A Better Reception for the Bank Rescue Plan

Introduction

This past Monday, Treasury Secretary Tim Geithner trotted out his latest version of a bank rescue package. The markets liked it, gaining almost seven percent on the news. After a brief respite of profit-taking on Tuesday, the markets resumed their climb on Wednesday, adding another two percent over the next two days. Although the markets traded lower on Friday, the earlier action helped both the Dow and S&P to their best month so far this year.

Back in February, when Geithner originally unveiled his plan, the markets had the opposite reaction, plunging on the news. In this article, we will examine the new plan in an effort to determine the reasons for the turnaround and to ascertain whether the latest reaction is justified.

Background

On February 10, when Geithner originally unveiled his bank bail-out plan, the Dow Jones Industrial Average dropped 382 points, almost a five percent decline, while the S&P 500 Average turned in a similar performance, falling 43 points. The biggest complaint about the package at the time concerned its lack of detail, specifically about how "toxic assets" would be valued.

Toxic assets, carried on the books of the nation’s largest banks, were creating a drain on capital. These were asset-backed securities (mostly backed by non-performing mortgages) or other non-performing loans. The banks had no way to accurately value these assets because they were essentially illiquid. They weren’t being traded. Because of accounting rules requiring the banks to "mark these assets to the market" - assigning current values to the assets (which were in most cases significantly lower than their values at the time of acquisition) - the banks were forced to either come up with more capital or face the possibility of bankruptcy.

Former Treasury Secretary Hank Paulson attempted to tackle the problem in October with the Troubled Asset Relief Program (TARP). Initially he planned to buy the so-called toxic assets, but ultimately wound up simply throwing capital at the banks.

Geithner’s plan had originally been extensively hyped by the Obama Administration as part of the Administration’s master plan that would eventually pull the nation out of its deepest recession since the 1930s. But when the Geithner’s product disappointed its advance billing, the markets reacted accordingly.

This week Geithner filled in some of the blanks and the market liked what it heard.

The Plan

Fixing the financial system, according to the Treasury Secretary, would require a two-pronged approach: targeting both bank assets and bank capital.

Bank capital would be addressed by the "stress" tests Geithner detailed in his first announcement. Analyses of banks’ capital would be performed under various scenarios, determining whether the banks could remain solvent in all types of financial conditions. Weaker banks might receive further capital injections or might even be taken over, temporarily, by the government.

The problem of the banks’ assets was the subject of Monday’s plan, called the "Public / Private Partnership Investment Program" (PPIP). The PPIP would provide a means for removing "legacy" assets from the books of the banks (there are no longer "toxic" assets; they have been renamed "legacy" assets - apparently a term more palatable to the general public).

The PPIP actually has two parts: one for legacy securities, asset-backed securities which the banks have been unable to sell, including securities that are backed by sub-prime mortgages and are no longer rated triple-A (these were not covered by previous rescue plans); and a second part which would cover whole real-estate loans carried on the books of the banks.

To handle the "legacy" securities, the government would create up to five joint ventures, between the government and private investor groups. The private group would be responsible for raising private equity capital. The government would provide one dollar of equity capital and up to one dollar of Treasury loans for each dollar of private equity capital raised. The partnerships would then go out and bid for assets. Government financing would be provided on a non-recourse basis. Banks would hopefully be willing to sell their assets at auction but would have the last word on whether they would actually sell those assets. Prices of the assets would be set by the auctions and would essentially be dictated by the private investors.

For the problem loans, banks would be encouraged to offer pools of problem loans for auction. Authorized investors would pre-qualify for dollar-for-dollar government equity and up to twelve times their equity stake in FDIC-guaranteed loans.
The plan is extremely attractive for private investors. As Bill Gross, founder of Pimco, a bond fund manager, put it, "This is perhaps the first win/win/win policy to be put on the table and it should be welcomed enthusiastically." In the case of the legacy securities (formerly known as toxic securities), the private partnerships will be able to leverage their capital by a factor of three and purchase assets at possibly very low prices. Because of the government equity contribution and non-recourse government financing, they have an opportunity to make some extraordinary profits while the government takes on most of the risk. In the case of problem loans, the private investors could achieve 12-to-1 leverage, again with little risk.

