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Gold prices blew through $300 Gold’s Perfect Storm on the Horizon
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(February 9, 2002) Gold prices blew through $300 on February 8th, capping a two-week, 10% upmove. Gold's gains in price this time stem from a wide variety of different factors which, taken together, seem to signal a long-term secular change in the gold market, unlike the spike-and-pullback we saw September 11th. Are we looking at the beginning of gold’s “Perfect Storm?”
The now-familiar phrase "perfect storm,'' before there was a George Clooney movie of that name, was the title of Sebastian Junger's book about the fatal trip of the fishing boat Andrea Gail in 1997. The phrase refers to this once-in-a-lifetime magnitude hurricane that was born of the 'perfect' conjunction of wind, moisture, temperature, atmospheric pressure, weather fronts, and sheer happenstance which, acting together, sank the Andrea Gail off the Outer Banks in 1997.

Gold for two decades now has been in the doldrums, the forgotten investment, and its price has actually dropped in that time from its 1980 peak of $850 to its current average of slightly below $290 over the past four years. In inflation-adjusted dollar terms, gold is probably cheaper today that it has been in 100 years. No one disagrees that it's undervalued today - what will wake it up, and when, are the only questions.

Gold is a stable and timeless element, but it's not of much use when times are good, the currency is strong, and the economy is booming. But when things get dicey, gold's great value and utility become evident as the alternatives available for your money appear increasingly risky.

The gold market stands on the edge of its own storm today. We'll look at a few of the significant factors which, taken together, seem to signal a sea change in prospects for gold.

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The most timely storm warning is the malady called Enronitis. This new word has been all over the financial press, and will no doubt be in next year’s edition of Mr. Webster’s dictionary.

The worst symptom of Enronitis is the chronic and recurring question: Who’s next? The fear among equities investors is that other stocks that they hold may be artificially propped up by similar flaky, shaky accounting tricks. Some of the more prominent suspects named include Tyco, Cisco, and IBM. Others cite the big banks, which hold some $51 Trillion dollars worth of derivatives, financial creatures that are so arcane and inexplicable that they cannot even be plausibly expressed on a balance sheet. We will also find most telecom firms and conglomerates to be likely victims of ‘corporate profiling’ in our search for the next Enrons. News that the FBI this week was investigating the accounting practices of Global Crossing, the now bankrupt, but once popular darling of the telecom investor set, is not the sort of headline to engender investor confidence.

Not that anyone was so confident before the Enronitis outbreak. Consider the absolutely lousy performance of US equities over the past two years. Very few investors have been immune, and it's disheartening to study your stock portfolio or retirement account and realize that, yes, these things can actually go down in value – money can disappear, and one’s retirement may not be so cushy as was once expected.

For some portion of this vast legion of the recently disappointed, the ‘flight to safety’ will be to gold itself.

Demand for physical gold is also coming from investors in gold mining stocks and gold mutual funds. Many are up 25% to 40% over the past few months, and we at Onlygold are seeing profits being turned into physical gold bullion. The market capitalization of all the gold stocks in the world is only $40 billion or so, and the 21 precious metals mutual funds in this country only some $2 billion. This is a small sector, and bidding it up further only makes for even higher P/E ratios. As gold shares valuations go higher and higher, many investors who think positively about gold will find that holding bullion itself is more sensible than chasing this small universe of producers.

Physical gold supplies are a mere bucketful compared to the sea of dollars sloshing around in the world, and it would take a very tiny percentage of investors fleeing equities and buying gold to strongly affect the gold market. Last year, some 2500 tons of gold were mined worldwide, worth about $24 billion. This is dwarfed by several orders of magnitude when compared with the size of the U.S stock markets. For instance, about that much dollar value in shares of Cisco change hands in a mere ten days.

To measure current US gold demand, let's use the most popular gold bullion coin in the US as a stand-in to represent gold bullion offtake in this country for the year 2001. The US Mint sold 709,000 ounces of gold Eagles last year. At $300/ounce, this represents some $212 million in sales of America's most popular form of gold bullion. In comparison, hundreds of NYSE and NASDAQ stocks trade more dollar volume than that each and every trading day, day in and day out. In a nutshell, the amount of gold traded is very small compared with the available supply of investor dollars.

The potential gold storm is not just a US phenomenon. The recent move in gold is remarkable for its universality. Against the yen, gold is up over 25% in a year, nearly 20% versus the Euro, and about 10% against the dollar. Gold is now valued higher not just in dollar terms, but is worth more in all currencies. This indicates the start of a fundamental revaluation of gold.

