Why invest in gold?

Too many investors miss the point of gold, but the yellow metal has something that dollars, yen, euros and yuan do not: it’s price can’t be easily manipulated. Therein lies its beauty.

Too many investors miss the point of gold. They look at it like a lump of metal well-suited for gathering dust in a vault. Gold, though, has something that dollars, yen, euros and yuan do not: it’s price can’t be easily manipulated. And that’s the key behind the metal’s meteoric price rise over the past decade.

As governments around the world quietly inflate their currencies, they are – in effect – reaching into our bank accounts and skimming some coin off the top. They do it quietly and most of us are none the wiser.

Right now, for instance, the official inflation rate in the U.S. stands at 3.56 percent. That means that if you stuff $10,000 into your mattress on Jan. 1, it’ll be worth $356 less than it would have if you spent it right away.

The numbers on the front of your bills stayed the same, but the actual purchasing power of those dollars went down. The supply of gold, on the other hand, can’t be arbitrarily increased based on political decisions out of Washington. If demand goes up, the price of gold is going to go up with it.

And, if the dollar’s going down at the same time the demand for gold is going up, the relative change in the value of gold will be compounded.

Still not sold? What if we hit double-digit inflation? You might have your cash sitting in a bank account that’s earning 1 percent interest every year. If inflation hits 10 percent, that means every dollar you have actually loses 9 percent of it’s purchasing power every year!

What’s scarier is the fact that many believe we’re already suffering through double-digit inflation. John Williams at ShadowStats.com calculates what’s known as the SGS-Alternate CPI number. It’s not something he made up. It’s actually the exact method Bureau of Labor Statistics used to report inflation through 1980. Since 1980, though, the government’s continuously fiddled with its calculations to make inflation look tamer than it would otherwise be.

Right now, ShadowStats reports that the inflation rate stands at 11 percent. That’s a scary number – unless, of course, you’re getting an 11 percent raise at work every year and your 401K is pumping out double-digit returns. Since most of us aren’t that lucky, precious metals like gold start looking attractive.

And, if metals look attractive to you and me, then they definitely look attractive to the Top 10 percent of the wealthiest Americans. Keep in mind, too, that that Top 10 percent owns fully 80 percent of all the outstanding stock in public companies. They know how and where to place their bets, and a lot of them are flocking to gold.

More arguments against gold

I’d rather invest in something tangible, naysayers argue. Something like oil or real estate.

Those aren’t bad ideas, but gold has distinct advantages over each of those alternatives. The most important advantage is the fact that supply of gold is largely static. Oil and real estate are intimately tied to market conditions.

If the cost of oil goes too high, consumers drive less and spend less. On top of that, businesses incur greater expenses and the price of goods rises. That slows down economic expansion and eventually drives down the price of oil. The same goes for real estate.

If the official inflation rate hits double-digits, there won’t be a bank in its right mind that would be willing to loan a consumer the funds to buy a house at today’s interest rates. And not many consumers would be interested in buying a house with a fixed mortgage around 10 percent.

The value of gold can’t be inflated away, and therein lies its power. In a world where economies around the world are racing to devalue their money, there are few places investors can turn. That’s why I’m confident we haven’t see the end of the bull market in gold.

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How much gold market manipulation do ETFs cause?

There hasn’t been a major downturn in gold prices since 2006 (when GLD was launched), and that means we haven’t seen the full destructive force of a bearish swing against GLD and other gold ETFs. If it ever happens, it could be downright brutal.

It’s hard to believe that a mere 7 years ago physical gold ETFs didn’t exist. The launch of the SPDR Gold Trust ETF (NYSE:GLD) in 2006, though, proved that there was a market for a simple, paper-based way to invest in gold bullion. The Gold Trust’s success spawned a mass of imitators, and now physical gold ETFs hold 2,100 tons of the metal in vaults around the world, according to The Globe and Mail.

Physical gold ETFs are particularly popular with hedge funds. Take John Paulson’s New York-based Paulson and Co. hedge fund, for example. As the single largest shareholder in GLD, Paulson’s fund holds some $4.3 billion in gold via the ETF. That’s good for 8 percent of GLD’s total value.

