Gold Bull Market Only in its Teens

There is every reason in the world to buy this dip in gold. We have not even reached the mid point of the bull market, let alone the leg that started in August. Ed Bugos takes us through the many ways to illustrate this idea.

Economist Henry Hazlitt, former Wall Street Journal reporter and "founding board member" of the Mises institute, wrote in the late 1960’s: "What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money… As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a ‘shortage of money’."

What he was saying is that early in the inflation, the value of money does not drop as much because the individuals determining its value are used to it having a stable purchasing power. Expectations, however, will change as the inflation progresses, and eventually the value of money drops faster…

That is how, yielding to cries for more money and credit, the dog chases its tail right into hyperinflation.

The bull market in gold started on a transition to "the middle stages" of an inflation cycle that began with Greenspan’s reign in the nineties. During that decade, the pundits argued that inflation was dead and that there was no longer any correlation between money supply growth and the price level, which was true if you forgave the method of calculation of both statistics, and ignored the technology bubble.

But, the fact was simply that we were in "the early stages" of a new inflation cycle.

The last one ended with Paul Volcker, Greenspan’s predecessor. Volcker had resolve, but that’s not saying much because America’s policymakers had nothing left to lose by 1978. Attempts to lower the long-term bond yield failed through the seventies as it went to higher highs whenever the Fed stopped lowering short-term yields. By the time Volcker got in, the economy suffered almost a decade of rising prices and interest rates, the stock market was trading at less than 10 times earnings, the dollar made new record lows, there were long lines at the gas stations, and the banks (to buy gold), and the policy of expanding money (inflation) was no longer boosting employment or growth… and then, stagflation!

Only then did the central bank and government deal directly with the root cause of the problem.

They face too much risk today for that kind of resolve. The stock market is trading at about 20 times earnings and bond yields are in the low single digits. People are only beginning to see that inflation is not quite dead. They are not yet demanding higher wages and pushing up interest rates because of it, at least not widely. It is not yet causing unemployment. The inflation policy is still a useful tool for the expropriation of wealth under the guise of illusory booms. It is not yet producing results that will make it unpopular. If it was abandoned now, the detrimental effects would be great. They cannot afford it.

Naturally, this predicament all but guarantees the later stages of inflation, where "prices rise by more than the increase in the quantity of money" as people lose confidence in the value of money.

From there we get the combination of rising prices and recession that people who can’t recognize the early stages of hyperinflation will call stagflation. I don’t think we’ll see that until the next recession, and if central bankers or politicians continue to bury their collective heads in the sand then, you’ll see the "crack up boom," a term that readers of this publication are no doubt familiar with by now.

So it is that the current environment for gold couldn’t be better. You have the Federal Reserve System slashing rates aggressively and leaning on depression era loopholes in order to stave off a financial crisis, which it caused by slashing rates and expanding credit too aggressively in the first place.

And it is doing it at a time when commodity prices are printing records that the pundits never imagined possible a decade ago, and when even the massaged inflation numbers are approaching the high end of a two-decade range! Combined with the bail out package offered by the government, where’s the discipline that will deter the reckless lending tomorrow? If you understand recessions as corrections to natural market ratios, these moves will only continue to underwrite poor quality economic booms.

We are seeing the Federal Reserve make history by expanding its reach past the government T-bill market into the mortgage and brokerage businesses, which will only help it generate more inflation more directly in the future. You have a free-falling currency that can’t seem to find a floor against other fiat never mind gold, national default rates running at a record pace, supply side shortages in gold caused by socialistic policies and resource constraints in some parts of the world, and so on.

You can add the fact that production costs in the gold business as well as MZM, the broadest measure of U.S. "liquidity", have both doubled since the bull market in gold began – raising the floor substantially.

So then, what triggered this gold correction?

The latest advance in gold kicked off with the spreading of the subprime crisis in the final months of summer 2007. The crisis has not likely peaked. Citigroup is predicting way more rate cuts ahead.

Why would a gold correction of any magnitude begin on the week that one of the largest brokers in the world blew up, especially when followed by the kind of policies that should have fired gold right up?

Was it a "sell the news" phenomenon? Maybe, but that would definitely mean buy this dip now.

Last week, the market expected the Federal Open Market Committee to cut its fed funds rate by a full percentage point, but it disappointed the market by cutting only three quarters of a point – on account that it was worried about inflation. The sentiment produced the best of all worlds: soaring stock prices and falling commodity prices, as if such a deep rate cut could actually boost growth and quell inflation all in one fell swoop.

C’mon. How’s that again? That’s right. The press told us the Fed was worried about stoking inflation expectations, so it held back the extra one-quarter of a percentage point.

Heck, it only needed to recognize that most of the leverage was concentrated on the bullish side of the commodity markets. By upsetting market expectations, this is where it would hurt the most. Add a conveniently timed rumor that the futures exchanges may lift margin requirements, and news that the Chinese had raised their reserve requirements, again, the catalysts for the correction becomes clear.

