How investors can profit from pessimism with gold stocks

 

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You're no ordinary pessimist: Your idea of a good time is a vacation at a dude ranch with the Four Horsemen of the Apocalypse. Your investment of choice? Gold, which flourishes in times of soaring inflation, war and social upheaval.

Gold prices have been creeping up lately, which means investors are feeling pessimistic, too. If you decide to ride the gold rally, you have three choices: gold bullion, exchange traded funds that buy gold bullion, and gold-mining stocks. True pessimists will stick with the bullion. Those who want to convert fear into dollars should buy gold-mining stocks.

Gold has been used as currency for millenniums. Aside from being scarce (and shiny), it's easily portable, provided you're not buying a house. And when people begin to suspect the value of paper money, they tend to buy gold.

Inflation is the most obvious way that paper money loses value. By most measures, inflation has been benign: The government's consumer price index rose just 1.4% the 12 months ended July.

Wall Street seems to agree, more or less: 10-year Treasury Inflation Protected Securities, whose returns are linked to inflation, currently yield a deflationary -0.65%. The implied inflation rate for the next 10 years, when compared with an ordinary 10-year Treasury note, is 2.3%.

Wait, you say: My gas station is a neon billboard for inflation, and so is my grocery store. That's true. But inflation is largely a result of central banks printing too much money in a rapidly growing economy. Whether you like Fed Chairman Ben Bernanke or not, he doesn't control the corn crop, the amount of oil that comes out of the ground or Middle East politics.

And some of the biggest assets in your life — from your house to your 401(k) to your salary — have likely gone nowhere or fallen in value. And this is why the Fed, as well as the European Central Bank, has been aggressively increasing the money supply and keeping interest rates low. When rates are low, corporations and homeowners can refinance their debt at lower interest rates and have more money to spend.

Those who believe in gold feel that the Fed will not be able to reduce the money supply in time to ward off inflation. If you're worried about hyperinflation — the kind where it's cheaper to burn money than use it to buy firewood — then gold bullion coins are probably your best bet.

Gold bullion coins, such as American Eagles, come in standardized weights and purity. In a pinch, you can cut them in pieces, as people did with Spanish silver doubloons in the 18th century. (It's where the expression "two bits" comes from, as well as the old practice of quoting stock prices in eighths of a dollar.)

The drawback with physical gold is storing it. The safest spot is a bank safe deposit box. If there's rioting in the streets, however, your bank may not be keeping regular lobby hours.

One way around the storage problem is an exchange traded fund that invests in physical gold, such as SPDR Gold Shares (ticker: GLD) or iShares Gold Trust (IAU). The fund buys and sells physical gold, and its share price closely tracks the price of gold. The drawback here: If paper money is severely devalued, stock certificates probably won't fare much better.