By Terry Coxon, Casey Research

It’s clear to me, even though it may not be clear to you, that unless there is something very unusual about your situation, if you have a traditional IRA, you should pay the tax now and convert it to a Roth IRA. Not just maybe, but definitely. Not just for a small advantage but for a big one. If you don’t convert today, you’ll ultimately surrender much more to the tax collector. You’ll be throwing money away. And you’ll keep throwing it away. It’s a result neither of us wants.

Your IRA is an object in motion, with money going in and out of it and investments turning over inside of it. It lives not just on your brokerage statement but across the years of your calendar as well. That’s why the Roth conversion question can seem so tangled. Because of the time dimension, deciding whether to convert isn’t as simple as deciding whether to replace one stock with another. But there is, as I’ll try to show, a way to look at the question that cuts through the complexity.

Comparisons

With a traditional IRA, you are allowed to contribute $5,000 per year of employment income (or $6,000 if you are 51 or older), and, if your income isn’t too high, you receive a tax deduction for the contribution. Earnings inside the IRA accumulate and compound free of current tax. Later, when you withdraw the money, it comes to you as taxable income (except to the extent of any contributions that weren’t tax deductible when made, which come out tax free).

With a Roth IRA, if your income isn’t too high, you may contribute up to the same $5,000 or $6,000 per year, but none of it is tax deductible. Just as with a traditional IRA, earnings inside the Roth accumulate and compound free of current tax. When the money comes out, assuming you are at least 59.5 years old and the IRA is at least five years old, the money goes tax free straight to your pocket.

Whether traditional or Roth, any IRA’s power to make you richer comes from tax-deferred compounding. Consider a simple example that compares an ordinary, taxable savings account with a traditional IRA. Assume, for the sake of simplicity, that:

• An individual is willing to forgo $1,000 of current spending.
• He’s putting money away for 30 years.
• His income tax bracket (federal and state) during the 30-year period is a constant 40%.
• The before-tax rate of return is a constant 5% per year.

The ordinary savings account starts with $1,000, the amount of current spending the investor is willing to forgo. Given a 40% tax bracket, the earnings compound at an after-tax rate of 3%, so at the end of 30 years, the investor has $2,427 in spendable cash.

The traditional IRA starts with $1,666.67, since, given the tax deduction and a 40% tax rate, that’s the amount that entails forgoing $1,000 of current spending. The earnings will compound at a tax-deferred rate of 5%, so at the end of the 30 years there is $7,203 in the traditional IRA. When the investor withdraws the entire amount and gives up 40% in tax, he’s left with $4,322 in spendable cash – 78% more than if he hadn’t used the IRA.

How does a Roth IRA stack up against a traditional IRA? Redo the calculations for a Roth and you find the same result, to the penny. The Roth starts with $1,000. The earnings grow at a tax-free rate of 5%, so at the end of the 30 years, there is $4,322 in the Roth IRA. And since withdrawals from a Roth can be tax free, it’s all spendable cash.

There is a fourth possibility, which I’ll call a “Lame IRA.” A Lame IRA is a traditional IRA that has been funded with contributions that were non-deductible because the owner’s income was too high. Like the Roth, it starts with $1,000, and at the end of the 30 years the balance is $4,322. But of that amount, $3,322 is taxable when it is withdrawn. After paying tax, the owner is left with just $2,992 in spendable cash. This is the weakest outcome for an IRA, but it still beats an ordinary savings account.

The Free Hand You Don’t Have

A 78% improvement in wealth accomplished with a traditional IRA is a big payoff for filling out a few papers. So if you had a free hand – meaning if there were no contribution limits – how much of your income and assets should you put into a traditional IRA?

Part of the answer is easy: any interest-earning dollar assets (cash, money market funds, T-bills, taxable bonds, etc.) that are part of your overall portfolio should go into the IRA. In your hands, the interest they earn is heavily taxed. Inside the IRA, the interest is tax-deferred. The ideal IRA would be at least big enough to hold all your interest-earning dollar assets.

The same goes for any part of your portfolio that you plan on devoting to short-term trading – trades that you expect to last for less than one year and hence would generate short-term capital gains. Unless you have an unhappy inventory of capital losses, your short-term capital gains will be taxed at the same rate as ordinary income, and they’ll be taxed currently – unless they happen inside your IRA. So your ideal IRA would be big enough to hold all your short-term trades as well.

Longer-term positions are a different matter. Unless your traditional IRA has a long life ahead of it (at least 20 years), you shouldn’t expand the IRA to make room for stocks you are holding for more than one year. Putting those stocks into the IRA risks a reverse alchemy – converting lightly taxed long-term gains into ordinary income.

