Gold to Rise

I have a report in my hands that is helping me understand the gold market. “Understand” is too confident a word. Because the gold market is too complex for mortals.

Is it a commodity? Is the market rigged? Is there a conspiracy against gold? How come the price has not responded to the biggest credit expansion in history?

It was easy to forecast the future of gold in ’73. Nixon had “closed the gold window” two years earlier – meaning that foreign governments could no longer trade their dollars for gold. For the first time in a very, very long time, the dollar was nothing but a piece of paper – with no connection to precious metals.

Nixon had, after all, stopped redeeming dollars for gold for a reason. There were too many people who preferred the metal to the paper. At $38 per ounce, gold was an irresistible bargain.

Rather than devalue the dollar against gold, Nixon simply cut the link between the two…letting the market do the devaluing itself.

Devaluing the Dollar: Mr. Market Takes up the Challenge

Mr. Market took up the challenge with great gusto and resolve. Within seven years, the price of gold had risen more than 20 fold. Mr. Market, you see, is given to excess.

Since then, the price has collapsed, and has traded in the $300 to $400 range ever since (except for a drop of around 20% in the late `90s). Now, gold is at $307.

If you go to Sears rather than Brooks Brothers, you can still buy a suit of clothes for the price of an ounce of gold – just as you could during the Roman Era, when an ounce of gold would get you a decent toga and belt.

We contrarian investors look for aberrations. Nothing seems to be out of order with the price of gold. It is where it ought to be…more or less…in terms of what you can buy with it – but for one very glaring exception.

While the price of gold was in full flower, in the late `70s, the stock market had lost its bloom. The Dow was, believe it or not, within a few dollars of the gold price. You could buy an ounce of gold for $850 at its high. That amount would also get you a unit of the Dow – with enough change left over to buy a unit of the Nasdaq, too, which – coincidentally – opened for business the very same year Richard nixed the gold sales.

Since then, the Dow has risen about 15 times. And the price of gold has fallen in half. So the difference is about a factor of 30. The Nasdaq action has been even more excessive. Nasdaq prices rose from under 100 (from what I can tell by looking at the chart on the Nasdaq web site) to over 4,500. This represents a 45-fold increase. Compared to the gold price, the Nasdaq is 90 times greater than it was in the late `70s.

Devaluing the Dollar: Regressing to the Mean

Something is clearly out of whack. Partly, it is the gold price. Gold was in a bubblish fever back in the late `70s from which it recovered quickly. Its condition has been stable ever since. But the big aberration is in the Nasdaq – apparently it contracted the bubble bug from gold and is now suffering its own fever. Had gold been at the same price in ’78 as it is today, you could have bought three units of the Nasdaq for one unit of gold. Instead, an ounce of gold gets you considerably less than one-tenth of one Nasdaq unit. Even deflating the gold price, therefore, still leaves a 3,000% gap between the Nasdaq and gold.

Regression to the mean alone suggests that the Nasdaq must return to some more modest position vis-à-vis gold. How this will be accomplished is the subject of this letter.

The report I mentioned at the beginning was written by Paul van Eeden, a broker at Global Resource Investments. It points out that for all the many tales concerning gold, the yellow metal continues to function as it always has – as the ultimate money. Alan Greenspan and all the world’s central bankers realize this. “Gold still represents,” said Greenspan in May, “the ultimate form of payment in the world…Gold is always accepted.”

Unlike a commodity, the gold price seems oblivious to both supply and demand. “During the past 10 years,” Paul writes, “the annual supply of gold, including scrap sales, has fallen short of the fabrication demand for gold by a cumulative 2,764 tonnes. This is more than one year’s total supply of gold from mining.” You would think that such a shortfall would boost the price of gold. On the contrary, there appeared to be no correlation.

It is perhaps a happy coincidence that the supply of gold tends to rise at about the same rate as the supply of everything else. GDP and population figures increase at a real, net rate of between 1% and 2% annually. Gold mining, which benefits from technological improvements, increases production at about the same rate. Thus, gold is not only money, but very stable money – it inflates at no greater speed than the things it is used to buy and sell.

Devaluing the Dollar: Wearing Your Wealth

Even gold jewelry, Paul argues, is really a form of money. People in ancient times found it convenient to wear their wealth. They still do.

Instead of following supply and demand figures, the price of gold, Paul tells us, tracks, inversely, the world’s reserve currency…the dollar. As the dollar rises, it buys more gold. As the dollar falls, it buys less. So if the dollar were to fall, the gold price would rise.

It is almost certain the dollar will fall in the months ahead…the U.S. dollar price depends on the success of the U.S. ‘new paradigm’ economy. America has a huge balance of trade deficit – the largest ever recorded by any nation in history. It can only be financed by foreigners who are willing to invest in stocks, bonds and other U.S. dollar capital assets. As long as Wall Street seems to be going up…foreign investors will probably be willing to invest their money in the American miracle. But when Wall Street goes into a decline, as is now happening, they will switch to more promising investments. This will cause the dollar to fall against major foreign currencies – and the price of gold to rise in dollar terms.

