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Why GOLD Crashed

How Well Do You Know Commodities?

Written by Briton Ryle
Posted April 24, 2013

“Buy what you know.”

Peter Lynch got to know Fidelity's president while he caddied for him from 1958 to 1966 at a Massachusetts country club. After finishing college on a caddie scholarship, he started at Fidelity as an intern.

Just 11 years later, at age 33, Lynch took over the Magellan Fund, which had $18 million in assets...

One of his first stocks was Taco Bell. By the time Lynch resigned as a fund manager in 1990, the fund had grown to more than $14 billion in assets.

Lynch averaged a 29.2% annual return, one of the best performances in history, because he bought what he knew.

Peter Lynch was among the first to try to demystify investing for the individual investor. And his simple advice helped people get into some of the best stocks of the last 20 years...

Buy companies with products you know, that you buy — like Johnson & Johnson (NYSE: JNJ) or Disney (NYSE: DIS); McDonald's (NYSE: MCD), Starbucks (NASDAQ: SBUX), or Wal-Mart (NYSE: WMT).

Sometimes, it's tempting to look at commodities the same way: stuff you can hold in your hand, that we make things out of, that we use.

We all put gas in our cars, so there's ExxonMobil (NYSE: XOM). We get that new buildings require steel and copper, so it made perfect sense that China's building spree would push a great steel company like Nucor (NYSE: NUE) to $75 a share, or copper giant Freeport-McMoRan (NYSE: FCX) to $60.

Even commodities like gold have a certain familiarity. It's easy to see why coins are collectible. And in this age of devaluation, it's almost reflexive that gold should be a store of value.

But unlike consumer products and services, commodities aren't always as friendly and approachable as they seem...

Gold's Wake-Up Call

On Monday, April 15, gold prices crashed 9% — more than $140 an ounce. That was after a +$50/ounce drop the previous Friday.

How could that be?

In an era where just about every central bank is competitively devaluing currency... where the Fed and the Bank of Japan are openly inviting inflation... how could gold prices possibly crash?

The simplest reason is maybe we don't know gold (and other commodities) as well as we think we do. 

The day gold plunged, China reported that its economy grew 7.7% in the first quarter. Analysts were expecting 8%.

Now, I'm sure if the U.S. economy was growing like that, nobody would worry about that missing .3%. But it's different for China. China's +10% growth has underpinned a large swath of the global economy for more than a decade.

Commodity exporters like Brazil, Australia, Peru, and many African nations are highly dependent on China. They suffer if China slows, even a little. But that's the problem: We don't really know how much China's economy is slowing.

It's pretty much common knowledge that China's economic numbers are part fact, part fiction. However, we can look to some other numbers that aren't fiction.

Like copper prices. Copper prices fell 1% yesterday to the lowest level since October 2011 after China's manufacturing numbers came in week. China uses 40% of the world's copper supply, and prices are down 13% this year.

Zinc (used to galvanize steel prices) prices are down 10% this year. Nickel (in stainless steel) is down 11% and tin is down 12%.

Spot coal prices at the Chinese port of Qinhuangdaoin fell to the lowest level since October 2009 as the rate of electric power output growth slowed.

Commodity prices suggest China's economy may have slowed a lot more than the latest “official” numbers suggest.

But what's that got to do with gold?

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The End of the Commodity Super Cycle

On Friday, April 12, the global head of commodity research for Citigroup's Citi Research, Ed Morse, proclaimed the end of the commodity super cycle:

The second quarter should provide another affirmation that the so-called commodity super cycle has finally ended and should usher in the first ‘normal’ year in over a decade in which, broadly, commodity prices end the year lower than when the year started...

Shifts in underlying investment patterns in China and other emerging markets are a critical source of change for aggregate consumption as China and other (emerging nation) growth shifts from more commodity-intensive fixed asset investments and industrial production growth to household-based and service sector growth.

For the next few years, each commodity looks more likely to be sitting on its individual supply/demand fundamentals than on more general factors affecting all of them.

This means that as either their separate long-term and short-term cyclical logistics take over, for some prices will rise while for others they will decline...

Gold is usually thought of as an inflation hedge. In essence, its value stays constant, but as the purchasing power of dollars falls, you get more dollars for your gold.

The scenario Morse is describing — in which commodity prices fall due to lack of demand — is the polar opposite of inflation. Morse is describing deflation.

With inflation, debt is king, because the currency with which you repay debt is losing purchase power. But with deflation, cash is king, because purchasing power rises as prices fall.

Now, this is no guarantee that gold continues to trade lower. But it's a good bet for why gold got such a beatdown last week.

Commodities have been in a bull market since 1999. And most investors have become pretty comfortable with them. But once commodities start turning on investors, we may well wonder if we ever really knew them at all.

My colleague Nick Hodge has found one little-known commodity that's the building block for a powerful new compound that is 200 times stronger than steel, thinner than a sheet of paper, and more conductive than copper.

Nick will be telling you how this compound could revolutionize the tech sector, the defense industry, and the medical field in the coming days... so keep an eye out for his presentation on the 6th element.

Until next time,

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 is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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