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The Truth Behind the Gold Crash

Were Terrorists Short Gold?

Written by Briton Ryle
Posted April 17, 2013

It was the biggest decline for gold prices since 1983. And the conspiracy theorists were out in force.

Some said it was Bernanke, pushing gold prices lower to prove that money-printing doesn't create inflation and weaken the dollar...

Others said it was an attack by investment banks like JP Morgan (NYSE: JPM), who are always thought to be covering a massive short position on precious metals...

Still others suggested that a hedge fund or two was going down, dumping gold for whatever price it could get...

If I had to pick a conspiracy, I'd say that whatever wing nut terrorist group is responsible for Monday's horrific bombing in Boston had a financial motive in addition to a perverse political motive. Bombs going off during a stock market rout just seems like more than coincidence. After all, there were large short positions on airlines before 9/11...

Still, Goldman Sachs (NYSE: GS) says the gold sell-off was sparked by fears that Cyprus was going to sell all or part of its 13.9 tons of gold, and that other indebted EU countries would follow suit.

And let's not forget that just last week, on April 10, Goldman made an aggressive call for gold, saying the bull cycle for gold was over and that investors should go so far as to short gold.

So, what's the truth behind gold's huge drop?

I don't know. And we may never know. But my heart goes out to the victims and their families, and I pray that they weren't the victims of a twisted profit scheme.

Personally, I don't like to believe in conspiracy theories. It's times like these I consciously try to put reason over emotion. I fall back on something my dad used to say: "If you hear hoofbeats... think horses, not zebras."

How Quickly We Forget

Yeah, my dad had some pretty colorful expressions. One time on the golf course, he told me I “knocked the pea-waddin' out” of the ball. I still don't know exactly what that one means. He said it was pretty common where he grew up in North Texas.

But the “think horses” one is a variation of Occam's Razor, that the simplest explanation is usually the right one.

I read that a guy named John Kemp from Reuters calculated that based on a normal distribution, you would expect to see movements like Monday's gold sell-off only once in every 500 million trading days — or two million years.

OK, that's a nice statistical argument. But Mr. Kemp makes a fatal assumption — that is, he says, “based on a normal distribution.”

Um, I don't wanna burst anyone's bubble (pun intended), but markets are not normal, rational, or predictable.

Was it rational for Starbucks to trade down to on $7.83 a share on November 17, 2008? Microsoft was worth about $150 billion in March 2009, and it had $75 billion of that valuation in cash.

Financial markets are emotional and irrational. That's especially true during sell-offs.

And the gold market may be the most emotional of any market out there.

No one has expressed the reason why better than Warren Buffett:

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobil (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers — whether jewelry and industrial users, frightened individuals, or speculators — must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Buffett likes things that create value. And the bottom line is it's people that create value — by creating new products or services, planting and harvesting crops, drilling for oil, and yes, mining gold.

Now, I'm not saying that you shouldn't own gold... You should. It's an asset like any other.

But let's not kid ourselves about intrinsic value. There's no proven formula that says QE + inflation = $2,000 an ounce for gold.

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Buy Value

Today the United States is enjoying a massive boom in oil and natural gas production. Oil imports have been cut dramatically. And we are on the verge of being completely energy independent in just a few short years.

And the reason is human innovation has made previously unrecoverable oil and natural gas accessible. In other words, we have created value where there was none.

Consider that just a few years ago, North Dakota's Bakken Shale Oil field was thought to have only one or two billion barrels of recoverable oil. Today insiders believe the Bakken may contain 28 billion barrels of recoverable oil.

Technological innovation turned the Bakken from a curiosity into a veritable goldmine. And it's doing the same thing for other American shale oil fields...

Investors stand to make boatloads of money as these “oil-tech” companies bring previously unrecoverable oil to market.

One such company was trading around $27 a couple years ago — before it made a huge run to $180 a share. Another pioneering “oil-tech” firm traded as low $3 a share in 2009. It was eventually bought out at $35 a share.

That's just a sample of the kind of gains some of these “oil-tech” stocks are making.

And these profits are not based on hope, fear, or any other emotion; they are based on oil prices and earnings.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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