In making the case for gold’s ‘perfect storm,’ it is hard to ignore the institutional short positions held in gold as a source of future gold demand. Forward sales hedge books of many gold mining concerns such as Barrick Resources come to mind. Also, the complex of gold derivatives outstanding (artificial short positions, held chiefly by banks) can be seen as a dangerous house of cards. Years of short-selling and the gold carry trade as practiced by and through the bullion banks probably make up lingering short positions which will have to eventually be filled. But all of these factors are hard to quantify, as trading positions among large institutions are not public information, and can change quickly. Nonetheless, they may in the future be huge factors in gold’s upward move.

No storm is complete without thunder, which can be heard in GATA’s attempts to prove conspiracy at the highest levels in the gold markets, consequently end that conspiracy, and thus allow gold prices to soar to their rightful level. We do tip our hats to GATA’s fine discovery efforts in uncovering federal intervention in the gold market, and bringing to light the shenanigans which have gone on the with the gold which we once considered our national reserve. Whether their noisy efforts contribute to gold’s ‘perfect storm’ remains to be seen.

Physical gold supplies are low, as demand for jewelry, industry, and investment has outstripped mined and recovered scrap supplies for four years running. The deficit in gold has been made up in part by sales by central banks - but other central banks have been buying, leaving a net small amount of gold actually freed up for private investors and users. Leasing of stored gold, with the attendant forward sales of future mine production, have combined to make up the difference. This means that, in essence, the gold market has been running on empty for quite some time. It has borrowed and converted much of central bank surpluses (in essence, stealing from idle stores of bullion), while simultaneously covering this situation by the forward commitment of gold mines' output for years to come (stealing from the future).

Thus, present gold supplies are borrowed, made into jewelry, and sold, while future supplies for the next few years are already spoken for. This scheme works fine, as long as the price of gold works its way downward, as it did quite obligingly from early in 1980 until the Summer of 1999. But all this unravels when gold prices rise - borrowed gold gets returned at a loss by he who has to replace it at a higher price, and the whole gold-lending house of cards comes to an end.

Gold price increases are inevitable without leased gold coming onto market, for where is the gold for jewelry, electronics, industrial uses, investors and hoarders going to come from? Not from gold mines that have already sold forward their future output. And there's the rub - once gold starts to rise in price, the whole gold business of the 1990's (borrowing from present supplies while tying up future supplies) comes to an ugly end. Gold supplies will become even tighter as bullion banks and dealers realize that this party is finally over, and the rules have changed.

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That today's world is in enormous turmoil is both a truism and a cliche - you well threaten to put your reader to sleep to say such a thing. Nonetheless, our world today seems uniquely and dangerously stormy and unstable - perhaps more so than at any other time since the Cuban missle crisis in 1962, or even Europe in 1939. Consider: India versus Pakistan in conflict over Kashmir, with nuclear weapons at hand. Israel and the Palestinians, in an escalating cycle of hate and vengeance. The West versus radical Islamic fundamentalists, with announced threats of further terrorism.

And speaking of the US versus Osama Bin Laden, whatever happened to him? This war on terrorism has taken some unsettling turns. For many, it hasn't really sunk in that this war hasn't come to much good yet. The Taliban have been chased out of Afghanistan, but so what? We haven't had much success tracking down the El Qaida leadership. And Don Rumsfeld asserts that hundreds of thousands of potential terrorists from the Al Qaida training camps are out and about, in the Middle East, Europe and America, with further terrorist attacks imminent.

All of the world's situation matters greatly to gold, especially in dollar terms. The US dollar has been for some time the world’s reserve currency. The ascent of the Euro directly threatens that position, as do the slowing of foreign investments in the US, lower interest rates on US dollar instruments, and any destabilizing tendency of the US to strike out on its own without regard to world perceptions of US intent. It is a delicate matter to parse rhetoric from fact in a presidential address, but by naming Iraq, Iran, and North Korea the “Axis of Evil,” President Bush risks being perceived as straddling the line between declaring war and saber-rattling. Neither position is of much comfort to the world.

Elsewhere, Japan is sinking, and South America’s second largest economy, Argentina, is on the verge of financial collapse. World trade has been limping along for some time, and new security measures threaten to further slow down travel and trade by imposing what is in effect a tax on mobility. This could be economically fatal coming on top of the current worldwide recession. The following is from the Economist’s special report: "Globalization," February, 2002:

“For the first time in the modern era of global integration, the world's biggest economies (and many emerging ones with them) have stalled at the same time. As a result, the principal measures of economic integration, cross-border flows of goods and capital, showed no advance last year. After growing by 12% in 2001 and by an average of 7% a year throughout the 1990's, the volume of global trade was virtually stagnant in 2001. Foreign direct investment flows also slumped, from more than $1.3 trillion in 2000 to barely half that in 2001, according to UNCTAD, a United Nations agency.

