Gold and Gravity

Gold up, dollar down – its suddenly front-page news. But does this mean the day of reckoning is nigh…or will tardy investors get one last chance to join the Trade of the Decade?

Is the gold price giving us a repeat performance of October’s fake-out in the oil market? My suspicion is that gold is acting a lot like crude did last month…running up to fresh highs – and making headlines all the way…

But this isn’t the main event. Not yet.

The day of reckoning for America, her deficits and her dollar, is surely on its way. Investors who haven’t yet bought gold as protection could be forgiven for thinking they’ve missed their chance. But we may see gold make the inevitable run up to $450 – as early as next week – and then experience a serious correction and consolidation.

For that, investors still not holding gold should read, "last chance to buy before the bull is untethered…"

First, note that as gold has screamed up since the summer, gold mining stocks have failed to confirm the move. Just as it happened with the Oil Sector in October, the underlying commodity has gotten way ahead of its producers. For instance, gold put on $5 – one full percent – between its Tuesday close in London and its Wednesday close in New York this week. Yet the two biggest gold producers in the world did not follow. AngloGold eked out a 0.56% gain on the day; Newmont mining, the world’s largest gold producer, managed a 0.71% gain.

Is this quibbling? Well, no. Newmont climbed as high as $49.96 in intraday trading Wednesday. But when you take a closer look at the chart, you see that it even though it closed up for the day, the second half of the session was all downhill…until it reached $49.55. In short, Newmont made a bid for $50 and couldn’t make it. The largest gold stock in the world is failing to confirm gold’s bullish move. Why?

Earnings gravity: Too Many Chasing Too Few

The answer is "earnings’ gravity". If you want to buy Newmont at p/e of 50, be my guest…and many investors will. But until the bullion price moves much higher – and starts making its way onto the income statements of the gold producers – the dearth of gold shares means you have too many investors chasing too few gold stocks, and paying too much for them. The total market capitalization of the gold and silver mining sector in the US is less than $136 billion. By comparison, Microsoft’s market cap is $296 billion. The equity upside of gold is limited until the bullion upside gets much, much higher.

Of course, there is the chance that the next "psychological level" for gold is $500 – that being simply such a glorious number that traders can’t resist it. Kevin Kerr, at Outstanding Investments, believes the technicals support gold all the way up to $475 in short order. This move would be aided and abetted by a huge increase in speculative longs in the futures market AND a surge in liquidity inspired by the launch of GLD, the New York listing for the World Gold Council’s bullion backed gold fund. It’s due next month, if not in the New Year.

Several hundred million dollars could flood into GLD as soon as it’s launched. The stock will enable U.S. institutions to take a position in "paper gold." Wall Street’s appetite for such financial chimeras is growing at what seems an exponential rate. Last week, cash inflows into Exchange-Traded Funds exceeded U.S. equity mutual fund inflows for the first time that I can recall – and this during a week when over $1.3 billion came in from the cold of the money market to the stock market sauna!

Moreover, such a flood of funds into GLD would be a vindication of the idea of "paper gold," at least in the short term. The idea behind GLD – and its London-list equivalent GBS, which has successfully matched the price of gold since its launch in January 2004 – is that they introduce liquidity to the gold market and create institutional demand for the metal. Up until now, U.S. pension funds and institutions – which is just a fancy way of saying mutual funds, banks, insurance companies, and brokerages – had no easy way to buy gold through the stock market. They had to do it through futures contract, or buy bullion. And legally, U.S. pension funds weren’t allowed to own commodities outright.

Few institutions want to buy bullion anyway, because it never pays a dividend. It’s essentially a savings account with zero interest, although if the dollar is getting worth less and less…then things priced in dollars go up…and pure inflation becomes one way to explain the rising gold price.

Earnings Gravity: A Can of Coke

It’s like a can of Coke that used to cost 25 cents now costing 75 cents or $1.00. Has the Coke gone up in value? Or has the purchasing power of your money gone down? Owning bullion when the currency inflates is one way to profit – in terms of paper dollars, at least.

