Simple Supply and Demand

In college, I wasn’t sure what I wanted to do when I grew up. I started out double majoring in political science and history. I thought I might want to be a lawyer. Then, in my sophomore year, I decided I wanted to teach. So I added secondary education as a third major.

My parents were supportive of anything I wanted to do. They only gave me two stipulations. I had to graduate in four years. And I had to be 100% self-sufficient as soon as I walked off Indiana University’s beautiful Bloomington campus.

Needless to say, I had a few sleepless nights. I wondered what I would end up doing…and could I make it in this dog-eat-dog world? Then I discovered my first economics class. Something clicked. All the charts, formulas and theories made sense. It was as if the proverbial light bulb went off over my head. This was my calling.

Economics is logical. When supply exceeds demand, prices fall…and vice versa. When demand is greater than supply, prices rise. It’s such a basic idea. Yet how many times do we apply that logic to the investments we make?

Gold Supply and Demand: Far Exceeding Supply

Probably not as much as we should. But if you have read The Daily Reckoning for the past three years, you know that demand for gold has far exceeded supply. As a result, gold prices rose steadily in 2002, and gold stocks dominated the market. It made perfect economic sense. But 2003 has been a different story…or so it looks on the surface. The yellow metal has fallen from a high of $382 on Feb. 5 to its current price of about $320. Both the XAU and HUI indexes are off 19% and 20% respectively.

From far away, it looks like the ultimate store of value is on the ropes. But if you move in to take a closer look, you might be surprised by what you see.

The world consumes about 120 million ounces of gold each year – most of it for jewelry. But gold mines only produce 80 million ounces a year – leaving a real deficit of 40 million ounces – or 50% of its production. Demand still far exceeds supply. So why are spot prices and stocks falling?

Nothing ever rises straight up for an extended period of time. In any major bull run, there are bound to be some correction periods. Take, for example, the most explosive gold rally in the past 100 years – the 1970s bull run. After coming off a double bottom in 1970, gold rose from $35 an ounce to $65 in the summer of 1972. Then the yellow metal consolidated for about six months, trading between $50 and $60 an ounce.

Investors who sold during the initial downswing (thinking the run-up was over) missed the next explosive rise. By January 1975, gold sold for about $180 an ounce. And as we all know, it didn’t stop there. Gold prices soon soared all the way above the $800 mark.

All during the 1970s, demand for gold remained high – as evident by the 9.9 million ounces of gold coins sold in 1979. (This was a record at the time.) Still, gold prices and gold stocks didn’t rise straight up; people took profits from time to time. And that’s what is happening today.

Gold Supply and Demand: Bull Run

Demand for gold exceeds supply by 50%. And as long as that remains true, this bull run is not over. If I am right, you can be assured of two things. One, this current correction in spot gold prices and in gold stocks is just that – a correction and not a downturn. And two, the best way to profit is to buy when everyone else is selling – that would be now.

So…what stocks should you look to own? You may scuffle, but your best bet for high returns will be to invest in the smaller gold producers – the juniors. Consider why…

Just to break even in terms of production, gold miners worldwide must find 80 million new ounces each year. Most of that gold is mined by the major companies. Or so most people think. But even the largest mines eventually get old and become depleted. So how do the world’s largest companies keep meeting that 80 million mark?

Not by finding new gold on their property. Nope, they acquire smaller, hungrier gold companies with fresher mines. Take Newmont Mining for example. Newmont is the world’s largest gold producer. Last year, it was able to replace 9 million ounces of depleted gold. President Pierre Lassonde said no other company has ever accomplished such a feat. How did it do it? It acquired two smaller gold companies – Franco-Nevada and Normandy Mining. This is key.

Major gold miners are running out of ways to replace lost gold. So, they are forced to look to smaller companies to pick up the slack. And that is one reason to own juniors now – in anticipation of more acquisitions and greater consolidation. When a smaller company is bought out by a larger one, shareholders usually benefit with a premium stock price. In the months leading up to the Franco-Nevada acquisition, its share price rose nearly 40%.

I expect to see more consolidation in the gold mining industry – especially as demand for gold continues to exceed supply. Large companies will keep looking to buy smaller companies to match last year’s production levels and take advantage of high spot gold prices above $300 an ounce.

And if all of my theories are correct, there couldn’t be a better time to capitalize on the junior gold miners than now. Many stocks are down 50% or more from their highs in the past year. Overall demand for the yellow metal remains high. And the herd has been on a selling spree for two months now.

If you are a contrarian with a tolerance for risk, this is your cue to buy.

Best regards,

James Boric
for the Daily Reckoning
April 7, 2003

P.S. This Friday, I’m headed back to Bloomington to visit my alma mater for the first time since I graduated. I can’t wait. Instead of contemplating life-altering decisions like what subjects to major in, the toughest decision I plan to make is: do I play 18 or 27 holes of golf? It’s more economical to play 27. That’s what I’ll do.

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What will happen when Baghdad falls?

Milton Friedman says that the economy will take off. The Nobel Prize winner believes the end of the war will bring prosperity. How he can know these things is a mystery to us…but who are we to argue with him?

On the other hand, what does he really know? The last time Baghdad fell to an invading army was in the 13th century, when the grandson of Genghis Khan brought a regime change to the desert capital.

