A Future So Bright
The Daily Reckoning PRESENTS: Between sky-high U.S. debt levels and the Fed’s knee-jerk reaction to flood the world with dollars, it’s not hard to see a bright future for our favorite yellow metal. But what about in the near term? James Turk explores…
A FUTURE SO BRIGHT…
Predicting year-ahead price action for any asset class is tricky, and gold, with its sensitivity to political as well as economic currents, is trickier than most. But tricky does not mean impossible. The way a Wall Street analyst might look at stocks versus bonds and conclude that one or the other is undervalued; it’s possible to use gold’s supply/demand trends and value relative to other assets to gain an idea of how it should behave in the short run. Here are two such approaches, both of which (surprise) are flashing screaming buy signals:
No asset, including gold, exists in a vacuum. Stocks, bonds, real estate, and precious metals all compete for the same limited pool of capital, which means that for gold to be attractive, its prospects must be not just good, but better than those of, say, growth stocks.
One way of making this comparison is the Dow/gold ratio, which computes how much gold it takes to buy the Dow Jones Industrial Average of major American stocks. As you can see from the chart below, this relationship has been rather volatile.
In 1971, gold was $40 per ounce ($1.28/gg) and the Dow was 890, meaning that it took about 22 ounces of gold to buy the Dow. Nine years later, less than one ounce would buy the Dow. By the end of 1999, the two had diverged once again, with gold at $279/oz. ($8.90/gg) and the Dow at about 11,497, for a Dow/gold ratio of 41, far higher than its early-1970s peak. But note that this time around, both numbers in the ratio have an extra zero. That’s because of inflation. A dollar purchases today what 10 cents purchased in 1971, so we need 10 times as many dollars to buy an ounce of gold or the Dow Industrials.
A Dow/gold ratio at the high end of its range implies two things. First, if historical relationships hold, gold is more likely to rise versus stocks in coming years than to fall. Second, the distance between the 1971 high and 1980 low gives a hint of how far gold can run this time around, especially with the financial gale now at its back.
One of the shocking things about gold is how little there is of it. In our sometimes frantic 4,000 years of searching, we’ve found perhaps 135,000 tonnes. Today, the world’s entire hoard of gold would occupy a single (admittedly very heavy) cube 60 feet on a side – equivalent to the volume of three good-sized houses or the bottom 10 percent of the Washington Monument. To put this in perspective, the U.S. produces about 240,000 tonnes of steel each day.
But unlike steel, where production can be expanded by simply building more factories, the supply of gold increases only when we find and mine new deposits. Since 1492, there has never been a year in which the world’s above-ground gold stock increased by more than 5 percent. The nineteenth-century average was about 2 percent, which is one reason that inflation was nonexistent for gold-standard currencies: The world’s money supply was constrained by nature to a low-single-digit growth path.
Although gold no longer circulates as currency, it still has both monetary and commercial uses. The demand from these sources is estimated at around 4,000 tonnes each year. The output of the world’s gold mines is currently about 2,500 tonnes, creating an annual supply shortfall of more than 1,500 tonnes, or approximately 50 million ounces.
For most commodities, a supply/demand imbalance of this size would cause either the price or the level of production, and probably both, to soar. But commodities are consumed after they’re produced, and gold, remember, is not just a commodity. Gold is money, which, once discovered, tends to be hoarded. So the vast bulk of what has been mined is still around, and the current deficit is covered by owners of previously mined gold. Central banks, as you know, sell and/or lend millions of ounces per year, which, together with other forms of “dishoarding,” like people selling their jewelry and gold coins, fills the gap. So while an annual supply shortfall of 50 million ounces is clearly a positive, absent a big jump in demand, aboveground stocks of gold are more than sufficient to make up the difference. In other words, current mine production is far less important for gold’s exchange rate than are trends in demand.
And on the demand front, things are looking up, thanks to the emergence of Asia’s sleeping giants. The whole world is setting up factories in China, both to exploit its cheap, highly motivated workforce and to gain access to a billion new consumers. This is bad news for U.S. and European factory workers, but for China, the result is an embarrassment of riches, including a trade surplus that exceeds $100 billion a year with the U.S. alone. By the end of 2003, China’s foreign exchange reserves – mostly in the form of dollars – exceeded $400 billion. And Chinese leaders, showing an historical savvy currently lacking in the West, were eyeing gold. Beijing is rumored to be buying much of the gold Western central banks are selling (and considerably more than the annual 100 tonnes it reported to the International Monetary Fund the past two years).
