The New Gold Rally

Bull markets are notorious for going much further than their earliest prophets ever imagined. That’s the message in oil prices. As a gold bull, Ed Bugos is taking heed.

A correction in oil prices is so inevitable that there is no point in even calling it, especially since I don’t have any great insights as to when it’ll start. But just when the world economy is slowing and central bankers are talking tough, the stickiness of this commodity’s price at heights that were unimaginable five years ago must be scaring the bejesus out of Bernanke. He can’t make heads or tails of it.

Ben won’t be there long, anyway, especially if he mucks this up.

Maybe the new administration will replace him. Then he could write a book debunking gold bug myths about the Federal Reserve System, such as the one about how the Fed is “the engine of inflation.”

Anyway, the markets, overall, are performing as expected.

They are treating the gold correction as though it were a healthy mistake.

Not only did it weed out the weak hands, but it gave central bankers a false sense of security in the face of escalating energy costs. With gold in the doldrums, bond yields relatively low and stock prices recovering, all looked good for a relaxing summer vacation – at least until last week.

Gold bulls are popping with enthusiasm about the post-FOMC recovery in gold prices.

They should be.

After breaking through $920, the market almost shot clean through the May high of $940, staring the reversal point at $950-960 right in the face. The chart bias has turned bullish. I would expect to see support hold above the $900-920 level if the market were to backfill over the next few days – to validate my bullish outlook. But it’s not just technical. The market is doing all the right things, fundamentally.

It has realized that the Fed didn’t really mean what it said, and if it did, it isn’t all that, anyway.

The focus of the debate is shifting to areas that make the Fed uncomfortable: The Dow failed to breach 13,200 and the inflation story is heating up, despite ongoing cracks in the economy.

These things are driving gold now.

Bull markets are notorious for going much further than their earliest prophets ever imagined.

That’s the message in oil prices. As a gold bull, I am taking heed.

What the Fed didn’t anticipate was that the oil price rise would be so sticky that it would embolden the inflationary psychology with or without gold. And it cannot afford to lose control over bond yields.

On the other hand, it cannot afford to tighten.

It can only try to talk down inflation expectations.

A whole new generation has grown up since 1979. It is not used to a tough Fed. The toughest Fed it has seen was in 1994. And putting aside the character comparisons, I’ll tell you this – it was only after several years of inflationary fallout, when people finally began to worry more about inflation than deflation, that Volcker was hired with a political mandate to attack the inflation monster head-on. At the time, CPI inflation and interest rate levels were already high, and P/E ratios were half today’s.

The Bernanke Fed is nowhere near such a mandate. It cannot have anything more in mind than Greenspan’s gradualism. Yet even that is dangerous at this time.

The Greenspan Fed was raising rates during a period of economic stability (2004-2005). Today, the Fed is talking about raising rates in response to an inflation outbreak amid a financial crisis.

C’mon! How are you gonna ‘splain that to the voters?

If Bernanke wants to survive long enough to secure another term, he’s not going to challenge the status quo, and the status quo is not willing to accept the kind of austerity package necessary to contain or defeat inflation. The Fed is damned if it does and damned if it doesn’t.

This means that prices will continue to rise until outright fear of inflation exceeds all others.

That’s why gold has the potential to catch fire here.

The market is beginning to understand this, too. It has seen Bernanke flip-flop from worrying about deflation to worrying about inflation a few times already. The Fed’s hesitation to act in last week’s Federal Open Market Committee meeting was like a starting pistol for this realization.

It’s too late to fix this break in confidence, and it’s too early for the Fed to really take it to inflation.

Watch gold prices double over the next year. My forecast is for gold to reach $1,200 by year-end, and $2,000 by next summer.

This may well be your last chance to buy the metal below $1,000 per ounce.

Regards,

Ed Bugos
for The Daily Reckoning
July 17, 2008

Before starting up Gold & Options Trader, Ed comes 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.

Has oil finally topped out?

Yesterday, the price fell another $4 – to $136. Still, of course, not far from its all-time high. But sliding…

“Oil is a bubble ready to pop,” say some analysts. “No, oil is merely responding to supply and demand,” say others.

What’s the real story?

As usual, you can count on us, here at The Daily Reckoning, to give it to you — straight, unvarnished and unmitigated.

Trouble is, the real world always has a bend to it. Everything has a lacquer on it. And mitigations are everywhere.

In the oil market, we see both a bubble…and a useful commodity responding to economic forces. If you want to see a “pure bubble,” you have to look at something like the tulip mania in Holland or the Mississippi affair in France or the dot.com debacle in New York. These were “pure” bubbles because neither tulips, nor shares in the Mississippi company, nor dot.coms had any real economic value. Their prices were based 100% on speculation – not supply and demand. And since there was no “there there,” as Virginia Woolf might say, there was nothing left when the speculation disappeared. Their prices could go to zero, in other words.

Will the price of oil go to zero? No…not a chance. If the oil market is in a bubble, at least it is a bubble mitigated by three very important circumstances: 1) oil is perhaps the world’s most useful commodity, 2) more and more people want the stuff, 3) it is priced mostly in dollars whose value, in terms of everything else, is going down.

