There are many serious weights overhanging markets around the world. But there are 10 in particular that have earned a spot on the “short list” of heavyweight challenges. Those threats consist of:

1. The potential for America to experience a double-dip recession.
2. The debt default of a sovereign nation.
3. The potential for contagion in the event of a domino-effect debt default across interconnected European nations.
4. The total collapse of the euro and resulting implosion of euro-denominated assets.
5. The global repercussions of a faltering Chinese economy, or from social unrest in that emerging Asian giant.
6. The threat of deflation across the globe if the recent leveraged bidding-up of assets (especially commodities, stocks and U.S. Treasuries) leads to a rapid unwinding of positions.
7. The insolvency of a major money-center bank and an ensuing bank panic.
8. Any of the geopolitical powder kegs finally exploding.
9. Another man-made ecological disaster, or any major weather-related disasters of epic proportion.
10. Or the proverbial “wild card” – essentially something out of left field that no one can anticipate.

Of course, this is just the “short list” of the potential economic, financial and political sledgehammers that could deal the U.S. and global economies a mighty blow. There are many other seemingly lesser potential threats that could still combine into a financial salvo big enough to devastate the hoped-for recovery.

There’s a reason to identify and inventory the major issues overhanging the global markets. And it’s not to wallow in defeatist misery.

If investors are buried in their analysis of corporate financials, investment fundamentals and specific potentialities, they’ll lack vigilance needed to navigate the current market and could end up being crushed by any one of these events. No matter how good your analysis may be, or how excellent any company-specific prospects are, systemic-market movements are like a flood that will sweep away, swamp and then drown anyone who isn’t perched on the highest ground.

Four Top Profit Plays

In today’s brave new world of interconnected global markets and intertwined economies, investors have to keep to the high ground. Constructing a flood-proof portfolio helps to achieve that objective.

Such a top-down/high-ground strategy provides investors with a big-picture view of where the floods may come from. The beauty of this New Age/post-financial-crisis approach is that it starts as a protective portfolio, instead of requiring the investor to construct protections around positions.

All of the enumerated overhanging weights listed above actually constitute macro-global scenarios around which core positions in your new world portfolio should revolve.

Here are a few examples of how to position your portfolio to reap some profits from what otherwise would crush your investments if you weren’t aware that they were even a threat.

1. Get Inverted: The potential for a double dip recession requires you to be ready to protect what remains of your portfolio. Know where support levels are in the market and be prepared to pare back your exposure if support levels are violated. Better yet, be prepared to buy any of the inverse-fund-type/exchange-traded-fund (ETF) instruments that offer profit potential when markets decline.
2. Get Current on Currencies: The debt default of a European nation and/or the potential demise of the European currency creates an opportunity to diversify part of your portfolio into an asset-class you may never have thought of investing in – despite this investment’s extraordinary potential. I’m talking about currency investments – but only those that lack the complication of actually trading currencies directly (which, by the way, is not hard and is actually another excellent portfolio investment vehicle). You can buy an ETF that positions you to profit handsomely if the euro falls in value, which it has been doing.
3. Check in on China: The prospect of China’s economy slowing down has major implications for almost all of the world’s economies and certainly for all the major commodity groups. An investment that would generate potentially solid profits would be a position that stands to appreciate if China’s real estate bubble implodes and if its economy cools down considerably. Again, there are ETFs and “put” options on those China-centric ETFs that give investors exposure to what happens in that part of the world.
4. Clean Up on the Commodity-Stockpile Closeout: Any investing discussion involving man-made disasters, natural disasters and supply-and-demand factors must also discuss the diversification into commodities. If the big economies of the world slow down, there will be massive sell-off of the commodities that have been stockpiled. These resources and raw materials won’t immediately be needed, since global production will slow down considerably, meaning currently carried inventories will be sold off. And if disasters affect the planting, growing or harvesting of seasonal agricultural commodities, there will be investment opportunities there as prices rise due to the supply being impacted. Once again, ETFs afford investors the chance to purchase instruments that trade like stocks and afford them liquid exposure to previously out-of-reach asset classes.

As these four examples demonstrate, it is possible to assemble sky-is-the-limit profit opportunities – even in the face of what is likely the world’s most-dour economic outlook since the Great Depression. There’s a financial irony at play here: The same interconnectedness that makes possible a sweeping debt contagion will be based on big-picture trends, and will be diversified in such a way as to diminish risk in a big way.

But that’s just it: By understanding the big global picture, the interconnectedness of these markets and the world in which we now live, observant investors will be able to see the risks – and at the same time understand how to turn those threats into profits when the expected market movements begin.

Another advantage to creating a more macro-global, top-down approach to your portfolio is that these big trends are all accompanied by big capital movements. Known as “capital waves,” these massive movements of global capital can be spotted as they develop, as they build, and even as they play out and roll over.