In 2002, Beijing removed the Communist-era ban on its citizens owning gold. In a survey quoted in the Hong Kong edition of China Daily, 20 percent of Chinese respondents said they were willing to move 10 to 30 percent of their savings into gold. An analyst quoted in the same story put the resulting increase in gold demand at about $36 billion, or about 300 tonnes annually.
India, meanwhile, is attracting almost as much foreign capital as is China, and in October 2003 ended a four-decade ban on bullion trading. Because India has traditionally been a huge market for precious metals (much of the gold mined in the West already ends up in Indian safes or adorning Indian women), the combination of rising incomes and more liberal ownership rules should have the same effect there as in China.
How will this suddenly much wider gap be filled? It’s possible that central banks – which, as you’ll see shortly, are more concerned with minimizing gold’s exchange rate than maximizing the value of their gold reserves – will step up their sales. And they’ll certainly try to talk the exchange rate down through anti-gold propaganda. But neither will do the trick, because government resources – of both gold and public credulity – are limited. Much more likely is that gold’s exchange rate will rise until the rest of us start converting our jewelry and coins into dollars.
for The Daily Reckoning
November 29, 2006
Editor’s Note: James Turk has specialized in international banking, finance and investments since graduating in 1969 from George Washington University with a B.A. degree in International Economics.
He is the author of two books and several monographs and articles on money and banking. He is the co-author of “The Coming Collapse of the Dollar” (Doubleday, December 2004).
In addition, James Turk is the Founder and Chairman of GoldMoney.com. Since 2001, thousands of individuals and companies have used GoldMoney® to buy gold to protect their wealth from today’s financial uncertainties. Many of them have also found GoldMoney’s patented process of digital gold currency payments to be an ideal payment solution for online commerce.
Did the sun ever shine more brightly? Did the air ever smell so sweet? Was ever there a fairer land, or a finer race to walk upon it?
Not according to the Dow…the VIX…or even the spreads in the bond market.
The Dow has never been higher than it has been these last few weeks. And last week, the VIX hit a new all-time record low. The VIX is an index of activity in the options market. People buy options when they are afraid that prices might get away from them. The record low VIX reading means that investors expect the going to be good forever.
Also at a near-record low is the spread between junk bonds and better credits. When the going gets rough, or people expect it to get rough, they insist on high-grade bonds, and lend only to ‘junk’ borrowers at much higher rates of interest. When the spread between the junk and the high-grade bonds narrows, it means investors see little risk.
You can hardly drop a mortgage broker out of a helicopter without him falling on a householder who believes a ‘soft landing’ in the property market is coming. And you can’t fire a pistol on a Wall Street window without mortally wounding an investor who believes the dollar will remain strong forever.
Yesterday, we reported on a research paper from Deutsche Bank that told us a “new global imperial cycle – meaning a cycling of funds that guarantees global prosperity – is now in place and…the global economy is thus entering a period of long-term prosperity.” Oh happy days! Oh happy days!
So confident and complacent are investors, that they lend the U.S. government – the world’s biggest single debtor – money for a 30-year period at an annual interest rate of only 4.51%. After inflation and taxes they cannot expect to have much left. Somehow, they must expect it to work out.
And we note too, that the mammoth growth in derivative contracts – heading towards a face value of half a quadrillion dollars ($500 trillion) – also owes its pullulation to institutional investors’ irrational equanimity. Investment firms sell Credit Default Swaps by the boatload, feeling sure that they will never have to pay up, because the credits definitely, surely, absolutely won’t default.
“Nobody is worried about anything,” says John Authers in the Financial Times.
This is not a Goldilocks scenario, says Ed Yardeni, speaking for the securities industry and the terminally delusional. This is ‘better than Goldilocks.’
But the funny thing about this funny ol’ world, dear reader, is that the more people expect things to remain the same, the more shocked and discomfited they are when they don’t. Just because everyone is fully invested in stability, in other words, it doesn’t stop the world from turning. It only makes the twists hurt more.
Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…
“You know what I like about the trading in currencies since last week? There’s a ton of two-way trading. There are just as many people on the other side of the weak dollar fence as there are on the other side.”