I don’t know how high gold will go…or how low the Nasdaq will go, but it seems likely that an ounce of gold will buy more of the Nasdaq in the future than it does today.


Bill Bonner
Paris, France
January 24, 2003

What to make it?

Building permits hit a record high in December.

But now a “plunge in consumer mood” (Atlanta Journal- Constitution) causes sharp “dip in mortgage applications” (Reuters).

Investors are fed up after 3 years of falling stock prices…still, more than 50% of households own stocks, according to yesterday’s news. And Wall Street strategists are as bullish as they’ve ever been, recommending near- record levels of stock market exposure.

Investors no longer believe the hallucinations of the bubble period. They no longer think that they’ll get rich quickly and easily just by being “in the market”.

Now they think they’ll get rich over a longer period of time by more carefully selecting their investments.

The first illusion was knocked out of them when the stock bubble deflated. Beginning in 2000, business borrowing and capital spending absolutely caved in. By the 3rd quarter of 2002, business borrowing was running at an annual rate of just $10.7 billion – down from $400 billion in 2000. Profits plunged and the smart money realized right away that it was time to get out.

The new lumpeninvestoriat who had been lured into stocks during the boom had no idea what was going on. The poor schmucks believed all the nonsense from Wall Street…and thought they could just hold for the long term. Stocks always go up in the long run…right? Heh heh…

Now, Mr. Market, dressed in black and leaning over the pulpit with an accusatory glare, is delivering a long and painful lecture. He’s warning that nothing goes up forever…that neither an individual nor an economy can expect to prosper without saving, discipline, forbearance and hard work…and that Wall Street’s real function is moral, not financial; it makes investors poorer, but wiser.

The little guys don’t want to believe it. They can’t admit to themselves that they’ve been the market’s patsies. “This year, stocks have to go up…they never go down 4 years in a row,” they whisper to themselves. “Nothing beats stocks over the long term,’ they chant, “even if there are some ‘soft patches’ along the way.”

And so the second illusion will have to be beaten out of them, too, for now it’s the consumer sector’s turn to be de-leveraged. Since the ’60s, the consumer has added to his debts…first, cautiously in the ’70s…and then recklessly in the in ’90s. While GDP rose 283% during this period, consumer debt shot up much faster – by 473%.

“You can’t do that forever,” says Mr. Market. “Sooner or later, you have to straighten up, stop spending so much and save a little.”

“The profitless, consumption economy is on the verge of ruin,” adds Kurt Richebächer, crying from the wilderness of the French Riviera.

In the front pews, America’s 79 million baby boomers look down at their hands…or gaze nervously at the window. They squirm in their seats. Maybe they’re not quite ready to change their habits…but they can’t help thinking about it. Retirement is too close. Instinctively, the boomer knows Mr. Market is right. He’s old enough to want to start saving tin foil…and paper bags…and Christmas wrapping paper – the instinct dates to the time his race had fur. Why fight it? Glory hallelujah…and so he makes up his mind to save a few bucks next week…and waits for the next sermon…

Eric…what fire and brimstone is Mr. Market sending down upon us?


Eric Fry, reporting from New York…

– GOLD! GOLD! GOLD! Like a Presidential sex scandal, the yellow metal’s surprising ascent is front-page news day after day, at least on the front page of the business section…Or maybe just on the front page of the Daily Reckoning. Yesterday, the gold price jumped $4.80 to $364.70 – that’s up more than $110 from the low of $253.85 that gold hit nearly one year ago. The ‘barbarous relic’ is conducting a very civilized bull market.

– In other news, bonds fell, stocks rose and the dollar fell. The Dow gained 51 points to 8,369, while the Nasdaq popped about 2% to 1,388.

– Most folks hope and believe that the President’s nifty $687 billion stimulus plan will be a perfect little pick- me-up, like the first cup of coffee in the morning. We think the plan is more like the tenth cup of coffee on the night before final exams – that’s the cup that speeds the heartbeat, while causing indigestion, failing to increase productivity one whit and preventing sound sleep.

– “The [President’s] proposed pick-me-up, even if passed intact, is too weak,” says James Grant. “That’s because] state and local governments are biting bullets even as the federal government is shooting them off.” Most states in the Union are facing severe budget shortfalls and are rapidly reining in their spending. That’s not good news, given the fact that the 50 state governments combined are much bigger spenders than Uncle Sam – and that dude knows how to throw money around! The expenditures of the state and local governments – equal to 12.2% of GDP – are nearly double those of the Federal government. “In short,” says Grant, “the actions of the state and local governments will be an offsetting drag to any federal stimulus.”

– Nor should we look for much stimulating spending out of the private sector. Neither corporations nor consumers are in much of a position to step up their borrowing and spending…Didn’t they do that already?