Understanding this simple-but-powerful concept makes it easier to manage your investments if everyone around the world is talking about the very issues that you’ve constructed your portfolio around.

Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready – and so were subscribers to his new advisory service: The “Capital Wave Forecast”. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Take a moment to check out Gilani’s capital-wave-investing strategy – and the profit opportunities that he’s watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]

Jim Rogers, Chairman, Rogers Holdings in an interview with ET Now talks about emerging markets, commodities as a space, Chinese property bubble and the expected economic slowdown. ( Watch )

Let’s start of with gold first because gold is back clearly at new highs. Where do you see it moving from here and more importantly, what are the factors right now dominating this move? Do you think it is a safe haven buying or it is the dollar movement or the Eurozone crisis which is still playing out?

It is all of the above. People in times of crisis frequently throughout history have looked for gold, not always but sometimes and that seems to be what is going on now. You have central banks which used to sell gold are now buying gold and you have massive amounts of people around the world clutching for gold, paper money everywhere is suspect, paper money everywhere is being debased.

What is your sense because there seems to be an emerging disconnect between natural gas and crude prices? Indian players like ONGC and Reliance Industries maintain that we will witness an upward bias from the current levels of $4.2 per unit. You have been long on natural gas, how much more of an upside are you foreseeing?

I am long on natural gas as a matter of fact but I have never said that someone should buy natural gas. You might look at it instead of crude. Crude is very very high compared to natural gas. I would think you will probably find opportunities in natural gas. How high will it go, I have no idea. I am not smart enough to know that. You should watch your TV everyday and then you would know. The world is running out of known reserves of oil and over the next decade or so, the surprise is going to be how high the price of energy goes and how high it stays. We are running out of energy whether you like it or not.

But talking about sugar as well, sugar has corrected almost 48% from its highs. One can believe that there is further downside while the others are averaging their stocks because they feel there is a bottom in place, what is your view?

I am not quite sure how you are looking at; sugar is down 75% or 80% from its all time highs. Sugar is up 300% or 400% from its lows of a few years ago. If you are talking about just this year, it has come down dramatically. I would rather be long sugar than short sugar. I have not owned sugar at the moment but I do not know whether one should buy it or not. I am not very good at market timing but sugar is another way to play energy plus sugar is another way to play the emerging prosperity in much of the world.

Several Asian economies including India are currently grappling with high inflation, you think governments could be swift enough to act upon this and will inflation really eat into returns for commodity bulls?

Rising prices is inflation. Inflation does not call prices to go up. Price is going up because of inflation. So I am optimistic about the price of commodities going forward. The governments spend a lot of money, that is going to lead to higher prices at least it always has. Now if governments stop printing money, then we are going to have other things going on in the world.

We have economic decline, continue the economic decline but so far, governments do continue to print money all over the world and many nations in the world acknowledge they have inflation. India happens to be one of the ones that are honest about it. America is dishonest, America lies about inflation. The UK lies about it but many Australia, Norway, China many others tell the truth and we do have inflation in the world and it is going to get worst.

What is your thought on the latest news really coming out of China? There has been a sharp minimum wage hike in the government sector. Do you think that is going to take away from China being the low cost manufacturing hub?

I am sure that China’s wages are going to go up a great deal over the next few years. Look at what happened in Japan, Japan used to be one of the lowest wage countries in the whole world and their wage is now among the highest in the world if not the highest and they are still very efficient in competitive manufacture of many goods.

What is your thought on agri commodities because most people are now turning bullish? Which pockets do you think would have emerging strength at this point of time and more importantly, what geographies would you be focussing on when it comes to agri commodities?

If I am going to look at commodities, I would rather look in Asia just because this is where the countries and the economies are sounder. There are some great places for agriculture, Canada, Australia, Brazil. Many countries not in Asia which have vast amounts of agricultural potential and there are probably wonderful opportunities.

I am of the opinion that agriculture is going to do better in the future, suffer less if you want to look at it that way, then most industrial nations are going to suffer less in stocks. At the moment, I happen to be long commodities and short stocks because the stock markets in the world are going to continue to have problems. If that is the case, I would rather own commodities than stocks and if the world gets better, commodities are going to do well as well.

Talking about China, China has been hungrily acquiring commodities globally; do you see this space actually accelerating with any signs of recovery playing out?

Many countries especially the Chinese, I guess they see what I see that there is going to be in the next decade or two serious shortages of commodities of raw materials developing around the world. Chinese are buying plantations and farms and mines and oil fields but now the Japanese are starting, some of the Middle East is also starting and it is clear that the world is going to face shortages in the future.

So they are buying them up. I would rather own farms than a seed on the New York Stock Exchange. I would rather own farms than many currencies. So you are going to see more and more of that in the future because people see the same things I see that there are problems coming in commodities.

But what is your sense, do you think India can compete with China space if acquiring energy security without significantly overpaying?

