substantially since September, the official consensus forecast may differ wildly from what most analysts currently believe. The $83 number is thus a lagging indicator, which doesn’t take account of financial sector disasters, sharply slowing output, or tight credit conditions.

Most analysts, finally made more cautious by five successive quarters of declining earnings on the S&P 500 index, currently believe that the S&P 500 will earn about $60 in 2009. What’s more, David Rosenberg of Merrill Lynch & Co. Inc. (NYSE:MER), who has been exceptionally bearish for some time with an estimate of $50, has been joined in bearishness by Goldman Sachs Group Inc. (NYSE:GS), which has brought its group estimate down to $53.

That’s much more scary. Taking the average S&P 500 multiple at around 14 times earnings, an earnings estimate of $60 would put a “median” estimate of the index at 840; an earnings estimate of $50 would put it at 700. Take a bear market low at 10 times earnings, and you could postulate an S&P 500 low of 600 or even 500.

Still, bear market earnings estimates can be taken only so far, especially those of analysts. After all, on July 7, 2008, a joint report by two top houses predicted that the S&P 500 index would have its best six months since 1982 in the latter half of 2008. That’s about as wrong as they could possibly have been!

Still, one should not be surprised by their failure; while one of the two well respected but wrong houses was Deutsche Bank AG (NYSE:DB), the other was – Lehman Brothers Holdings Inc. (OTC:LEHMQ). Truly, a lot can change in six months.

2009 Bears

Nevertheless, while it’s clear that from an earnings viewpoint 2009 should be approached with caution, it is also clear that some sectors and countries will do reasonably well, while others have futures that are truly scary.

Some of the more bearish sectors and regions include:

• Financial services: The entire industry appears to be scaling down to a fraction of its 2007 size, as many of the innovations of the last 20 years turn out to have been spurious. Investment management also is destined to be much less innovative and less lucrative in the wake of the Bernard Madoff scandal. Eventually, banks and other financial institutions will emerge from the downsizing, but 2009 is much too early to expect that.

• Real estate and construction: Housing won’t bottom out until mid-2009 at the earliest, and will recover only very slowly thereafter. Non-residential construction will also be very limited, as offices, stores and hotels will be in glut. There may be some money to be made in road construction from President-elect Obama’s infrastructure program, however.

• Emerging markets with no money: The emerging markets that rely on borrowing to fund themselves will be out of luck, as debt will be expensive and hard to come by. Eastern Europe and most of Latin America will be in for a thin time, as their balance of payments and in many cases budget deficits will take years to straighten out.

• Western European countries with high cost bases: The Western European countries with expensive labor and high taxes will find life tough in 2009, particularly if they previously enjoyed a real estate bubble or were big in finance. Germany will probably do fine because its high-skill labor is highly competitive and it had no housing boom; Britain, Spain and Italy will be in a much more difficult situation.

2009 Bulls

Conversely, there will be sectors and countries whose earnings can be expected to hold up well, and whose shares are worth looking at:

• Gold mines: Inflation is almost certain to return in 2009, because of all the fiscal and monetary stimulus. That has to be bullish for gold, other precious metals, and mining companies.

• U.S. exporters: The rest of the world will show some economic growth, and the U.S. budget and payments deficits and expansionary monetary policy will make U.S. exporters benefit, unless they are involved in businesses that depends heavily on tourism, such as aircraft.

• Healthcare providers: Pharmaceutical companies may have problems with President elect Barack Obama’s healthcare plans, because the returns for patented drugs will be reduced, but hospital chains and other healthcare providers will probably benefit from an overall increase in government healthcare spending.

• Asian countries: In general, Asian countries will do better than the United States and Western Europe, because their cost bases are less overblown and their competitiveness is greater. China and India may have problems, but I like the prospects for Korea, Taiwan and Japan and for companies in those countries involved primarily in their domestic markets. If the Indian election in spring goes to the pro-business BJP party, it will be a buy too; if not, India will have difficulty funding its overblown government sector.

• Brazil: Brazil has a well-balanced economy, less foreign debt than it used to have, and a monetary policy of high real interest rates. It can, therefore, afford to expand domestically through monetary means in a way no other country can.

Source: Gloomy Earnings Prospects Hold Key To Stock Buying

This from Money Morning:

Gold hit two historic milestones in 2008.

First, in early March, the “yellow metal” hit its all-time high of $1,030 an ounce.

Just months later, the price of gold for December delivery had plummeted to $681 an ounce, a 21-month low and 33.9% drop from its record high.

Most gold bugs were equal parts puzzled and broken-hearted. The world’s stock markets tanked, as did some of its biggest economies. In such an environment, they thought, gold should have risen. After all, gold is widely considered to be a safe-haven investment when everything else is spiraling south.

