At the end of another week, we reiterate our simple investment formula for your benefit, dear reader, but this time, with a new twist: Buy gold! Sell Goldman!

Goldman Sachs stock slumped again on Tuesday, although the company had just announced record profits. Goldman is top dog in the "dog and pony" show. But its latest profit report establishes not only a new record for Goldman, but also a record for the whole breed. Net income doubled to $2.31 billion for the second quarter. Based on results for the first half of the year that makes Goldman the most profitable firm in the history of the financial industry.

And yet, its stock fell.

We are keeping an eye on Goldman these days, because we think it will tell us something: something about the economy, and something about the times we live in. Every dog has his day. Goldman has had a month of them. We
wonder: what kind of world is it that Goldman would be on top of?

It is one that rewards money mongers. Previous American economies rewarded people who drilled for oil, built bridges, or made mattresses. This one gives its blessings, its honors, and its profits to people who deal in money itself. Goldman deals in money like a Vegas card dealer. Its shuffling is so smooth and so sure that the White House has invited its top shuffler to Washington, hoping he'd bring some of that financial razzamatazz along with him.

Yesterday, we tried to get to the bottom of the Goldman mystique.

Laboring as always to better serve our dear readers, we happened to travel to Germany, where we ran into an old friend who is a professional investor and a heavy user of hedge-fund products. We put our conundrum to him.

"Here's a question," we began. "Trading is supposed to be a zero-sum game, right? Well, how is it possible that a company like Goldman - with thousands of traders - can make 75% of its revenues from trading? You'd think their lucky trades would be balanced out by their unlucky trades. They can't all be lucky. And they can't all be geniuses. As Buffett says, there aren't that many geniuses around.

"Or to put it another way, here's a company making billions, mostly by trading. Who's on the other side of these trades? Who's losing? Where does the money come from? How is it possible for so many traders to have a result that is so far beyond equilibrium...it seems to defy gravity."

"Yes, it is a curiosity," said our friend. "You're right about hedge funds. I mean, what you wrote about them. The average person will do no better in hedge funds than in mutual funds. In fact, he'll do worse, because of the fee structure. As you noticed, if he gets lucky, the manager will stand right there beside him, with his hand out, when the payoff comes. If he's unlucky, and the fund loses its bets, he'll be in line alone. The manager won't share the losses.

"'The average man doesn't wish to be told that it is a bull or a bear market,' wrote the legendary Jesse Livermore once. 'What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn't even wish to have to think.'

"You're right, too," continued our friend, "that there aren't 8,000 geniuses running hedge funds. The average return will not be very good. But you're wrong to tell investors to stay away from them. I'm invested in several hedge funds. In every case, the manager has figured out some special little sweet spot in the market. Usually, it's some little thing that most people don't know about. For example, one fund I'm in is run by a guy who just makes a point of catching the 'earnings surprises' before Value Line.

"Value Line figured out that you can do well by buying companies whose earnings are better than forecast. After the earnings come out, it takes Wall Street a while before it adjusts its view of the company to the higher earnings. But it also takes a while for Value Line to get the news and update its rates. This manager uses the same simple idea; he just moves faster. And he consistently beats the market.

"There are anomalies out there. Good hedge fund managers find them and exploit them. And good investors find the hedge funds that do that and negotiate their own fees to a reasonable level. But the average investor has no idea. He picks up a hedge fund like he buys a bottle of wine - because someone told him it was good. And then, he pays fees that are so high it is almost impossible for him to make any money."

"But what about Goldman?" we asked.

"Goldman is said to be the largest hedge fund in the world, but in fact, it is, the largest collection of hedge funds in the world. It has hundreds of them. It has a great reputation...and it has its hands in more deep institutional pockets than anyone. So, it get so much money under management that it makes a fortune, even when its results are not spectacular. And in a sense, it is also the bank. It is not just playing in the casino; it is the casino. Goldman is trading so much money for so many people, it makes money no matter which way the markets go."

The question for investors is this: Is the casino getting bigger, or is business falling off? Investors answered yesterday: they sold Goldman. For once, we think they were right.

*** Poor George Soros. He tried to get the France's highest court to overturn a conviction for insider trading, dating back 20 years. The Cour de Cassation upheld the lower court. Poor George still has a rap sheet. Maybe he could use some advice from Goldman.

*** And what about our favorite metal? Will we have to live through another long, dark teatime of the soul, when gold falls for 20 years as it did from 1980-2000? Or, are we merely enjoying a correction in a major bull market?

Gold is now officially below our buying target. We're not too sure where we left the last buying target, but wherever it was, gold is comfortably below it. Buy. If the price drops below $500, buy more.

But wait. How do we know that this is not a trap? Why can't gold just slide back down to $250?

As usual, we can give you no sure answer. We know no more than you do. All we have is faith. And a theory. We have faith in our fellow human beings. Given enough temptation, they will yield to it. That temptation, for a central banker, takes a predictable form: it is the temptation to create "money" out of thin air. In this, the U.S. Federal Reserve has led the way for the last four decades. Tossing off the last vestiges of gold-backing in 1971, it has sprinted toward temptation like a dipsomaniac to a free drink. Vast increases in the world's supply of money and credit have been registered, while the world's supply of gold barely increased at all.

You can easily forget to notice...amid all the noise of share prices, Fed policies, economists' apologia, analyst reports, charts, graphs, and new headlines. The essential truth is hard to hear. You have to hold your hands over your ears and let it whisper to you: all the world's paper currencies have been inflated. But if paper currencies are to lose value, they must lose value against something. That something, by tradition as well as convenience, is gold.

A few weeks ago, we yearned for a substantial correction. Now, we have one. We guessed that the bottom would come between $550 and $650. We gave ourselves plenty of room, but maybe not enough.

In the bull market in gold, so far, the yellow metal has risen along with its base metal cousins. In the bull market still ahead, it will shoot up like a plume of vapor. Investors have been shocked by how much gold can fall at this stage. In the next stage, they may be shocked by how much it can rise.

Bill Bonner is the President of Agora Publishing.  For more on Bill Bonner, visit The Daily Reckoning.