Pricing Problems

One of the questions surrounding the initial announcement of a rescue package was how the assets would be priced. The Treasury hopes this will be answered by the auction system the government would be setting up. But this system has itself a number of problems.

With regard to legacy securities, the banks will have to take a write-off against capital for any losses incurred in the sale of these assets. Consequently, the banks are going to be in no rush to sell these assets, especially at fire-sale prices. (Plans by the SEC to remove the mark-to-market requirement, currently underway, will make it even less likely that banks will be willing to unload these assets.) So they will try to hold out for the best possible price they can get.

Private investors, knowing that the federal government will bear most of the risk of loss in acquisition of these securities, would be more willing to pay higher prices for these securities than if they were being forced to shoulder the risk themselves.

We believe the government will wind up financing (and partially owning) securities that carry a greater risk of loss than if the securities had been offered in a pure auction (one where the buyers were not backstopped by the government).

Other Problems

As Bill Gross said, the policy appears to be a win/win/win situation, but mostly for the private investors. It will probably solve the toxic asset problem. Most profits will go to the private investors. If losses are incurred, however, they will be borne by the taxpayers. The government runs the risk of a creating a program that will be viewed by the general public as another scheme for the "fat cats" on Wall Street to get rich at the expense of the little guys on Main Street. That’s not what Wall Street needs at this time, nor does the government need this.

A second problem that has been raised by a number of observers is the problem of bank recapitalization. Banks, according to these observers, need a lot more capital. The only way this capital can be raised, they argue is through debt-for-equity swaps, either with the government or with private investors. Should the government be involved this would mean the possibility of some type of nationalization, probably of a temporary nature.

A final problem that has been raised is the fact that the program does not address the real problem in the system - the need for restructuring. In the 1990s, the Japanese financial system was faced with similar problems regarding bad loans. The Japanese government tried to paper over the problem by feeding capital to the banks and keeping bad banks afloat. However, the problems were not really solved until the government allowed a number of the "bad" banks to go under. Many observers believe the same medicine is needed for the US financial system, that no bank is "too big to fail."

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Currency Outlook for March 23 - 28, 2009

Introduction

The Federal Reserve, at its Open Market Committee meeting this week, announced it was drastically expanding its purchases of both government and private-sector securities. In so doing, it changed the landscape for currency trading. The Dollar fell sharply against all major currencies following the announcement. Now, the question is: What does this mean for the future of the Dollar and for the other majors?

Background

In the period following the Lehman Brothers bankruptcy last September, the Dollar, the Japanese Yen and the Swiss Franc all rose against the other major currencies. It had now become evident that the economy was rapidly deteriorating (even though the National Bureau of Economic Research subsequently reported that the US economy, at least, had actually been in a recession since December 2007). Investors began looking for safe havens in which to park their cash and the above-mentioned currencies emerged as the most-favored destinations.

In normal times, the primary factors dominating short-term currency movements would be interest rate differentials. The currencies with the highest interest rates, all other factors being equal, would also turn out to be the strongest currencies.

However, when authorities began to discern the seriousness of the current recession, it was the Federal Reserve that acted the most aggressively, driving interest rates downward. Other central banks reluctantly followed the Fed’s lead. As a result, US interest rates were soon well below the levels of interest rates in the other developed countries, with the exception of Japan, where interest rates were already close to zero. In normal times, this would have driven investors and speculators out of the Dollar.

But, in looking for a safe haven, investors were more concerned in safety and the avoidance of risk. The fact that the Fed had been the leader in tackling the problems of the recession probably meant that the US would also lead the rest of the world out of the recession. In addition, US Treasury securities were the safest in the world, thereby adding to the Dollar’s allure.

The Japanese Yen actually outperformed the Dollar during this period, having already begun rising on the back of liquidation of Yen-carry trades (trades in which investors had borrowed Yen at low interest rates in order to sell the Yen and invest in other higher-yielding currencies). These trades were the first to go when financial institutions began de-leveraging in the wake of the collapse in values of other securities held by the institutions. On the assumption that Japanese institutions, and therefore the Yen itself, were less exposed to so-called "toxic assets," investors reasoned that the Yen would hold up better than most of the other majors.

The Yen strength came despite the weakness of the Japanese economy, probably the weakest of all developed economies.

The Swiss Franc benefited by virtue of its traditional role as a safe-haven currency.

