I’m holding on to all of my gold and gold stocks, and I’m holding on to my short plays on the market. I’m a pessimist. I think we see Dow 5,000 before we see Dow 11,000, but I hope I’m wrong.

Well, it’s not looking like I’m going to be wrong, is it?

I’m not going to be wrong, I’m afraid, because the world has changed.

The modern world began in 1978, with the start of the reigns of those icons of capitalism, Ronald Reagan (in 1980), Margaret Thatcher (1979), and Deng Xiaoping. (Okay, okay, Deng Xiaoping was never officially the leader of China, but from 1978 onwards he had significant influence on China, and he did encourage the Chinese people to individually begin taking risks, and that did bring about the greatest increase in the standard of living that any society has ever seen in a 25 year period). In the 1980s and 1990s we all worked hard to get ahead, and taxes were being lowered to reward earners.

Those days are gone. 50% of voting age Americans no longer pay taxes. They receive from the government, and therefore have no incentive to work. A “soak the rich” methodology is now politically expedient if none of us are rich anymore. More government spending is inevitable, although I’m not sure President Obama is capable of spending as much as that other icon of freedom, George W. It’s hard to top a trillion dollar deficit, but I digress.

The change became obvious on July 13 of this year when the Boys agreed to bail out Fannie and Freddie, boosting the bank stocks (temporarily) and the U.S. dollar (temporarily) and killing the commodities markets (oil dropping from $140 to $50).

It could be argued that oil dropping from $140 to $50 is deflationary. It could be argued that the huge number of house foreclosures will drop the price of a house, which is also deflationary. Perhaps, in the short term, that’s true. Longer term, not so much.

Inflation is an increase in the money supply; deflation is a decrease in the money supply. If twice as much currency is chasing the same number of goods, prices appear to rise, which is why we think rising prices means inflation. The money supply certainly appears to be increasing, with the national debt set to increase by somewhere between 50% and 100% this year thanks to the bailouts of Fannie and Freddie, the TARP program of $750 billion to bailout out the banks, and who knows what else to bail out the auto industry and everyone else. Longer term, that’s inflationary.

Let me be more specific:

Short term, prices are falling. The price of a barrel of oil has dropped by two thirds in the last few months. House prices are crashing. Unemployment is rising, which drives down the price of labour (or “labor” for my American friends). But that is a short term phenomenon.

In the medium term, all of the new money created by governments around the world will be inflationary. There is no way you can print that much money without the money supply increasing. That’s inflationary, and that’s good for gold. Really good, if you look at Friday’s action:

Gold peaked in March, and is still in an obvious down trend, but Friday’s $51 increase in the spot price is a nice start.

Even better is the action in individual gold stocks, like K.TO – Kinross Gold Corp. , up 28% on Friday. That’s more like it. Most impressive is that the Kinross chart is different than the gold chart. Gold is still in a downtrend, but Kinross appears to have broken the downtrend, which is a very positive development. I’m not selling.

Interestingly, every gold stock is not the same.

ABX.TO – Barrick Gold Corp. had an even bigger gain on Friday, up 32% on the day. However, as the chart shows, it’s downtrend from the summer remains in place, so all is not perfect, yet. We could still be experiencing a bear market rally. In fact, by definition, that’s exactly what we are experiencing.

Let’s take a closer look at the numbers. Specifically, let’s take a look at my gold and silver holdings, and compare their closing price today to their closing price on October 31, 2008:

The table tells the tale: The major gold producers have done well, the big silver producers have done o.k., and the small silver guy (Silver Wheaton) went down.

This makes perfect sense to me. The market is tanking, so if I want to use gold as a safe haven, I’m not putting my money in the little guys; I’m putting it in the big, safe guys, and that’s exactly what happened.

What To Do From Here

My plan, for your consideration, is as follows:

First, I don’t believe all is good with the market.

Clearly the DOW is back to the bottoms of September, 1998 (7,795) and September, 2002 (7,528). The bottom on Thursday was 7,553. The optimist would tell you to look at the uptrend line (the blue line on the chart above (you can click it to enlarge it); extending back to before the 1987 crash the uptrend line is still in place, so we are simply in a huge correction within a long term bear market. The optimist would also tell you that we are at a triple bottom, which is very strong support, so we should rally from here.

I don’t believe it. The DOW was over 14,000 last year, and it fell to under 8,000 this week. A drop of almost 50% is not a correction in a bull market; that’s a bear market. We have violated the 1998 lows from ten years ago; that means the gains of the last 10 years are gone; that’s not just a correction. That’s a bear market.

Therefore, my plan is to remain short the market.

