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Perfect setup for a gold rally: Wall St. 'flash crash' meets rising mistrust of paper currencies

May 12, 2010 | 10:00 pm

Anyone in the business of pushing gold as an investment shouldn't have had to work very hard this week.  Wall Street's "flash crash" and the European Union's largess did the heavy lifting.

Gold surged Wednesday to another all-time high, egged on by more chatter that Europe’s rescue plan for its weakest states is another big step down the road to severe inflation or debasement of paper currencies, or both.

This is the easiest way for gold bulls to pitch the metal, of course, because it’s basically like selling insurance: You aren’t sure you’ll need it, but it seems prudent to have it.

And after last week’s stock market flash crash, prudence is all the more in vogue. That’s a blessing for anyone hawking the yellow metal, which can’t offer interest or dividends to investors but can promise to always keep the same weight and gleam, and always be worth something -- unlike, say, General Motors stock.

Gold75-10 Near-term gold futures in New York jumped $22.80, or 1.9%, to $1,242.70 an ounce on Wednesday, the second consecutive record high. Silver and platinum also rallied, though they remain below their recent price peaks set in 2008.

Gold now is up 13.5% year to date, more than twice the 5.1% gain of the Standard & Poor’s 500 index.

Governments have printed massive amounts of money since 2007 to rescue their economies and financial systems. The European Union on Sunday committed to doing more of the same, agreeing to fund almost $1 trillion in loans to struggling member countries if they can’t raise needed cash in the private bond market.

The latest gold market rally represents, in effect, some number of investors worldwide voting their disapproval of the EU’s plan -- or at least, voting their fear of its consequences.

J. Kyle Bass, a Dallas hedge fund manager who made a fortune betting against mortgage-backed securities in 2007, has been warning clients for the last year that the next catastrophe could be a global hyperinflation rooted in governments’ unprecedented money creation.

In a letter to clients on Tuesday, Bass sounded more convinced than ever that serious inflation is ahead. From the letter:

The pattern is now set. This is exactly how very smart people meeting together in order to “solve” a debt crisis frequently (and now permanently, it appears) mistake a solvency crisis for a liquidity crisis. From now on, it seems everything will be deemed to be a liquidity crisis that will be met with more “bailouts” and debt-financed spending. This will eventually break traction in a violent way and facilitate severe inflation or even hyperinflation.The one thing the EU taught us this weekend is that paper money will be worth less (maybe much less) in the future.

What to do? “We increased our holdings of gold on Monday morning,” Bass said in the letter, although he didn’t spell out how he owns the metal, or how much he owns.

Whether serious inflation is coming still is a matter of great debate. There are plenty of people who see a greater likelihood of deflation. But if you have a growing distrust of paper currencies, for whatever reason, the case for gold is a simple one to make; the only question is whether patience might net you a better entry point.

Goldeagle Not surprisingly, gold demand in Europe reportedly has surged this week as the euro has continued to sink, eroding euro-zone consumers' purchasing power. The currency fell to $1.263 on Wednesday, down from $1.269 on Tuesday. The euro briefly rallied to $1.309 on Monday after the EU rescue plan was announced, before fading again. It has lost 16% of its value against the dollar since Nov. 25, while gold has risen 4.6% in dollars since then.

What is gold really worth? That’s the problem: It can’t be valued in the same way that a stock or bond can be valued, because it doesn’t produce cash flow. If you're buying gold as insurance, the cost obviously is a lot steeper than it was a few years ago. But if it turns out that you didn't need the insurance, and gold tumbles or languishes, presumably the rest of your portfolio would make up for it (as during the 1980s and '90s).

If a fair price for gold is unknowable, investors at least can count on the metal's historical function as hard money that will always have some intrinsic value.

Paper currencies may come and go, and likewise companies, but gold is forever.

-- Tom Petruno