With so much capital tied up in physical gold ETFs, what happens when Paulson and other hedge fund managers decide they’re ready to unwind their positions? It’s the ultimate question, and it’s one that will likely lead to a lot of profits and a whole lot of losses (for people on the wrong side of the trade) in the future.

Some investors argue that gold ETFs have driven up prices for gold artificially fast by lowering the barrier to entry. As the share price in gold ETFs climb, those ETFs are forced to accumulate more physical gold bullion. That in turn puts upward price pressure on gold spot prices, which in turn leads more people to invest in gold ETFs, etc. That cycle leads to what some investors refer to as an echo chamber or a self-fulfilling prophecy on gold prices.

When sentiment turns against gold, then, the results could be ugly. Just as physical ETFs make it easy to invest in the yellow metal, it also makes it easy to sell. If enough gold investors dump their shares in GLD and other physical gold ETFs at the same time, spot prices for the metal could plummet with the fresh glut of supply. That in turn could lead more people to sell off their shares in GLD and related ETFs.

Not everyone’s convinced the effects of GLD are that powerful, though. David Franklin, an analyst at Canada’s Sprott Asset Management, tells The Globe that money flowing into ETFs has likely just come at the expense of investing in gold mining stocks. Juan Carlos Artigas, an investment manager with the World Gold Council, points out that ETFs account for just 8 percent of global gold demand. Contrast that with jewelery demand, Artigas says, which holds a 50 percent share and coin demand, which drives about 25 percent of gold demand.

Both are valid points that seem to indicate ETFs aren’t manipulating markets as much as people might think. I buy the arguments for the most part, but recognize that they’re just theories. There hasn’t been a major downturn in gold prices since 2006 (when GLD was launched), and that means we haven’t seen the full destructive force of a bearish swing against GLD and other gold ETFs.

I imagine if John Paulson sold off a large stake in GLD, a lot of investors would follow suit, and the results wouldn’t be pretty. Sure, the hedge funds will have nice returns, but the man on the street might end up sitting on a collection of gold that’s worth a fraction of what he paid. I don’t see that happening anytime soon, but when it does, I hope to stay well clear of the carnage.

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India silver price to outpace rise in gold?

A number of factors have vendors looking for big gains in India’s silver prices in 2011, gains that could easily outpace the rise of the price of gold.

Rapidly rising gold prices have made it more acceptable for Indian families to offer gifts of silver rather than gold at their daughters’ weddings. “Only poorest among the poor in India could have thought of buying silver jewelry for the marriage of their daughters some years back,” writes CommodityOnline. A number of factors are driving up demand for silver in India, though, and here are a handful of reasons why silver’s price rise might outpace gold’s in 2011:

1) The high cost of gold. At $1,430 per ounce, the cost of gold jewelry is moving out of reach for low-income Indians. “Silver has emerged as a fashion statement as many people find difficult and unrealistic to buy gold jewelry at these high prices,” John Luckose, the owner of a small gold and silver shop in Kochi, tells CommodityOnline.

2) Fresh investment demand. Year-over-year food inflation is running rampant in India. The rate, as measured by wholesale prices, topped 10 percent (10.05 percent) for the week ended March 12, according to The Economic Times. Inflation is also finding its way into prices for non-food items with manufactured goods inflation at 6.1 percent last month. As prices climb, silver coins and bars present an attractive, low-cost means of protecting assets.

3) The wrong sort of attention. Wearing flashy gold jewelry in India could be enough to get you mugged. “People fear wearing gold jewelry these days as high gold price has led to several incidents of gold jewelry snatching on streets,” Luckose says. “Many customers coming to us say that they feel comfortable wearing silver jewelry.”

4) Some boats rise faster than others. India is the world’s largest consumer of gold. It accounted for around 24 percent of world gold consumption, according to the World Gold Council and the Bombay Bullion Association, and demand for gold as an investment soared 73 percent last year. That sounds like a lot until you compare it to last year’s growth in demand for silver in India. Silver imports climbed more than six times 2009 levels in the first six months of 2010, according to commodities brokerage Karvy Comtrade. If that trend stays intact in 2011, silver’s price rise will likely dwarf gains in the price of gold.