India does not have as much money as China does as you know. China is the largest creditor nation in the world. India has got a lot of foreign currency reserves but India also has huge amounts of debt. That is one of the things that worries me about India anyway; all the huge debt spilt up in India plus your government is continuing to add debt. So it is going to be difficult to compete.

India should be one of the great agriculture producing nations of the world. If your government did not have these bureaucratic nightmares against farmers and making it so difficult to be a farmer, you have got the soil, you have got the climate, you have got everything. Your government makes it almost impossible to be a successful farmer as you know; thousands of Indian farmers commit suicide every year because the government just makes it almost impossible. If that changes, India should be and could be one of the great agriculture producing nations of the world. You have been in the past in your history, you could be again.

Which according to you is the strongest currency at this point of time and which one would you be most bullish on right now?

I am trying to deal with that very very problem. There are currencies like the Singapore dollar which is very philosophically sound. I own the yen. I own the Swiss franc. I am thinking about selling my US dollar. The Canadian dollar is certainly sounder than the US dollar. It is a complicated issue for me these days. I own the renminbi but you cannot just buy and sell the renminbi, it is a blocked currency.

It is like the rupee; you cannot just buy and sell the rupee easily. I am looking for the place to put my money and of the place that I am actually thinking about at the moment is the euro. I own some euros which are not helping at the moment but it is getting so beaten down and the US dollar has been so positive and so popular that maybe these are swapping my US dollars for euros, I have not done it yet but I am thinking about it.

And do you invest in the Chinese property market? Would you be buying anything there?

No, one of the bubbles in the world right now is the urban cost of real estate in China. No I expect and the Chinese Government is doing its best to call its prices to go down in China. I am sure they are going to be successful, I would not think about buying property in China right now but I probably would not think about buying property in most places because if we are going to have an economic slowdown again which I am sure we would have over the next few years, there will be better opportunities to buy property and of course interest rates have to go up eventually and when interest rates go up, that is going to hurt property as well. So for most people in most places there will be better chances to buy property in the future.

What is your call on frontier markets? Some of these markets are running away while the emerging and the developed world has really been giving negative returns at this point in time. Sri Lanka seems to be quite hot favourite with some of the investors. What is your thought? Are you looking at any of these frontier markets?

No, I have been investing for frontier markets and is now a call for 30 years. At the moment, I am not looking at any of those places. I am so stocks sure that one of the areas that I am so sure has been emerging markets because they were very very overexploited in 2009 and part of 2010.

So I certainly would not be investing in frontier markets. There may be some wonderful opportunities and there probably are but even if there are and if I am right about what is going to happen in other stock markets and other economies, there will be better opportunities. I have them on my radar screen, I am watching to see what happens but I do not see anything that is really cheap anywhere in the world right now as far as the stock market is concerned.

What really are the big bets for 2010?

Jim Rogers: 2010 is almost over. I am not really thinking too much about 2010. It is 2011 that one has to worry about. I expect more currency turmoil in the future. I am shorting stocks, I have been shorting emerging markets, I have been short technology, the NASDAQ in the US because that was very very strong in the last 18 months or so, stronger than the world economies going to be. I am sure a major international financial institution that people think is very sound, I happen not to think so and I own commodities.

I hope that if the world collapses, shorts protect me on the long side and then short side and if the world starts going into even more money printing, then commodities will save me on the long side. This weekend, the G-20 finance ministers met and they said that they are going to withdraw fiscal stimulus.

The Americans did not say it but the others did. If that starts happening, you are going to see more and more economic slowdown around the world and that is why I am not optimistic about stocks but if that happens, if we do have more slowdown because the G-20 starts withdrawing stimulus, I suspect the central banks will print money because that is all they do. So I would rather be long commodities and short stocks which is what I am doing.

Shorting stock is probably one of the most unusual ways to make money on Wall Street. And I think the best way to explain it is with a story.

Say a friend lets you borrow his brand-new car for an extended time. So for all intents and purposes, the car is yours.

One day, a complete stranger sees you with the car and says, “I’ll give you $52,000 to sell this car to me.”* Unsure of what to say, you take his phone number and say you’ll think about it.

You’re very curious, so when you go home, you do some research and discover that $52,000 is a very fair price for the car. But you also learn that the local car dealership is having a big sale in two weeks, so there’s a good chance the car will sell for a lot less than it sells for today.

You call up the man who wants the car and agree to the sale. You meet him, and he hands you a check for $52,000. That’s a nice chunk of change…but now your friend is out a car. Luckily, you know what you’re doing.

Two weeks later, the car sale starts, and you’re able to buy the exact same model of car — from its color to its option features — for $42,000. You’ve now replaced your friend’s car and kept a nice $10,000 for yourself at the same time.

What you’ve done is known as short selling. And short selling a stock works pretty much the same way.

Make Money Selling Something You Don’t Own

When you want to short a stock, you simply call your broker and say how many shares of a company you want to short.