What about gold? The top federal tax rate on gold profits is 28%, which, depending on your state, gets the bill to, perhaps, 34%. In any case, the rate is less than the ordinary income rate you pay when profits come out of a traditional IRA. So if you are planning to liquidate a traditional IRA within the next few years, it’s not the place to hold gold. But if your IRA is going to stay in business for another decade or longer, you likely will be selling much of the gold and reinvesting in something else, including interest-earning assets and perhaps short-term trades. In that case, yes, the ideal size for a traditional IRA would be big enough to hold most of the gold that is part of your overall portfolio.

So, in general, moving your directly owned assets into a traditional IRA would be to your advantage. But there are limits. Moving assets whose return is taxed lightly could be a mistake.

With a Roth IRA, however, the picture is much simpler. Ideally, if it were possible, all your investments should be wrapped up in a Roth, for zero tax when profits are earned and zero tax when profits are paid out to you. Of course, that ideal isn’t available, but it demonstrates that with a Roth IRA, bigger is unambiguously better. And that gets us closer to answering the Roth conversion question.

Deconstructing a Traditional IRA

Again assume, for the sake of simplicity, that you face a constant tax rate of 40% far into the future. Regardless of how wonderfully profitable the investments in your traditional IRA turn out to be (or how disappointing), and no matter how long the money stays in the IRA, 40 cents of every dollar that comes out will be lost to taxes. You’ll only get the 60 cents to spend. In other words, your traditional IRA is in fact a 60/40 partnership between you and the government.

Now take a close look at your 60% share, which is all you really own. Its returns are free of current tax. And when the partnership liquidates (when money comes out of the IRA), you’ll collect your 60% share tax free. Sound familiar? Your 60% share of a traditional IRA is indistinguishable from a Roth IRA. It is a virtual Roth. And the other 40% isn’t yours at all.

Viewing a traditional IRA in that light, if the government were willing to sell its share and you could use your directly owned (non-IRA) assets to buy it, would it be smart for you to do the deal? The effect of a buyout would be to move your directly owned assets from their high-tax environment into the shelter of a Roth IRA. And we’ve already established that it is always better to have a dollar in a Roth than to have a dollar in your pocket. So if the government invites you to buy them out, you should almost certainly accept the offer.

In fact, the government is making you such an offer right now. It’s called a Roth conversion. Accept the offer. It’s a migration of assets from a high-tax environment to a zero-tax environment. Unless you believe that income tax rates are going to decline drastically, put your wealth on the boat.

Four More Factors

Moving more of your financial life into a tax-free Roth zone is by itself a compelling reason to make a Roth conversion. But there are several more advantages:

Inflation Protection

The years of rapid price inflation that many of us are expecting will increase the value of an IRA’s tax protection. Inflation generates profits that are accounting fictions but nonetheless are taxable. A stock whose price doubles during a period when what you buy at the grocery store has gotten twice as expensive hasn’t delivered a real profit. But when you sell the stock, your “gain” will be taxed as a capital gain… unless the stock is in your IRA.

The tax picture for interest-earning assets during rapid price inflation is even uglier. Yields on money market instruments tend to rise along with inflation rates, on average leaving the investor with a real, after-inflation return of about 1%. When inflation is running at 14%, for example, you can expect money market returns to be in the 15% neighborhood. But the entire 15%, not just the 1% true return, will be taxed – unless the investment is in a shelter such as an IRA. Avoiding a big tax bill on fictitious income adds to the importance of sending as much of your wealth to Rothland as possible.

No Minimum Distribution Requirement

With a traditional IRA, you must take a minimum distribution every year starting at age 70.5. Your IRA is forced into a slow liquidation, which pushes wealth back into the environment of full taxation. Dollar by dollar, tax deferral comes to an end.

With a Roth IRA, on the other hand, there are no minimum distribution requirements. You can let the money ride as long as you like. In nearly all cases, the best approach is to not touch the Roth until you’ve run out of directly owned assets. For many investors that means letting the Roth grow tax free for years past age 70.5.

Heal the Lame

If any of your contributions to a traditional IRA weren’t tax deductible when you made them, your IRA is, to that extent, lame. The tax cost of moving those contribution dollars to a Roth is exactly zero, and the future earnings of those dollars can come out of the Roth tax free.

Additional Tax Savings

The range of investments that the tax rules permit an IRA to hold is broad – far broader than what you can get with any stockbroker, mutual fund family or insurance company. An IRA is authorized to own real estate of any kind, for example. It can own copyrights, patents and other intellectual property and collect royalties. It can own an equipment-leasing business. It can even have a foreign bank account.

