| Gold
Conquers Fear
by Hugo Drax
 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! |