The broker then “borrows” the stock shares, either from his firm’s account or from other investors. He then immediately sells those shares on the open market. The money from the sale is yours to keep.

So if you short 100 shares of stock at $50, your broker will borrow 100 shares of the stock, sell them, and then deposit the $5,000 into your account.

But don’t make the mistake of thinking this is free money. Always remember that you will need to return the borrowed shares at some point. This is called “covering the short,” or “buying to close” your position.

The goal is to cover your short for a lower price than what you borrowed it for. For instance, if the stock you shorted falls to $40, you can instruct your broker to buy shares to close your position. Your broker buys 100 shares at $40, taking $4,000 from your account to pay for the transaction. The shares he bought are then returned to whom he borrowed them from.

Meanwhile, you’re left with $1,000 of pure profits.* But notice that the lowest a stock can go is to zero. So your maximum gains will never be higher than what you earned when you initially sold the stock. In the example above, you’ll never make more than the $5,000 you got for shorting the stock.

Now, the downside to this strategy should be clear.

If the stock rises, you could be in trouble. You might have to buy back the stock at a higher price than you sold it for. For instance, if you cover your short at $60 per share, your broker will need to spend $6,000.* Since you got only $5,000 when you originally shorted the stock, you’ll need an extra $1,000 in your account to pay to close the position.* If the stock goes to $70…$80…$100…you’ll have to pay that much to cover the short. In other words, your risk is theoretically unlimited.

But it probably won’t come to that. Since you’ll need enough money in your account to cover the short, your broker may ask you to deposit more money.* (This is sort of like a margin call.)

Short traders know this. So when a stock seems to be on a run, they’ll often race to limit their losses by covering their short positions. Unfortunately, their buying can run up demand for the stock. And as you know from basic economics, increased demand leads to higher prices.

This is called a short squeeze — traders covering their shorts artificially boost a stock’s price. (In my newsletter*Strategic Short Report,* we want to avoid short squeezes at all costs).

Another thing to keep in mind is that when you sell someone else’s stock, they are still eligible to receive the stock’s dividends. Since you borrowed their stock, you must pay any dividends the stock pays out.

So as you can see, shorting the stock itself is a good idea only in very certain situations (situations that will be coming up this very summer, by the way). You are forgoing the biggest gains, but your trade will tend to be less volatile. Often, this is our best route if we are confident that a stock will fall, but less confident about when.

Also, some good short-selling targets are so small that they have no exchange-listed options.

Strategic Short Report will recommend short sales in situations in which it’s the only way to profit on the downside. More often, however, we will use another option which we’ll discuss in the next issue of Whiskey & Gunpowder.

See you then.

Regards,
Dan Amoss

Dan Amoss, CFA, is managing editor for Strategic Short Report and a contributing editor to Whiskey and Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment adviser for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives and sell-side analysts and writing proprietary research for the fund’s management team. Special Report: From Hulbert’s No 1-Ranked Advisory Letter Over 5 Years, GOLD $2000: Five entirely new ways to play the gold trend and a hidden way to snap up gold- for less than one penny per ounce!

http://whiskeyandgunpowder.com

Human nature being what it is, sucker punches to the portfolio can erode more than your net worth. They can wreak havoc with your sense of self-worth as well. After more than 20 years at the helm of U.S. Global Investors, a leading investment management firm that specializes in gold, natural resources, emerging markets and global infrastructure opportunities, Frank Holmes says that it’s important to segregate bad things that happen on the outside from the good person you are on the inside. Knowing full-well that even the most prudent investor can’t escape the wild volatility that’s come to characterize the markets, in this exclusive interview with The Gold Report, he also offers some sage advice about how to avoid vulnerability to that volatility.

The Gold Report: In a recent interview, you stated that price-wise, gold performs exceptionally well whenever three factors coalesce—negative interest rates, deficit spending and an increase in the money supply. Essentially, as I read it, the combination of those three factors makes gold a hedge against a devaluing currency—whether it’s dollars in the U.S. or euros in Greece, Portugal or Germany, wherever they use euros. Is this coming confluence the major reason Americans and Europeans should be investing in gold at this time?

Frank Holmes: Yes, and deflation is the big factor to remember at the back of this. It’s fighting deflation, and 80% of the time since the year 2000, interest rates on U.S. Treasury Bills have been less than the CPI number. That means a negative interest rate environment, and it means the government is trying to fight deflation; it’s not really concerned about inflation. Gold will rise when you have temporary short deficits, but what we have is sustained long-term deficit spending while we’re fighting deflation and negative interest rates. That makes gold extremely attractive against the U.S. currency. Although the dollar is not currently as anemic as it was, we’ve seen that in the U.S., and we’re certainly seeing it in Europe, with what has taken place with Greece and the debasement of the euro. Interest rates in Europe have not risen either; they’re basically negative.

