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The Madness of Crowds: How to Play Bonds, China, and Gold in 2012

Yes, I know that markets are irrational.

I read Charles Mackay's 1841 classic, "Extraordinary Popular Delusions and the Madness of Crowds" long before it ever became fashionable.

Even so, when you think about it, 2011 must set some kind of record.

As investors, that means we need to decide whether this madness will continue in 2012 and which direction to take.

Take the madness in the bond world, for instance.

Long-term bonds of a country with an out-of-control budget deficit and a worrying trade deficit are currently yielding 1.6% below inflation.

In other words, year after year, investors are willing to pay 1.6% of their capital to hold them. On top of that, investors have been so keen on this miserable asset in 2011 they have bid up its price by no less than 26%.

Conversely, China is revolutionizing the world economy.

Year after year, China puts up growth rates of 8% or more, and the latest data suggest that will continue throughout 2012.

What's more, Chinese stocks stand on a bargain-basement price-to-earnings (P/E) ratio of less than 8-times earnings. Yet, in 2011, investors shunned these bargains, giving the Chinese market a pathetic return of minus-22%.

It is Madness I Tell You

Do you see what I mean when I talk about irrational?

To a Martian, these statistics would be proof that earthly markets had lost their collective minds. That's not just a random walk – it's a deliberate stroll that will destroy your wealth.

For investors, it raises the question of how long this irrationality is going to last. Will this extreme irrationality persist in 2012, or will it reverse?

The first conclusion to be drawn is that current markets are unhealthy, and largely the product of government meddling.

Western governments have been pumping money into the global economy since 2008, and running budget deficits larger than ever before in peacetime. Meanwhile, the Chinese government has been engaging in massive "stimulus" itself, but financing it through the banking system.

When you look at current markets as massively distorted, the right conclusion becomes clear: Treasury bonds are a bubble, inflated by massive money printing worldwide and the troubles in Europe.

And while they may have done well in 2011, they are likely to reverse sharply sometime in 2012. Therefore, Treasury bonds should be avoided at all costs.

As for the Chinese economy, it is facing severe headwinds due to massive problems in the banking system that will make some kind of crash and recession inevitable.

The Bright Spots are China and Gold

However, the latest data from behind the Great Wall is still encouraging. China's purchasing managers' index in December ticked back up to 50.3 from 49 in November.

If that were a U.S. index, it would suggest the economy was just barely expanding.

However, according to The Economist and Goldman Sachs Group Inc. (NYSE: GS) analyst Yu Song, the Chinese index is mis-calibrated – a "break-even" index of 50 actually corresponds to industrial production growth of about 10% per annum!

The index would actually have to fall to 44-45 before zero growth was reached and it's currently well above those levels.

That suggests Chinese growth may slow, but will likely continue in 2012 at a rate that would be a roaring boom by Western standards.

Even still, investors looking to invest in China should avoid the banks, and other sectors such as construction and automobiles that depend on bank finance.

However, a modest investment in basic consumer sectors, such as food processing and clothing, may well make sense. After all, the Chinese economy isn't going away any time soon. So basic goods purchased with cash by the middle classes are probably a good investment area.

Consider China New Born Corporation (NYSE: BORN), for example. The company makes corn-based edible alcohol, a key ingredient in the Chinese drink of baijiu.

Since Chinese consumers pay cash for their booze, they may tend to drink more, as Americans once did during the Great Depression. China New Born Corporation is currently priced on a 1.6-times earnings multiple and at 43% of book value, as if it was a swindle. But the reality is the company was brought public properly with Goldman Sachs as the lead, so is likely to be on the up-and-up.

For those who don't want to speculate on the proclivities of Chinese drunks, there's always gold.

It may have fallen out of favor recently, as T-bond prices have soared even higher, but it looks a much better safe haven to me.

U.S. Federal Reserve Chairman Ben S. Bernanke has said he's not increasing interest rates until the middle of 2013, the Bank of England has announced a huge new bond buying program, the European Central Bank (ECB) is certainly not going to tighten any time soon and Japan also looks unlikely to do so.

All that money has to go somewhere, and gold looks the obvious beneficiary.

The easiest way to play the bull market in gold remains the SPDR Gold Trust (NYSE: GLD). However, to get a greater upside potential, you may want to consider long-dated call options on GLD.

For example, the January 2014 240 options (equivalent roughly to a gold price of $2,400 per ounce) are trading at $7.70 right now, giving you a big profit if gold trades upwards in a final "spike" to $3,000 or $4,000, as it well may. For instance, on a historical basis, the gold price quintupled in the 18 months between 1979 and 1980.

But remember, as MacKay astutely reminds us, the madness of crowds never ends well.

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Join the conversation. Click here to jump to comments…

  1. Ron Umberger | January 11, 2012

    With your suggestion, what ROI from the 7.70-240 Strike price do you estimate. Should Gold go to $2400 an oz. in 2012.

  2. Burt Shane | January 11, 2012

    Dear Sir,

    Greetings all the way from Romania into the New Year!

    Decent of you to offer advice on BORN and GLD options. Being new, I am curious:

    – Suppose one buys the Jan14 240 GLD Call, as you suggest at $7.70.
    – Suppose by good fortune, gold hits 2000 by end 2012. (Would that be equivalent to GLD at 200?)
    – If so, where would you expect the price of this option to be at that point?

    Burt Shane

  3. William W. Andrews | January 11, 2012

    If someone says a public offering is legitimate because Goldman Sachs was the lead, I can never trust him again! You really think Goldman Sachs was not involved in MF Global?!

  4. Chris Phillips | January 11, 2012

    Investing in GLD is investing in unallocated "paper gold". Not a good idea. Get the physical stuff with no third party risk if you want good long term protection for your wealth

  5. Bob | January 12, 2012

    The important thing is not to be deceived by the data coming out of China. As this article points out, at some time, likely in the not too distant future, China's banking system will blow apart because it contains a huge amount of garbage loans. Other problems are that financials coming out of Chinese companies are not to be trusted. As the saying goes, Chinese corps. keep 3 sets of books, 1 for the govt., 1 for the investors, and 1 for themselves. Also, 1/2 the GNP figures out of China are attributable to infrastructure and construction projects of a dubious productive nature. So real growth maybe? 4% vs. official number of 8%. High time that the financial press aired some of this dirty laundry, although conversely there can be no denying that the Chinese govt. has deep pockets to delay a crash thanks to the offshoring by foreign corps.

    • Ed Invests | January 13, 2012

      I am sure there is money to made in Chinese stocks, but everythiing you say is true. There are many more dogs around in their poorly regulated system. I owned one chinese stock for a couple of years and it went to zero virtually overnight due to falsified financials. I only get bit once. If you are brave enough to enter the Chinese fray, put a sell order on your buy when purchased to limit downside loss, and move the stop point upward with gains….actually good advice for any buy in any exchange. I will never be caught again.

  6. Arthur Robey | January 14, 2012

    Paper gold stocks can be manipulated by JPM. Physical gold cannot.
    Paper is used to manipulate the price of physical gold. This is why gold is down low, but paper and physical will part company if there is too much tension between them.

  7. Randal Racho | March 10, 2012

    I recently unsubscribed to your newsletter. Please resubscribe me. Thank you.

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