The latest from John Hathaway:
Iraq news has dominated the gold market since late last year, and may continue to do so for
several more months. It is quite possible that the related hype and fear explains much of the
acceleration of the gold price and the increase in its volatility. For example, gold at $380 was
trading approximately 15% above its 200-day moving average, the largest premium in the last 15
years.
The shares of gold mining companies have under-performed the metal by a substantial margin.
For example, the shares of senior North American producers trade at a premium of only 12% to
their average net asset value (NAV), according to BMO Nesbitt Research. This is well below the
38% average of the last two years, and at the low end of a five-year range. The NAV premium is
one of many useful valuation measures. Its current low level suggests that share investors doubt
that the recent highs in the gold price can be sustained. It is one of many indicators depicting a
consensus that Iraq is responsible for the run up in the gold price. Another sign of skepticism is
the recent torrent of equity financing, especially by the Canadian intermediate and junior
producers. The near exclusive reliance on the investor-unfriendly ?bought deal? method of raising
funds favored by Canadian investment bankers suggests a bet on lower gold and share prices by
industry insiders.
While it is difficult to escape the impact of war news on short-term money flows and sentiment,
the rationale for allocating assets to the gold sector transcends Iraq. The bull market in gold
commenced six months before the peak of the NASDAQ bubble, and will mark its fourth
anniversary in August of this year. The gold price had moved from $252 in August of 1999 to $295
in May of 2001, several months before 9/11. In May of 2002, gold surpassed $320, several months
before Iraq became front-page news. Geopolitical developments have no doubt heightened investor
anxiety. But even without these developments, the global investment landscape is threatened by
storm clouds.
Paramount among these is the overvaluation of the US dollar. The US currency topped out versus
a trade-weighted average of other currencies in May 2001, and has been in steady decline since.
Thanks to dollar overvaluation, US consumers have enjoyed a decade long influx of attractive
imported goods and low inflation. Thanks to dollar overvaluation, our trading partners have enjoyed
increasing exports and strong domestic economic conditions. A weakening dollar changes all
this. Fear of further dollar weakness will be self-reinforcing to the extent it triggers divestment of
massive dollar asset positions accumulated by non-US governments and investors over the past
two decades. The dollar represents 76% of world central bank reserves. As was the case with the
dot COM stocks, the US dollar is over owned and over valued. The dollar will weaken
substantially, and lead to higher US inflation along with weaker foreign economic conditions.
In its January 3rd, 2003 commentary, Bridgewater noted that ?a drying up of private demand
combined with support from official sources is a classic warning sign of an imminent collapse in a
currency. We believe we are on the precipice.? Official sector support for the dollar is especially
strong in Asia where dollar trade surpluses are huge and growing. According to Bridgewater, the
US is now relying on the official sector for 40% of capital inflows, the highest in ten years.
The problem posed by a weakening dollar for our trading partners and by extension, the world
economy, is deflation. It is not surprising that world central bankers are beginning to call for
radical actions. On November 13, 2002, Greenspan announced ?there?s no meaningful limit to
what we could inject into the system were that necessary.? In a now-famous speech, Federal
Reserve Governor Ben Bernanke promised to crank up the printing presses to stave off deflation.
His words were echoed by Charles Bean, chief economist of the Bank of England, in a November
25, 2002 speech entitled ?The MPC and the UK Economy: Should we Fear the D-words??
High-level officials of the Japanese Ministry of Finance (Haruhiko Kuroda and others) have been
advocating that the Japanese Central Bank target 3% inflation as their paramount goal targeting.
The Federal Reserve has been creating credit at an annual growth rate of 26% over the last three
months, significantly above the already high trailing twelve-month growth rate of 10%.
No wonder investors are running for cover. Miniscule bond yields offer little protection against the
prospect of an orchestrated devaluation of the world?s key currencies. A paradigm shift in the
relative valuation of paper and tangible assets is underway. In such a shift, the list of safe havens
is short. A new generation of investors, still conditioned by overripe 1990?s platitudes extolling
paper assets, will discover what a previous generation had learned and forgotten---the merits of
gold.
That we are in the early stages of a dollar sell off has been obscured by Iraq news. Hope
flourishes that war fears are simultaneously dampening economic activity and stock market
expectations. This view assumes that hostilities in Iraq will be surgical, short, and without
longer-range economic implications. The historical precedent of a repeat of the first Gulf War is
priced into the markets. In the build up to the 1991 war, gold and oil rose while the stock market
sagged. But three months before the first cruise missiles were launched, these trends reversed.
