Earlier this month, James Rickards, a well-known investment banker and risk manager, published several newsletters alleging that the Federal Reserve, the central bank of the United States, is insolvent. He believes if you look at the Fed's balance sheet, you'll see that the debt the bank has issued vastly outweighs the assets backing it.
If Rickards is right, the Fed is in the same predicament as millions of homeowners -- it's underwater.
The United States should re-adopt the gold standard. Not only should, but must, and eventually will be forced to do so. Based on the number of dollars vs. the ounces of gold held by the Fed, he thinks it would take about $5,500 to equal roughly one ounce of gold.
But it's an interesting assertion when you consider that Rickards is not your typical gold bug. He is the former general counsel for Long Term Capital Management (LTCM), the infamous hedge fund which, after making spectacular annualized returns of +40%, crashed and lost billions after the Russian financial crisis in 1998.
His experience at LTCM may have given him unique insight into the gold market. When LTCM imploded, it was rumored to be short 300-400 metric tons of gold with no possible way of getting its hands on enough physical gold to cover its short position.
The rumors go on to say that in order to prevent utter chaos in the gold market (can you imagine the price explosion on rumors of a gold shortage?), an event that most likely would have spilled into other financial sectors, the New York Federal Reserve secretly arranged for a handful of investment banks to quietly bail out LTCM. In exchange, LTCM principals were forbidden from ever discussing it.
LTCM had racked up massive amounts of debt that it couldn't repay. Rickards is saying that the U.S. government is in the same predicament.
The Barbarous Relic
Gold has a pretty dramatic history, and it has a tendency to baffle modern investors. It throws off no dividends, has little industrial value, and confers ownership only in…itself. How strange that anyone would want it at all.
But the argument always comes back to one simple fact: for whatever reason, for thousands of years, people have considered gold to be money.
To put the equation "gold equals money" in context, consider that an oft-mentioned rule of thumb is that one ounce of gold should be approximately equal to the cost of one high-quality man's suit. This relationship seems to have held for centuries. Brett Arends, contributor for the Wall Street Journal recently mentioned it when he wrote about a London hedge fund manager who argues that the rule dates all the way back to ancient Rome, when a well-to-do citizen could spend one ounce of gold to buy a top-of-the-line toga.
Even if it doesn't shoot to $5,500 in the near future, there are a number of reasons gold is a vital component of a well-balanced investment portfolio. The most compelling rationale being that gold is a particularly effective hedge against both inflation and international crises.
With the current inflation/deflation debate, two ongoing wars, a volcano shutting down travel over Europe, constant threats of terrorism, concerns about global warming, confrontations with a nuclear North Korea and a desperately-wishing-it-were-nuclear Iran, an uncertainty hedge sounds pretty good these days.
If you are inclined to add gold to your portfolio, there are several ways to do it. Gold can easily be a part of your cash holdings, your long-term holdings, or your speculative/trading holdings, depending on your portfolio needs.
Most portfolios should contain some percentage of cash. Along with foreign currency, gold will diversify your cash holdings.
It is fairly easy to find gold bullion, the generic form of physical gold. Gold bullion generally comes in two forms, coins and bars. The weight and purity are specified, but bullion has no additional value as a collectible. The American Buffalo, Canadian Maple Leaf and South African Krugerrand are gold bullion coins recognized around the world.
If you're interested in starting a coin collection, a certified rare coin dealer can provide information on the premiums that collectable coins can expect to command. Collectable coins generally have some sort of historical significance and are prized for their condition and scarcity. Collectable coins can be a good inflation hedge, but they are not as effective as bullion if you're looking for a cash substitute.
Funds and ETFs
If you don't want to physically hold gold for whatever reason, there are many mutual funds and exchange traded funds (ETFs) focused on the sector. In fact, ETFs consumed more than 10% of the world's new gold supplies last year.
The most well-known of the gold ETFs is the SPDR Gold Trust ETF (NYSE: GLD). GLD holds physical bullion for investors, and it now has approximately 1,130 metric tons of physical gold in its vaults. To put that in context, GLD has stockpiled more gold than the reserves held by Switzerland.
There seem to be ETFs for any kind of gold exposure you're looking for, including a number of inverse and leveraged ETFs. As always, it's important to understand that inverse, double and triple ETFs are complicated instruments comprised of derivatives contracts. They are not appropriate for long-term investors but may work in some situations for short-term investors and/or traders.
Investing in the stocks of gold mining companies is an interesting way to indirectly invest in gold. Generally, gold miners are divided into two groups – juniors and seniors. As you can probably guess, juniors are smaller, riskier businesses. In many cases, they haven't even taken gold out of the ground yet – they may simply control the land under which they hope to find a mine. Once gold is discovered, juniors are usually bought up by their big brother companies, the seniors.
Seniors tend to be larger and more geographically diversified, and some even pay dividend distributions each quarter. Last July, my colleague, Nathan Slaughter, wrote the following in a great piece about gold miners:
"[I]if you're looking to amplify your exposure to rising gold prices, why not go right to the source? Whenever gold prices are on the move, shares of gold producers like Goldcorp usually behave like bullion on steroids."
Nathan went on to recommend a closed-end fund that focuses on senior mining companies. It's gained over +45% since he recommended it last April, and he recommended it again this month. It wouldn't be fair to his subscribers if I disclosed one of his top performers, but if you're interested in learning more about his newsletter, feel free to click here.
Gold futures contracts are not for the faint of heart. They are derivatives that are integral to the gold market, but may be a little confusing for most individual investors. You can easily lose 100% of your investment, but you can also end up with multiples of your original investment. High risk, high reward.
Whether you want to buy a few gold coins or buy gold futures on margin, there is an option available to meet every investor's needs. If you'd like to learn more about supplementing your investments with gold or other commodities, click here to read our article on Commodities as a Porfolio Hedge.