Anyone can gain access to such investments for his IRA by moving it to a custodian that will allow the IRA to own a limited liability company. The individual manages the LLC that his IRA owns, and the LLC buys and owns the investments. It’s a way to free yourself up to invest IRA money in almost any way you choose.

The structure can provide an additional benefit. It can cut the tax bill on a Roth conversion by one-third or more. That is accomplished by adopting a valuation strategy that has become commonplace in estate planning.

The amount of taxable income that you recognize on a Roth conversion is equal to the “fair market value” of the property that moves from the traditional IRA to the Roth. For all tax purposes, fair market value means the price that would occur in a transaction between a willing buyer and a willing seller. If the property is a non-controlling interest in an LLC, its fair market value will depend on what’s in the LLC and also on the terms of the operating agreement that governs the LLC. With the right terms, that fair market value can be pushed far below the interest’s pro rata share of the LLC’s assets.

An example may make this less mysterious.

Suppose you have a traditional IRA that owns an LLC that in turn owns $100,000 worth of marketable stocks. Under the terms of the LLC’s operating agreement:

• The Manager (you) has the discretion to make distributions at whatever time the Manager chooses.
• No owner of an interest in the LLC may sell it without the consent of the Manager.
• The Manager can be replaced, but only with the unanimous consent of the owners.
• The LLC can be liquidated, but only with the unanimous consent of the owners.
• The operating agreement can be amended, but only with the unanimous consent of the owners.

How much would anyone be willing to pay for a 50% interest in your IRA’s LLC? Certainly not $50,000. All he would be getting is the right to wait for you to decide to make a distribution, and he would have no power to get rid of you or to change the rules. So the fair market value of the 50% interest would be less than $50,000. How much less? A professional appraiser would tell you the fair market value of the interest is no more than $35,000 (possibly even less than that).

That valuation discount translates into tax savings. Move a 50% interest in the LLC to a Roth, and you recognize taxable income of only $35,000. The following year, repeat the exercise. That will put the entire LLC, with its $100,000 of assets, under the Roth umbrella, and you will be paying tax on just $70,000 of income.

Jumping

The advantages of converting a traditional IRA to a Roth stack up. Move more of your wealth into a tax-free environment. Achieve greater inflation preparedness. Escape the rules on required minimum distributions. Turn non-deductible contributions into a generator of earnings you can withdraw tax free. Cut the tax cost of getting spendable cash from the IRA by using a valuation strategy when you convert.

The advantages stack up so high that if your traditional IRA could read this article, it would be jumping around the room and waving its arms high and shouting “Convert me! Convert me!” I hope you can imagine hearing that advice and taking it. Every time you or anyone else acts on a legitimate opportunity to save on taxes, he deprives the government of the means for more mischief. You’d be doing us all a big favor. I do my part. Now it’s time for you to do yours.

In addition to his role as economist and editor with Casey Research, Terry Coxon is a principal in Passport IRA and the author of Unleash your IRA.

The information included in this article is not to be construed as legal or tax advice; should you consider a Roth conversion, make sure to discuss your plans with your own CPA and tax advisor.

[Another thorny investment area is the world of exchange-traded funds (ETFs); they are not always what they appear to be. This free report on the top ten misleading ETFs will help you avoid the brambles.]

Mayan prophecies aside, many of the senior Casey Research staff believe that economic, monetary, and fiscal pressures could come to a head this year. The massive buildup of global debt, continued reckless deficit spending, and the lack of sound political leadership to reverse either trend point to a potentially ugly tipping point. What happens to our investments if we enter another recession or – gulp – a depression?

Here’s an updated snapshot of the gold price during each recession since 1955.

Clearly, one should not assume that gold will perform poorly during a recession. Even in the crash of 2008, gold still ended the year with a 5% gain. And with the amount of currency dilution we’ve undergone since that time, it seems more likely gold will rise in any economic contraction than fall. Indeed, if the response of government to a recession is more money printing, precious metals will be a critical asset to have in your possession.

Even if the gold price ends up flat or down this year, the CPI won’t. Gold’s enduring purchasing power is why we hold the metal.

How about gold stocks?

In spite of the debilitating 1970s that suffered from stagflation, price controls, three recessions, and the Vietnam war, gold producers rose over 600% while the S&P was basically flat. And that includes a roughly 65% fire-sale correction, much like we saw in 2008. To be clear, gold and silver stocks won’t be immune to selloffs if a recession or worse temporarily clobbers our industry. But in the end, we’re convinced they will prevail.