This week it all changed when the Federal Reserve, having cut interest rates as far as they could, decided that additional, stronger measures were required. The Fed, along with other central banks, had already indicated that it would supplement its low-interest-rate policy with "quantitative easing": buying securities, government and otherwise, and paying for those securities with money created by the Fed. Until this past Wednesday, however, the Fed’s actual purchases of these securities had been limited. The Bank of England, on the other hand, which had also signaled it would use "Q.E.", had actively purchased UK gilt-edge bonds (’gilts").

On Wednesday, following the conclusion of the FOMC meeting, the Fed announced it would buy $300 billion worth of US government securities - Treasury notes with maturities between two and ten years - over the next six months. The Fed also said it would more than double its purchases of mortgage-backed securities - debt issued by Fannie Mae, Freddie Mac and Ginnie Mae - to $1.45 trillion.

The yield on ten-year US Treasuries immediately fell 50 basis points, to 2.50 percent. Currency traders also began selling Dollars, frightened by the inflationary implications of the Fed action. The purchases would increase the size of the Fed’s balance sheet to $3 trillion. Traders were concerned that the Fed would have difficulty selling enough securities to reduce the size of its balance sheet, once the economy began recovering and inflation resumed increasing. Following the Fed announcement, the Dollar fell 3.2 percent vs. the Euro and 2.3 percent against the Japanese Yen.

Now the question is: Have we turned a corner and are we entering a new phase in currency trading? Or, is this simply a short-term setback for the Dollar and can it soon resume its recent strength?

Outlook

Eurodollar

On March 5, the European Central Bank lowered its main financing rate by a half-percent, to 1.5 percent, its lowest level since the Euro was formed in 1999. ECB President Jean-Claude Trichet indicated more rate cuts could follow. Nevertheless, with key rates at other central banks virtually equal to zero, ECB rates remained the highest among major developed countries. Thus, traders this week bought Euros.

Euro - One-Year Chart March 20, 2009

Source: CNBC.com

European interest rates could move lower, if the ECB were so inclined. A European Union report said that the economy in the Euro region contracted by 1.5 percent in the fourth quarter, an annualized decline of more than five percent, and its biggest drop in thirteen years. The largest members of the EU recorded similar declines in the quarter: France, an annualized decline of 4.8 percent, and Germany, a drop of 8 percent (also annualized).

Europe can expect more of the same, or worse, in months to come. Germany is the EU’s largest economy and the German trade surplus fell to its lowest level in seven years in January, following a 20.7 percent decline in exports in the month. Germany’s economy is heavily export-dependent. Export volumes are forecast to decline 7.1 percent in 2009 and its GDP is projected to contract by 2.5 percent this year.

The second largest economy in the EU is France and French industrial production was down 13.8 percent in January, its largest year-on-year drop since 1991 (industrial production in the EU, as a whole, was down 10.1 percent). While France is not as dependent on exports as Germany, its exports are still projected to fall by 7.3 percent in 2009 and its economy could contract by 1.4 percent this year.

Therefore, for the short-term, we believe the Euro will appreciate vs. the Dollar, based strictly on interest-rate differentials. Longer term, however, the strength or weakness of the Euro will depend on the speed and strength of the US recovery and how well Bernanke manages resurgent inflation. In the long term, inflationary expectations will take over as the key factor governing currency trading.

British Pound

The chief economist at the Bank of England, Spencer Dale, this week expressed cautious optimism that Britain was "probably well through its recession." If he is correct, then the British Pound may have already seen its lows.

British Pound - One-Year Chart March 20, 2009

Source: CNBC.com

In its most recent forecast, however, the Bank of England forecast that UK GDP will contract 3 percent in 2009, its largest decline since the Second World War, following an annualized decline of 5.2 percent in the fourth quarter.

We would wait until the UK begins posting more positive economic numbers before going long Sterling.

Japanese Yen

The Japanese Yen continued to gain against the Dollar this week despite a gloomy economic outlook. Japan is more dependent on exports than any other developed nation. Japanese exports fell 45.7 percent in the year ending in January 2009, with the exports to the US down 53 percent, to Europe, down 47 percent, and to China, down 45 percent.

Japan recorded its first current account deficit in thirteen years in January, 172.8 billion yen ($1.75 billion). To demonstrate how far and how fast the Japanese current account has fallen, Japan had a current account surplus of 24,800 billion yen in 2007.

