Gold Conquers Fear
by Hugo Drax
Gold Conquers
Fear The
recent train bombings in
Spain
have renewed fear of additional terror attacks. Moreover, the change in
government from the election in
Spain seems to have brought about
policy changes that may encourage the terrorists who are responsible. It
is not our purpose here to comment on the election or the politics of the
Socialist victor. However, we must examine the economic impact.
Another series of well-coordinated terror
strikes have taken place. This time, the chosen date was 11th of March.
The previous national attack on September 11, 2001 was exactly
two and a half years after the largest terror incident in
Spain’s modern history took place. Attacks on other
coalition nations such as
Britain, and renewed attacks on the
United States, seem likely.
Gold Up, Stocks Off
Gold’s price has been spurred upward as a
result. It has surged from its recent doldrums and is now hovering
steadily back above the $400 per ounce level. Stocks were off markedly on
the news of the terror attacks, both in
Europe and in the
United States. As a result, the Federal Reserve
announced it won’t be raising interest rates soon, keeping the 1% rate in
place for the foreseeable future.
Stocks rebounded slightly on the news from
the Fed, but have not recovered to their recent highs. Nor are those
highs within range of the peak a few years back. Even if we were to see
the Dow Industrials exceed its all-time high, we should not be overly
enthusiastic, since the value of the dollar has fallen dramatically in
recent months.
The dollar is not at all what it used to
be. In fact, the true measure of the Dow’s peak in inflation-adjusted
dollars, or in ounces of gold, was in 1999, at a bit over 41 ounces of
gold to Buy the Dow. Since that time, the price of gold has increased--
from a low in 1999 near $254-- to a recent price of $403 per ounce. It
now takes only 25.3 ounces of gold to Buy the Dow.
Stocks remain comparatively overpriced.
Price to earnings ratios for broad market indices such as the S&P 500
continue to be well in excess of 25. Historically, the price to earnings
ratio has been between ten and fifteen. When a trend line returns to its
mean value, it often does so by dropping well below its mean. Again, in
secular bear markets, historically, price to earnings ratios have dropped
as low as three to five.
So why have stocks been so high lately?
There is very often a bear market rally which takes the market back up
after its initial decline. This first bounce seems to have peaked at
around 26.8 ounces of gold to Buy the Dow. Only by ignoring the effects
of inflation and the devaluation of the dollar against many other
currencies does the stock market seem bullish in recent months. In fact,
it seems unlikely to recover its previous highs, even in inflated dollars.
The present condition in the American
markets should be used as a selling opportunity. Stocks are broadly
higher, but not for fundamental reasons. Expect a return to falling
prices, so sell while you may limit your losses or lock in some profit.
Deficit
Scares
If the stock market doesn’t worry you,
consider the deficits. There is a trade deficit, a fiscal deficit, and a
deficit in the government’s ability to meet future obligations.
The purpose of the dollar devaluation
policy has been to boost exports, slow imports, promote tourism here by
foreign visitors, and slow American tourism abroad. Together, these
factors were expected to benefit the current account deficit. However,
the effects have been nullified by unintended consequences of other
related policies.
Consider the trade policy of a devalued
dollar. In theory, a weaker dollar makes American exports preferable on
the world market. However, with
China
and many other exporting nations pegging their currency to the dollar, or
closely following the dollar with their own monetary policies, the benefit
to American exports is marginal. Indeed, the
USA continues to increase its
imports from China. Chinese exports benefit, as much, or more, than
American exports from the low dollar, which is also a low yuan. No wonder
policy leaders, including President Bush, have called on the Chinese to
remove the peg to the dollar.
American imports of oil are not helped by
the devalued dollar. After all, OPEC continues to price oil in dollars,
so it is now taking many more to Buy the same quantity of oil. Russia's
recent announcement that it intends to price its oil exports in EU euros
is not good news for the dollar. Should OPEC make the same decision, many
dollars now overseas for oil purchases will be returned to the USA forcing
prices up markedly.