Now, the last factor that is important in that triangle of factors that have a big impact is money supply. Gold hasn’t gone to $2,000 yet, which a lot of gold fanatics had speculated because the growth in money supply has been anemic in the U.S., and in fact has contracted in Europe. The perfect storm where gold takes off is when money supply and deficit spending grow while real interest rates fall below zero—that is, when the rate of inflation exceeds the nominal interest rate. Gold will rise dramatically when those factors come together.

TGR: Over what timeframe should we be expecting this? Will it be gradual? Will it continue as it’s been? Or should we see a rampant ramp-up on gold?

FH: I am not looking for a huge spike. I think it’s going to defy the speculators, rising and falling back. What’s really important will be the price-takers and price-makers. The price-takers—the jewelry buyers—have historically been the most significant factor. Every time gold has spiked about $100, price-takers stop buying, gold corrects and falls, and then immediately they come back in and start creating an underlying support.

Now the price-makers—that’s the investment world—are coming in, seeing the currency debasement, seeing more people waking up it. These price-makers are basically owning gold, making a bet that it’s going to trade higher. It’s very important to remember that India took a position last October to become a price-maker, in addition to being the biggest price-taker in the world. They didn’t want just dollars and euros and pounds sterling and Swiss francs as their reserve currencies. They want gold; they’re diversifying.

This was very significant in 2005 when Russia decided to take 5% of foreign exchange revenue from oil and redeploy that back into gold as a reserve. Gold basically hasn’t traded below $500 since then. What’s taking place in India and many of the emerging countries, where deficit as a percentage of GDP and deficit per-capita is substantially less than in Europe or America, means that those governments are trying to diversify and protect their overall foreign exchange reserves. Gold is clearly becoming an important part of that, and I think that phenomenon will grow. As it does, we will see gold trade at higher prices.

TGR: With the price-makers exerting more influence, would the seasonal adjustments in gold go away? Should we expect new seasonal adjustments coming into place?

FH: I think we’ll always have seasonal patterns, and they’re very important in what they do as an overlay. I also think that we’re dealing with a huge credit cycle bust. Smaller credit cycle busts usually take about five years to repair themselves. 1986 was the beginning of the S&L crisis, and it didn’t bottom until ’91. So if this major bust started in 2008—some say 2007—we still have another three or four years to go before we have some resolution.

But I expect waves of fear. Greece, for example. Then all of a sudden it’s going to be Portugal. Both of these countries will have issues dealing with their huge debt bubbles that have been broken and policies from governments that are much more socialistic in their mindsets. It’s very much like the ’30s. That basically sets itself up for more protectionism, more unionism. I think this will be factor when people go to gold as a greater source of confidence. But that doesn’t mean you go to buy gold to get rich overnight or the world’s coming to an end. It’s an ongoing volatile process of dealing with this credit contraction.

TGR: If the credit cycle bust repairs itself, will it also resolve—in some manner—many of the monetary issues we face today?

FH: Yes, I think we’ll see some type of resolution in the next four to five years. Situations morph and do funny things, but if you go back to the ’80s, it was Latin America that had all the debt crises. Many of those economies are very robust and strong today. In the ’90s, Asia and Russia imploded, and their economies now are extremely strong on a relative basis of debt to leverage.

So now Europe and America are in these crises. I think we’re going to go through this saga of change. Countries with free-market monetary policies are the ones buying gold. Those that are much more socialistic in their economic policies are the ones that advocate selling gold. I think we’re going to see those dynamics unfold in different countries over the next several years. It’s interesting that Gordon Brown is gone from power in England now, and he’s the one who sold all the gold at $300. What would have happened if England had its gold today? The arrogance back then was the government would always be smarter than owning gold.

TGR: These days, of course, we’re hearing about the credit and world reserve currency issues in the more advanced countries, whereas in the past it was Zimbabwe or somewhere else that didn’t represent a significant portion of the global economy. Now that the “first world” countries are in trouble, many of the pundits are projecting catastrophes.

FH: I always like to see if the people who call for the most catastrophic events bet with their own money. Are they the biggest buyers of gold themselves? I am a gold investor, and I do have money in gold, and I do give it as gifts, etc., but I am not betting on a catastrophe. I am betting that things will get going again. Look at how Resolution Trust oversaw the workout of the S&L collapse of the late ’80s and ’90s. A lot of people lost money and lost their homes in that whole process, but many of them came out stronger and better, money came back in and bought those buildings, and things got going again. So, I believe what we have here is a super wave—it’s bigger than was expected; it will bring lots of doubts and pain—but it will abate.

The problem has been in the mismanagement of leverage, and I really think it’s important that you’re not seeing it in mainstream media. You’re not hearing all the debates. The media spotlight hits anyone who’s made money. This just plays on the people’s emotions. Policies will be well-intended, but they will be flawed because they don’t deal with the underlying problem; the abuse of leverage.