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15 gold price predictions for 2011

A number of influential traders and executives have publicly weighed in with gold price forecasts for 2011. Here’s a recap of the more memorable predictions from 15 trading professionals and individuals.

A number of influential traders and executives have publicly weighed in with gold price forecasts for 2011. Here’s a recap of the more memorable predictions:

Chuck Jeannes: Goldcorp Inc.’s (NYSE:GG) CEO sees gold at $1,500 an ounce as “easily achievable,” and he could see the price eventually rising as high as $2,300 if and when inflation sets in (The Street)

Dennis Wheeler: Coeur d’Alene Mines Corporation’s (NYSE:CDE) CEO “would not be surprised” if gold prices rose to $1,500-$1,600 an ounce in 2011 (Reuters)

Sean Boyd: Agnico-Eagle Mines Limited’s (NYSE:AEM) CEO argues gold at $1,600 an ounce in the next 12 months would “not be a stretch” (Reuters). “Gold will ultimately go above $2,000 and I think it’s going to go in steps so I could see $1,600 this year,” he tells The Street.

Mark Cutifani: The CEO of AngloGold Ashanti Limited (NYSE:AU) see gold range-bound between $1,300 and $1,500 an ounce in 2011 (The Street)

Rick Rule: The founder of Global Resource Investments, which was acquired by Sprott Inc. (TSE:SII), expects “some event-driven spike in metals prices.” “I have no earthly idea where gold will close, but to be a good sport and play the game, I’ll say $1,750,” he says (SeekingAlpha)

Aaron Regent: CEO of Barrick Gold Corporation (NYSE:ABX) tells The Street he believes the “forward curve would suggest a gold price in the $1,500 range” (The Street)

Ian McAvity: The founder of the Central Fund of Canada (CEF), Central Gold Trust (GTU), and Silver Bullion Trust (SBT.U) expects a “monetary panic” in the dollar or euro to push gold to $2,000-$2,400 per ounce this year or in 2012 (SeekingAlpha)

Mark Bristow: The CEO at Randgold Resources Ltd. (NASDAQ:GOLD) expected gold to rise as high as $1,500 an ounce (The Street)

Morgan Stanley (NYSE:MS): The investment bank has set a gold price target of $1,512 an ounce for gold in 2011 (The Street)

Ross Norman: The co-founder of TheBullionDesk.com is looking for gold to trade between $1,350 and new all-time highs of $1,850 per ounce (SeekingAlpha)

The Street reader survey: Of the almost 6,000 people who have taken The Street’s gold poll, 47 percent believe gold prices will finish between $1,500 and $1,800 an ounce in 2011 (The Street)

James Turk: The founder and chairman of online precious metals vendor GoldMoney.com sees gold sprinting much higher “probably in the first half” of this year to $2,000 per ounce (SeekingAlpha)

Charles Oliver: The senior portfolio manager of the Sprott Gold and Precious Minerals Fund, Oliver sees currencies around the world continuing to plummet in 2011. He expects that will push gold up to $1,700+ by the end of the year (SeekingAlpha)

Adrian Ash: A researcher at BullionVault sees individual savers moving into gold bullion this year as negative real interest rates erode buying power. That could push gold 20 percent higher this year to $1,695 an ounce (SeekingAlpha)

Richard O’Brien: The president and CEO of Newmont Mining Corporation (NYSE:NEM) sees gold eventually rising to $1,750 an ounce by 2012 thanks to the protection the metal provides against inflation. In 2011, he sees gold trading between $1,350 and $1,500 an ounce (Reuters)

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What could cause a gold price crash?

A fast and furious correction in gold prices to $400 an ounce sounds hyperbolic. Still, every investor should always look toward worst-case scenarios before investing. Here are a few things that could prompt a gold price crash.

There hasn’t been a shortage of gold skeptics during the 10-year run-up in gold prices that started in 2001. That’s probably a good thing, though. It’s only when everyone is convinced that a commodity is heading higher that the risk of a dramatic correction in prices sets in.