Don’t lose patience with, or confidence in, your gold holdings. What happens to the price over any short period of time is only one chapter in the book of this bull market, and we think you’ll be happy by the time that last chapter is written.

[If you have questions on how to invest in gold in the current market conditions you aren't alone. If you act fast, you can be among those who get to hear Jeff Clark discuss his thoughts and answer selected audience questions. The Gold Investing in 2012 and Beyond: Your Questions Answered! call is absolutely free – but you must sign up by midnight EDT on April 6.]

The charts below compare saving $100/month in gold and silver vs. an interest-bearing money-market account. For our projections, we assumed gold’s average annual gain of 18% since 2001 will continue through 2020. For the money-market account, we used an annual interest rate of 1% in 2012 and added 0.5% each year, so that by 2020 it’s earning 5%.

Here’s what would transpire by 2020:

If you invested $100/month from January 2012 through December 2020, your total contributions would amount to $10,800. In the money-market account, your savings would compound to $12,959.48, for a gain of 20%. For gold, however, the value of the metal would reach $27,025, for a return of 150.2%.

For silver, we’ll assume it matches its 25.3% average annual gain from the last ten years through 2020. Here’s how it would stack up against money saved in a money market account.

The money-market account would again gain 20%, but the value of silver would reach $39,302, for a total return of 263.9%.

[We caution against investing more money in silver than gold; the metal is much more volatile, and has large industrial applications that could hinder the price in a poor economy. And if fear is high, gold will be sought before silver.]

As you consider these data, keep in mind the power of dollar-cost averaging. Using this strategy to accumulate gold and silver will lower your cost basis automatically because you’ll buy more ounces when prices are low and less when they’re high. And that highlights another gain: Buying systematically removes emotion from the equation. “Buy on dips” is good advice, but it doesn’t tell you exactly when to buy. A commitment to dollar-cost averaging eliminates that question.

You may argue that interest rates will be higher later this decade, and you’ll probably be right – but we offset that likelihood by excluding any mania in precious metals. Also, taxes must be considered, as rates are higher on capital gains for gold and silver than for passive income, yet you’d still be left with a much greater return.

At the risk of repeating ourselves, at this point, with the monetary and fiscal predicaments confronting many of the world’s governments, and the probable responses they will employ, we recommend a good chunk of your savings be held in gold and silver.

Is There a Best Time of the Month to Buy Gold and Silver?

If you’re going to dollar-cost average your purchases, it might be useful to know if there are days of the month that are better to buy than others.

We measured the performance of both gold and silver for each day of the month from 2001 through 2011, and then calculated the average daily return.

Here’s what we found for gold.

Clearly, the 13^th, 15^th, and 23^rd are ideal days to buy since the price tends to be the weakest.

Here are the data for silver.

The 13^th and 15^th again stick out as good days to buy.

If you’re accumulating on a weekly basis, we found Tuesday is the weakest and thus a good time to buy (as well as Friday for silver).

A few things to consider if you decide to use this information:

• *The figures are averages, so there are days when prices bucked the trend. View these results as tendencies, not certainties.
• *These days might fall on weekends or holidays and so won’t be available every month.
• *The calculations use daily closing prices, which would be almost impossible for an investor to match.
• *The results measure past performance and can’t predict the future (though we see no reason for a significant shift).

That said, if you arrange to buy gold on the 13^th and silver on the 15^th of each month – or on Tuesday for either metal if buying weekly – your cumulative gains stand a statistically greater probability of being slightly higher. Again, your mileage may vary.

By Jeff Clark, Casey Research

[Jeff Clark and Louis James, both on Casey Research's metals team, do their best to wring actionable ideas out of every possible bit of information they find regarding precious-metals investments. And now you have an unprecedented opportunity to hear them discuss their ideas and maybe even answer your question. Learn more, then act fast – you must sign up by midnight EDT on Friday, April 6.]

Goldman Sachs: ‘Gold to hit $1,840/oz in six months’

Goldman Sachs, one of America’s most notorious banks, has often been incorrect in predicting a bursting of the gold “bubble” many times over the last decade’s bull run. In yesterday’s note, however, the wallstreet bank makes clear that they are now much more in tune with the driving forces of precious metal prices. We have made the case for precious metals based on a negative interest rate environment for some time, but we did not think our analysis would turn out be aligned with Goldman Sachs.