However, Money Morning Contributing Editor Martin Hutchinson – an investment banker with more than 25 years’ experience on Wall Street and a leading expert on the international financial markets – understood perfectly what other investors did not.

“Gold is not a safe haven against recession,” said Hutchinson. “It’s a safe haven against inflation.”

In the past year, commodities prices skyrocketed – across the board. That was especially true of oil, which hit a record high $147 a barrel. Corn, wheat, and soybeans all hit record highs, as well.

That price escalation tightened household and corporate budgets, and was a primary reason why the U.S. economy posted a gross-domestic product (GDP) decline of 0.3%. With that negative growth, the third quarter was the beginning of what many experts believe will be the nation’s first recession since 2001.

However, the inflation epidemic has waned significantly, as global demand for raw materials has plummeted.

Price for such staple foods as corn, soybeans and wheat have all come down from their record highs – in near-lockstep fashion.

Corn futures are down nearly 50% from their summer high of $8 per bushel. The same is true of soybeans and wheat, with each having lost roughly half their value. In fact, wheat hit a 16-month low in mid-October.

As most of us noticed, gas prices have fallen 48% from their July 17 high of $4.114 a gallon.

And not coincidentally, gold has fallen 22% in that same time frame.

However, this report examines the pending commodities rebound – a projected slow-and-steady increase in commodity prices that will reverse the breakneck plunge below fair value that commodities have experienced for much of this year.

Our objective now: To chart the expected path of gold prices in the New Year.

This report also reveals another wild card inflationary indicator that Hutchinson believes will carry gold prices to $1,500 an ounce by the end of 2009.

Two Catalysts For Gold’s Climb

The U.S. Department of Agriculture’s Oct. 10 Crop Production Report said acreage for a handful of staple food commodities has shrunk:

• Corn acreage fell 1.2%.
• Soybean acreage dropped 1.4%.
• Canola acreage dropped 1.9%.
• Sunflower acreage shrank 0.8%.
• And acreage of dry edible beans fell 0.7%.

That naturally translates to higher prices because it squeezes the supply of the particular commodity. And it does so at a time when demand continues to escalate from populations in China, India and Latin America. And higher prices equal inflation.

But Hutchinson – who correctly predicted this last run-up in gold prices – says there’s another catalyst that’s right now inherent in the U.S. economy that could help vault gold prices to $1,500 an ounce by the end of 2009. And it has to do with the much-ballyhooed $700 billion rescue plan.

The philosophy behind the rescue plan is elegantly simple: By providing a portion of the $700 billion to foundering U.S banks, the Treasury Department believed it could provide banks with badly needed capital, and get them to start lending money once again – jump-starting the economy in the process.

Since September 2007, U.S. Federal Reserve policymakers have cut the benchmark Federal Funds target rate nine times – from 5.25% down to the current 1.0% rate – to increase bank-to-bank lending and bank-to-consumer lending.

“The government is pumping money in so many banks, and that money has to come out somewhere,” Hutchinson said.

Right now, banks aren’t boosting lending. Instead, they are using the cash to finance buyouts of other banks. Even so, that money will “come out” into the economy in the form of higher stock prices for banks. That will make consumer/investors wealthier, and could make them more confidence in the economy. If they’re more confident, they will spend. As that happens, food prices should begin ticking upward, adding another set of thrusters to gold prices.

“Everybody thinks that because we’re having a horrible recession, we’re not to going have inflation. I think that’s probably wrong,” Hutchinson said. “I think gold has quite good hidden-store value.”

As gold prices increase, count on more investors leaving the sidelines to invest, too, causing the surge in gold prices to accelerate and steepen.

“As gold goes up, it gets more popular and investors start piling into it,” Hutchinson said.

And if gold gets anywhere near the $1,500 mark, sell. Prices that high will likely fall back or plateau as the Federal Reserve begins raising interest rates and strengthening the U.S. dollar, Hutchinson said.

Five Ways to Play Bottom-Basement Gold

Before we get too far ahead of ourselves, let’s first look at five ways to play bargain-basement gold prices.

The SPDR Gold Trust ETF (NYSE:GLD) – formerly StreetTracks Gold – is a fund whose shares are intended to parallel the movement of gold prices. Since gold prices started falling along with gas prices, SPDR Gold Trust has stayed within a 0.5% margin of gold prices. This exchange-traded fund (ETF) eliminates any investor concern over storage and delivery while giving them exactly what they want – gold.

Toronto-based Barrick Gold Corp. (NYSE:ABX) has 27 mines, mostly in North America and South America, and is developing or exploring 11 more. With a market cap of more than $20 billion, it has considerably more liquidity than most mining companies. Barrick is primarily a gold miner, but it also has copper and zinc mining operations. As far as investors are concerned, there are two ways to look at that: It’s not a pure play, per se, but then again, this is a company stock, not a bar of bullion. Also, having operations other than gold can help stabilize the company’s bottom line in case problems arise at a gold mine.