So, the low dollar doesn’t seem to be doing
much to spur exports or limit imports overall. The trade deficit isn’t
improving rapidly. And the current account deficit isn’t, either. The
balance of payments includes matters such as tourism, which used to be a
much faster growing industry. Unfortunately, policies to address security
concerns at the airports together with fingerprinting for visa applicants
has discouraged tourism a great deal. And, with many
Caribbean nations and other tourist destinations
pegging their currency to the dollar, the flood of tourists has many
potential outlets outside the
USA. Not only is the low dollar
not spurring foreign visitors to the USA enough to overcome their newfound
reluctance to brave the security policies, but the low dollar is not
discouraging Americans from visiting countries whose currencies are pegged
to the dollar.
Fiscal Policy
Fiscal policy is largely driven by
political considerations, but has a major impact on economics. While tax
cuts and spending cuts are traditional fare for conservative politicians,
the current Republican majority in both houses of Congress seems unwilling
to cut spending. The deficit has zoomed, and an end is nowhere in sight.
Unfortunately, the official numbers of tax
receipts versus spending don’t tell the whole story. There are future
obligations, including Social Security and Medicare obligations to
retiring Baby Boomers which are looming ever larger. By some estimates,
there may be as much as $44 trillion in obligations among the federal,
state, and local governments. This figure is over four times the gross
national product of the USA.
What does that mean? It means that if just
10% of GNP were dedicated to debt service, it would take 44 years to pay
down the principle at zero percent interest. We can’t really expect low
interest rates forever.
Indeed, at some point, the low dollar
policy will give over to currency competition. The dollar will plummet
further, and only by raising interest rates will it be possible to attract
users back to the dollar. Raising interest rates, raising taxes, and
cutting spending are things to look for in future monetary and fiscal
policies, whether they are politically palatable, or not.
Election Solution
One should be careful about expecting much
change if the Democrats win the White House. The influence of the
President on monetary policy is not very significant, even with the
anticipated appointment of a successor to Alan Greenspan sometime in the
next four years. It is also unlikely that a Kerry Administration would
have a major influence on fiscal policies. Taxes might increase somewhat,
but spending is unlikely to decrease broadly, except in response to
substantial economic calamity. Many political analysts point out
similarities in the backgrounds of Bush and Kerry, both of whom have
wealthy families, went to Yale, and are members of the Skull and Bones
Society. A sea change in policies does not seem to be in the cards.
If you are counting on the election to
bring about meaningful political change, you should consider the recent
experience in
Spain. Pre-election terror attacks would represent a
significant shock to the markets. If the election did result in a change
in leadership then markedly different policies overseas might be seen as
appeasing the terrorists.
Plunging Dollar, Higher Gold
As the dollar continues to deteriorate on
world markets, it seems very likely that a flight to value will increase
the dollar price of gold. Central banks may respond with attempts to
support the dollar, or reverse established policies and dump gold from
their inventories. However, neither form of interference has in the past
made a significant difference. Central bank intervention is pretty much a
waste of time, and often a waste of taxpayer money.
Experts such as George Soros, Sir John
Templeton, and Warren Buffet have been diversifying their currency
portfolios away from the dollar. Templeton, in particular, predicted a
40% drop in the dollar “in the next few months” back in October 2003, and
about half this drop has already been seen.
Renewed terror attacks, trade deficits,
fiscal deficits, and unfunded future obligations are not the extent of the
problems facing the dollar and the financial markets generally. There is
also a serious problem in derivative positions by major banks and
financial institutions such as Fannie Mae.
Derivatives Implosion
On Tuesday, Bloomberg.com reported that
Fannie Mae’s derivative holdings have surged by 59 percent to over a
trillion dollars at the end of last year. Derivative positions are often
used as a hedge against changing interest rates or other risk factors.
Scrutiny in this area has been greater since Freddie Mac last year
admitted that it had under-reported profit by five billion dollars over
three years by using derivatives to reduce earnings volatility.
