Friday, September 29, 2006

>Gold & Hedge Funds

"They are not all geniuses."

That was the verdict from colleague Dan Denning, who is visiting the office this week.

"There are something like 8,000 hedge funds," he explained. "But there aren't 8,000 different trading strategies. Let's face it, these guys all study the same models and same theories."

We were having breakfast together. There, on the table between the toast and the tea, was the subject of discussion: do all these hedge funds and other sophisticated financial paraphernalia really make the world markets more stable?

"No," was our conclusion.

There are two ways of looking at it:

On one hand, some of the brightest minds in the financial industry have been occupied with the task of convincing investors that the proliferation of derivatives and derivatives of derivatives...and derivatives of derivatives of derivatives...actually help make the markets more stable. Investors themselves have noticed a remarkable lack of sturm und drang in the trading pits. The professionals explain that it is because sophisticated; globalized, information-drenched markets disperse risk.

"But they don't really disperse it at all," says Dan. "They aggregate it. They all trade the same things using more or less the same strategies and formulas."

Every hedge fund manager's head pulsates with the same delusions...the same superstitions...the same prejudices...and the same low predilections. Each pretends he is a disinterested scientist, carefully studying the markets with the precision of a Poincare and the intuition of an Einstein. But he is no such thing; he is actually more like a hair-stylist...ready to coif his portfolio to suit the latest trends and fashions. Yes, he makes his customers look like jackasses - for who would really want his money run by a barber?

But at least they look good when they go out in public. And if he charges a lot for the service - 2 and 20 is the going rate - who can argue with it? Hedge funds are a form of conspicuous consumption; lowering the price would destroy the whole illusion!

But now the gumshoes are taking a look at this happy swindle. Timothy Geithner, chief of the New York Fed, seems to have taken up Dan's point. Hedge funds, he says, are a "major risk." The derivatives market may be concentrating risk, rather than dispersing it, he says. He adds that neither hedge funds nor derivatives have "ended the tendency of markets to occasional periods of mania and panic. There are aspects of the latest changes in financial innovation that could increase systemic risk in some circumstances by amplifying rather than dampening the movement in asset prices."

And even the FBI is on the case. The team that J. Edgar Hoover built is worried that hedge funds may be "luring small savers in to risky investments," according to the Telegraph. Chip Burrus, speaks for the
lawmen: "People that aren't expecting to have this type of risky investment in their portfolio end up taking a bath...[they] just get fleeced left and right."

What business it is of the FBI - investors taking losses was never before on the G-men's beat - we don't know. But hedge fund managers - beware!

Soon the Department of Homeland Security may be rounding you up and sending you to Syria for water boarding.

And not a moment too soon.

*** Gold has risen over our $600 target price. But barely. What's ahead for the metal? If only we knew!

So far, there has been nothing unusual about the gold price action. It was under $300 when George W. Bush took office. Since then, it shot up with other commodities - to over $700...far outpacing the returns you were likely to get from any other major asset class.

As gold gathered momentum and press coverage, the need for a correction increased. From $725 an ounce on May 12, the price fell to $567 on June 20th. Since then, it has been up and down and nowhere in particular, 'building a base,' say the pros, for another move upwards. We now may be at the beginning of that next move to the upside.

But this assumes that we are right about the major trend. We judge gold to be in a bull market. For two decades, the price of gold fell. Now, we figure, it is going in the other direction. Of course, it is more than that. A lot has happened during those two decades.

The world's supply of 'money,' debt and credit has vastly increased. By contrast, the supply of gold hasn't even kept up with increases in GDP. And while there is no reason that gold should go up with increases in GDP, credit derivatives, beer or anything else...there is still a tendency for things to go wrong from time to time. And when things go wrong, people begin to hunker down...and wonder what they really have...and what it is really worth. They watch their hedge fund accounts blow up...they see their dollar bills shrink by inflation...they look at the news programs and realize their stocks are only worth a fraction of what they were a few days before...they talk to their neighbors and realize that their house is worth only half what they paid for it. What can they do?

They reach for something solid to hang onto - something real...something that holds up under pressure. They reach, traditionally, for gold.

Gold is not a perfect money. Nor is it a perfect way to store wealth. But its defect in good times becomes its virtue in bad ones. When the going is good, the returns from gold can't match what you get from a heavily leveraged hedge fund or a house in a hot market. But when the going gets tough, gold gets going...and soon passes all the burnt out hulks of hedge funds...and bombed out houses...and worn-out bonds.

We don't buy gold to make money; we buy it not to lose any.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.

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