Here is what Goldman analysts say regarding gold in their latest report:

“Under our gold framework, US real interest rates are the primary driver of US$-denominated gold prices. However, after being remarkably strong in the first half of 2011, this relationship broke down last fall, with gold prices falling sharply in the face of declining US real rates, as tracked by 10-year TIPS yields. While gold prices have returned to trading with a strong inverse correlation to US real rates since late December, at sub-$1,700/toz they remain below the level implied by the current 10-year TIPS yields.

We believe that despite last fall’s decline in 10-year TIPS yields, the gold market may have been expecting that real rates would soon be rising along with better economic growth, leading to a sharp decline in net speculative length in gold futures. Accordingly, a simple bench-marking of real rates to US consensus growth expectations suggested a level of +40 basis points by year end. Our models suggest this higher level of real rates would be consistent with the current trading range of gold prices. As we look forward, our US economists expect subdued growth and further easing by the Fed in 2012, which should push the market’s expectations of real rates back down near 0 bp and gold prices back to our 6-mo forecast of $1,840/oz.”

In short, Goldman, and us, expects US real interest rates to decline as the perceived “economic growth” slows and the Federal Reserve jumps in with more monetary stimulus. The six month gold forecast of $1,840/oz by Goldman implies a 24% annualized rise in the price of gold going forward from today.

Bloomberg recently reported on Goldman’s call for gold, and you can see the video segment here (if reading an e-mail, visit PinnacleGold.com to see the video):

Macquarie Private Wealth: ‘Gold to hit $2,250/oz’

On an even more bullish tone from Macquarie in Canada, the managers of more than $100 billion in funds, expectations are for gold prices to soon top $2,000/oz. Macquarie’s reasoning is similar to Goldman’s in that they expect long term yields to come back down, the economy to slow, increased sovereign crises around the world, and additional Fed easing. Macquarie also points to the seasonal nature of gold and that March is traditionally a bad month, coupled with unusually high negative sentiment and the bargain prices being offered at present, indicating gold is likely very attractive now to longer term holders.

Macquarie presented the following images to help make their case:

Exchange-traded funds have been all the rage in recent years – they are easy to buy, easy to sell, and often have lower expense ratios than index mutual funds. But the Casey Research team dug deep into the complex world of ETFs and found that in many cases, their names can be utterly deceptive.

Here are a few excerpts of our revealing special report, The Top Ten Misleading ETFs.

Market Vectors Junior Gold Miners (GDXJ) – This ETF sure has a funny definition of a junior mining company. In my opinion, a junior miner is a small, speculative company just getting off the ground. Our publication, Casey International Speculator, specializes in this particular kind of company. If I had to put a number on the market cap, I’d say that junior miners fall under the $500 million mark. If you really want to push the definition to its limits, maybe a market-cap ceiling of $1 billion could still qualify for junior status.

Regardless of the exact line of demarcation, most of us can agree that “junior” means “small.” Furthermore, most investors can agree that market caps over a billion dollars are anything but small. A billion isn’t a major, but it’s clearly in mid-tier territory. That said, the Junior Gold Miners ETF’s top 10 holdings are all over a billion dollar or more. The top holding, with 5.23% of assets, even has a market cap of $2.4 billion – that’s not exactly a junior, to say the least, and neither are the other companies on the list:

SPDR Gold Shares (GLD) – Since the last two funds had problems with rolling over futures contracts, you might be thinking to yourself, “Well, why not just buy funds that actually hold the underlying assets?” That’s a genius idea… if it were only so simple. Even SPDR Gold Shares (GLD), a fund that holds physical gold, has much hidden in its fine print.

At first blush, most investors think that GLD securely protects their gold and that they can retrieve it upon request. Yes, GLD has a giant vault where gold is actually kept. However, exchanging your paper shares for gold is much harder than the click of a mouse that gets you into GLD.

First of all, to retrieve the gold one must have special permission – meaning one is either a broker or market maker. And there’s another footnote worth mentioning: Gold can only be redeemed at a minimum of 100,000 shares of GLD, equivalent to 10,000 gold ounces (a little over $17 million at current prices). For the high rollers reading this article, that might mean something. For the average Joe out there, that means you will never be able to redeem your GLD shares for gold. Those shares are nothing more than pieces of paper – or worse yet, electronic bytes in your account.

With a closer examination of GLD, even the high rollers are misled by GLD. Deep in the SPDR Gold Shares prospectus, the fund includes an option to redeem gold requests in cash rather than physical metal. So, even if you are holding $17 million in GLD, you still might not receive your gold upon request in the case of a crisis in the gold market.