The question today is whether there is pent up institutional demand for "paper gold" that is bullish for bullion. A lot of institutions could allocate a small percentage of their cash to gold, perhaps as much as 5%. And with gold rising in dollar terms – and also in terms of British pounds now as well – there would be no "yield penalty" to pay. The gain in bullion prices would match, or exceed, the yield on U.K. gilts or U.S. Treasuries – plus you’d have the safety of owning nature’s own currency!

With paper gold, like GBS and GLD, accepted and flourishing, "earnings’ gravity" on gold stocks may no longer be a check on making money in the yellow metal. With GBS and GLD, so the theory goes, you get more liquidity in the equity side of the gold market. And whichever way the gold price goes in the near-term, the launch of the new Amex Gold Miner’s Index (GDM) should also be great news for options investors if and when those vehicles become "optionable" – especially as it’s composed of more volatile junior exploration stocks.

I made the enhanced liquidity argument myself – about a year and a half ago, when gold was much less popular. Today is different. Gold is "hot". But is it "hot" in the way that, say, Britney Spears in a skin-tight red rubber suit is "hot?" Or is gold warming up because it’s at the centre of a major shift in investor sentiment about asset allocation and the need for diversification?

With gold making 16-year highs, and the dollar making fresh lows in euro and yen terms, I’m more inclined to take recent developments as a sign of a near-term top in the gold price. In contrarian terms, whenever the crowd is all on the same side of the trade, the trade is nearly over.

In this scenario, GLD launches…goes a-googling its way up briefly…and then plummets to earth at the rate of 32 feet per second per second when the lustre of the first buy tarnishes.

That’s when we should buy it. And that’s when you should go hunting for gold stocks again – buying them at a much lower price. Or, you can do what I’m telling my options readers: Sit tight with your long gold positions, and buy put options on them for a near-term correction in the gold price.

In the long-term – but before we’re all dead – I’m still mega-bullish on gold. Markets rarely move in straight lines, however. Just ask anyone who bought crude oil futures over $55 a barrel in October.

And with so much sentiment so universally bullish on gold, even the staunchest gold bull should keep both feet planted firmly on the ground.


Dan Denning
for the Daily Reckoning
November 23, 2004

P.S. Has Dan gone crazy? Regular Strategic Investment readers will be very familiar with Dan’s reputation as a doom and gloomer. So why’s he recommending gold short plays and equity long plays? And how are they making so much money?

"The Federal government has maxed out its credit card," writes colleague, Dan Ferris. "So it’s doing what any good American would do.

"It’s getting another card.

"Congress is getting set to raise the federal debt limit $800 billion to $8.134 trillion. It cleared the Senate Wednesday night and went to the House last night. It’s thought that this will get the government through Sept. 30, 2005."

The Clinton Administration added to federal spending at a rate of 1.5% per year. George W. Bush got out the credit card and boosted spending nearly four times as fast – an annual rate of 5.1%.

According to what we read, even if every ounce of gold ever mined had been available to it, the Federal government still wouldn’t have had enough money to cover its deficits in George W. Bush’s first term.

And at the present rate, another $5 trillion in deficits is expected over the next 10 years – twice as much as all the gold ever mined.

Gold rose during the first Bush term – by about 70%. And since Bush’s reelection, it has gone up another 6%.

And now it’s official – the dollar is going to go down. Greenspan said so.

"I’ve got no problem with that," was Secretary Snow’s attitude.

And here at the Daily Reckoning we don’t doubt it. But what still bothers us is how the dollar can be allowed to fall so gently, so expectedly, so serenely that no one gets upset about it. The world has more of its money in dollars than any other measure. For the last four years, dollars have lost value against gold and other major currencies. And now, everyone seems to know that it will lose even more in the years ahead.

It is as if travelers were told in advance that their plane would crash. Wouldn’t at least a few of them to change their plans?

Here at the Daily Reckoning, we never wonder when we will die – because the day will come no matter what. The thing we want to know is where, so we can stay away from the place. If you knew the dollar was going to crash, dear reader, wouldn’t you want to avoid it?