I continue to hold RSW – Rydex Inverse 2X S&P ETF, an ETF that attempts to increase by twice the drop in the S&P 500. In other words, a drop of 10% in the S&P should lead to a gain of 20% in this ETF. As the chart shows, it’s extremely volatile (obviously twice as volatile as the market). On Friday it was down over 9%, but there are days when it can be up over 10%. It’s volatile, but it’s a great hedge against further drops, and I’m in the money on it now. It’s currently 20% of my portfolio, so that shows you how bearish I still am.

Second, I’m holding my gold and silver shares, as shown in the table above. I realize we are still in the correction phase of the market. However, as I described in detail discussing gold price manipulation in previous posts, the gold price has been artificially depressed by JP Morgan (to increase their profits on the short side), and JP is working with the government (hence the sweat deal on Bear Sterns) to keep the gold price down, lest the populace realize how bad the situation really is (hint: it’s really bad). If gold was at $2,000 per ounce the talking heads couldn’t show up on CNBC and say “now’s the time to buy”. No-one would buy until a new currency was established.

But, you can only keep the lid on a volcano for a limited period of time. Gold was up over 5% on Friday, finally getting over $800 (intra day) for the first time since October, and actually touching it’s 50 day moving average, also for the first time since mid October. Those are positive signs, that lead me to believe the shorts are unwinding their positions, and are even perhaps moving to the long side.

I continue to expect investors to increasingly take delivery of Comex gold contracts in December (which may even lead to a Force Majeure on the gold market if the gold doesn’t exist in the warehouses to cover the contracts. We could easily see $1,000 or more per ounce by the end of next month, so now is not the time to sell gold shares. (Physical gold bullion isn’t a bad idea either).

That being said, the first wave back to gold shares will be a flight to quality, so the senior producers should increase faster than the unproven juniors. So, I’m in the seniors now (see table above), and will only move into the more speculative juniors once the seniors have had a run.

Could I be wrong? Of course. I’ve been wrong for the past year and a half, which is why my portfolio is down 46% year to date. It’s been a disaster. However, as price deflation ends and inflation kicks in, gold will soar, and there will be serious profits to be made.

Timing wise, I expect continued volatility, but since I don’t know when the explosive uptick will start, I’m staying put. (It may have started on Friday, but realistically a pullback for gold on Monday would be more logical, with the big move upward not happening until December or January).

Finally, I’m keeping a third of the portfolio in cash. If I am wrong, I’d like to have some cash on hand for further bargains. (And yes, I believe we will see Dow 5,000 before we see Dow 11,000).

That’s the game plan, so please continue to post your thoughts on the Forum; we’ll chat again next week.

It seems Bart has found the right formula for making money, as many a Springfield kid is in the Simpsons basement, shelling out big bucks for the spectacular Super-Barto Jackpot Drawing.  Tennis balls, baseballs, and the occasional apple are all stuffed into the dryer machine, today’s boy’s cheap alternative to a drawing machine. But all dryers have their limits, and this one starts rattling wildly out of control.  Bart leans over the dryer to reach the “Off” button, but doesn’t succeed.  The dryer is pulling the gas conduct as far as itcan go, and it quickly snaps, turning the gas dryer into a flame-thrower. The kids scale the stairs in terror.

“No refunds, force majeure, read the back of your tickets.”– Bart Simpson

The world keeps getting scarier and scarier. Last week I wrote, extensively, about why gold is falling, and why gold will spike up in November. So far, my prediction is looking completely wrong. Of course, I’m looking wrong only if you believe things will get better, soon.

It looks to me that the world is getting far worse, not far better.

Thanks to yellowcaked (a.k.a. “The Chairman of the Board”) over on the Forum for this link to a story on Gold Price Manipulation by Rob Kirby. I suggest you all take five minutes to read the article.

I’ll wait.

Now that you are back, if I may summarize what you just read, it goes something like this: Bear Sterns was “long” on gold. They were holding around $12 billion worth of long gold futures, betting that the price would go up. On the other side of the table was JP Morgan Chase, who were betting on a decline in gold, and therefore had billions of dollars of short derivative contracts.

On the weekend of March 15, 2008, with gold trading above $1,000 per ounce, the take out of Bear Sterns was arranged, and JP Morgan got to see their books, where they discovered the huge Bear Sterns long position. So what does JP Morgan do? They “fire bomb” the price of gold, (by either buying more shorts, or selling long contracts) driving the price of gold down by $100 from March 17 to 19. As a result of this drop, the book value of Bear Sterns’ long position drops by millions of dollars (probably over a billion, actually), putting them in an even weaker position for the take over that finally happened on April 8, 2008. Of course it also made JP Morgan’s short positions even more valuable.

(Last week I included a link to the Office of the Comptroller of the Currency and the June 2008 report (here’s the pdf link; look on page 29, in Table 9 where we could easily see that, yes, in fact, JP Morgan controls a huge amount of derivatives in gold).

