Gaming the System

The other day I took a cab ride to the airport. I was in a great mood before I got in the taxi! I always strike up a conversation with the driver – it’s nice to get the perspective of other people in my travels. He was pleasant enough and talkative too. I quickly steered the conversation away from small talk towards the economy and business in general. He mentioned that he was uneasy about the economy because of all the foreclosures. His business was improving, but he was not quite ready to sound the all clear.

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I asked him about his experience with the housing market so far and how it had affected him personally. To my surprise his tone turned to one of extreme excitement as he recounted his tale.

He bought a house in need of serious renovation in the mid 90s. He paid about $125,000 for the house in a suburb of Washington DC. After putting around $30,000 into the house, he moved in with his family. His payment was around $1,000 per month. During the boom of the mid-2000’s the value of his home soared to almost $500,000. The banks were offering him money left and right to cash out of his mortgage. He did, to the tune of around $200,000. He took the $200,000 and invested it a rental home generating around $2,000 per month in rental income. By this time he had also paid down a good chunk of his old mortgage and now held just one consolidated mortgage with a rate of around 6% on which he was paying about $1,600 per month. So far, I applauded his actions.

Then the crash hit. His home, being close to DC did not really lose that much value, after all DC is about the only place in the country where there is tax payer funded growth. The conversation took a curious turn. What he told me next confirmed my fears that the moral fabric of the US is being stretched to its limits.

A friend of his told him that if he wanted to, he could reduce the payment on his house by $500 per month by doing one simple thing. That “thing” was to default on his mortgage and thanks to the government sponsored rate forgiveness, drop his interest rate to near zero. He checked it out with his lawyers and they concurred. So, he went on to miss a few payments and engage the lender in this program. The lender came back and offered him a 1% rate for the first three years, and then a 1% escalation thereafter for 5 years capped at 4.32%. His payment was lowered to just over $1,000, making him an extra $600 per month.

Now, I was not applauding him. I asked him what he thought if everyone decided to do this? His answer was that no one was losing money and wouldn’t it be better if everyone’s rates were lower instead of all the foreclosures. Of course, that sounds great doesn’t it? Except for one thing. Unbeknownst to him, apparently, was the fact that the lower rate he was paying was subsidized by the government NOT the generosity of the banks. That subsidy was being paid for by people like you and me who are going to be paying more in tax, and by the government printing press. There is no free lunch -except for people who game the system.

Gold’s New High

The printing presses are leaving their mark. Gold has rocketed to new highs above $1,350 per ounce. People are starting to pay attention to something we have been squawking about for eons. Gold stocks are finally starting to rally as well, as people realize that they are getting $1,350 per ounce for something that cost them $400 to pull out of the ground. The XAU index of gold mining is hitting new highs as gold shares, which make up the index, are also rallying.

Some are calling for a correction of around 10% based on the recent run-up. I would view any correction in the price of gold as a buying opportunity. Just to get back to the price it was at its all time inflation adjusted highs from the 1980s, the price would have to exceed $2,200 today. And we are nowhere near that number…yet.

Gold has always been viewed as the ultimate hedge against inflation. But, according to numbers coming out of governments all over the world, inflation is non-existent…what gives? There are two reasons that gold is moving higher. First, it is priced in US dollars and each time the Treasury increases the supply of dollars, something they are very, very adept at doing, the value of the dollar decreases, and the price of gold increases. Second, gold is being viewed as a fear trade. People are still scared of further economic calamity, and for good reason.

Political uncertainty, economic uncertainty, funky behavior in the stock market, fear of terrorism…none of these are diminishing. And, in the midst of the current election season, each party is ratcheting up the rhetoric, scaring people even more.

What You Need to Do

If you haven’t already done so, you need to take a position in gold or gold shares. You may want to wait a few days to do this. Nothing goes up in a straight line forever, and while the fundamentals are intact for a continued bull run in gold, gold shares represent a better opportunity right now. But, they are subject to pullbacks and the vagaries of the market in general. If we do see a pullback in the market or in gold, take the opportunity to buy shares in companies like Goldcorp (GG-NYSE) and Yamana Gold (AUY-NYSE), two senior producers that are undervalued at current levels.

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Best regards,

Kevin Raymond


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