Gold resumed the downtrend that had been in force prior to investor awareness of Iraq. Let?s hope
optimistic expectations as to the military result for a second Gulf war prove justified, but it would
be wrong to extend the analogy to market outcomes. At the very least, the financial markets can
tolerate nothing less than a highly successful military campaign.
These superficial media-centric speculations overlook fundamental realities. As recently stated by
eminent market observer Richard Russell (1/24/03) ?the bear market started in 1999. This bear
market is about correcting a 25-year-old bull market. This bear market is about overvaluation, over
stimulation, too much debt, too little savings, a falling dollar, a Fed chairman who didn?t know
what was happening, and a Fed that never took away the punch bowl.? It is difficult to know what
the consensus view is at the moment, but Greenspan?s most recent ?guidance? is probably fairly
representative. In recent congressional testimony, Chairman Greenspan blamed economic
sluggishness on the Iraq situation. The expectation that sustainable relief lies in a resolution of
the Iraq conflict, while plausible to many, lacks rational foundation.
The sweep of a secular bear market cannot be understood in purely economic terms. Financial
and economic developments interact with and are in turn influenced by social and political forces.
For the past several years, a place for gold in investment portfolios seemed justified based on
purely economic considerations. Early advocates merely tacked on geopolitical risk as part of a
pro forma litany of concerns that any potential investor might wish to consider.
This moment, however, demands more than token consideration of non-economic issues. The
world of 2003 differs vastly from that of the early 1990?s. It is true that the purely military equation
seems more favorable than 1991. Aside from this single facet, however, the picture is muddled. In
1991, a unified nation and international coalition faced the unknown but greatly feared military
capabilities of the Iraqi regime. The domestic economy was sluggish but on the mend. The stock
market rise, well into its third year following the 1987 crash, was interrupted for three months by
the prospect of a Gulf war. Following the fall of the Berlin Wall in 1989, the global prestige of the
United States and the free market system seemed limitless. The credit cycle, powered by the
twin boosters of Federal Reserve credit injections and celebration of the triumph of free market
economics, was primed to enter warp speed.
Today, an administration that had gained office in the most closely contested election in history,
leads a divided country against the same Iraqi regime, whose conventional military capability is
lightly regarded by comparison to a decade earlier. The justification for military action is hotly
debated. Relations with many former coalition partners are fractious. The prospect of military
action by a narrow coalition ?of the willing? lacking UN support is real. The weak domestic
economy is a growing source of political contention. Stocks have been declining for three years
and are in the early stages of a secular bear market. The post mania discrediting of the business
community has taken on a life of its own. Several developing countries have abandoned the free
market model and prospective candidates for similar action is growing. The credit cycle is sloping
downward as investors and institutions move away from a ?trust anything? mentality to ?trust
nothing.?
New also, global terrorism portends economic, political and social implications that we have yet
to fully grasp. The widespread esteem formerly enjoyed by business and financial institutions will
be difficult to restore in the near term. To date, perspective on these and other crucial issues has
not been forthcoming from the usual pundits and partisans. Perhaps clarity has been stifled by
the immediacy of too many critical events in time and space. Illuminating comments offered by
Edward Danks, a former Presbyterian pastor now overseeing church missions in Kenya, stand out
by comparison. During a recent visit (2/1/03), he said: ?The storm of terrorism that has broken
upon us brings with it one of the greatest tests we have ever faced as a nation?.perhaps the
greatest since the Civil War. Terrorism throws into conflict our ?Freedoms? on the one hand, and
our ?Security? on the other. Must we set aside some of our ?Freedoms in order to assure our
?Security?? Or will we risk our ?Security? by continuing to affirm our ?Freedoms?? ?. It is no easy
question. Second, there is the collapse of morality and ethics in the corporate world?..The
collusion between investment management, banks, corporations and accounting firms has been
catastrophic in its impact upon our nation.? (www.norotonchurch.com). According to Danks, these
two developments, together with the scandal plaguing the Roman Catholic Church, challenge core
Western social beliefs and political alignments. Rather than business cycle and stock market
outcomes, the bedrock of social conventions is in play.
Against this backdrop, the willingness of individual and institutional investors to prefer paper
assets as a store of value will continue its retreat. For the foreseeable future, paper assets will be
mired in financial purgatory. The decade and a half from 1968 to 1982 provides a good historical
analogy. For those fourteen years, the financial markets were trapped in a trading range, while
gold advanced from $40 to $800. Despite the Vietnam War, the Watergate Scandal, the vicious
1973-74 bear market and the late 1970?s bout of double-digit inflation, the financial system
survived and evolved. It was not the end of the world. The period simply marked a lengthy
succession of events that added up to poor financial market returns. It led investors to prefer
tangible to financial assets.