Denver-based Newmont Mining Corp. (NYSE:NEM) is primarily a gold producer with operations in the United States, Australia, Peru, Indonesia, Canada, New Zealand and Mexico. Its reserves are hovering around 86.5 million ounces. Like Barrick, this is a mining stock play, and is subject to market swings – as well as fluctuations in gold prices. That can be a significant tailwind, especially if you believe the stock market has bottomed out or is close to doing so. Hutchinson – forever a value-oriented investor – warned that Newmont might be a little too pricey now. Investors may want to wait for the company’s stock price to settle before getting in.

Hutchinson thinks the best value for a gold mining stock can be found in Yamana Gold Inc. (NYSE:AUY), another Toronto-based company that’s small now, but has rapidly expanding production.

But for investors who just want gold – not an ETF or stock – the best avenue is an EverBank Select Metals Account: EverBank accounts has a minimum deposit that is 98% lower than its competitors, and its commission costs are up to 86% lower than other metals’ brokers and bullion banks. It offers two types of gold accounts: Unallocated (your purchased gold is pooled with that of other investors, eliminating storage and maintenance costs; the minimum deposit is $5,000), and Allocated (you directly own the gold you purchase, held in your own private account; $7,500 is the minimum deposit here).

Both types of accounts can be set up 24/7 online. But if you prefer the phone, call 866-326-6241, and be sure to give them the code 12608 when setting up an account.

We should point out that the publisher of Money Morning has a marketing relationship with EverBank, but that’s because its products are among the best in class.

Source: Five Ways to Play Gold’s Rebound to $1,500 an Ounce

However I have a much different and technically far more accurate interpretation of the parable. After eating a bowl of porridge which was neither too hot nor too cold, the little clueless blonde is ultimately chased out of the house by three angry bears. Wall Street bulls will be similarly dispatched. However, upon further reflection I believe that the “Goldilocks” scenario is apt in a way that none of its adherents realize. Wall Street might actually have it half right for a change. In this case it’s the first half, “gold.”

Thus far in 2007, as all eyes have been fixed on oil’s sharp decline, few have noticed the resilience of gold. Since January 1, while oil is off by about 13% and the Dollar Index is up close to 2%, the price of gold has held steady. In fact the gold market has sold off several times in recent months, but held the line at $600 on each occasion. But while gold itself has shown strength, gold mining stocks are off about 7% thus far this year, as traders continue to discount a price decline that has yet to materialize.

To me, this action is indicative of some serious physical buying. For now the growing demand is being satisfied by nervous longs exiting the market and speculative shorts betting on a decline. However, a market that refuses to break will eventually turn and head higher. When that happens, a spectacular gold rally will likely ensue. Those who sold prematurely will rush to re-establish their long positions and those who sold short will rush to cover. With few sellers left to take the other side of the trades, the price of gold will spike higher.

On the fundamental side, gold’s outlook continues to brighten. Bond prices continue to fall, with the yield on the 10 year now up 40 basis points from its December low. Despite Wall Street’s positive spin that rates are rising based on evidence of an improving economy, the gold market indicates something far more troublesome. My hunch is that this bond sell-off will gather momentum, with ten year yields exceeding 5.5% by spring.

A continued rise in yields will dampen the hoped for springtime demand for new homes (typically the busiest home buying season) that many are hoping will help the housing market turn around. Rather than a flood of new buyers, I expect a deluge of sellers. If anyone thinks the supply of unsold homes is high now just wait until the fall. With today’s inflated prices, the process of waiting for a qualified homebuyer is becoming the real world equivalent of waiting for Godot.

As if higher interest rates weren’t bad enough, the recent re-emergence of traditional mortgage lending standards indicates that a return to traditional real estate prices may not be too far off. Of course that is a huge problem as traditional prices, which are underpinned by incomes, the ability to offer down-payments, or rental returns, are far below current levels.

During the recent real estate mania lenders assumed that down payments, fully amortized loans, documentation of income, and various ratios that traditionally measure affordability, no longer applied. Lenders became convinced that this was a new era where their sophistication and skill at assessing and managing risk meant that virtually anyone could borrow any amount. The reality of course was that it was not smart lenders, but a speculative bubble that saved the day. As home prices kept rising borrowers could re-finance or sell their way out of any problem. However, as real estate prices fall and homes become harder to sell, defaults are on the rise.

In a misguided attempt to prop up the housing market, the Fed will reluctantly cut interested rates. However, this will actually have the opposite effect on the housing market. The dollar will plunge sending long-term interest rates higher, exacerbating the recession, and making housing even less affordable. In the end Bernanke will feel he has no choice other than to rev up his helicopter engines. The recent strength in gold suggests that those engines might already be warming up.

Source: Don’t Forget the ‘Gold’ in ‘Goldilocks’