The endgame in the war between paper and things

published 25 January 2012

Since the turn of the millennium, there's been a savage war raging between paper (ie, stocks and bonds) and real things'.

Following the dotcom collapse, paper assets have struggled. While real things (commodities and gold in particular) have had their down-days, by and large they've prospered.

Today I want to take a look at how the war's progressing. I think we could be into the final phase, and that there are perhaps just three or four years left now.

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In this issue I'll explain why you need to prepare for the next flashpoint in this struggle.

How the sub-prime blow-up changed everything

After the dotcom bust, investors started coming back to stocks en masse in 2003. The next major turning point was probably in 2007 when sub-prime debt overwhelmed the banking system. Turncoats like hedge fund manager John Paulson made hundreds of millions on bets placed against Walls Street's sub-prime paper creation. He went on to make plenty more betting on gold.

On the whole, the banking industry was crushed. Bear Sterns and Lehman's were the big names, but hundreds of banks were bailed out, nationalised, or taken over. Northern Rock was the first casualty over here, but bigger fish followed, in particular RBS and HBOS.

Overall, I'd say the start of the millennium saw a decisive win for real things'. If you'd had your money in commodities (especially precious metals), you'd have done very nicely compared to the poor guys that put all their faith in paper.

2009-2011 witnessed the great paper comeback as central banks and government have fought to save paper assets from destruction. It's what you might call a period of consolidation for paper. And what a great run it's had. From Easter 2009 right up until this summer, stocks and bonds have rallied hard.

Those of us that have played both sides (paper and things) have done well.

But there's a big problem...

I suspect that the paper fight-back has cost the governments dearly. Let me explain.

The final battle the fall of sovereign debt

Government bail-outs to save the banks and government stimulus to save the economy have risked the solvency of most Western nations.

I reckon the end game is now in sight. Between now and 2015/16 is my best guess. It's what I like to call the 'financial system reboot'.

The game has already changed. Governments have already made promises that are likely to be broken.

Bonds that used to be the very definition of risk free' are being re-evaluated. 2012 could be the year of the sovereign-debt default. Just look around

Ireland has wrecked a perfectly sound national balance sheet in order to prevent the Irish banks from starting off an international bank-run.

In Europe, more and more sovereign (taxpayers'!) money is going to be sucked into the black hole that is the European banking sector.

We all know about Greece. But what about Hungary? Although not a part of the euro, the consequences of a debt default here could be just as devastating. Austrian banks are full of rotting Hungarian debt.

The Hungarian parliament has tried just about every trick in the book to keep its economy from imploding. From attempting to steal' the nation's pension funds, to reclassifying foreign debt (from foreign currencies into the local forint); the government has even subverted the justice system and landed themselves in very hot water with the EU.

There are two important points here. First when a government is in trouble, be very, very wary never underestimate how far it's willing to go. And second, the next flashpoint in this war could come from anywhere. It's not just Greece that's in danger.

And once the defaults start, then the banking system is into another vicious cycle of debt destruction.

Here's what I'm doing to survive this war

Though I call it a war between paper and things, in reality it's more complicated than that. That's because things' are measured with reference to paper money. Usually it's dollars...

And it's kind of difficult to get your head round this problem. We're all used to measuring the value of everything with reference to paper money. When the paper markets take a turn for the worse, they tend to bring down the value of precious metals too.

That's why you have to be prepared for price volatility in the commodities and precious metals markets. But don't let it put you off.

It strikes me that most investors have got nearly all their money on the side of paper: shares and bonds. That's why governments across the globe are fighting so hard to keep paper afloat.

But I think 2012 is likely to see the start of the end game.

If I'm right, then even a modest 10% of your assets held in precious metals could see you ride out the final battle in much better shape than most investors.

As for me, I'm keeping a foot in both camps. I'll continue to hunt out the best places for my paper-based wealth. There are always great opportunities if you look hard enough.

But at the same time, my bet is that it's the hard assets that could make me some real profits when the financial re-boot comes.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.