Japanese Yen - One-Year Chart March 20, 2009

Source: CNBC.com

Japan registered a quarterly GDP decline of 3.2 percent in the quarter ending in December and GDP is projected to fall 3.8 percent for all of 2009. It may decline more than that.

We see little further upward potential for the Yen at this point.

Swiss Franc

The Swiss National Bank last week (March 12) sold Swiss Francs in the currency markets, the first direct intervention by a major central bank since the Japanese intervened in 2004. The Franc that day fell 2.6 percent against the Euro, and 2.3 percent vs. the Dollar.

Swiss Franc - One-Year Chart March 20, 2009

Source: CNBC.com

With a target range for its own key interest rate of 0 - 0.5 percent, the Swiss were concerned that the strong Franc (as a safe-haven currency) would further cut into Swiss exports. The SNB recently lowered its own GDP forecast for 2009 to - 2.5 to - 3.0 percent, down from -0.5 to - 1.0 percent, its most recent forecast.

The Swiss intervention sparked concerns about a possible currency war. With Japanese officials also worried about the strong Japanese Yen cutting into Japanese exports, traders feared the Japanese might also begin intervening. We think such concerns are misdirected. The Swiss intervention was relatively successful because of two reasons: its shock effect, and the relative illiquidity of the Swiss Franc in international currency trading. The reason the Japanese have not intervened in currency markets since 2004 is because the intervention was ineffective then and would continue to be ineffective today. The Yen market is much more liquid than the Swiss Franc and would easily swallow up any central bank selling.

We would nevertheless stay away from the long side of the Swiss Franc because of the intervention threat.

US Dollar

We have talked extensively about US economic problems in recent weeks. We believe the economic stimulus package enacted by Congress and the Obama administration will be effective in bringing the US economy out of recession IF the Administration can fix the banks. Treasury Secretary Geithner’s rescue plan, when it was initially rolled out, left numerous questions unanswered. He is supposed to reveal his latest plan this coming week. We’ll see if he is able to quiet his critics.

Over the short-term, the aggressive easing by the Fed should keep the Dollar under pressure. On a longer-term basis, the key to the Dollar will be how well Bernanke and the Fed manage resurgent inflation. It will be a difficult job. We have already talked about the magnitude of the Fed balance sheet. On top of that will be the inflationary problems caused by the Obama budget - should it pass.

The Administration projects that the Obama budget will cause the Federal deficit to swell to 12.3 percent of GDP in 2009, from 3.2 percent in 2008 (although the Administration forecasts the deficit will shrink to 5.9 percent by 2011 and 3 percent by 2013). Total US borrowing will increase by $2.56 trillion in 2009 and $1.14 trillion in 2010. US borrowing in 2010 will total $9.5 trillion in 2010, 65 percent of GDP! These figures are based on the Administration’s growth forecasts for the next four years, rosy ones.

Should the Fed manage to keep inflation under control in the face of these forecasts, and should the US recovery be relatively strong, we can see the Dollar recovering its strength. But these are shaky assumptions.

Legal Disclaimer: Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary and does not constitute investment advice.

Forex Trading Tips for Beginners

1. Go to the casino if you want to gamble. Investing without doing research/analysis is same as gambling. Knowledge is power.

2. Before investing real money always use a demo account.
example: Kerford Investments Demo Account.

3. No one can predict the future - when the market is moving it moves.

4. Trade with you head not your heart -
Don't let your emotions get the better of you when you are losing and don't get greedy when you are winning.
Over reaction and over trading will lead to increasingly risky behavior and will end up costing you mentally and monetarily.

5. The market is not your friend - accept your losses as a part of trading. Trading is not a science and if you accept your failure you can manage it well and use it to your advantage.

6. Avoid FOREX strategies that you do not fully understand.

Legal Disclaimer: Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary and does not constitute investment advice.

What Can We Expect from the G20

Introduction

Finance ministers from the Group of 20 (G20) will meet in London this weekend in preliminary talks before the heads of state of the G20 meet in London beginning April 2. The Obama Administration is hoping that the April 2 meeting will be used as a springboard for greater stimulus from all the nations. But the Americans are facing stiff resistance from many of the parties involved. What’s more, the participants can’t seem to agree on the nature of the problem or on the actions that should be taken to correct the situation.

