What happens now that the U.S., the world's superpower, has launched an unprecedented and unlimited bond buying program called QE3?

The Aftermath

Years from now we'll feel the dramatic effects of the aftermath caused by the Fed's actions.

A rampant uproar in inflationary pressures is likely to occur and will be combated by a quick and massive increase in interest rates - just like in the early 1980s where Fed Chairman Paul Volcker imposed extremely high interest rates (the fed-funds rate touched 22% in July 1981), to beat out stagflation (a period of high inflation, slow economic growth, and high unemployment.)

To prevent their currencies from falling further, foreign central banks were forced to sell dollars and let their domestic money supplies contract. The aftermath was an extremely overvalued dollar.

While stagflation was defeated, the combination of high interest rates, an overvalued dollar, and large fiscal deficits caused a sharp increase in the U.S. trade deficit. This eventually led to the world-wide recession of 1982-1983 (see America's Gold Wiped Out.)

No Other Choice

The only foreseeable way to avoid the above scenario is a sudden and massive sustainable increase in jobs.

But there's no way that will happen (see A Really Big Problem.)

What to Do?

The easy answer is to invest in gold, silver and related stocks (and other hard assets such as fine art, collectibles, and real estate.*) But that also doesn't mean you should do this forever, as most gold bugs will tell you.

(For Canadians, this will not be the case in the short term as housing prices in Canada have yet to crash and remain at levels with little upside. However, we're finally seeing decreases in both prices and demand. Eventually, overall real estate in Canada will make sense as an inflation hedge - but not yet and not for a while.)

I am not a gold bug. I simply invest in bull markets and strong fundamentals; gold has both (silver does too.)

When the Fed finally decides it needs to curb runaway inflation, as it did in the 80s, that's when you sell your gold and gold stocks. Of course, you will eventually buy them back at much cheaper prices.

(Those who say, "Never sell your gold," will never make money investing in it. I am an investor and that means I invest to make money. You don't make money if you don't sell.)

But don't worry; we still have a long, long way to go before that's happening. We're nowhere close to explosive inflation yet and it will be sometime before we experience it (see It's Time to Get Stinky.) Housing prices in the US remain subdued and economic conditions around the world remain weak.

However, once global growth begins to accelerate and capacity utilization increases, economic bottlenecks will cause the price of inputs, such as energy, to rise:

There will then be another inflection point when countries will realize that by allowing their currencies to appreciate, reduced import prices will spur productivity and domestic growth. This will happen when it becomes apparent that the savings resulting from lower input prices exceeds the export losses associated with a stronger currency. Though the timing of this event is difficult to forecast, its occurrence will likely cause Bretton Woods II (our current monetary system) to collapse. - Scott Minerd of Guggenheim Partners

By then, gold prices will be so high it wouldn't matter - those invested in the right gold and silver stocks will have made a ton of money in the process.

When Will Gold Stop

The real answer is never. It will always climb - just like everything else (well, except for currency.) However, there will be long periods where it does nothing. Now is not one of them.

At the beginning of 1970, gold was trading at $35 (under Bretton Woods). As soon as the United States unilaterally terminated convertibility of the US dollar to gold, gold has never looked back. By 1980, gold had shot up to over $800 and never dipped below $250; that's a rise of 2185% and 615% respectively. While gold took a dive following those years, its price floated at a much higher base level than ever before.

Source: Usagold

Even under Bretton Woods, countries fought for currency stability and pegged their currency to the dollar - much like they do today. As I mentioned before, when the US prints, so does the world. The more money is printed, the higher the price of gold will go. It's not rocket science.

A lot of things need to happen before gold's current rise stops and turns stagnant. We'll need a strong recovery in the economies of the world, we'll need a higher dollar, and we'll need much higher interest rates. Furthermore, these all need to come together in unison to seriously curb the price of gold. I don't see that happening anytime soon.

That means gold will go much higher.

As Scott Minerd of Guggenheim Partners had noted:

"The U.S. gold coverage ratio, which measures the amount of gold on deposit at the Federal Reserve against the total money supply, is currently at an all-time low of 17%. This ratio tends to move dramatically and falls during periods of disinflation or relative price stability. The historical average for the gold coverage ratio is roughly 40%, meaning that the current price of gold would have to more than double to reach the average. The gold coverage ratio has risen above 100% twice during the twentieth century. Were this to happen today, the value of an ounce of gold would exceed $12,000."

Will we see $12,000 gold? Maybe. Not soon, but a strong possibility in our lifetime. But we wouldn't need that to make our fortunes in gold.

As a matter of fact, we simply need gold to inch up a few hundred dollars before certain gold stocks take off.

Gold stocks have recently outperformed gold for the first time in years (see A Really Big Problem.) When gold decides to make its move, I believe we're going to see gold stocks once again take centre stage in a big way.

Of course, I wouldn't invest in just any gold stocks. There are thousands of them, many of them garbage, and they're all vying for your money. So which ones deserve it?

Narrowing Down the Playing Field

Over the past year, 3 of the 4 stocks I covered have climbed significantly since my initial report*. That's because they all fit in one of the following three categories:

1. Producers that are increasing production and decreasing costs, while lagging in price when compared to peers (Timmins Gold, up 23%*)
2. High grade explorers next to producing, or near production, mines that are takeover targets (MAG Silver and Balmoral Resources, up 43% and 70% respectively)
3. Near term producers with strong Preliminary Economic Studies and blue sky, take-over target potential.

So far this year, I have covered companies in categories 1 and 2. That means I am now looking for a company in category 3.

I just came back from a site visit last week to look for just that. And I think I have found it.

This company has:

• Strong capital structure (no warrants, ever) with a low float
• Excellent infrastructure; next to a major highway, power, and experienced local workforce
• Minimal production start-up costs
• Initial PEA highlights a payback period of just over one year (1.2 years) with current gold prices and 1.7 years at $1500 gold.
• A new high grade gold-silver vein discovery that is attracting the attention of majors in the area

Of course, none of the above criteria would make any sense if their management team wasn't top notch. Any company I invest in needs to be meticulously managed, with a team proven to make money for shareholders.

Just a few years ago, this same team was able to raise over $250 million for their last company. They also turned their previous $1 stock to over $10 in less than two years. Now they're onto a new near-term production project.

If everything checks out, be prepared for one of my last company reports this year; I cover no more than 6 companies per year.

Make sure to check your emails next Sunday.

Until next week,

Ivan Lo

Equedia Weekly