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Of course, the perfect breeding ground for higher gold prices versus any currency is profligate government spending. Another storm warning is that in less than a year, the U.S. has gone from a budget surplus to prospects of deficit spending ‘as far as the eye can see’ in order to pay for added defense expenditures, beefed-up airport and border security, and a host of other new plans, from agricultural supports to high-tech military gear, all in the name of "homeland security." The U.S. currency is still strong, but its time will soon come, especially as the Euro comes into wider acceptance as a reserve currency alternative to the dollar. How much longer will the world finance our deficit?

“The dollar’s days as the premier global reserve currency are numbered. The repercussions of a dollar revaluation will be profound and long-lived. It is not too soon for investors to assume defensive positions in light of these prospects and it will not be long before they discover that gold is a core component of investment defense.”

“…Gold today is an opportunity to take a low risk position that the financial markets are in the late stages of a blow off. At the very least, it provides insurance against such an event. We are looking forward to an imminent reversal in gold’s status as an outcast among financial assets.” - John Hathaway, Tocqueville Asset Management, February, 1999. (see Tocqueville.com)

Hathaway’s words from early 1999 seem particularly prescient today - he practically called the exact climax of the financial market bubble. Those of his readers who bailed out of stocks in February 1999, and into his gold fund, have been richly rewarded. Hathaway's affection for gold at today's levels is echoed today by Tim Wood (see TheMiningWeb.com) posted February, 2002:

“This should not be seen as a call to switch all you have into gold - not unless you can absolutely afford it. But raising portfolio exposure to 15 or 20% may not be remiss. If things go badly that will be sufficient to make a world of difference. If we escape the expected decompression then there's not too much harm done.”

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An important and positive trend for gold today is the youth and affluence of its newest fans. Today’s gold buyer is quite unlike his or her father or grandfather, who probably put away gold during the 1970s and 1980s as a hedge against inflation. It has been nearly twenty years since gold was a widely popular investment in this country, and the new generation of buyers come from a strong equities market background, and for the most part they haven’t owned gold before. Therefore, their outlook on gold is not colored by the grinding negativity engendered by the slow erosion of gold’s value during that 20-year period. Gold to them is a fresh alternative, an investment choice now free of the political, semi-apocalyptic "goldbug" baggage that came with gold ownership a generation ago.

Yet many older gold buyers are also returning to the gold market. The generation that bought and sold gold back in the 1970s and 1980s sees gold today at a very familiar and reasonable price, and as a sensible alternative to the pitiful returns offered today by fixed-rate investments such as bank CDs. To older investors accustomed to guaranteed returns of from 5% - 12% as bank certificates of deposit have paid over the past 20 years or so, today's promises of around 3% seem pretty thin gruel, indeed. No wonder they are coming back to gold, which only needs to go up $10 or so in a year's time to beat a 3% bank rate.

Young and old, today’s early buyers of gold are basically value investors. They are buying gold at prices that were last seen during the late 1970s. These value investors will dominate while gold still trades between $265 and $350. Momentum and trend-followers will take interest at $400 to $500, new money will engender higher prices, which will attract more new money, and then the real piling on will begin. This inevitable process can't be hurried, won't be without fits and starts, and may take years to run its course.

As with most long-term secular market changes, gold will overdo on the upside as the storm reaches its peak (and the general public by the millions decide that it's time to climb aboard) before finally settling in a price range more in line with the true value of the US dollar against gold. By then, we will have forgotten those good old days, the first two years of this century, when gold could actually be purchased at prices reminiscent of 1978.

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There's another book about swordfishing that's very much worth reading, though there hasn't been a movie based on this one yet. It's entitled The Hungry Ocean, and was written by ship's captain Linda Greenlaw, whose own fishing boat the "Hannah Boden" survived that same storm. For some reason, a phrase from the flyleaf of that book sticks in my mind:

“Savage weather, equipment failure, too few fish, and too many sharks…”

“Savage weather, equipment failure, too few fish, and too many sharks…”

Say it a few times, and it starts to sound like a description of gold's upcoming perfect storm.

-Richard Smith, February 9, 2002

 

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