– “There’s no question that we have a debt bomb,” says Morgan Stanley economist Stephen Roach, “but I’m not sure how long the fuse will turn out to be.” Nor do we. But we are fairly sure that the fuse is glowing brightly and getting shorter by the day.

– “If the U.S. debt bomb ever explodes, the detonator probably will be the residential mortgage market,” asserts Barron’s Jonathan R. Laing. “Home prices have nearly double the impact on consumer spending than does the ‘wealth effect’ from rising or falling stock prices. And home prices have been on a tear, rising nearly 50% nationwide over the past six years…Consumers have tapped this surging equity value through wave after wave of cash-out mortgage refinancings, transforming homes into ATMs.”

– Because homeowners have been withdrawing cash from their homes like so many $20 bills, they are sucking the equity out of their homes even faster than the red-hot housing market is adding to it. Thus, the housing wealth effect is more vulnerable to reversal than ever. If, heaven forbid, home prices should fall rather than rise, we might finally hear the miserable “Boom!” that Laing anticipates.

– “Gary Shilling calculates that 39% of U.S. homes are owned free and clear,” writes Laing, “and that the remaining homeowners have debt burdens exceeding 80% of the value of their homes. In other words, many Americans have little margin of safety should home prices level off or should they fall as much as 20%, as they did in many overheated areas in the late Eighties.”

– Last year, Americans sucked about $250 billion worth of equity out of their homes that they did NOT reinvest in real estate. A sliver of this quarter-of-a-trillion dollar pile of cash found its way into savings accounts. But most of it was spent on stuff like yoga classes, Disneyworld vacations and Eminem concerts. The memories remain, but the money does not.

– In other words, a big portion of the refinancing proceeds has gone to money heaven. And now that refinancings are slowing down, what other cash-flow rabbits could we possibly pull out our macroeconomic hat? The President’s “pick-me-up” cannot begin to compensate for the dwindling refinance activity.

– “If the housing bubble bursts, instead of gently deflating, the nation’s economy could be in for a major meltdown,” Laing concludes. “In essence, then, the American home is a bulwark for the economy. As long as housing values stay high, the nation is sheltered from a detonation of the debt bomb.”

– If the bomb does detonate, we should expect numerous secondary explosions throughout the U.S. financial markets.


Back in Paris…

*** On this day in 1848, traces of gold were discovered on the Californian lands of Swissman Johann Sutter…and thus was born the great Gold Rush of 19th-century California. What will progeny think of the great Gold Up, Dollar Down – GUDD – trend of the early 21st century, we wonder? Hmmm…Keynes’ ‘barbarous relic’ has made quite a dent in history for itself…

*** Like a teenager forced to go to cotillion, your editor is frequently manacled, muzzled and taken to dinner parties by his wife. None of these soirées are entertaining enough for prime-time reality TV, but they are occasionally interesting enough to keep him awake.

“The American landing in North Africa changed the course of the war…it was the beginning of the end for the Germans. They had to move two divisions from Stalingrad to Libya. The rest is history.”

Speaking, Mr. Junot…a former terrorist (against the German army)…army officer…politician…father-in-law to Princess Caroline of Monaco…was not so much recalling the events of history as reliving the events of his own life.

“Mr. Junot is 87 years old,” explained our host later. “Throughout the 20th century, he seemed to have an uncanny way of being present at the major events of French history…or knew people who were.”

“You know,” Mr. Junot turned to your editor, “we had the biggest, most powerful army in the world – at least on paper. But it was unbelievable how stupid people can be…

“My own uncle was in WWI…he was in the cavalry. He actually charged the German lines on a horse with a saber in his hand. Unbelievable, but true. And his enemies were holding lances!

“And then, at the beginning of the Second World War, Gamelin [Maurice Gamelin, in charge of French and British forces when the war began] went to the front, where the German tanks were racing through the north of France…and asked ‘Where are the pigeons?’ He wanted to send a message to Paris and thought it was still the era of carrier pigeons. “My uncle was so patriotic. But he had gone deaf from his war wounds…so he couldn’t listen to the radio. And the newspapers were all tightly controlled by the Germans and the Vichy government…

“Ah…WWII that was a completely different. No one knew exactly who the enemy was. We had many French people join the Germans. You know, it was the French soldiers fighting for the Germans who were the last to surrender in Berlin. They must have figured they had no choice. They would be killed by the Russians…or by the Allies…might as well fight to the bitter end….

“People just wanted to fight…there were the Resistance fighters…the Pétainists…the Fascists…the Communists…

“Well, my uncle was an old soldier. And he was loyal to Pétain. So when his sons were old enough, he sent them to join the Milice [Petain’s army, then supporting the Germans]! He had probably never heard of de Gaulle and had no idea that there were Free French Forces fighting too. One of the sons showed up in Orléans to enlist – while I was there, working for the Resistance. The Allies had already landed in Normandy. Joining up with the Pétainists at that point would have been a disaster…so I took him aside and explained to him what was going on…

The Daily Reckoning