For instance, all this new financial legislation being proposed doesn’t do anything with Fannie Mae, which just came back for another $8.4 billion in bailout money last month. With leverage of 80:1, a 2% mistake in the portfolio is all it would have taken to wipe out Fannie Mae, but Fannie Mae goes on. Other examples: Merrill Lynch was 25:1. Lehman Brothers was leveraged over 30:1. When Japan peaked in 1989 and started its huge deflationary cycle, its banks were leveraged 30:1.

Really, the biggest problem is having financial institutions with excessive leverage. The odds are that they simply cannot manage it. But the rules coming out and the regulations being debated do not deal with that leverage; they deal with anyone who’s made any money. There’s confusion about the cause and effect of our problems.

TGR: Do you think the governments in Europe and the United States will actually identify the cause and address it?

FH: I don’t know; I haven’t seen it. It’s not in the mainstream media. And it’s not a political party issue; this is a thought process with both Republicans and Democrats who ignore Economics 101.

It’s not so much the derivatives. Yes, we want them listed and we want better disclosure and transparency. But leverage remains the underlying issue. Most of the companies with big derivatives problems had very leveraged balance sheets. The real demonstrative factor is being leveraged 30:1 and then having derivatives on the books that are also leveraged.

Look at what took place in real estate. People were allowed—even encouraged—to buy homes with 100:1 leverage. Brokers ran around creating mortgage products leveraged 25:1. That tells me that we have to deal with the amount of downpayment. In China, people have to put at least 25% down if they want to buy a home, and most of the time it’s 50% down. That makes a big difference. It doesn’t stop the short-term volatility in housing prices, but it does stop the bankruptcies and foreclosures. When you have lots of that, the process of cleansing it in the marketplace takes five years.

TGR: Can we actually get to a resolution related to credit without addressing the leverage issue?

FH: I don’t think so, but that’s going to be later in the cycle. It’s really just the beginning of the cycle, and we’re going to go to Human Behavior 101—good intentions without really assessing the law of unexpected consequences that’s unfolding in front of us. The pain and the difficulty for people that comes with managing the volatility.

TGR: How do people manage the volatility?

FH: It’s so important to understand the 12-month volatility in the markets. For gold, over any 12 months for the past 10 years, plus or minus 15% is just normal. With gold stocks, it’s plus or minus 40% over 12 months. Any day you look at your stocks, you could be down 40% for the past year or up 40% for the past year. That would just be one standard deviation. That would be normal.

Once you realize that, you know that you’re at great risk if you’re leveraged. But if you’re not leveraged, you can turn around and use the down drafts to help you make more timely decisions. When you get huge runs—like when gold stocks climb 80% in a year—mathematically that’s two standard deviations. When they go up that much in 12 months, there will be a correction.

It’s just understanding that volatility.

TGR: How about with equities?

FH: The S&P 500 is more volatile than the gold. Over any 12-month period, I think the S&P is 17% and gold bullion is 15%, but gold stocks are much more volatile than the S&P—almost 3:1. That’s the most important part. If you ignore that, you’ll be buying at the top when gold is taking off because lots of negative news is breaking, but then it will correct, you’ll be all upset and you’ll be getting out of it and taking your losses. Use the volatility to your benefit.

TGR: So a prudent investor would wait to see if it’s adjusting down 15% and start buying there. If it gets up too high, don’t get too thrilled about it and buy more, but wait for it to come back down?

FH: Yes. You can usually expect mean reversion—that’s the mathematical premise that all prices eventually move back toward the mean or average—even in a rising bull market or a declining long-term bear market. Each asset class has its own DNA of volatility. Basically, think of human relationships; some people are much more extroverted than others, and some are introverted. It‘s the same thing with asset classes.

TGR: And the junior gold stocks?

FH: They are so volatile that it’s a non-event for them to go plus or minus 60%.

TGR: Plus the additional risks of going belly up?

FH: Not really. More technology and biotech companies go belly up than mining companies. Actually very few do. They get recycled, they get refinanced and they start all over again but seldom do they go bankrupt. I am not saying you can’t lose a lot of money. You can lose 98% of your money on these puppies as they roll back their shares or refinance or go through that process, but bankruptcy doesn’t seem to happen often in the gold space.

TGR: So, understanding the volatility and understanding the kind of fears that we’ll face while we’re resolving credit issues and leverage issues, suppose prudent investors want to get into gold as a hedge against inflation and deflation. What do they do?

FH: Buy gold on down days. If you’re going to spend 5% of your assets in it, look for days when it falls about $35, then buy in 1%. Use that as a process to accumulate a position. Buy gold on sale.

TGR: That’s physical gold. What about gold stocks, and juniors versus seniors knowing that juniors are more volatile?