In this article, we will try to sort out the issues and make some predictions regarding the meeting itself.

Background

In 1971, as the Bretton Woods system was breaking down, finance ministers from five major developed nations - the US, UK, France, Germany and Japan - began meeting informally to discuss many of the problems then facing the world economy. This group became known as the Group of Five, or G5. About fifteen years later, the group was expanded to include Italy and Canada and became the Group of Seven (G7). The finance ministers from the G7 met regularly, with heads of state from the seven nations meeting formally on an annual basis. The meetings were used as means to discuss current economic problems.

In the early 1990s, Russia was occasionally invited to join the meetings. Around this time, it was recognized that the influence of some of the original G7 members was declining in importance while many nations in the developing world were exercising a greater economical impact. The G7 nations realized that many of these developing countries needed a voice in global affairs as well and the Group of 20 (G20) came into being. The G20 included the original G7 countries plus twelve of the developing nations with the European Union itself as the twentieth member.*

The Problem

It is generally recognized that the current recession is global in nature, unlike the recessions of the 1970s and 1980s, which were strictly US problems, or the Asian contagion of 1997-1998, which was essentially an Asian problem. Consequently, the recession of 2007-2008 needs a global solution.

It is also widely recognized that the forces involved in the current crisis are major ones: a tremendous loss of wealth (estimated in the area of $50,000 billion worldwide); excessive use of debt in the deficit countries with the result that much of this debt has become "toxic", that is, unlikely to be repaid; and a general breakdown in the normal functioning of the financial system.
What is not recognized, or agreed upon, is the degree to which the global recession affects the various players involved. Nor is it agreed as to who caused the problem, or just what is necessary, or how, to even attack the problem. Can monetary policy do the job? Or do we need a mix of monetary and fiscal policy?

Finally, what should the solution look like? Do we try to restore the system to its state before the crisis developed, i.e., with consumer demand in the West, particularly in the United States, supporting export-dependent economies in The East? Or do we attempt to create some other economic model?

The Issues

The Obama Administration wants each country in the G20 to aggressively increase its fiscal stimulus. The Administration’s stance stems from the belief that any action to stem the current crisis must be massive, decisive and sustained. It is based on the US experience during the Great Depression of the 1930s, when failure to provide a large and sustained stimulus prolonged the Depression. Larry Summers, former Treasury Secretary under Bill Clinton and now Senior Economic Adviser to the President has said that the G20 should agree to boost domestic demand. Christina Romer, chair of the White House Council of Economic Advisers said, "The more that countries throughout the world can move toward monetary and fiscal expansion the better off we will all be." Treasury Secretary Tim Geithner, in calling for a tripling of IMF resources (from $250 billion to $750 billion - twice as much as the IMF itself has asked for), said that each country in the G20 set a goal of fiscal stimulus equal to two percent of GDP in both 2009 and 2010.

Not everyone in the American camp, however, agrees with this goal for the G20. Fed Chairman Ben Bernanke has said, of the upcoming meeting, that it is "asking too much (of the G20) to come out with detailed proposals in many different areas." He believes that a better goal would be to establish some principles that would guide reforms around the world. He is urging caution on fiscal stimulus initiatives, preferring to balance the short-term benefits of stimulus against long-term risks to public financing.

And there are those who feel the current level of stimulus put forth by the Obama Administration is too little. Martin Wolf, senior economic writer for the Financial Times, for one, feels the US package is "disturbingly modest" at only 4.8 percent of GDP (over the next two years). He quotes a recent report from the IMF that says that fiscal policy, in the current situation should be " timely, large, lasting, diversified, contingent, collective and sustainable."
Martin Feldstein, former chairman of Ronald Reagan’s council of economic advisers, believes that the US package will offset only 40 percent of the lost demand from 2009 and 2010. He believes a second fiscal stimulus package is likely.

