Derivatives, ETFs, and Other Confusing Investments

You may have heard of the SPX, XAU, EFTs and a bunch of other derivative/paper types of investments that seems very confusing. Would like to know more about it?

Well.....you've come to the wrong place. (Again, they actually PAY me to do this!)

I don't know much about that kind of stuff, as it is mostly used by traders and speculators to make a quick buck. Since I'm not that smart, I stay away from anything with initials. (Especially the IRS.)

But, I am about to tell you all that you need to know about these things.

Investor A thinks the price of gold is going down. He writes a contract and offers to sell gold to Investor B at $900/ounce. Investor B thinks the price of gold is going up to $1000/ounce, so he buys the contract.

Now A doesn't actually have the gold he is selling, and B doesn't really want to buy the gold. They just each want to make the difference on the price movement.

This is known as a "naked" contract. (no clothes) You are selling something you don't have.(no gold)

So even though A doesn't have any gold, the contract is still enforceable by B to demand delivery of the gold. But this never happens as no one wants the hassle of exchanging physical gold.

Back to our story.

Now if gold goes up from $900 to $1000, Investor B gains $100. Why? Because he theoretically buys the gold from A at $900 and sells it at the current market price of $1000.

Investor A obviously loses $100. He now has to "theoretically" buy gold at $1000 and sell it to B at $900.

It is a paper transaction only. That is the key thing to remember, and billions of dollars of these contracs are outstanding.

So Why Do I Care?

Regarding gold, there are thousands upons thousands more of these little paper "claims" to gold out there in cyberspace than there is "physical" gold. And that is no big deal as long as no one wants to enforce their contract and take delivery of the "physical" gold.

But, what if our "paper" economic system were disrupted? What if foreigners all decided that they no longer wanted to be paid in dollars, but in gold? (This is already happening with our Asian and Arab trading partners and they have hinted that it will escalate.)

Overnight, the dollar coud become worthless, or at least deeply devalued. Gold would skyrocket in price. And everyone who has one of these legal contracts that says they can buy gold at $900/ounce will demand their gold.

Problem is....there's not enough of it to go around........at any price, which fuels the cycle and forces gold prices higher and higher.

And if you think that can't happen here, don't forget, that is exactly what happened in pre-WWII Germany.

Europe quit taking Germany's "inflated" paper money and demanded gold in exchange for goods and services. This sparked a massive decline in the value of their currency, and in the end, it took a whole wheel-barrel load of Deutchmarks to buy a loaf of bread.

Germany needed gold and/or other tangible assets, and Hitler rode in on the white horse and saved the day by stealing it from....guess who?.....the Jews.

"And now," as Paul Harvey used to say, "you know the rest of the story."


Conclusion

If you don't own physical gold, you are at risk. At HUGE risk.

I have been in the financial business since 1983 and I can tell you with certainty that this house of cards will fall sooner or later. Hopefully it will be later, but it could be tomorrow.

And when it does, your investments in tangible assets will save you.

So stay away from anything with initials, and people named Adolph.


If you care to read more articles about gold as an investment, go to our Gold Commentary site. If you wish to purchase gold, go to our Bullion Services site.

The Dow-to-Gold Ratio

The Dow-to-Gold ratio is an interesting statistic of some usefulness. It simply tells you how many ounces of gold it will take to buy one share of the Dow Jones Industrial Average. In layman's terms, it tells you whether gold is more expensive than stocks or visa versa.

The following excerpt from an article entitled "Why Gold is the New Currency."


"The median stock (as measured by the Dow Jones Industrial Average) to gold ratio over the last 106 years was 5.4. In other words, during the 20th century, on average 5.4 ounces of gold would buy one unit of the DJIA.

Today, it takes more than 12 ounces of gold to buy one unit of the DJIA. So in spite of gold’s mammoth rise from $250 to $860, the precious metal is still quite cheap relative to stocks.

So while the mainstream financial media and the Federal Reserve might be proclaiming an end to the commodity boom and the beginning of a new bull market in stocks, I don’t buy it. In real terms, stocks are anything but cheap. Gold on the other hand, is clearly undervalued."



Although I agree with a lot of the author's conclusions, I disagree with his conclusion that stocks are overvalued. Here's why.

First, the gold/stock ratio may not be a reliable indicator since they are always tinkering with the Dow components, which can make the true ratio an unknown. But I fully agree that gold is still undervalued LONG TERM.

Stocks however do not by default become overvalued simply because gold is undervalued. There is no rule of the universe that says two asset classes cannot be undervalued at the same time.

Short term I think you will see stocks rebound strongly for 2 reasons.

First, as boomers approach retirement realizing that they are needing to put away massive amounts of money over the next few years, this demand for stocks will push up their prices regardless of whether they are overpriced or not.

Second, as foreigners are dumping their dollars, they are buying US assets.....real estate and companies/stocks. The Arabs just traded some of their dollars for a stake in Citibank. They see value here, and they have shown themselves to be pretty astute investors.

It is the DOLLAR that gold is tremendously undervalued against. As the Fed continues to print more dollars out of thin air, by default, the existing amount of dollars become worth less and less. This increase in money supply is only going to continue to get worse, not better.

So, I can see gold going to $5000 against the dollar. And, if, for the sake of arguement, the historical 5/1 ratio holds true, then look for the Dow to hit 25,000.

Tangible assets...gold, stocks and real estate are the only safe harbors.