We are on a train and cannot remember the figures exactly, but we believe the value of all the assets in America itself is something like $50 trillion. The value of U.S. dollar assets outside of the country is probably near $5 trillion. We’re told that foreign central banks have 63.8% of their assets in dollars. And there are an estimated $100 trillion worth of derivative contracts – most of which are quoted in dollars.

On the surface of it, a modest 10% decline in the dollar would mean a loss of some $15 trillion – or more than the total GDP of the United States…and more than 30 times all the profits of all the publicly traded companies in America. Even if we have over-estimated the loss by 10…it is still enough money to make us think someone might want to protect it.

Yesterday, matching willing sellers with willing buyers, Mr. Market came to a price of exactly 449 paper dollars for every ounce of gold. Apparently, there are more sellers of dollars and more buyers of gold than there were the day before, or a week ago, or a month ago, or a year ago. Still, there are not so many that anyone is alarmed. A polite decline in the greenback is something everyone expects.

Still, we can’t help but wonder: When will be get a surprise? When will the greasy crowds show up? When will the dollar’s decline switch from well mannered to rude?

We don’t know, but we must be one day closer.

More news, from our friends at The Rude Awakening:


Eric Fry, reporting from center of the financial universe…

"Obviously, it is not entirely fair to ‘credit’ Bush with either the dollar sell off or the commodity rally. The Yale-educated Texan is certainly not to blame for America’s massive current account deficit, nor did he single-handedly create the nation’s massive private and public indebtedness. He inherited most of these ills. The problem is…he’s unlikely to correct them soon, if at all."


Bill Bonner, back in London…

*** Dan Denning…and a bad case of leprosy at Fannie Mae…

"Billion dollar parts of Fannie Mae’s balance sheet keep falling off. When it’s a toe or a pinky people can politely pretend not to notice. But $9 billion!? That’s got to be at least a nose, an ear, and a bottom lip. Surely markets must now realize something is seriously diseased in the mortgage lending market?"

Last week, Fannie Mae announced it would not meet the deadline for posting third-quarter financial results after the independent auditor had refused to sign off on the accounts. Fannie, it is alleged, "has been accounting improperly for derivatives" and, if the SEC agrees, will post an additional $9 billion after-tax loss.

*** The economy of Afghanistan is booming, reports yesterday’s "Liberation." The numbskull Taliban practically ruined the Afghan economy back in the year 2000 when they decided that pushing drugs was against Islamic law. They outlawed the opium trade and reduced production from 4,600 tons in 1999 down to 200 tons in 2001.

But then came the U.S. and its allies. We Americans love democracy – especially when we can slip our own stooge past the voters. Hamid Karzai, former CIA asset and now duly confirmed president of Afghanistan, also banned opium. But nobody paid any attention; maybe they thought he didn’t mean it. Production this year has bounced back to 4,200 tons. One in ten Afghanis works in the opium industry, with a household income averaging $17,000 per year.

Afghanistan has become the world’s first real "Narcdo-nation," says the Liberation. Trade in the stuff represents 60% of the country’s GDP. Even in Colombia, narco trafficking is only 7% of GDP.

*** U.S. Editor Wanted in London!

Our colleagues at MoneyWeek magazine in London are about to launch a U.S. version. They need an American financial writer/editor to take charge of the U.S. edition, working from the office in central London. Some experience is required, as is an open mind and a sense of humor.

*** Jules is applying to colleges. He is targeting expensive, Ivy League schools, despite his father’s advice.
But he was discouraged; the first time he took the SAT tests, his scores were at the low range of what the good colleges require. But then, he took a very expensive SAT preparatory course. For three or four days, he boned up on how to take the SAT.

This week, we got the results: H is scores went up more than 150 points.

"What sense does that make," he father asked. "The tests are supposed to be measuring whether or not you have an aptitude for college-level work. What they really measure is whether your parents put out nearly $1,000 for a course in how to take the tests. The whole thing is nonsense."

"You’d be better off not going to college at all," he advised his son. "Get a job somewhere. Start a business. Travel. Open your eyes. Read. You’ll probably learn more, faster than you would in college."

Jules paid no attention.