Of considerable interest is the total
volume of derivative positions, now $208 trillion worldwide, as measured
by the Bank for International Settlements as of
June 30,2003 . Again, to put it
all in perspective, that’s nearly 21 times the gross national product of
the USA.
Many analysts consider the very large
derivative positions of major banks to be akin to a major volcanic
eruption, such as the impending explosion of the
Yellowstone caldera which could produce major
earthquakes and send a cloud of ash into the stratosphere to blanket much
of
North America at nearly any time in the next one to
ten thousand years. There’s nothing to be done about it except pray it
doesn’t happen while your money is tied up in a certificate of deposit
somewhere.
Warren Buffet, certainly a proven
financier, has described the derivatives market as a nuclear explosion
waiting to happen. A derivatives implosion would devastate many financial
markets, again inspiring a flight to value in gold.
Buy Gold on Scarcity
If you are looking for other reasons to
expect a higher price of gold, look no further than supply and demand.
GATA.org estimates that the gold vaults at the world’s central banks are
now half empty. Gold has been flowing steadily out of their vaults for
over a decade now with sales, loans, and swaps.
Above ground stocks of silver have also
eroded. By some estimates, supply has been less than demand for 14
years. The price of silver has jumped recently, and while spikes in the
price of silver are not as long-lasting as spikes in the price of gold,
this one seems to have legs. The number of ounces of silver it takes to
Buy an ounce of gold reached an all-time high recently, and has only begun
to drop with silver at $7 and above. The
USA government stockpile of two
billion ounces of silver has dwindled to nearly nothing.
Short positions on silver are very high,
and exchange officials have raised margin requirements on silver at the NY
COMEX. Potentially, short sellers would be trapped if the longs demand
delivery owing to a lack of readily convertible reserves. No doubt in the
long run a great many sources of silver may be brought on line at a high
enough price of silver, but a spike to prices above $50 per ounce would
not be surprising.
Owing to the years of depressed gold and
silver prices from 1996 to 2003, mining exploration has been minimal.
From discovery to bullion on the street takes three to five years in
countries with policies favorable to mining and seven to ten years in
countries with unfavorable policies hindering new mining activity. Even
re-opening a mine may take eighteen months to three years, depending on a
host of factors such as accessibility and permitting requirements. So,
there is a real supply trap.
Fortunately, the gold mining stocks have
been doing very well lately. This surge in values provides much-needed
cash for major producers to acquire production by purchasing high quality
junior mining companies with large in-ground reserves.
Unfortunately, the major gold producers in
South Africa have been adversely
affected by the falling dollar. Gold and silver trade in dollars on major
markets. So, with a decline in the dollar, the South African rand has
been increasing. Costs for mines in
South Africa are in rand while
revenues are in dollars, a bad combination of factors. Indeed, the price
of gold in rand has dropped by nearly fifteen percent in recent months.
Similar monetary policy troubles are seen with other major gold producing
countries, such as
Australia, New Zealand, and Canada, all of which have
thriving mining sectors and all of which have seen their currency
appreciate against the US dollar.
This suggests a trend of declining
production for some of the largest producers of gold and silver in the
world. Obviously, shareholders will be reluctant to put up with such
behavior amidst rising prices for bullion.
So, what to do? Expect the major producers
to replace their ounces by purchasing other companies with proven reserves
in the ground.
For how much? Probably for prices in
excess of $100 per ounce of gold still in the ground, owing to various
competitive factors. Not only are the majors competing with each other to
Buy high quality junior producers, they are also competing with the
investor community who are anticipating this trend. From an investor’s
point of view, if you own shares of majors or juniors, there is a
beneficial cycle coming your way. Higher share prices result in more
demand for ounces in the ground to boost production results in higher
share prices. Higher metal prices spur demand for ounces in the ground
while bringing attention from institutional investors.
Conquer Fear
You can conquer fear today by Buying
gold and silver. Fear is going to be detrimental to most industrial
and technology stocks, but it should be very good for metals and mining
stocks.
If your portfolio is already weighted
toward cash, consider moving your cash into gold today. There’s no better
hedge against devaluation and inflation than gold!