The Europeans are not buying the US arguments. The UK has passed a fiscal stimulus package equal to 1.4 percent of GDP, but Prime Minister Gordon Brown said that there will be no additional stimulus in next month’s budget package (fiscal stimulus already enacted will comprise only 0.1 percent of GDP in 2010). His Chancellor of the Exchequer, Alistair Darling, said that the G20 summit should focus on implementing fiscal measures already in the pipeline.
European Union ministers, meeting last week in Brussels have taken an even firmer stand. They have said they have no plans to add to recent stimulus packages. They prefer to see what effect the packages that have already been passed will have. Their main concern is that more government debt at this time could threaten the stability of the European Union.
Peer Steinbruck, the German finance minister, categorically stated that "we are not debating any additional measures." And Jean-Claude Juncker, the chair of the "Eurogroup" of ministers said: "The sixteen finance ministers agreed that recent American appeals insisting Europeans make an added budgetary effort were not to our liking."

In regard to the argument that they should step up their stimulus as a percentage of GDP, they point to the fact that they have more automatic stabilizers in place than the Americans. Therefore, their stimulus, as a percentage of GDP, is actually higher than it would seem at first blush. (Automatic stabilizers are conditions of economic spending already built into the system that automatically increase as the economy slows, and vice versa. One example of an automatic stabilizer would be unemployment benefits, which increase as unemployment increases and more unemployed men file for benefits. The resultant spending of unemployment checks automatically provides a fiscal stimulus.)

But the Europeans may be underestimating the severity of their own economic problems. Most European economies are extremely export-dependent and their economies are expected to underperform the US economy in 2009. French industrial output contracted by 13.8 percent, year-on-year, in January, its worst performance since the data began being recorded in 1991. German industrial production also contracted sharply in January and February. In addition, German exports were down 20.7 percent in January from January 2008 and were also down 4.4 percent from December of 2008. Industrial production in the UK fell by 5.6 percent in the three-month period ending in January, compared to a decline of 4.6 percent in the three-month period ending in December.

The other country that many have been counting on to help out in the fiscal effort has been China. Last week, in fact, markets rallied when Chinese Premier Wen Jiabao was expected to announce an additional stimulus package, on top of the $585 billion package the Chinese announced last November. The hope was that the Chinese would make an attempt to prop up domestic demand. Instead, the Chinese declined to provide any additional stimulus, insisting that the Chinese economy would still achieve 8 percent growth in 2009.

Eight percent growth this year will be a stretch for the Chinese. Exports were down 25.7 percent in February, while imports, which declined 43 percent in January, fell another 24 percent in February. So much for a growth in domestic demand.

The Chinese have continued to blame the US for the current crisis and maintain that the US should take the lead in correcting the problem.

The Wrong Solution?

Not everyone believes massive stimulus for the US and other economies is the right solution. Stephen Roach, chairman of Morgan Stanley Asia, argues that policies aimed at recreating the boom years, that is, policies that encourage US consumers to take on more debt and begin spending again, are the wrong policies. He feels that these policies will only perpetuate the imbalances that existed before the current recession began: a global system that depends on excessive demand in the US and export-dependent economies in Asia - these policies led to record debt burdens, zero savings rates and asset-market bubbles in the West and over-dependence on exports in the East.

What is needed, Roach feels, is a solution that would provide better balances in these economies: higher savings rates and the reduction or elimination of current account deficits in the West and lower savings rates and greater domestic demand in Eastern countries.
Failure to achieve this balance only sets up the global economy for the next crisis, which he believes will be worse than the current crisis.

Conclusion

We look for little substance to emerge from next month’s G20 meeting. The gulf between the two sides just seems too great. It is unfortunate, but a great opportunity will be wasted and the current recession will probably last longer than necessary.

* Members of the G20: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States and the European Union

Legal Disclaimer: Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary and does not constitute investment advice.

The Case for Investing in Gold

For thousands of years, gold has been valued as a global currency, a commodity, an investment and simply an object of beauty. As financial markets developed rapidly during the 1980s and 1990s, gold receded into the background and many investors lost touch with this asset of last resort. Recent years have seen a striking increase in investor interest in gold. While a sustained price rally, underpinned by the fact that demand consistently outstrips supply, is clearly a positive factor in this resurgence, there are many reasons why people and institutions around the world are once again investing in gold.

METHODS OF INVESTING IN GOLD

Investment in gold can be done directly through bullion or coin ownership, or indirectly through certificates, accounts, spread betting, derivatives or shares.Investors using fundamental analysis analyze the macroeconomic situation, which includes international economic indicators, such as GDP growth rates, inflation, interest rates, productivity and energy prices. They would also analyze the total global gold supply versus demand. In 2005 the World Gold Council estimated total global gold supply to be 3,859 tonnes and demand to be 3,754 tonnes, giving a surplus of 105 tonnes. While gold production is unlikely to change in the near future, supply and demand due to private ownership is highly liquid and subject to rapid changes. This makes gold very different from almost every other commodity.