Normally, we can set aside the first two circumstances. Everyone knows oil is useful. Everyone knows the Chinese, the Indians and all the other foreigners are becoming addicted to it – just as Americans have been addicted for the last 50 years. These circumstances come as no surprise to anyone…and markets can sort them out. They were obvious in the oil market two years ago…they are obvious now.

Of course, even if they are obvious doesn’t mean investors have noticed. And in today’s oil market, it looks as if investors are suddenly waking up to something they should have seen a long time ago. But we suspect that the real surprise to most investors is the third circumstance. During the last 15 years – a period known as the Great Moderation – it was inflation that seemed to be taking a long nap. The band was playing loud music. Free drinks were passed around. Everyone was there – except inflation. Maybe it was out of town, some wondered. Or, maybe it was dead. Whatever happened to it, inflation was not around.

But, then the old party pooper showed up – and people began looking for their hats and saying goodbye to each other.

“US consumer prices up most in 26 years,” was yesterday’s most telling headline. Even the Wall Street Journal announced a price increase – to $2 an issue.

If you’re an oil sheik whose only asset is $100 billion worth of oil under the desert sand, you pay attention. The dollar has lost about 25% of its purchasing power – depending on how you measure it – in the last 5 years. If inflation rates just stay the same, the poor oil sheik stands to lose more than $25 billion by 2013. If he doesn’t think he’s getting a fair deal at today’s oil price, he’s likely to put a little crimp in the oil pipeline – reducing production until the price increases.

On the other hand, if the price of oil goes up enough, he’s likely to think that he should get it while the gettin’s good. Then, he would increase production – driving down the oil price.

Our guess is that the oil market has probably over-reacted to circumstances. When investors realized how much demand was increasing…they bid up prices. And when they realized how much inflation was increasing…they bid up prices further. And when speculators saw prices rising so much, they bid them up even further.

Now, oil is probably ready for a correction. Ten years ago, an ounce of gold would buy about 10 barrels of oil. Today, it buys only about 7. As is the case with oil, gold has responded to the increase in inflation rates. As to everything else, it is probably indifferent. So, if we were just adjusting the oil price to inflation, it should probably sell for about $95 a barrel.

As to the forces of supply and demand – Mr. Market would know better than we do. But Mr. Market, for all his sage experience, has a tendency to over-react. He probably over-reacted to growing, worldwide demand. Now, growth rates are declining throughout the world; he will probably over-react to that too.

So, where will the price of oil go? We wish we could tell you. It might very well sink below $100. But it will never sink as low as a busted dot.com or a crushed tulip bulb.

Even if the price of oil does drop, the U.S. has gotten the message: the time to find what will power the ‘car of the future’ is now.

“The coal revolution is here,” Byron King tells us. “It’s always been cheap and plentiful. Now it’s going to be clean, and soon it will even be liquid. It’s also going to cause a massive shift in world power. Two American companies will profit big time.”

Discover the fastest-growing energy source in the world. Also the cleanest and safest. America may miss out, but you can still profit.

*** The stock market seemed to delight in oil’s slippage yesterday. After weeks of falling prices and gloom on Wall Street, investors were ready for a little fun. So the Dow went up 276. Even the financials started tapping their toes.

The dollar managed a feeble improvement too; after hitting a new all-time low against the euro (EUR) this week, it rose to $1.58.

And gold? Mr. Spoilsport lost $16, to end the day at $962.

*** If you were describing the day’s action in terms of our “war” between inflation and deflation…you’d have to say it was a draw. Deflation has been gaining territory – following its massive counterattack, launched a couple weeks ago. But yesterday, the front stabilized. Stocks were up, not down. And consumer price inflation was back in the headlines.

On the other hand, gold’s big drop was clearly a victory for deflation, not inflation. And we got an item from the Wall Street Journal that reminded us that the U.S. economy is still just beginning a deflationary pullback:

“Record Store Closings.”

We were too busy to read the accompanying article. For a second, we thought we might have misread the headline. Maybe it meant that ‘record stores’ were closing. Then we remembered; there aren’t any stores that sell records any more. So, we must have read it right the first time – retail is in trouble.

There is probably nothing surer, dear reader. After a spending spree that saw Americans spend ALL there money…and then some, they are not now going to spend MORE. It’s not possible. Instead, they are going to spend less. And that means the retailers are going to sell less. And it means that they are going to need fewer clerks…and less space.

This is not the time to be holding retailers…or shopping malls – especially those that are far out in the boonies.

*** Heard from an old friend with a new idea:

“Global warming is much more of a threat than I thought. I’m embarrassed that I dismissed it for so long without any evidence. Apparently, there is much less dispute in the scientific community on this subject than we thought. Very few real scientists doubt that the climate is changing…and that the changes are at least in part caused by man. And from what I hear, since it is a problem caused by man, it is also something that we can fix at relatively little cost – or, at least that part of it caused by mankind.

“Not that I’m sure of any of this. Maybe the whole thing is wrong. I don’t know. But then, I don’t know if my warehouse is going to burn down either. And I still buy insurance. From what I’ve heard, the cost of insuring the world against the worst effects of climate change – if the theory is correct – is relatively low. Of course, the world doesn’t work as a business…or a household. But if I were running the world…and I were treating it as a business, I’d buy the insurance. Even it fit turned out to be untrue, I’d still think it was a good buy.”

Until tomorrow,

Bill Bonner
The Daily Reckoning