It’s one of the main reasons I don’t believe this correction. Most commodities are due for a correction of some magnitude, and that the dollar is due for a meaningful bear market rally, and that these things are going to cause choppy trade in gold. But gold should be able to decouple from those correlations as the market realizes that the bull market in commodities is about money, and that the dollar is not the only inflationary currency.

This advance in gold will continue without a serious interruption until either it is allowed to blow off on its own into an unsustainable froth, or the Federal Reserve targets inflation – by raising real interest rates (past neutral), or reserve requirements, or some form of credit tightening.

It does not have this resolve today, clearly.

Corrections are healthy. By all counts, one was due in gold anyway. The market was getting a little too far away from its 40-day moving average, and exhausted the $950 implied objective of last year’s breakout weeks ago. If you are expecting the current leg to outperform the 2005-06 rally, as I am, you were/are expecting gold prices to make it past the $1100 level before experiencing an intermediate correction of the sort we saw in 2006 – 27% from peak to trough and lasting six to twelve months.

The current correction has been half that depth so far. There are similarities. But it has not triggered any real intermediate sell signals in my model. The bullish case for a climax at $1200 plus (before this summer) is not yet injured on the chart – so long as the bulls hold the line at between $850 and $900.

The last highest low in the intermediate (7-month rally) sequence is at $885 in the cash market. The market could just be making some elbow room for a lunge higher.

It could consolidate for a few weeks yet, as the Dow tests the parameters of its newly forming bearish trend. That conviction is young itself, and it is having trouble engaging because the Fed is fighting that trend. A rally in stock markets engendered by the Fed’s rate cuts could alone reignite concerns about inflation, but if not, if it starts to fail, I expect gold will be ready to begin move to my $1200-1400 target.

And it could all happen in months.

Unlike the base and other precious metals, oil, and almost any other commodity, gold has not yet seen the kind of upside volatility that would force me to call a correction beyond what is considered normal.

Unfortunately, the situation is more tentative for gold share investors. A bear market on Wall Street means rising risk premiums and contracting value multiples, and gold stocks are not cheap. Mining companies are not immune to the effects of rising costs on production and development. They are businesses. And as shares, they are not immune to rising bond yields.

Bond yields are not rising right now, but they will. It’s difficult to find values in the gold share sector today, at least at the mid to large cap levels. Consequently, I believe they will have difficulty keeping up with gold, especially if stocks are falling.

On the other hand, I’m finding many values in the juniors and small caps, many of which have been in decline since the 2006 peak in gold – and that have sat out the entire 400 dollar rally since August.

In some cases, the decline is warranted as they went to absurd values in the 2003-2006 period. In other cases the decline has left many juniors trading at or near their cash break up values.

The obvious point is that the seven month old gold rally has not reinvigorated much froth broadly. And the risk/reward ratio now favors the juniors, though because they are risk assets there is the chance that they could fall further if the general stock market environment continues to deteriorate.

My advice is to continue to generally overweight gold directly (physical or ETF), reduce or hedge your positions in the expensive mid to large cap precious metals producers, sell all your non-precious metal resource shares, and accumulate the best quality junior gold, silver and platinum assets from here on.


Ed Bugos
for The Daily Reckoning
March 27, 2008

P.S. Since this bull market is barely in its prime, I will be spending a lot of time over the next year generating top-notch investment prospects in the precious metals junior equity space for Gold & Options Trader. This head start will pay off big when gold prices reach the $2,000 mark. Don’t miss out.

Before starting up Gold & Options Trader, Ed came straight from the North American heart of the gold market – Vancouver’s Howe Street. During the nasty commodity bear market in the ’90s, Ed still guided his clients to gold profits in Argentina Gold and Arequipa, both of which became buyout bait for Barrick. He also founded the "Bugos Gold Stock Index" which included no more than 10 stocks at any time. From December 2001 to May 2006, his index gained 200%, averaging 30% compounded annual gains. And his index was composed solely of mid to large-cap producers, not the exploration of junior companies.

Yesterday, we were uncertain. But now, we’re not so sure…

What we were uncertain about was whether we were looking at a great buying opportunity for gold…or whether the correction will continue.

Today, we’re not so sure we should even be asking the question.

Gold shot up again on Wednesday – to $949. The dollar took a dive – down to $1.57 per euro (EUR). And the Dow fell 109 points.

It’s all guesswork, of course. But let us return to the big picture to try to figure out what is going on.

The economies of the West are clearly entering a rougher period. When the last great bubble popped – in housing and the financial sector – it seemed to take the wind out of the whole economy. Consumers have less to spend…and no obvious way of getting more. And Wall Street is less eager to lend. Even though the Fed is opening up the throttle, trying to make money easier to get, the banks are pushing on the brakes. They are afraid to lend.