That is the problem, dear reader; things like this don’t happen every day…so it’s impossible to know what comes next. When was the last time stocks fell three years in a row? When was the last time manufacturing payrolls dropped for 32 months without a break? When was the last time business profits, as a percentage of GDP, declined for 4 decades?

When was the last time the Fed cut rates 12 times consecutively…without producing a serious recovery?

When was the last time the world’s second – and perhaps third – largest economies were in deflation? And when did the U.S. last run a $500 billion budget deficit…and another $500 billion trade deficit? And when was the last time the U.S. consumer was so completely tapped out by debt – with debt at 200% of GDP – that he could no longer carry the world economy forward?

We have never been here before, dear reader. Where we will be tomorrow is anyone’s guess. Friedman’s guess is as good as any. But probably no better.

Over to Eric Fry with the latest market news:

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Eric Fry, reporting from the Big Apple:

– One step forward for the coalition forces, two steps backward for the US economy. The only aspect of the American economy that is advancing as swiftly as the coalition forces toward Baghdad is the tally of unemployed workers. The Labor Department’s monthly jobs report last Friday showed a loss of 108,000 jobs. And the weekly tally of initial jobless claims soared to 445,000 last week – the eighth straight week above 400,000.

– But the stock market cannot be bothered with such minutia; it marches to a different drummer. Battlefield headlines set the cadence for the stock market, not the economy. The Dow Jones Industrials gained 132 points to 8277, while the Nasdaq climbed 1% to 1383. As stocks gained ground, the safe-haven assets retreated: gold and Treasury bonds both yielded ground last week, with gold falling $6.40 to $326 an ounce.

– How long, we wonder, can the lumpeninvestoriat turn a blind eye to the struggling U.S. economy? “The current earnings-warning season has been quite negative,” Barron’s observes, “with nearly three downside revisions for every company raising its profit forecast. First-quarter earnings for S&P 500 companies are expected to rise 8.7% over a year earlier. But strip out energy companies that feasted on high oil and gas prices, and the increase for everyone else is put at only 4%. The consensus projected growth for all of 2003 has fallen below 12% from 14% at the turn of the year, and most of that is expected to come with a quick ramp in profitability in the second half.”

– The stock market would appear to be ‘pricing in’ something better than 4% earnings growth. At current levels, there is little room for disappointment. “The fact is,” Barron’s continues, “the current valuation of tech stocks can’t easily accommodate erosion in this year’s profit picture. Pip Coburn, tech strategist at UBS Warburg, notes that the tech sector now trades at 29 times expected 2003 operating earnings, compared to an average forward valuation of 26 in the pre-bubble period of 1992-96. And the current multiple is based on earnings that are expected to soar by 34% this year.”

– Ominously, the meager earnings ‘growth’ that is managing to appear results from cost-cutting, rather than from revenue growth. In other words, mounting job losses are a direct consequence of corporate America’s efforts to ‘grow’. “Since the start of 2001, when the economy slipped into recession, U.S. employers have cut more than two million jobs” Dow Jones news reports. Since July 2002, monthly job losses in the manufacturing industry have averaged 50,000.

– All else being equal, an investor would prefer to see a company prosper because business is booming, not because pink slips are swirling around company cubicles like crows around Tippi Hedren. Though the stock market is holding up for now, the economy looks more like a Hitchcock film every day…

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Bill Bonner, back in London…

*** Gold dropped last week – as low as $325. But gold stocks seemed to want to go up. Gold’s day will come, of course…but it may not be today or tomorrow.

*** A brief reflection, of no importance, on Sunday’s religious service in our local church: as long-time readers may know, your editor attends the French Catholic mass regularly, despite the fact that he is neither French nor Catholic. He gets along well enough, but occasionally is confronted by something puzzling.

First, the Sunday service was not held on Sunday, but on Saturday night. It was called a Mass of Reconciliation, or alternatively, a Penintential Mass. At one point in the service, all of a sudden, the priest placed a big-print version of the bible on a little table in front of the altar and then moved to the side of the church. All was quiet. No one moved.

Then, just as suddenly, Col. Aubray, a big man with direct, military bearing, crossed the church, heading in the priest’s direction, as if he was going to negotiate a surrender. Your editor knew that the colonel had exchanged harsh words with the priest on the previous weekend. On the cleric’s side, the charge had been that the congregation was much too traditionalist…and unwilling to accept change, the main one being the lack of priestly attention. There simply aren’t enough ordained clergymen in the area to keep the churches open and to attend to the needs of the quick and the dead. On the colonel’s side was outrage, for Père Marchand had not even bothered to come to administer last rites and extreme unction…for which there had been more need than the usual this past winter. In the months of January and February, 13 people from the commune had been interred, only one with benefit of clergy.

“I can’t drive down here from Poitiers every day,” the priest had explained.

(“Why not bury them all at one time,” was Jules’ helpful suggestion.)

So, when Col. Aubray crossed the aisle to approach Père Marchand, your editor half expected the two men to come to blows. Instead, what ensued was a whispered conversation, followed by the sound of creaking bones, as many other churchgoers rose to approach the Book and then the Priest. Each walked up, read a little passage, meditated for a moment…and then moved on to make a brief confession to Père Marchand. Parishioners seemed to want to stand long enough before the Book to show that they were humble enough to recognize their faults…but not so long as to cause their fellow Catholics to begin to wonder.