The Oldest Hedges are New Again

Back in 2008, after the failure of Bear Stearns and the bankruptcy of Lehman Brothers, the Dow dropped more rapidly than it had ever done before — more than 50%. That’s less than the 80% decline during the Great Depression, but back in 1929, that decline took three years.

The most recent plunge took just 17 months.

Let’s recap…

Lehman Brothers declared bankruptcy on a Monday.

By that Wednesday, over $144 billion had been rapidly removed from money market funds. That’s 20 times more than the average weekly withdrawal.

By Thursday, the panic reached banks, which began hoarding cash in unprecedented amounts. Rather than the $2 billion normally on hand, U.S. banks were holding $190 billion.

Without the participation of these funds, the economy would effectively shut down.

This is the closest the United States has been to an economic collapse… ever.

If this conversation hasn’t already brought back nightmares, then this next part definitely will:

That thing that happened in 2008? It’s going to happen again…

And again… and again… and again.

It might not happen for the same reasons, but it will happen. That’s the cycle of the market.

There are a few things you can do to prepare for impending financial doom. I recommend we all start learning skilled trades so we can barter those services for food and clothing.

(Tip: According to my history books, blacksmiths were one of the most valued figures throughout medieval villages.)

If you don’t have the confidence to work the anvil, there is another strategy. This one has the perk of also contributing to your financial portfolio, even without a financial collapse on the horizon.

Let’s look at the Dow between 2007 and 2010:


Note the dramatic plunge highlighted in grey. That’s the Great Recession.

Now, let’s look at the price of gold during the same period:


Again, take note of the grey area.

The same trend can be seen for silver:


What does this all mean?

People buy up gold and silver during recession. As recession worsens, people buy more gold and silver. Arguably, they buy it out of fear.

There are fears that governments won’t be able to pay off their debts. (These aren’t completely unwarranted; we’re seeing it in Greece right now.)

There are fears about the health of the banking system, about the decline in the value of assets.

There are fears about the stability of the paper dollar, particularly that the dollar will return to its intrinsic value: nothing.

(Let’s all remember that money is paper. There are reasons certain pieces of green paper are worth more than other very similar pieces of the same kind of paper: Money only has the value we attribute to it. That value is volatile, especially under financial stress.)

You might have some of these fears.

So in the face of systemic collapse, the general strategy is to seek out more stable stores of value to protect your principal.

Enter: Silver and Gold.

Aside from the price drop in October 2008 during the deepest depths of the recession, gold prices continued to rise into 2009, gaining about 25% by the end of the year.

The same occurred for silver — the price fell dramatically in late October to below $9.

But by the end of 2009, silver prices reached $14.67, the second-highest average since the high reached in 1980. During the same period, gold prices jumped from less than $900 per ounce to $1,200.

Drivers of the price of gold are macro rather than micro. Gold lacks the strong link to the economic cycle that other commodities have. Gold prices are driven more by economy-wide interest rates and financial stresses (like the recession) than by the typical variables of supply and demand (number of mines, mine output, etc.). In general, gold is insulated from market volatility.

Right now, JP Morgan has the biggest stockpile of silver the world has ever seen. The financial firm increased silver stores from 5 million ounces in 2012 to 55 million physical ounces now.

We have to wonder if this is in anticipation of another crisis. CEO Jamie Dimon said it himself not too long ago — another financial crisis is coming.

If you, like so many others, are concerned about protecting your savings into the future, gold or silver (or both) should be part of your portfolio.

You can always buy actual bullion bars or coins, but storage can be an issue. Even if you decide to utilize a third-party storage resource, there’s usually a fee depending on the size of the bullion.

You could be like my grandfather and keep bars under your mattress, but I’m sure we can all see the inherent risks there — backaches are the worst.

With bullion, there is concrete evidence of your investment. You can hold it, touch it, sleep on it. In the worst-case scenario, you already have inventory to start your blacksmithing conglomerate. Other than that, though, there isn’t a significant level of utility here.

There are a few other options like ETFs, certificates, and derivatives.

Exchange-traded funds have become increasingly popular in the past decade. ETFs absorb some of the features of mutual funds and some features of market-traded securities and merge the two together. They are efficient and low cost and offer a diverse range of investment choices. Rather than owning physical gold or silver, you are essentially the beneficiary of a debt owned by a trust and backed by its gold or silver.

But we prefer the idea of getting to the source, and that means mining companies.

Investing in mining companies has the highest potential for reward… if you find the right one.

Essentially, you should be “mining” for your mine.

There’s a significant difference between junior and senior mines. There’s also a significant difference between their respective levels of risk. Senior companies are large and well capitalized. For the most part, they have access to large mines that have produced (and will continue to produce) a stable amount of silver or gold each year.

No one is saying you need a PhD in geology, but it’s worth it to do some research into the mining district itself, its historic yields, and the availability of infrastructure in the area.

Has this district shown stable production? If it’s a new mine, is it near other successful veins?

It might seem elementary, but the presence of roads, electricity, and labor play a huge role in production potential and cost. If a junior mine must establish that basic infrastructure, it will have an impact on the cost of ore mined and the cash generated by the project.