But wait – there’s more. Though GLD seems like any other ETF, it isn’t. GLD is structured as a grantor trust. Hence, the investor doesn’t pay taxes similar to regular ETFs. Instead, the investor pays taxes on the underlying assets – in this case, gold. Unfortunately, gold is taxed for long-term holdings at a higher rate of 28% as a collectible instead of the 15% capital gains tax. What seems like a simple fund actually has a world of complicated specifics in the fine print.

iShares MSCI Emerging Markets Eastern Europe Index Fund (ESR) – What do you think of when someone says “Eastern Europe?” The Iron Curtain, stuffed cabbage, kolaches, pierogies… No, besides that. For anyone who’s been asleep for the past few decades, Eastern Europe now has more countries than most can count. In the Balkans alone, there’s Slovenia, Croatia, Bosnia, Serbia, Montenegro, Macedonia, and even Kosovo… not to the mention all the other countries, such as Romania, Bulgaria, Lithuania, Estonia, the Ukraine… and the list goes on.

With so many different countries and stock exchanges, an ETF would seem like a perfect way to cover them all. Unfortunately, the MSCI Emerging Market Eastern Europe Index Fund (ESR) will cover none of those countries just mentioned. In fact, the ESR does a better job of covering Russia, with a 76% allocation, than the rest of Eastern Europe – a whole 21% of the fund is invested in Russia’s Gazprom alone.

Besides Russia, the fund only holds a couple of other countries including Poland at 16%, the Czech Republic at 4.1%, and Hungary at 3.4%. Though some companies in the fund may serve Eastern Europe, this is hardly what most investors had in mind for an Eastern European ETF. If investors really want a Russian ETF, those are not hard to find.

[To find out what the other 7 ETFs are – and whether you might own one yourself – click here for your FREE special report, The Top 10 Misleading ETFs.]

India was the largest buyer of gold last year, with China and Russia also adding notable quantities. Central banks in general have been net buyers of gold in the last few years for the first time since the end of the Bretton Woods monetary regime led to major sell offs. Despite recent buying by governments, gold still only accounts for less than 1% of total global assets, significantly below its historical trend, but this will change if buying patterns continue or intensify.

At the end of the Bloomberg segment, co-host Alix Steel questions whether or not retail demand can pick up for some speculated declines in investment demand. Those close to the research seem to think differently in that investment buying will more than make up for the shortfalls in jewelry sales. Thomson Reuters gold research team, GFMS, expects gold to hit around $2,000/oz in 2012, on increased investment demand (read more on this) despite higher gold supply and lower retail demand.

Watch the Bloomberg segment discussing China’s buying (visit PinnacleGold.com to watch the video if reading in an e-mail):

Fed’s “Sterilized” Bond Buying Plan

In his CNBC interview host Maria Bartiromo asks Jim about a recent report from the Wall Street Journal on a possible bond buying strategy being considered by the Federal Reserve. The plan, in its basic form, involves the Fed purchasing assets like mortgage-backed securities (MBS) and then immediately borrowing the money back from the seller with a short term contract. The Fed believes this plan would enable them to support the lowering of long-term interest rates while simultaneously tying up the money used to so, thereby preventing inflationary price pressures elsewhere.

However, like all the Fed’s plans, they try deal with the symptoms of a problem while aggravating the cause. In this case, artificially suppressing interest rates is bad enough, as Grant point out, the “Fed wants to manipulate long term interest rates lower… but in so doing it is manipulating perceptions of risk.”

The foolish attempt by the Fed to try sterilize their buying just adds insult to injury. Inherently, if the Fed is borrowing money, the money will have to be returned, so the “sterilization” is actually temporary. Moreover, for the Fed to borrow money, they must pay an interest rate, and in this case it will be a meta-market rate, thereby enriching banks further at the expense of many. The rate the Fed pays is also created by additional printing, so in the end the plan to prevent inflationary pressures actually creates more of them. And a last fact made clear by Grant is that the Fed’s plan entails borrowing short and investing long, which is the basic model of banks who create maturity mismatches and are at constant risk of bankruptcy.

Central Bank Balance Sheets are Out of Control

Grant is one of the few commentators who correctly focuses on the central bank’s balance sheet as a key metric for monitoring macro manipulation. Grant wisely asks, “What does the Fed have against the price mechanism?” Grant in the past has highlighted the leveraged nature of the Fed’s balance sheet and its catastrophic growth and debasement. With all the focus on the Fed, however, people have missed the fact that the European Central Bank (ECB) has grown their balance sheet larger than the Fed’s despite the fact the Euro zone is a smaller economy than America. Grant says the ECB’s “balance sheet is positively exploding. It is one third larger than the Fed’s… the Fed is a piker compared to what the ECB has recently been doing.”