Since the real economy relies on consumer spending and credit to keep going, it seems a good bet that it will slow down. Already, the United States is probably in recession.

Implication: sell U.S. stocks and property.

So far, the stock market and the technical outlook are not confirming this advice. What do they know that we don’t? Could they see another big boom on Wall Street? Or are people holding stocks merely a hedge against inflation and a falling dollar? Is it possible that the stock market intends to stay where it is while inflation does the work of reducing the real value of its shares? Over the last ten years, the S&P has gone nowhere. But inflation has trimmed 25% to 30% off stockholders’ wealth.

Financial shares have been hit especially hard this year – they’re down 30% to 50%. Speculators are wondering if it isn’t time to buy. Here at The Daily Reckoning, we don’t claim to know, but as we mentioned yesterday, it looks like the bubble in the financial sector has popped…and even if there is enough credit to pump up another bubble, it’s not likely to be in financial stocks. They’ve had their day; the next bubble will elsewhere.

So, now let us turn to the picture outside the United States. If there is a substantial downturn in the United States, we’d expect a downturn almost everyone. The United States sneezes, as the saying goes, and the rest of the world gets a cold. But we’re beginning to think that this time it might be the other way around.

Growth rates in emerging markets have been running two to three times those of the United States. Overseas stock markets are booming – but skittish. And few are cheap. The only big exception is Japan – which is held in such contempt by global investors that we are buying it out of sympathy.

There is no doubt that a slump in the United States will hurt these foreign markets. Some export energy to America. Some export food. Others export finished products. A decline in U.S. demand will mean fewer sales at lower prices.

"I’m selling all my emerging markets stocks, except for China," says our old friend Jimmy Rogers.

How bad will the foreigners be hit? How long will the slump last?

We don’t know, but for every American consumer who is slacking off, there are three or four foreigners eager to take his place. The problem is that the foreigners haven’t had the money. Or, they didn’t want to spend it (the Chinese are said to save nearly half of what they earn…savings rates are very high in other foreign countries too).

Making up for U.S. spending won’t be an overnight thing. Still, in India and China, wages have been rising about 10% per year. In Russia, they’ve gone up by a factor of 6 over the last 8 years. And bet to us that, sooner or later, demand from domestic sources will more than make up for spending by Americans. So you may want to use this current weakness to buy into foreign markets at good prices. Looking at the long sweep of things, many of these foreign markets look like they are ready to grow and prosper not just for a few more years…but for a few generations.

One of the most important of these growing markets is India. We got in touch with our friend Ajit Dayal, formerly running George Soros’ Quantum Fund, and now running his own shop in Bombay.

What’s going on in India, we asked. The 200 leading stocks on the Bombay exchange have fallen 32% this year. But over the last 12 months, they’re still up 45%. What gives? Is it still a buy?

"Yes," he replied… "Very, very much a buy. India’s economy will grow by over 6% per annum in real terms for the next decade, giving investors ample opportunity to make sensible risk-adjusted returns of 15% to 20% per annum. That is a likely 4x to 6x increase in your investment in 10 years."

Chris Mayer agrees: "In 2003, a study by Goldman Sachs made some bold predictions:

"That by 2020, its economy will be larger than Great Britain’s…by 2040, it will be the world’s third largest economy…and by 2050, its per capita income will have grown 35 times over.

"But get this…five years after those predictions were issued, India’s growth rate is actually higher than the study assumed.

"Investing in India today is very much like investing in China 13 years ago. Imagine how wealthy you’d be if you’d started investing in China in 1995!"

Chris tells us that’s the opportunity that lies ahead in India… especially as something called the ‘Golden Quadrilateral’ nears completion in just a few short months.

*** A prudent investor could very well decide to keep his powder dry until the next trend reveals itself. But thus is the big question raised…what powder?

An investor needs a baseline. He needs to be able to figure out whether he is making progress or backsliding. An American typically keeps score in dollars. But there’s the rub…the dollar is a baseline that keeps moving. When the euro came out in 1998, it quickly fell against the dollar – from $1.12 down to 88 cents. That was the era when the NASDAQ was flying and Americans were still the world’s most admired people. Since then, the tech stocks have crashed…the information age has proved a disappointment…the War against Iraq didn’t go as planned…housing has gone down…and Wall Street has shown itself to be as incompetent as the rest of us. (We all knew Washington was incompetent already.)

And now, as if to underline the point: Europe’s esperanto money has risen to $1.55. In terms of what a dollar will buy in the United States, a dollar is down around 25% so far this century. In terms of what it will buy in Europe, it is down by about 50%. In terms of gold, it has shrunk 75%.

So where should an American keep his money? This was a much easier question when gold was under $500 and the dollar was worth more than the euro. Of the three, the dollar was the last place you wanted to be.

