Clarification on Alternative Realities

Dear Reader,

It's that time again… the happy emails are filling our inboxes at Casey Research. With gold flirting with the $1,800 mark, it is once again clear that the rumors of gold's demise have been greatly exaggerated. Of course, we're always glad to hear from satisfied customers who are making money on our investment recommendations, but some emails can be concerning. A few subscribers are way over-allocated toward gold.

At Casey Research, we recommend holding one-third precious metals, one-third other investments, and one-third cash. Most people in the industry would consider our one-third precious metals allocation outrageous. Yes, we know that we're pushing the envelope here, but some readers are even outdoing us. I've received emails from some readers who state they're holding from 50% to nearly 100% of their investments in gold, silver, and mining stocks. They're very happy with their holdings because they've made piles of money in the past few years. Of course, I'm happy for them too; but to be honest, at those allocation levels, they're playing with fire.

Gold is probably one of the best investments of the decade and will probably continue to perform for the next decade, but that doesn't mean that there aren't real risks involved. Let's consider a few scenarios:

  1. Is there a scenario where gold could take a serious tumble? Yes; if there's a roaring economic recovery, I'm sure some confidence in world governments might be restored. It isn't entirely impossible to imagine. Maybe the central banks of the world can pump enough money into the system to create another bubble. Perhaps the right-sized bailout could calm the market for a short period of time. I don't think that Washington or Brussels can fix the economy permanently, but perhaps they can kick the can further down the road. Many people thought that it was the end of the road in the late '70s, yet we've somehow managed to last this long. Could we be thinking the same thing in 2020?

As the saying goes, the market can stay irrational longer than you can stay solvent. If the market goes into another artificial boom, investors with 100% precious metals portfolio could take a big hit until the bubble pops again.

In the big picture, the governments of the world are doomed. In the short term, they might have another trick or two up their sleeve. Do I actually think that the economy will suddenly start booming from a stimulus or some European bailout? No. Is there a possibility of this happening? Yes.

  1. Don't forget gold's performance in 2008. Everything was sold off during the crash, including gold. That ended up being an excellent buying opportunity, but remember that even the precious metals are not crash-proof. Even if you don't want to diversify into stocks, hold more cash just in case a buying opportunity opens up. It's always good to keep some money safe for a rainy day – and needless to say with the situation in Europe, the sky is getting very cloudy.
  1. Sometimes mining stocks can be quirky things. For example, in the last few months, mining stocks were lagging gold prices. The miners almost seemed to develop a mind of their own. One can have the best-laid plans in the world, but if the market doesn't it see it the same way, then there could be trouble. Suppose the market develops a much stronger preference for physical gold over mining stocks or vice versa. Where would that put your portfolio? Or suppose institutional players fled the junior miners at the first sign of a crash, abandoning good projects alongside the bad. Would that be a setback for your portfolio or devastation?

During the height of the real-estate bubble, home owners believed that housing could do nothing but go higher. Are we in a similar gold bubble? No, but we shouldn't be as careless as the people who helped cause this crisis. There's no such thing as a risk-free investment. In the housing bubble, it wasn't just home prices that bankrupted investors. – their portfolio allocations contributed as well. They were leveraged to the hilt in real estate. If these same people had spread out their investments over gold and even the stock market or bonds, they would likely have fared much better. These allocations would have made them necessarily more liquid, if nothing else. Instead, they placed all of their assets in one basket.

I'm glad that many of our readers are doing great, and we plan to continue making money with gold for a long time. That said, today is a good day to take a look at your portfolio and see how much is allocated toward precious metals. If you're way over our one-third suggestion and have some profits on the table, consider trimming down. At Casey Research, we're about as bullish as you can get on gold, but we recognize there are other opportunities worth diversifying into, whether it's big-picture investment in The Casey Report, technology in Casey Extraordinary Technology, or energy plays in Casey Energy Opportunities. In short, be bullish, but please don't be reckless.

Next, David Galland adds some additional commentary and clarification to his article from Friday. If you're about to send him an email regarding it, take some time to read this first.


Alternative Realities Redux

By David Galland

In last Friday's edition of Casey Daily Dispatch I wrote an article titled Alternative Realities, to which I would like to add a bit of clarity. The theme of my article was that the exclusively human trait of creating alternative realities, many of which have little or no connection to physical realities, can lead to serious consequences – personally, to societies, and in the squandering of public budgets.

The problem with writing a long article in a single, short day – the case with my Alternative Realities article and most of my Friday postings – is that it leaves no time for presenting a complete dissertation on the topic at hand. As I have received a number of emails from dear readers and friends in response to the article, I want to correct the record.

First and foremost, allow me to state unequivocally that it was not my intention to dismiss the unique human tendency of creating mental constructs and acting on those constructs as being a bad thing. Far from it.

In the arts, for example, the greatest joy to the aficionado comes from seeing something in the work that he can relate to in a very individual and personal way – something that resonates, that moves and inspires. Therefore, while one man might view a stack of wood on the floor of a museum and think it was left there by an inattentive construction worker, another might experience an upswell of emotion at the stark symbolism of man's hardwoods holocaust.