World financial wealth held in the form of paper assets stands conservatively at $50 trillion. The
investment stock of gold, including central bank reserves, amounts to slightly more than $900
billion at the recent price. Central bank reserves of 33,000 tonnes account for slightly less than
half of a very conservatively estimated investment stock of gold. Physical gold theoretically
available to the market is at most $500 billion. Central banks, once feared as relentless sellers of
the metal, are beginning to rethink their past folly. The net supply of central bank gold has been
diminishing. The well publicized 400 tonnes being divested according to the Washington
Agreement is being partially offset by the quiet accumulation of others, including the People?s
Republic of China. Iraq related hype notwithstanding, a significantly higher price target for gold
seems appropriate. A reallocation of 1/10th of 1% of world financial assets, or $50 billion, would
swamp the physical market, especially if it coincided with recognition by the central bank
community that the dollar, rather than gold, is their least attractive asset. A mere $50 billion
equates to more than two years of annual gold production, a quantity that could not clear the
market within several hundred dollars of today?s price.
UN resolution 1441 was adopted November 8th 2002. Greenspan?s ?virtually no limits? comment
came on November 13th. Bernanke?s famous speech was delivered on November 23rd. Gold?s
breach of $330 occurred on December 12th, triggering a lift off to the highest levels in six years.
Both monetary and geopolitical factors contributed. While media coverage of the former was
scant, coverage of the latter has been incessant. The imbalance in media attention helps explain
investor confusion as to underlying causes for gold?s strength.
Gold is peerless as a tangible and as a financial asset. Its intrinsic value is not subject to
question. Its market price correlates inversely with investor assessment of paper alternatives,
including the dollar. It is uncomplicated and straightforward. One does not need to pore through a
200-page prospectus to comprehend all relevant merits and detractions. It is liquid in comparison
to income producing real estate, collectibles, and most other tangible assets. It is more compact
and transportable than wheat, oil, soybeans or other commodities. Gold is scarce relative to
paper. It is difficult, dangerous, and often unprofitable to mine. It does not have a cusip number. In
the past three and a half years, it has outperformed all currencies and financial markets. In a
climate when trust is receding and belief in fat returns on financial investments is fading, a
reallocation of 1/10th of 1% no longer seems preposterous.
What about the dollar? It is being issued at an accelerating pace by a sovereign government
managed by former investment bankers, lawyers and corporate executives. Its intrinsic value is
subject to their collective interpretation of the mandates of sovereign interests. Its market price, in
terms of gold and other currencies, is determined by the collective assessment of those who hold
it, especially for investment purposes. The fact that the marginal investment holders of dollar
instruments are foreign has been true for decades. New is the fact that the worldview of foreign
dollar investors may no longer coincide with the actions or perceived intentions of those who are
in a position to maintain or undermine the dollar?s intrinsic value. What is also new is that non-US
holdings of dollar investments have reached a magnitude where an opinion downgrade would
overpower domestic policy considerations, objectives, and initiatives. At 40% of the treasury
market float, a foreign exodus would result in higher US inflation and interest rates, irrespective of
Federal Reserve or Treasury actions.
Recent expressions of intent by the Federal Reserve pay only lip service to the notion of currency
stability. The new focus is reassurance that any action will be taken to avoid deflation. In the
1930?s, markets anticipated a sharp fall in the intrinsic value of the dollar three to four years in
advance of the actual hike in the official price of gold. For example, the black market price of a
$20 gold eagle in 1930 was $30. In the late 1960?s, investors anticipated the breakdown of an
official dollar link to the gold price. Market pressure forced the London Gold pool to disband in
1968, forcing an increase in the official gold price from $35 to $41. In 1971, the same pressures
forced the US to close the gold window. In today?s regime of floating exchange rates, the slightest
pretext of a gold anchor is gone. The currency?s intrinsic value is defined by market faith in the
ability of central bankers and national governments to get it right. The advancing gold price
signifies shakiness in the foundations of the floating rate/ central planning monetary regime.
Without an unimpeachable link to a unit of value beyond reproach, the dollar is no different than
an overpriced stock, capable of successful illusion until investors no longer choose to believe.
From Investor Shrub:
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