FH: The psychology is that when gold rises above its 50-day moving average, money flows into gold. When it goes below its 50-day moving average, money flows out, and the juniors get spanked more. I think the reason for the 50-day benchmark is because Yahoo and Google have technical statistical default buttons set the 50-day and 200-day moving averages.

I was at a conference for CEOs recently, where they talked about some fascinating research showing that the investment public trusts—the word is “trusts”—the CEOs and brokers and money managers when a stock or fund they’ve invested in rises above their 200-day moving average. When it’s falls below, they don’t trust. It has nothing to do with the fact that everyone else is below and you’re much outperforming; it’s a psychology of people. You see money flows take place as a result of those ups and downs.

I’m looking at the psychology of the marketplace and how people make decisions, and trying to find reasons other than just emotionally buying at the top and selling at the bottom. It’s tough, but it’s useful to have something of a discipline. The easiest way to do that is to know what a particular asset’s natural volatility is over any 12-month timeframe.

TGR: Is that trust linked to the 50-day moving average more driven by psychology or the fact that we’ve become more technical traders?

FH: Usually psychology. For instance, we see huge spikes, based on statistical models. We could back-test and show you those spikes. We could also show you spikes in bought deals and financings relative to what we call triangulation. Things are overbought; gold is way above its 50-day moving average, way above its normal volatility, news is very, very bearish, and lots of financings are knocking on the door. That’s usually the worst time. That’s usually correction time. We always ask ourselves if we’ve got triangulation going on there. We don’t want strangulation.

TGR: Everybody’s always asking you about gold. But you’re a big fan of natural resources broadly speaking, buying into this commodities supercycle. From where you sit, are your interviewers missing the bigger investment story by concentrating on gold?

FH: Yes, I think it’s much broader than gold. A super socioeconomic shift is going on. The thesis is that in 1970 China and India represented basically 1% of global GDP. Now they’re 10%, but they contain 38% of the world’s population. Their GDPs are growing at three times the rate of Europe or America. Okay, 38% of the world’s population is a lot, you might say, but only one-tenth of the world’s GDP? But some really important factors are different than in 1970.

TGR: Such as?

FH: China and India get along with each other. They both have the Internet now. They both are economic engines and looking for trade. They’re both seeing the rise of the middle class as in the movie Slumdog Millionaire. In China, 300 million people speak English; more people are speaking English in China today than they do in the U.S. America. And India is pushing further along that path. Every child now has to have an education—it’s the law there now. So they’ll be building new schools, new systems, new hospitals. The shift of populations to urban centers is creating greater demand for resources, services and infrastructure as well. The estimated needs for infrastructure spending are staggering—trillions of dollars across the world to develop water, energy, transportation and telecommunication networks. That infrastructure building needs copper, needs cement.

So now you have this supercycle infrastructure spending, along with the cultural affinity toward gold as gifts and increasing appreciation of gold as a monetary asset in these countries. That creates backup demand for gold as well as backup demand for all the other commodities to build up their infrastructure.

TGR: A lot has been written about China investing in commodity companies, stockpiling commodities, converting their U.S. dollar reserves into commodities. Is there still a commodity play for China?

FH: Yes, there’s no doubt. They’re trying to manage runaway price increases because they believe it causes social instability. What’s really important to understand is it’s a two-pronged model for China—social stability and a means for people to make money. They’re very conscientious in fine-tuning social stability and job creation year after year. Infrastructure spending is the most important for long-term job creation; but at the same time, people get upset if food prices spike or they can’t afford to buy a house. So the government tries to come up with policies to maintain the balance. I think they’re very proactive. They’re not naive. The Communist Party wants to stay in power, and the only way to do so is to ensure social stability and a means for people to get jobs.

TGR: Does this drive just the commodity supercycle? It seems that it would also trigger a technology boom, a transportation boom, a consumer boom.

FH: They’re all coming. The significant consumer impact comes later in the cycle. Consumption as a percentage of GDP is much higher in India than China. China’s fixed assets are higher, but I think we can expect to see the fixed assets explode in India. But it’s not a linear process, not a straight line. It’s bound to be fraught with lots of volatility and excitement and opportunities to make money (and lose money).

TGR: What are some of the commodities your fund is focusing in on as you look at the supercycle?

FH: Copper is a great precursor for industrial production, from making appliances and air conditioners to putting up electrical units across the country. Net coal is important; iron ore for the consumption of steel; zinc coated for the cars they’re making. They’re interrelated, and one has to track them and look at supply and demand factors and then look at the government’s policies. We’re big believers that government policies are precursors to change, both domestically and internationally.

TGR: In terms of copper, net coal, iron ore and zinc, is there a way an individual investor can play those commodities?

FH: The cleanest way is to invest with an active money manager—and not the ETFs. If you buy stock ETFs—equities, not the bullion ETFs or commodity ETFs—and they go up on a big day, they trade at a premium to NAV. If you sell on a down day, they trade at a discount. Trading equity ETFs can end up costing you a lot more money than a mutual fund with a good active manager who understands rotations that take place in the different commodities and how they relate to the equities.