Still, at least one portfolio manager is sounding the warning bell on gold prices. Charles Lemonides of New York’s ValueWorks, LLC, recently appeared on Canada’s Business News Network arguing that if gold dips below its March 15 lows, we could be in for a steep sell-off that might see gold prices tumble to $400 an ounce.

“I think there’s a lot to be said for what’s happening in the gold market and the commodities markets setting up for a classic collapse,” he said on Wednesday, according to IBTimes. “Once that correction starts it becomes very fast and very powerful and is very dangerous for investors.”

A swift fall to $400 an ounce wouldn’t so much be a “correction” as a “wholesale slaughter,” but Lemonides argues that gold producers are rapidly building up capacity that will soon flood the markets with cheap gold. That could drive down demand and – in a sort of trading echo chamber – push prices even lower as scared investors jump ship.

Still, a fast and furious fall to $400 an ounce sounds hyperbolic to say the least. But every investor should always look toward worst-case scenarios before picking a potential investment. Here are a few things that could prompt a gold price crash:

Changes in Fed policy. It’s no secret that one of the biggest drivers for gold prices right now is the loose monetary policy that the Federal Reserve has embraced. With interest rates near zero and quantitative easing in full force, there isn’t just a threat of inflation in the future; it’s almost a sure thing. Investors eager to protect their capital in an inflationary environment are moving into gold out of the hopes of protecting their assets against debasement of the dollar. If the Fed were to suddenly and unexpectedly announce a change in policy (an interest rate hike, or an early end to QE2, for example), gold prices would likely fall in the near-term.

A surging dollar. One of the more curious outcomes during the height of the housing market crash and financial crisis in 2008 was the surge in the value of the dollar – even as the Fed took extraordinary measures to inject more liquidity into the economy. The dollar climbed as investors sold off their stocks, swapped their currency for greenbacks and ditched just about every other form of investment they were holding. The net effect was a 28 percent plunge in gold prices between March and November of 2008 from more than $1,000 per ounce to $720 per ounce.

A brand new gold rush. The third and least likely scenario (in my mind) that could cause a rapid decline in gold prices is precisely what Lemonides describes: a sudden surge in gold supplies. Excess supply could push down prices quickly and trigger a panicked sell-off in gold. I just don’t see that much supply entering the market in the short-term. Gold prices have been rising for a decade and that gives gold producers enormous incentive to get their product to market. They’ve been working hard to increase output for years, and they’ll continue to do so. It would take a new world-class deposit that’s buried under just a few feet of soil in an easily-accessible, politically-stable region to spark a large sell-off in gold. More than likely, though, it’d just spark a rush into the shares of the company that owns rights to that deposit.

That’s not to say I take the chances of a gold sell-off lightly. If sentiment turns against precious metals, it will do so quickly, but I can’t see sentiment changing in the near future – particularly as rumors of QE3 hang like a cloud over the future of the dollar. And, as investors grow increasingly wary of the dollar’s prospects, it becomes more unlikely that’ll we see a repeat rush into the dollar like we saw in 2008 should another Black Swan swoop down on the market.

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How would a gold standard work in the 21st Century?

Utah’s proposal presents an interesting wrinkle on the gold standard by allowing an official alternate form of legal tender to co-exist with the dollar. Would such a proposal be feasible? Perhaps.

The recent news that Utah representatives have passed a bill that could usher in a gold standard, got me wondering what it might be like to have a gold standard that co-exists alongside the U.S. dollar.

Traditionally, the gold standard worked by fixing the value of the dollar to a set amount of gold. Consumers bearing dollars could visit a local bank and exchange their dollars for bullion at an exchange rate determined by the government.

The problem, of course, was that by fixing the value of the dollar to a specific commodity, the government no longer had the means to artificially increase the monetary supply. If authorities wanted more dollars in circulation, they’d have to increase gold holdings in order to back those dollars.

Utah’s proposal presents an interesting wrinkle on the gold standard, though, by allowing an official alternate form of legal tender to co-exist with the dollar. Businesses and consumers could exchange dollars OR Federally-issued gold and silver coins during financial transactions.