But now the buck is already down. Will it go down even more? Or is it time for a dollar rally? Now we’re not only uncertain…we’re unsure too. It is still early in the credit crunch. If it crunches hard enough, the dollar will pop up…squeezed out like a pea from a peapod. On the other hand, there will probably come a time when the feds bring out the helicopters and begin throwing dollars out of the cargo hatch. Then, like Germany in the ’20s… Argentina in the ’80s…or Zimbabwe today (see below)…we’ll see some real inflation!

In the meantime, it’s probably best to play it safe. Here’s what we’re doing with our own money: we’re splitting our cash into three parts – and putting each third, equally, into gold (which we expect to double again from here)…Swiss francs (CHF), (because we fear the dollar could fall apart at any moment)…and the dollar itself (because you never know.)

Or you could see what our friends at EverBank have up their sleeves. Right now, they are offering multiple ways to diversify your portfolio with foreign currencies. For example, their World Currency Access Deposit Account is a great choice if you seek to diversify your financial portfolio globally against a depreciating U.S. dollar, without locking yourself into a fixed term. And it’s a smart business solution if you require a cost effective account to manage your foreign currency exposure. Be one of the first to find out all about it here.

*** Zimbabwe is back in the news. The inflation rate has risen from 100,000% to 200,000% since we last reported on the situation. But no one is counting very closely. Speaking of a cost of living increase in Zimbabwe is a like speaking of an increase in the snake population in Ireland. There isn’t much of living to be had at any price. The shelves are mostly barren.

The big question in Harare is not whether Mr. Mugabe will win or lose the election on Saturday, but how he will steal it.

*** And one final thoughtful note…from Joel Bowman, reporting from the Persian Gulf, on what happens to all those fat profits made by oil exporters…and how costs always rise to fill the space available to them…and why whenever a nation discovers that it has an unearned advantage, it quickly finds a way to disadvantage itself:

"A friend who visited Dubai recently remarked to me that the emirate seemed to have one foot in the 13th century and the other in the 21st. His wife was shocked to learn that the political structure of the Emirates is basically akin to a feudal society; Sheikhs at the top, appointed by birthright, and imported, increasingly disgruntled, serfs laboring away at the bottom. A benevolent dictator is a marvelous thing…until things turn bad, i.e., the oil stops a flowin’.

"I found it interesting to note that the Saudis, perhaps the most expansive central planners in terms of intervening in individual’s lives, now spend $55 of every barrel of oil sold just to provide welfare for their citizens. This is a country with the largest reserves of the hottest export around and it requires a price seen less than two years ago just to balance the books! The only thing outpacing the rise in crude price, it would seem, is the over-reaching arm of the planners.

"(Venezuela, according to a report someone forwarded me recently, needs an astonishing $97 per barrel of oil to meet Hugo’s financial obligations…Iran and Nigeria require something like $75…not that I think it’s going back to these prices, but the margin between profit and just covering their expanding welfare buttocks is getting rather thin.)

"There is a region-wide nanny state syndrome that, in my opinion, will eat into every last drop of oil revenue long before the final well is exhausted…that’s if the SWFs don’t blow it all by ‘bailing out’ all the west’s financial institutions in the process – a practice that has seen the loss of billions for the Abu Dhabi Investment Authority, Mubadala and other, centrally planned and controlled funds.

"Back to the point though. Assuming that humans will remain a constant in any centrally planned equation, governments come up with hair-brained schemes to promote the interests of ‘a class’ or ‘a culture’ rather than let the individual fellow sink or swim for himself. This almost never works. History is full of examples. Here’s just one from my neck of the woods.

"The GCC determines that employment of nationals is of utmost importance, regardless of talent, merit or resume. (I can only surmise that this is motivated by cultural pride, as any company would surely want to hire the vast array of talented Indian IT gurus, for instance, before they settled for an Emirati who waltzed in around 11am and clocked out at 2 after an hour and a half lunch.) So, the central planners go to work…

"Qatar just announced a 20% ‘Qatarization’ (not to be confused with ‘racism’) initiative to be implemented by March 31 2009. That means every company must [hire] one Qatari for every four non-citizens on their books…or lay off a bunch of ‘imports.’ The Emirates and Bahrain are employing similar tactics as are Kuwait and Saudi.

"One may find themselves sympathetic to the cause of preserving the culture of a particular region…or not…but the fact is, making it illegal for companies to operate an employment system based on meritocracy will cripple them, particularly the smaller businesses.

"There’s obviously much more to it, but you get my drift.

"So, to hell with good intentions. You don’t count your investment returns until point of liquidation. And woe to the man who ever said, ‘Well, I intended to make a big fat profit…that’s what I had planned on.’"

Until tomorrow

Bill Bonner
The Daily Reckoning