In any case, Grant easily and accurately generalizes all central banks noting that “they are printing by the tonne… interest rates have never been lower… central banks have never been easier… central banks are manipulating expectations about the future of long term interest rates.” Grant extends the point by noting that inflation is appearing in market assets that a directly impacted by ultra low interest rates. Grant questions why “companies that have not made a profit in five years are issuing debt as if the company was solvent… the Fed is dulling the risk censors of the entire market place. Is this good?”

History is Against the Fed

There are not really any empirical instances of stimulative measures proving to be more effective than allowing the market to resolve distortions, despite policy makers constantly telling us ‘things would be worse if we had done nothing’. The best example, brought to light by historian Thomas Woods, which is rarely faced, is the 1920-21 depression where nominal GDP collapsed by more than 20% and unemployment hit 14%. In that case, the fiscal and monetary authorities did the opposite of what is commonly expected in today’s mainstream; the government balanced the budget and did not print money. The result was a quick reversal of one of the largest economic shocks which was considered over in less than two years with unemployment falling to 3%.

Gold and its Standard Should Be Embraced

Grant is one of the few economic commentators with the cahonas to call for a return to the gold standard, understanding that gold provides an invaluable service in preventing manipulation. Grant calls for an “intelligent moves towards a sound currency… a currency that is based on a standard not the whim and discretion of a bunch of mandarins sitting in Washington, DC.” Grant even suggest that the Treasury issue longer dated bonds backed by gold as a way of bringing interest rates down in a sustainable, sound manner. Something that is unlikely to be considered seriously by those in charge, but an interesting idea nonetheless.

Grant’s main view of gold is that he sees its price movements as an important measure of the market’s faith in central banks. “The price of gold is as it were the reciprocal of the world’s faith in the deeds and words of the likes of Ben Bernanke,” Grant says.

See the full video interviews (available on Blomberg…

McEwen’s time frame is reasonably short, and sees prices reaching the predicted levels by 2015-2016.

Stocks are Overvalued

Despite very weak inflation adjusted returns over the last decade, stocks still remain a poor investment relative to key metrics. The best and most common measure of a stock’s value is its price to earnings ratio. This breaks down the price of a stock to the earnings one can hopefully expect per share unit, and this provides an objective way of comparing varying stocks or measuring the market as a whole.

At present the price to earning ratio, commonly called the p/e ratio, is about 23 to 1 for the S&P 500 stock index:

This means that for every $23 dollars you would need to spend to acquire a stock you’ll receive only $1 dollar in earnings per year. Effectively, the stock would need to keep pace with its current earnings for the next 23 years just to fundamentally justify the base purchase price today, book value aside. If current earnings are likely to decline on an inflation adjusted basis, this situation is much worse.

In many respects, the current p/e ratio indicates stocks are too expensive. For one, the historical mean p/e is 16.41 to 1 and the median ratio is 15.81 to 1. Stocks right now, then, are at least 40% more expensive than their historical average.

In addition, dividends from stocks do not even make up for inflation. The dividend yield of the entire S&P 500 index is 1.94% per year, which is about 1% below the current Consumer Price Index (CPI) annual increase. Therefore, dividends actually are producing negative real returns, destroying the purchasing power of investor’s funds.

Houses are Overvalued

The most recent complete data available is from 2010, but the factors involved do not appear to have changed much since then so the information is equally applicable to present conditions. Since all residents need to either rent or own a home, the best measure for tracking the affordability of house ownership is the rent to buy ratio. This ratio takes the median house price and divides it by the median 12 month rental cost. The resulting value is effectively how many years an owner would need to keep an active renter to justify the price spent on the house.

Houses presently cost 22 years of rental income, which is above the historical average of 15. This is calculated by taking the median gross rent from 2010, $855 (source: US Census Bureau), multiplying it by 12 and dividing it by the median sales price for houses at the end of 2010, $226,900 (source: US Department of Commerce). Its important to note that this measure assumes the house is bought outright, rental income will not fall, houses will pace with inflation and there are no maintenance costs. If financing, broker fees, drops in rental rates, property taxes and maintenance factors are included house values become even less attractive by a wide margin.

Cash, Bonds and Fixed Income are Overvalued

Bond yields on short-term investment grade instruments are close to zero and even longer term yields on government bonds do not exceed 3%, the present inflation rate, by a substantive margin.

Given these facts, no fixed income instrument is producing a positive real return when relative risks are adjusted out of the equation. With bond prices at multi-decade highs, and yields nearing the zero bound, prices are technically restrained from moving much higher. If the inflation outlook turns out to be worse than the Bureau of Labor Statistics (BLS) estimates in their CPI, and default risks spike up from their historical lows, bond values look even worse than the already gloomy outlook.

