It’s because of the insane level of derivatives being trading throughout the global financial markets – about $700 trillion.  There’s not much new here for me to comment other than I still view derivatives as THE biggest threat to owning dollar-based assets in long term positions.   

However, if this is a new topic for you, the below piece from 60 Minutes does a nice job of explaining what derivatives are and how they work, in common sense language:   

Even if the derivative house of cards does not collapse any more than it already has, I am no less long term bearish on the dollar and other currency-based investments.  Eventually the American greenback will return to its slide in buying power and investors that own hedge positions will be thankful.

My favorite method to hedge against a devaluing currency is with gold - both through direct ownership in gold bullion and by owning shares of a gold-mining mutual fund.  So if you have concerns over the Fed’s devaluation of our currency then this is where you should be. 

To put the Fed’s actions in perspective, consider this:  Eight years ago there were just over $5 trillion circulating through the system.  At last check this number had risen to nearly $9 trillion – almost a double in the quantity of paper money.  That action, historically, spells inflation. 

Recently I returned from Europe to see firsthand how our friends across the pond were being impacted by this economic environment.  Not surprisingly, things seem very similar to life in the States.  The shopping centers were busy, the restaurants were full, and the only negatives I witnessed were in regard to the financial industry and media’s drumbeat of doom and gloom. 

Purchasing power parity tells me that the dollar is currently undervalued compared to the euro and the fact the stock market is rising in the face of negative economic data tells me there is a very good chance that we saw the market bottom back in November. 

Of course there are no guarantees but what I do know is that the economic news will continue to worsen but the upside to ownership investments look a whole lot more promising than the downside.

As of now, it looks like by mid-2009 we will be facing a rapidly improving economy and that’s why the stock market has been rising in the face of all the current bad news. 

Be sure to tune in to our radio show each week for more discussion. 

Have thoughts or questions?  Leave them in the comment field below.

Related Articles:

• Stock Market Volatility & Investor Expectations
• Gut Check Time and the Transfer of Wealth
• Lessons from an Innovator in Global Investing, Sir John Templeton
• The Story On Derivatives

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Aron Huddleston talks with WOWT in Omaha about what investors should be focusing on in today’s market environment:

 Video used with permission of WOWT

Update:  The transcript to Roland’s video can be viewed by clicking the link below.

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A question I often get is, “What, in your opinion, is the biggest threat to the global financial markets?”

The mainstream media never touches on this but I believe that financial derivatives are the biggest threat.  These highly speculative instruments, most often used by big money center banks, are what I think would most likely trigger the collapse of the world’s debt structure.

Here’s the story.

Financial derivatives are simply man-made bets consisting of two parties.  Party A enters the bet in hopes of earning massive profits but in order to create the derivative, they need a counter party to wager against them.  This is where Party B comes in.  They enter the bet looking to hedge against some form of risk.

Say you are a financial derivatives trader.  You can speculate (or hedge against) the movement of interest rates, commodity prices, exchange rates, or just about anything else you wish to gamble on.

Those who participate in this global casino are required to place only a fraction of their bet down thus enabling derivative traders to control an enormous amount of assets using a tiny amount of money.  This is where the danger comes in.

While traders can make big bucks being on the right side of the bet, there is also the risk of crushing losses.

This is what happened recently when a rogue trader for the second-largest bank in France made a bad bet totaling over $7 billion in losses, the largest in banking history. 

But despite instances like these, the monstrous growth of financial derivatives continues.

Over 20 years ago, with derivatives trading around $1 trillion on a daily basis, I upped the gold hedge position in our portfolios to offer additional safety.  That decision protected us during the huge stock market crash of 1987 brought on by derivatives.

Today, on the same daily basis, derivatives are trading at $500 trillion.  To put that number in perspective, the U.S. has an annual GDP of $14 trillion.  That means a 3 percent decline in the derivatives market would be greater than the total annual economic output of the world’s richest nation.  Scary stuff.

If the derivative dike ever breaks, a panic would sweep the financial world.  Bonds, money market accounts, bank CDs, cash, and all other dollar-based assets would plummet in value instantaneously.

History tells you that in these cases gold, common stock, and other tangible assets not linked to paper money become a source of value for investors.  Derivatives alone are reason enough to keep a small portion of your wealth in gold-related assets. 

For the remainder of your serious money, globally and geopolitically diversify it across ownership positions for maximum safety.

How large the derivative mess will grow to before the bottom falls out is anyone’s guess.

I predict we’ll continue muddling through just as we always have but just in case this house of cards one day comes crashing down, I know my investments will be safe when the dust settles. 

That’s what I call peace of mind – and real world financial safety.    

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