[Related: Utah gold standard could become a reality]

Would such a proposal be feasible? Perhaps. To illustrate, let’s imagine a world where your bank or financial institution offered you a special, gold-backed savings account. By transferring dollars from your checking account into your gold-backed savings account, you’d effectively be “buying” and holding gold. Rather than being denominated in dollars, cash in your savings account would be denominated in XAU (the currency symbol for gold).

For its part, the bank would allocate physical gold holdings to your account whenever you transferred cash into your gold account. The bank would store this gold in a vault and, presumably, charge you a fee for the service. Under such a scenario, if the price of gold rises relative to the dollar, your savings would rise, too.

Ideally, your bank would also allow you to make purchases directly from your gold-backed savings account. You’d swipe your debit card as you always do, the gold in your account would be exchanged for dollars at prevailing rates and your purchase would be processed in dollars.

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The beauty of such a scheme is the value of gold to dollars wouldn’t be set by the government as it was in the past, but rather, it would be electronically determined by the current market price for gold.

Sounds like a win-win for everyone. There are dangers in such a plan, though. If the public started to show a preference for holding gold over dollars, the value of the dollar would plummet and the price of gold would rise dramatically. Banks would have difficulty backing your savings with physical gold and investor confidence in the dollar might crumble – not just here but around the world.

[Related: Why invest in silver?]

The biggest threat to any currency, of course, is a loss of faith in that currency. We’ve seen that happen in South America during the ’70s and ’80s, Germany after World War II, even during the dying days of the Roman Empire. If consumers were to lose faith in the dollar, they’d be eager to spend their dollars for whatever material goods they could get their hands on and prices would begin to rise quickly.

Utah’s plan to create an alternate legal tender might accelerate a rush out of the dollar. But it seems to me that process has already started. Perhaps what we’re seeing play out is simply a symptom of a bigger problem: the U.S. debt burden has become too large. No matter how much Americans might like to return to our post-war lifestyles, the balance of power is shifting East. Our consumption levels have to fall more in line with reality, and that’s going to cause pain along the way.

If there is a way to have the dollar peacefully co-exist alongside an alternate tender in the U.S., though, the solution lies in the banking system. Give me the ability to sign up for a gold-backed money market account or a gold-backed savings account, and I’ll happily sign on the dotted line.

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China gold reserves too small, adviser says

Households and businesses purchased more than 300 tons of the metal last year, and that trend looks to continue in 2011. If the government jumps in, everyday gold buyers may find themselves unable to afford gold.

A widely respected economist in China, Li Yining of Peking University, has joined a chorus of advisers urging the Chinese government to increase the country’s gold reserves as a hedge against inflation of foreign currencies.

“China should increase its gold reserves appropriately, and China must take every chance to buy, especially when gold prices fall,” Li told China’s Xinhua news agency.

At least one government official argues that building up China’s gold reserves would drive gold prices too high for everyday consumers.

“The gold price shot up last year, and surging gold prices have forced Chinese people to pay more as there is strong demand for gold for those getting married and other events,” Yi Gang, head of the State Administration of Foreign Exchange, said recently.

China’s appetite for gold is large. Households and businesses purchased more than 300 tons of the metal last year, and that trend looks to continue in 2011. If the government jumps in, everyday gold buyers may find themselves unable to afford gold.

Still, China’s official gold holdings are much smaller than many other countries – amounting to just 1.7 percent of its foreign reserves, according to CNBC. With a population of 1.34 billion, that equates to about $37.45 worth of gold per person for a total of $50.19 billion. The U.S. holds nearly five times as much bullion.

Here’s a break-down of the Top 10 largest gold reserves in the world (click for larger view):

After falling rapidly in January, gold prices have spiked in the past six weeks in the face of turmoil in the Middle East and Northern Africa. All told, the metal’s up 3 percent since the start of the year. If the Chinese government starts buying in earnest again this year, expect prices to climb even higher.

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Not enough gold in the world to return to a gold standard, Bernanke says

In an appearance before the Senate Banking Committee, Bernanke pointed to a flaw he sees in a gold-backed currency: namely, that there’s not enough gold in the world to go around.

Rumblings that the U.S. should return to a gold standard have started trickling into the media as the public grows wary of a ballooning budgetary deficit. In an appearance before the Senate Banking Committee earlier this week, Federal Reserve Chairman Ben Bernanke was asked directly about the possibility of the U.S. returning to a gold standard.