GOLD VERSUS STOCKS

The performance of gold bullion is often compared to stocks. They are fundamentally different asset classes. Gold is regarded by some as a store of value (without growth) whereas stocks are regarded as a return on value (i.e. growth due to anticipated real price increase plus dividends). Stocks and bonds perform best in a stable political climate with strong property rights and little turmoil.

Since 1800, stocks have consistently gained value in comparison to gold due in part to the stability of the American political system. This appreciation has been cyclical with long periods of stock out performance followed by long periods of gold out performance. The Dow Industrials bottomed out a ratio of 1:1 with gold during 1980 (the end of the 1970s bear market) and proceeded to post gains throughout the 1980s and 1990s. The ratio peaked on January 14th, 2000 a value of 41.3 and has fallen sharply since.

Investors who invest in stock and gold can recall a time when a share of Google's stock and an ounce of gold were both near $700. On January 4, 2008 23:58 EST, it was reported that an ounce of gold outpaced the share price of Google by 30.77%, with gold closing at $859.19 per ounce and a share of Google closing at $657 on U.S. market exchanges. On January 24th 2008, the gold price broke the $900 mark per ounce for the first time. The price of gold topped $1,000 an ounce for the first time ever on March 13, 2008 amid recession fears in the United States. Google closed 2008 at $307.65 while gold closed the year at $866.

TECHNICAL ANALYSIS

As with stocks, gold investors may base their investment decision partly on, or solely on, technical analysis. Typically, this involves analyzing chart patterns, moving averages, market trends and/or the economic cycle in order to speculate on the future price.

USING LEVERAGE

Bullish investors may choose to leverage their position by borrowing money against their existing gold assets and then purchasing more gold on account with the loaned funds. This technique is referred to as a carry trade. Leverage is also an integral part of buying gold derivatives and unhedged gold mining company shares (see gold mining companies). Leverage via carry trades or derivatives may increase investment gains but also increases risk, as if the gold price decreases, the investor may be subject to a margin call.

BULLS VERSUS BEARS

Since April 2001 the gold price has more than tripled in value against the US dollar, prompting speculation that the long secular bear market (or the Great Commodities Depression) has ended and a bull market has returned. In March 2008, the gold price reached above $1000 before falling under $800, which in real terms was still well below the $850 peak in 1980. In the last century, major economic crises (such as the Great Depression, World War II, the first and second oil crisis) lowered the Dow/Gold ratio (which is inherently inflation adjusted) substantially, in most cases to a value well below 4. During these difficult times, investors tried to preserve their assets by investing in precious metals, most notably gold and silver.

FACTORS INFLUENCING THE PRICE OF GOLD

Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of stored gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.

According to the World Gold Council, annual mine production of gold over the last few years has been close to 2,500 tonnes. About 3,000 tonnes goes into jewelry or industrial/dental production, and around 500 tonnes goes to retail investors and exchange traded gold funds. This translates to an annual demand for gold to be 1000 tonnes in excess over mine production which has come from central bank sales and other disposal. Central banks and the International Monetary Fund play an important role in the gold price.

At the end of 2004 central banks and official organizations held 19 percent of all above-ground gold as official gold reserves. The Washington Agreement on Gold (WAG), which dates from September 1999, limits gold sales by its members (Europe, United States, Japan, Australia, Bank for International Settlements and the International Monetary Fund) to less than 400 tonnes a year. European central banks, such as the Bank of England and Swiss National Bank, have been key sellers of gold over this period.

Although central banks do not generally announce gold purchases in advance, some, such as Russia, have expressed interest in growing their gold reserves again as of late 2005. In early 2006, China, which only holds 1.3% of its reserves in gold, announced that it was looking for ways to improve the returns on its official reserves. Some bulls hope that this signals that China might reposition more of its holdings into gold in line with other Central Banks.

REASONS WHY GOLD WILL RISE IN 2009

• Secretary of the Treasury Paulson talked of the current crisis being potentially worse than the Great Depression.

