Two Ways to Profit as You Stabilize Your Portfolio With Gold

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

There it was again - the inevitable question that I've been getting time and again lately at investing conferences: "Keith, why don't you recommend gold?"

Well, actually, we do - just not for the reasons many investors might think. And certainly not in the way they might think.

Let's me explain ...

The Gold Standard Exits Stage Right

In contrast to what those late-night television spots would have you believe, many studies show that - when adjusted for inflation - the real value of gold has not changed significantly over the past 100 years. That's pretty amazing when you consider that we've experienced two World Wars, the Cold War, two Gulf Wars, as well as countless episodes of inflation, stagflation, growth, and recession along the way.

That's not to say that gold's price never changes. After all, just look at how the yellow metal has performed of late.

In the past, however, gold prices were a lot more stable and a lot of that was due to the fact that gold had a "real value" derived from something called the "gold standard." If that rings a bell, it's because prior to 1971 the world's major economic powers jointly agreed to value gold at a mutually agreed upon price, and currencies were adjusted accordingly.

The bottom line: This underlying agreement meant that when the going got tough, we could buy gold and be confident that we knew what it was actually "worth."

Trading by Fiat

Today, however, the world's major currencies "float" against one another in the open market, so gold pricing is as much a function of supply and demand as it is the result of investor emotion.

That's because governments now rely upon "fiat" currencies - money backed by government promises, instead of by gold - to trade against each other's balance sheets. This means that money is no longer backed by hard assets, but is instead associated with paper money. The term fiat also specifically refers to currency that is not pegged to such underlying assets or precious metals as gold bullion.

Paper money is literally worth nothing - except when it's valued as a means of exchange, backed by a government promise and affected by the supply and demand of a given currency.

Here's how that comes into play.

If there is a large demand for the stocks or bonds of one country, that nation's currency is likely to rise as foreign investors bid for currency to make those investments and to pay for goods and services. In its simplest form, paper money is worth the amount of consumable goods or investments for which it can be traded directly or indirectly.

Where this gets interesting, however, is during times of significant unrest. The world's investors have historically viewed the U.S. government and the U.S. Treasury as the safest alternative, and have therefore "parked" their money in dollars until more certainty returned to the markets. In other words, they may hate our guts, but boy do they love our dollars - particularly when the going gets tough.

By implication, and with speculative issues put aside, buying gold is therefore not about hedging the markets as so many people commonly think. Instead, it's about hedging the falling U.S. dollar. 

Therefore, if we want to own gold, it's prudent to do so in a way that dampens gold's historical volatility by combining ownership of the yellow metal with a steady income stream - such as dividends, or even government bonds.

Two Ways to Hedge Income

One such investment that fulfills this objective is the Prudent Safe Harbor Fund (PSAFX). This fund holds U.S. government securities, as well as the securities of foreign governments whose currencies are expected to appreciate against the declining greenback.

The fund also holds dividend-producing shares of major gold-related companies. Because income-producing stocks tend to be far more stable then other investments during periods of interest-rate stress, both the bond payments and the dividends kicked off by underlying holdings tend to dampen gold's pricing volatility, while still allowing investors to participate in the appreciation.

That may be too convoluted for your tastes, so a more direct route would be to pick up a few shares of the StreetTracks Gold Trust (GLD). It's an asset-backed exchange-traded fund (ETF) that doesn't burden us with physical gold ownership, but does provide us with a direct link to gold's pricing. It's sort of a gold "futures contract" without the burden of forced delivery and required bullion storage. As an added benefit, there's no systemic risk associated with gold mining companies and related investments - after all, those firms have to pay for the same fuel, electricity and inflationary costs we do to get the yellow metal out of the ground.

How much should we buy?

That depends. However, here's something to consider that will probably help you make that decision.

When inflation escalates, gold prices rise, too. But when gold goes up, bonds go down. Therefore, by implication, inflation causes gold to rise and bonds to fall. It's not an exact science, but my research suggests there's a 10:1 relationship here, meaning that for every 10% change in bond prices, there's a corresponding 100% change in gold prices in the opposite direction.

For instance, if you own $10,000 in bonds and $1,000 in gold, and interest rates rise by 1%, your bonds can be expected to fall 10%, or $1,000. On the other hand, under the same circumstances, gold should rise by 100%, or double to $2,000. In other words, gold actually stabilizes the value of your bonds, and protects their income stream.

Assuming this is true and these relationships hold in the future, owning 1% of the face value of your bonds in the GLD ETF should offset the interest rate of your bonds at a time when inflationary pressures are rising.

[For Money Morning's latest investment research report, detailing the outlook for gold and gold prices in the New Year, please click here. The report is free of charge. Watch for other Outlook 2008 stories, an ongoing series currently appearing each day in Money Morning].

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About the Author

Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.

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