“It did deliver price stability over very long periods of time, but over shorter periods of time it caused wide swings in prices related to changes in demand or supply of gold. So I don’t think it’s a panacea,” Bernanke said.

The soft response to questioning from Sen. Jim DeMint (R., S.C.) – a long-time Bernanke detractor – leaves a tiny window of hope that a gold standard might be something the Fed’s actually considering. “It’s not a cure-all, but it could be helpful,” Bernanke seems to be saying.

It’s difficult to imagine Bernanke would endorse a gold standard. He’s long maintained that the Federal Reserve kept too tight of a grip on the money supply by raising interest rates during the Great Depression. Once the public began losing faith in the dollar, they were all too eager to trade greenbacks for gold, which further contracted the money supply and ultimately led to deflation.

Linking the dollar to a fixed amount of gold would constrict the Fed’s ability to prop up the money supply. Bernanke himself pointed to another flaw he sees in a gold-backed currency: namely, that there’s not enough gold in the world to go around.

“I don’t think that a full-fledged gold standard would be practical at this point,” Bernanke said.

He could be implying a watered-down gold standard of sorts is possible in the future, but I’m not convinced Bernanke believes that. Inflation is one of the few tools the Fed has to spur growth (or at least the perception of growth). Giving power up is always more difficult than accepting it, and – so long as the public retains faith in the dollar – it would serve little purpose.

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Triggers that could push gold to $5,000 per ounce

While they may not be readily recognized, the triggers that could push gold over $5,000 per ounce are always there.

Few investment vehicles are more maligned or misunderstood than gold, and yet there is logic in the price movements of the metal. As paper currencies get debased, it makes sense that finite commodities including oil, precious metals, food and raw materials will cost more. The question is, how much more? In order for gold to reach $5,000 per ounce, the state of the financial system would have dramatically different than it is today. That’s not out of the question, though. Here are three triggers that could potentially push the cost of gold to $5,000 per ounce:

1) Rampant inflation. Since gold is a finite commodity, it functions as a store of value. If the price of the dollar falls, it will cost more to buy gold. It’s helpful to think of higher gold prices not necessarily as a rise in the cost of a particular metal but rather as a reflection of the loss of the dollar’s purchasing power. If the value of the dollar falls dramatically in the coming years (as many have predicted), the price of gold and other commodities will inevitably go up.

2) Political instability. If the ongoing unrest in Egypt has taught us anything, it’s that investors abhor uncertainty. Political instability, war, acts of terrorism and other exogenous events create uncertainty, which forces investors into safe haven trades like commodities, gold and cash. This makes sense. Successful investors are, after all, good at accessing risk, and there is no way to access risk when political stability begins breaking down.

3) Oil shocks. The main impetus behind the 20-fold increase in gold prices during the 1970s was a sudden and unexpected surge in oil prices. If the unrest in Egypt were to spread to some of OPEC’s biggest players like the United Arab Emirates, Kuwait or Saudi Arabia, oil prices could spike dramatically, and gold would follow suit. “The two oil shocks of the 1970’s saw gold prices rise by more than 20 fold in just 9 years – from $35/oz to $850/oz,” GoldCore director Mark O’Byrne tells MarketWatch. “A 20-fold increase from trough to peak would see gold rising to over $5,000 an ounce in the coming years.”

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Worldwide gold supply and demand growth in 2011

Gold mining supplies have remained relatively stable over time with some 2,600 metric tons per year being brought to market.

Gold mining supplies have remained relatively stable over time with some 2,600 metric tons per year being brought to market, per Taiba. That’s the equivalent of 91.7 million ounces of gold worth $125 billion at today’s prices.

That sounds like a lot, but those supply gains haven’t kept up with worldwide gold demand in recent years. Based on third-quarter numbers from 2010, global demand for gold in 2010 was on pace to rise 48 percent (12 percent per quarter), pushing demand over 3,600 metric tons in 2010. That gap between supply and demand helps explain gold’s quick rise, and many investors see that trend continuing in 2011.

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