Gold Report readers should just be aware that the leverage for every 1% move in a commodity usually translates into a 2% to 3% move in the underlying companies. The volatility is much greater for the equity than for the commodity itself—both on the upside and the downside.

TGR: And as you said, you pay an invisible markup when buying an ETF on the upside, and on the downside, it sells at a substantial discount.

FH: Yes, depending on when the transactions are made. It can add up, too. These premiums and discounts can be wide, especially on days with big NAV changes, and the premiums/discounts can swing very quickly from one extreme to another. We’ve seen 6% swings in a matter of a week, and I think we saw a 14% swing over two weeks in the Russia ETF, with people buying in on a big up day and selling on a big down day. You can track where the money flows are the biggest. They left a lot of money on the table. So, I think there are associated risks with those ETFs.

TGR: Are some countries today undervalued based on the government policies that have changed or enacted recently?

FH: I think when a country looks as if it’s undervalued, there’s usually an election going on. So one has to turn around and ask why that country is underperforming all of a sudden, and one has to go look at the election trend and see what the leadership is—or is just uncertainty that’s the trigger? You may laugh, but I think that Greece may have some great opportunities because in percentage terms some of those public companies have fallen dramatically, way below their fundamental valuations. Baron Rothschild always said to make big money, “you buy when there’s blood in the streets”—as there is now in Greece. That’s a classic of when things are down, in percentage terms, on the most extreme levels.

TGR: Speaking of elections, do you see some opportunities in Colombia?

FH: How will things fan out after the May 31 elections? Will the policymakers favor economic activity? We don’t know yet. The best performing stock on the Colombian Stock Exchange last year was Pacific Rubiales Energy Corp. (TSX: PRE; BVC:PREC), a Canadian company listed in Colombia and producing oil in Colombia.

I think being early in those countries, which we were, is a benefit because we were able to identify great government policy and get behind wonderful entrepreneurs with a great track record. They’ve been through the ups and downs before and that’s truly important when navigating these markets. You just don’t go into a country for the sake of a country; you have to make sure what the policies are for job creation and social stability. You also have to make sure that the CEOs and directors of the companies that you’re investing in know how to navigate through the culture, the legal environment and the politics of that particular country.

TGR: Only 15 years ago, risks were such that you needed armed guards just to visit Colombia.

FH: Today that’s Mexico. It rotates. We go from a free market to a socialistic, back to a free market. It just rotates. The job of an active money manager is to be able to see that rotation and move quickly with it.

TGR: Any last thoughts for our readers today?

FH: I think it’s really important for people to understand peaks and valleys in life. It’s almost like a philosophy to understand that we all have them. The peaks are not just at the good and bad times that happen to us; they’re also how we feel inside and how we respond to outside events. How we feel depends largely on how we view our situation. I believe the key is to separate what happens to you from how good and valuable you are as a person. If you don’t, all of a sudden you end up buying at the top and selling at the bottom when you see a big correction. You start to feel terrible about yourself, which affects your sense of self-worth as well as your net worth. It affects everything in your life.

Your beliefs and values shape your actions. I try to tell people to know the volatility so they can manage and understand these factors better and make better decisions. I want to help them avoid becoming a victim to the ebb and flow of the tides, but rather help maneuver their ship easily in and out of the harbor.

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc. (NASDAQ:GROW), a registered investment adviser with approximately $2.7 billion in assets under management and a year-over-year increase of 400% in per-share earnings for the quarter ended March 31, 2010. The company’s 13 no-load mutual funds, which offer a variety of investment options, have won more than two dozen Lipper Fund Awards and certificates over the last 10 years. Its World Precious Minerals Fund was the top-performing gold fund in the U.S. in 2009— the second time in four years it achieved this distinction. Frank has been U.S. Global Investors’ CEO since purchasing a controlling interest in the company in 1989. He co-authored The Goldwatcher: Demystifying Gold Investing, which was published in 2008. A regular contributor to a number of investor-education websites and speaker at investment conferences around the world, he maintains an investment blog called Frank Talk, writes articles for investment-focused publications and appears as a commentator on business channels such as CNBC, Reuters Television, Bloomberg Television, Fox Business Channel and CNN’s Your Money. Frank, who has been profiled in Barron’s, Fortune, the Financial Times and other publications, was named Mining Fund Manager of the Year by The Mining Journal, a London-based publication for the global natural resources industry, in 2006. The World Affairs Council’s chapter in San Antonio, Texas—home base for U.S. Global—named him 2009 International Citizen of the Year. In addition to achievements as an investor in international markets, the award recognized Frank’s involvement with the William J. Clinton Foundation to provide sustainable development in emerging nations and with the International Crisis Group to avoid and resolve armed conflicts around the world.

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