So, why is it that physical demand for gold is going through the roof, but the paper price has been dropping since March? Could it be the billions of dollars of manipulation introduced by JP Morgan?

Could be.

There are two schools of thought on what the future holds, summarized as follows:

1 Everything will be fine. The USA is the economic engine of the world. Americans invent more products, and consume more products, than anyone else. The USA is also the police force of the world, so long term the USA will be in great shape. The events of the past few months are just a temporary set back. This market bottom is a great buying opportunity, so start buying.

2 The world is ending. Well, not actually ending, but the financial world that we knew and loved is being drastically altered. Some exhibits in support of this theory:

First, thanks to yellowcaked for this link to an article from the Jim Willie newsletter. I’ll let you read the entire article; the grammar and writing style is not great, but I agree with his main point: paper currencies are dying, eventually to be replaced by a currency backed by gold.

Second, thanks to whatsupdoc for the link to the Brokers With the Hands on Their Faces Blog. You know things are bad when every newspaper and on-line news source has to run a picture like this every day.

Third: Okay, enough goofing around, the real argument that proves that we are in bad shape is the disjoint between the price of physical gold and the price of “paper” gold traded on the Comex. We discussed gold lease rates and physical gold last week, so I won’t elaborate again. However, let’s cut to the chase:

The price of gold and silver has been falling since March, and yet if you actually go and try to buy physical gold and silver, supplies are very short. I’ve tried, in numerous different places. There is some supply available, but not much. Back on October 4 I reported that there was virtually no silver available at Scotiabank in Toronto; I wanted to buy 100 silver one ounce Maple Leaf coins, and they would only sell me 25 of them, for a total purchase of only a few hundred dollars.

In other words, the laws of supply and demand don’t seem to apply; even with no supply, the price is going down.

Of course we know that is not the case. The price of the physical metal is going up. On eBay or in any coin shop you will pay a significant premium over the spot price. Now here is the kicker:

If I can go and buy a contract for the delivery of 1,000 ounces of silver on the COMEX for $9.40 per ounce, and take delivery and sell that 1,000 ounce bar at my local bullion dealer for say $11 or $12 or $15 per ounce, why wouldn’t I do that?

I would. It’s called arbitrage, where you can buy something in one market and sell it in another.

In the past, it has never made sense to take physical delivery of a 1,000 ounce bar of silver, or a 400 ounce bar of gold. You would need to arrange transportation, insurance, storage in a secure vault, and then perhaps pay assay charges when you went to sell the metal. It’s much easier to simply sell a paper representing the underlying asset. No storage. No insurance. No delivery costs. Simple. And that’s exactly what’s been happening. Traders have sold the paper.

But what happens when someone, who understands arbitrage, decides to actually take delivery of the metal?

And what happens when there is no metal to deliver?

You see, my friends, the only way JP Morgan and the other big boys could have crashed the market, is by selling short product that they don’t actually have. As long as no-one asks for the product, the game is on. But as soon as someone asks for delivery, the gig is up.

John Embry of Sprott Asset Management stated on BNN (the Canadian Business News Network) on October 21, 2008 that he believes many investors will take advantage of the arbitrage opportunity, and start taking delivery, probably with the December contracts. If a significant number of contract holders elect to settle in physical metal, there will not be enough metal in the vaults to meet demand. (You can watch the clip on BNN; start watching at around the 13:50 mark).

He believes the exchange will have to declare force majeure to prevent disaster. In other words, the market will say “sorry, we don’t really have your gold and silver; due to exceptional circumstances, we will allow the contracts to settle in cash, not metal.”

And guess what an admission that there is no metal will do to the real price of gold and silver? It will make it go through the roof. Which is why I continue to believe that November or December will be a great month for gold or silver.

Bart Simpson had to declare Force Majeure when his little scam blew up, with disastrous consequences; the explosion of the COMEX will be similarly deadly.

So I will repeat my plan: I will continue to buy whatever limited amount of physical gold and silver I can (and store it in a bank safety deposit box or other secure facility; I have no intention of keeping it at home). As an aside, Sprott Money is selling physical metal; this may be a great solution for Canadian buyers.

I will not sell any of my gold stocks. I’m not buying more now, but if we keep having down weeks the temptation will grow to average down. I have sold November calls against the gold stocks I own, so that if prices do drop further I will at least pocket the premium.

I will keep holding my RSW – Rydex Inverse 2X S&P ETF, which so far have been great insurance against the crashing stock market.

The rest of my money will be kept in cash.

It’s a simple plan, that will either work out brilliantly, or be totally wrong if the governments of the world keep propping up the markets. Time will tell, but I believe time will tell soon.

As always, thanks for reading, and feel free to respond below or on the Forum.

See you next week.