• Alan Greenspan told Congress that the financial meltdown had left him in a “state of shocked disbelief.”

• Reputable economists are saying “this looks an awful lot like the beginning of the second Great Depression.”

• U.S. consumer confidence has fallen more sharply than in any period since records began in 1978.

Since September 9, we have seen the nationalization of Fannie Mae, Freddie Mac and AIG; the socialization of the auto industry; the disappearance of the investment banking industry; a $700 billion Bailout with more to come; the bankruptcy of Lehman Brothers; the “breaking-of-the-buck” of the supposedly rock-solid money market funds; the largest bank failure in history; the implosion of global stock markets; the collapse of home values, retail sales and consumer sentiment; the biggest fall in industrial production in 34 years; and an unprecedented shattering of confidence in both commodities and financial assets.

It is increasingly apparent that fear predominates. Individual investors are abandoning anything with the slightest hint of risk. Last year was the worst year for global equity markets since the Great Depression, with the Dow suffering its worst annual decline since 1931. Investors are pulling huge amounts of money from hedge funds, stock mutual funds and bond mutual funds in one of the biggest flights to safety the financial industry has ever seen.
Defensive Asset Class have assets that have similar risk/return characteristics, are positively correlated with each other and are traditional inflation hedges that are negatively correlated with stocks – they do well when stocks do poorly. Historically, the principal Defensive Asset has been gold.

Of the major assets, only Treasuries and gold have escaped the selling panic that has gripped the markets. Gold rose 5.4% over 2008, ending the year above $850 a troy ounce. Gold bullion reached $1,030.80 in mid-March and Mints around the world ran out of popular gold coins and small gold bars after the collapse of Lehman Bros. in September.

The U.S. rate cut to virtually zero lowers the opportunity cost of buying gold and gold ETF holdings have exploded from 7 million ounces to over 30 million ounces in less than four years
Gold is different from other precious metals such as platinum, palladium and silver because the demand for these precious metals arises principally from their industrial applications. Gold's value rise arises from its use and worldwide acceptance as a store of value and a safe haven.

Other precious metals have also been classified as Defensive Assets, but have not performed as well as gold during this crisis. For example, investment accounts for about 90% of the demand for gold, while investment makes up only one-third of the total demand for platinum. Therefore, although gold has done well, platinum's demand from industrial uses has fallen rapidly, particularly because of the high concentration of uses of platinum in new automobiles – an endangered species in an economy in which automakers are begging for funds from Washington just to keep them afloat.

Gold's price has been bolstered by the view that it is a safe haven in times of economic or political uncertainty, while platinum's industrial demand has fallen precipitously. Platinum reached its all-time high of $2,267.00 per ounce in March, but fell like a rock from there, as did silver. Platinum fell nearly 60% from its March peak, while silver fell 47%. The last time that gold traded for more than platinum was January 21, 1994, when gold closed at $381.70 and platinum at $380.90.

REFLATION

Gold benefits from the cure for deflation, rather than from deflation itself. At some point, the market is going to get over its concerns about deflation and become concerned about inflation – that will be the real inflection point for gold.

Dollar weakness, plentiful liquidity and policy reflation will be persistent themes over the next year or so. Massive fiscal and monetary stimulus have combined to weaken the dollar, but are expected to do so in an orderly fashion since no country wants a strong currency in a deflationary world.

In the past twelve months, the Federal Reserve's balance sheet grew by 146%, the European central banks' by 58%, the Swiss national bank's by 74%, and the Bank of England's by 158%. Huge amounts of money supply growth are on the way.

The Fed and central banks throughout the world are sending so much money sloshing through the system that they will eventually generate a bad case of inflation. While inflation isn't apparent today, stimulus packages and bailouts mean much more money in the system, which is classically inflationary. Historically low U.S. interest rates, U.S. dollar weakness, and the longer term inflationary pressures of the Federal Reserve throwing trillions of dollars at the U.S. economy make the environment favorable for gold and other tangible assets.

The dollar has benefited from the global flight from risky assets, as well as the unwinding of bets made with borrowed dollars. That has come as a surprise to many who expected that increased government spending and a collapsing U.S economy would cripple the dollar.

In the longer term, the dollar's health remains dependent upon foreigners' appetite for U.S. assets, which will decline as the economy falters and the government continues to inject additional liquidity.

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