Commodities are the Only Answer

Competitive valuation is largely the reason commodities have outperformed all the above asset classes in recent times and given that all other assets remain heavily overvalued, commodities should continue to shine. Real assets have more going for them than just competitive returns as well, and will be sought after for safety, quasi-insurance, and protection in an unusually uncertain economic environment. Commodities are unique in that there is no counter-party risk and the strong liquidity is sought after while economic calamities plague the global financial environment and credit system.

To keep trade competitive, governments around the world are debasing their currencies in an attempt to cheapen their goods on the international market. Instruments that are tied to cash, therefore, are in constant danger of governmental manipulation cheapening their returns. In addition, many assets are presently driven by the credit environment and the sustainability of the credit system has never been in such disarray in modern history. Given these facts its not hard to see why the only assets which have no credit risk, cannot be debased, and have strong liquidity are outperforming the rest.

On a valuation perspective, commodities do not have traditional financial metrics since they do not produce cash flow, but there do exist contexts which provide a means for measurement. For one, on a historical basis, commodity prices still seem attractive, as many metals are trading below their nominal highs and almost all are trading below their inflation adjusted highs. Furthermore, gold, one of the most reserved commodities, only makes up less than 1% of global asset allocation which is about at a historical low.

Another major, under-appreciated reason to see commodities as undervalued is the presence of large outstanding naked shorts in the derivatives markets which imply a potential short squeeze effect continuing if price rises persist. All this said, and remaining powerfully true, the real valuation driver for commodities, however, is the deterioration of the currencies they are priced in. With the present intention of central banks to monetize the collapsing credit system, there is no visible end to the potential for commodity price rises then.

The notion that commodities are the only place to run is no longer unique to “gold bugs” like us either. The philosophy is starting to hit the mainstream as money managers find it increasingly difficult to find returns by traditional investment allocations. For example, the lack of real returns in bonds and stocks was recently pointed out by famed bond king Bill Gross in a Bloomberg interview:

In all, the commodity market is far from saturated and the fact remains that there are no other viable alternatives to park cash in at present. So far as this remains true, the commodity bull market will continue to roar forward.

Firstly, it’s worth noting that gold and silver have already had very appreciable gains in 2012, including earlier this week, and even with yesterday’s decline still both metals remain significantly in the green year to date. That said, yesterday’s declines are noteworthy and its worth investigating the source of these price moves.

Market Decreases Bets for Additional Monetary Stimulus

The major reason for the speculative declines in precious metals relates to prospects for Federal Reserve policy. Given this week’s weak housing and capital goods data, many were expecting Bernanke to give forward guidance on new monetary stimulus measures. Instead Bernanke not only did not mention an extension of “Operation Twist” or a third quantitative easing program (QE3), but gave minor lip service to the inflationary consequences of increased gas prices.

The best evidence that yesterday’s declines in the metals are the result of reduced bets on monetary stimulus is found in the increase in mid to long term interest rates:

Investors reduced their holdings of government bonds and/or made bets against their price increases because they anticipate less support for longer term bonds by the Fed. This viewpoint, however, is sorely mistaken.

QE3 Will Arrive and the Fed is Impotent to Tame Inflation

What eludes many investors is the inevitability of a third quantitative easing program. Not only is the program likely because of prior supportive statements by Chairman Bernanke and other members of the Fed leadership, but its a necessary constraint of Fed accounting.

As I’ve discussed before, the Fed’s balance sheet has several constraints given their low capital levels. In particular, the Fed’s high leverage ratio indicates that they cannot sustain even a 2% loss on their assets, most of which are Treasuries and Mortgage Backing Securities (MBS), without going insolvent:

The only way for the Fed to prevent insolvency is, therefore, to avoid any substantive losses on their holdings. This can only be done by sustaining demand for these assets, and the Fed can do so with money printing, effectively putting a floor on the prices of the securities they hold. Given this fact, any significant losses on bonds that are held by the Fed will be short lived as the Fed can be expected to revive their prices soon after with increased purchases.

Moreover, the Fed cannot raise interest rates, as I have discussed many times in the past. The Fed simply cannot afford to pay even 1% more on the astronomical size of reserve balances at the Fed for a period of less than four years without going bankrupt. Because of this constraint, interest rates will remain low, Fed stimulus will remain high and, therefore, the forces driving precious metal prices higher will persist. Yesterday’s falls should be viewed as a buying opportunity for precious metals as the reasons for the fall will inevitably abate.