For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig
And more thoughts:
*** Economist Milton Friedman died a few weeks ago, and our friend Mark Skousen was one of the last people that had the opportunity to spend some time with him before his passing…
“I was at the New Orleans Investment Conference when I learned that free-market economist extraordinaire Milton Friedman, died on November 16. He was a dear friend,” Mark told us.
“I was probably the last person to go out to lunch with Milton. We met at his favorite restaurant in San Francisco, where I showed him a picture of him standing next to John Kenneth Galbraith, the premier Keynesian and welfare statist of the 20th century. Galbraith towered over the diminutive Friedman. Beneath the picture was a funny line by George Stigler: ‘All great economists are tall. There are two exceptions: John Kenneth Galbraith and Milton Friedman.’ Milton was so pleased with the photo and caption that he sent it to all his friends only two weeks before his passing.”
*** Last week, on Thanksgiving, former Russian spy, Alexander Litivienko died of radiation poisoning in a London hospital.
The facts surrounding this story seem to be straight out of a spy novel: someone acquired polonium-210, also known as radium F (not an easy feat), most likely slipped it into Litivienko’s food or drink, causing his organs to shut down and his imminent demise. Oh, and did we mention that Litivienko was an outspoken critic of Russian President Vladimi Putin, and had accused Putin of ordering his assassination before he died?
All we need now are some ‘splosions and DiCaprio and we’ve got the next Scorsese blockbuster.
Of course, Russian authorities brushed off the idea of Putin’s involvement in the former spy’s death as “silly,” but according to Strategic Investment’s Dan Amoss, this event shows the re-emergence of Russian nationalism and totalitarianism.
“Putin’s hubris is being manifested in the oil patch,” says Dan. “Western capitalists are under the impression that Russia will ramp oil production in response to our desire for more supply. From what I’m reading, Russian energy infrastructure is in far worse shape than is widely perceived.
“This James Bond-esque story adds to the body of evidence that Russian government policy is taking on the characteristics of organized crime.”
*** We looked at a chart of the dollar since 1987, and we think we saw a big crest in ’02…with a right shoulder peaking out in January of this year. This right shoulder now seems to be in the process of breaking down.
Do you believe in charts, dear reader? We don’t either – but we’ll take what we can get. Charts often reveal patterns that the unaided mind cannot quite see. Everything is there – all that the market thought and did over a period of time. What we see when looking at a chart of the dollar that indexed against other currencies, is that the dollar could be about to enter a major decline. It has seen its high point. It has found support on the way down. Now…what we wait to see is if that support can keep it near current levels.
*** Talk about Google. Talk about the Chicago Mercantile Exchange. What about Wall Street itself, asks colleague Chris Mayer. The New York exchange is also priced for perfection: Mayer:
“You can add the NYX to this list, too. Ten times sales and 119 times trailing earnings, 46 times forward earnings.”
*** On the home front, we’re beginning to understand why Christianity was such a big hit.
First, we’ve been watching the HBO series on “Rome.” Not a single segment goes by without some scene of perversion or violence.
“Centurion, how would you recommend we find our eagle?” Caesar asked one of his subordinates. (The eagle was the Roman army’s standard, presumably stolen by the Gaullic terrorists). “I guess we should crucify one man from each tribe…and continue doing so until someone tells us where it is,” replies the soldier. And so, the crucifixions began…and the eagle was returned.
It was a mean time to be alive. Pity, charity, brotherly love… there are few signs of them. All a man could count on was force of arms…alliances…power…and bodyguards. At least, that is the impression you get.
Last night, we went to see Maria in a play – the Tales of Ovid. Here again, we found the ancient world full of unpleasant things. A young woman pretends to be someone else so she can sleep with her father…a man rapes his sister-in-law and then tears out her tongue so she cannot speak of it (the sister-in-law later gets revenge by killing his son…and cooking him for the man to eat)…King Midas…almost brought to death by his own greed, and then forced to wear asses’ ears…Narcissus, so in love with his own image, he is ruined by it.
We would tell you more, dear reader, but we were so unsettled by the sight of our little girl in partial undress that we could barely watch. Nudity may be in fashion on the London stage, but a father shouldn’t have to see some things.
With so much murder, wickedness and unbridled lust around them…no wonder Christ’s message was so gratefully received.