The Advantage of Gold

The unemployment rate in the US rose to 10.2% in October, which was its highest rate since April 1983, according to figures from the US Labor Department. It rose from September's figure of 9.8%. The economy lost 190,000 jobs in the month. Not so encouraging for investors either. Another sign that the economy isn’t out of the wood. No green shoots either. Green shoots need roots, and those still are missing in this economic climate. The underlying economy is still sick; it cannot provide very much nourishment to resurgent economic activity. Almost all essential “root systems” of economic activity remain impaired, diseased or compromised in some way or another.

The credit crisis seems to have put fear back in the spines... "The 500 largest US companies - excluding financial firms - hold the largest cash hoard as a percentage of assets since 1960. The Wall Street Journal reports, “That cash hoard is nearly $1 trillion, or about 10% of total assets. That was in the second quarter, for which we have full numbers. So far in the third quarter - with 248 of the 500 firms reporting - cash has increased to 11.1% of assets.”

Corporate leaders are becoming attentive to danger, at least for now. The credit crisis seems to have exploded the traditional equilibrium between cash and debt. Of course, this "equilibrium" was no such thing, as corporate cash levels have been perilously low for years, at least in the finance sector.

"Cash is the financial equivalent of a big, soft pillow. It helps you sleep better at night. After the credit crisis turned small balance sheet leaks into lethal holes, executive suites around the country seem determined not to let that happen again.” The Wall Street Journal reports and highlights the case of Alcoa, the big aluminum producer. “It sits on $1.1 billion in cash, up 28% from a year earlier. It cut its dividend, even though it is making money. The CFO said, 'We're just going to be extremely prudent.'”

But there might be another reason they sit on all that cash. "They might just not see many good opportunities to invest in right now. In other words, the piling up of cash in America's corporate treasuries may just mirror the weak economy."

The rise in gold comes as India's central bank does the smart thing. Central banks need reserves. And historically, the only reserve a central bank can trust is gold. Putting US dollars in your vault - instead of gold - is a little like laying in a supply of lettuce to tide you over in a bad harvest year. Imagine what would have happened if pharaoh had stocked up on lettuce instead of grain? Those 7 lean years would have been a lot leaner than they were. “The Pharaoh was not stupid. He stored up grain for seven years, when the harvests were bountiful. Then, when the seven lean years came he released the grain to the people, in solving the problem.”

The Chinese have seen what happens when one relies on dollars for a reserve. They’re stuck with trust on lies. The Indians are cleverer they buy gold.

Gold has outperformed stocks and bonds this year as it heads for the ninth straight annual gain. The Standard & Poor's 500 Index has risen 15 percent in 2009 through yesterday while returns on the benchmark 10-year US Treasury note are down 5.7 percent.

Gold may average $1,125 in 2010, "with strong investment demand anchored by a negative real-interest-rate environment and probable central bank purchases,"  Toronto’s Desjardins Securities Inc. said in a report.

"Companies that become too big, complicated and debt-ridden should be allowed to 'creatively destruct,'" says Nassim Taleb, author of The Black Swan. Creative destruction often is shared with innovation when something new kills something older, or when a depression takes place.

Taleb likens the process to natural selection. "Why is it that there are no land animals bigger than an elephant?" he asks. "Because nature doesn't permit it. Bigger animals die off. Likewise, the market system disposes of companies that are 'too big to fail.' It gets rid of them."

Unfortunately, says Taleb, “the US government is impeding this natural process. The government is preventing the bankruptcies of large corporations that would clear the way for a new generation of healthier, more nimble, corporate organisms. Furthermore, these trillion-dollar bailouts are polluting the financial ecosystem with toxic piles of debt.”

"We're not destroying debt," Taleb complains. "When you move it into the government, it stays in the government and that's a problem."

An economy is geared to produce for real demand. Or it is misled by artificially low interest rates to produce for a level of demand that doesn't really exist. The deceit can go on for a very long time. But, eventually, some form of adjustment must take place - usually a recession restores order by reducing both production and consumption.