Likewise, much of the entertainment value that comes from reading a good book, or watching a good flick, comes from the anticipation that the work is going to proceed along a path invented in the mind's eye, or from being pleasantly surprised when it does not. Another fellow, however, may have been anticipating an entirely different twist of plot and be disappointed.

In the sciences, the value of imagining – expressed by creating hypotheses to be tested – is a powerful and incredibly positive force. In fact, it's the essential spark that sets off the scientific process and allows for human progress. This applies to medicine as well, though I remain a skeptic about much of what is routinely passed off as "alternative medicine." Search "natural cures for cancer" on the Internet and you will be greeted with 2,530,000 results. While there could be an efficacious cure among the sea of listings, absent a serious and rigorously meticulous scientific evaluation, what you are mostly left with are fantasies, fictions, and deliberate falsehoods of the sort that have been peddled off the back of wagons since the invention of the wheels needed to roll said wagons from village to village.

(For more on serious breakthroughs now in the works on curing cancer, check out The 'Curing Cancer' Portfolio from Casey Extraordinary Technology.)

I could go on, but hopefully that will clarify my views, if for no other reason than to head off a lot more emails pointing to those omissions, among others.

Summing up my view, it is that we need to understand how malleable our human perceptions of reality are, and make sure that when it comes to taking or advocating actions with real consequences – whether destroying the Constitution and bankrupting the country in the hunt for a small gang of Islamic malcontents, or evoking any one of a thousand new "perfect-world" regulations – we first should don our skeptic's glasses, the better to look through the imaginary trees to the forest as it actually is.


Additional Links and Reads

Congress: Trading Stock on Inside Information? (60 Minutes)

This 60 Minutes segment on Congressional insider trading is simply outstanding. However, I would like to correct it on some points. The video points out that some Congressman made trades after negative briefings with the Fed. That part might not be so bad. After all, consider who was running these briefings – the same people who said that everything was fine only a few years ago. If one had acted on Bernanke's past advice, one's portfolio would be nothing to brag about. At the end of the day, you're hearing someone's opinion about the market.

However, purchasing shares of healthcare or insurance companies right before a vote on a major health care overhaul… well, that's something entirely different.

While this story covers Congress, think about everyone else getting rich from this information – from staffers to relatives to just random residents of D.C. One really doesn't have to be far on the inside to acquire tradable knowledge. For example, when I worked in D.C., I had a pretty good idea that the first bailout vote was not going to pass.  Remember the one where the market fell over 700 points in a single day? I was just a lowly intern at the time, but still I could gather enough information to understand that the panic on the Hill was much worse than what CNN was reporting at the time. If the information leaks that far down, just think about how much money is being made up there.

Italy Obsessed by "Lo Spread" as Yields Surge (Bloomberg)

I wanted to link this in reference to a recent reader question. The reader asked, "Back around 1983-4 Canada Savings Bonds were paying 14% interest. Today Italian bonds are paying 7%. Were things much worse back them? Or maybe I should ask, What's the big deal?" The Italian obsession with the spread between Italian bonds and German bonds deals with this issue.

The interest-rate level itself can't tell us much. It's the inflation rate and the risk premium that matters. For example, when inflation expectations are very high, bonds must pay higher rates to compensate investors. Otherwise, bond investors would make negative real returns. On top of inflation, the market charges a risk premium on any bond – this is what really tells us the condition of the country in question. The risk premium is the difference between the return on the safest investments to the bond in question after inflation has been considered. That's why the Italians are obsessed with the spread between German bonds and Italian bonds.

By looking at a historical interest rate, we can't immediately say that we were worse off in one period than another. We have to consider differences in inflation and the risk premium. Inflation expectations can push yields very high while the risk premium might be extremely low. A good example of this case is the US 10-year note with 12% and 13% yields in the '80s. The case with Italian bonds is almost the exact the opposite; they have low inflation, but a very high risk premium. So while 7% doesn't sound like much compared to 13% interest back in the '80s, the fact that the higher rate is almost all risk premium is very concerning. If inflation expectations were the same today as they were in the late '70s and early '80s, Italian bonds would be through the roof – much higher than that 14% with the risk premium added on top of the inflation expectations.

Jobs, Economy Remain Dominant Concerns for Americans (Gallup)

I've often heard the phrase, "War is the health of the state." I'd like to make an addition to this statement: Recession is the health of war. According to this poll, the wars are way down the list of important problems for most Americans. Of course, that's for good reason with the recession still in full swing, but still it's amazing how far the topic has dropped.

Another interesting poll result is the low concern for inflation. Only 3% consider it a problem. Sure, maybe at the moment, it isn't so bad, but all that money-printing won't come without consequences. Looking at this poll, I'm afraid that a lot of people will be caught with their pants down when inflation really starts kicking in.

That's it for today. Thank you for reading and subscribing to Casey Daily Dispatch.

Vedran Vuk
Casey Daily Dispatch Editor

Nov 14, 2011