Why Gold is Set to Soar

John Myers, ever the contrarian gold bug, suggests the fundamentals for higher gold prices haven’t been this good in over a generation.

"Many of today’s investors were still in diapers during the great stagflation of the 1970s. Those who weren’t will never forget the darkest period in modern financial market history."

Stephen Roach,

Morgan Stanley Dean Witter

A decade ago I was 14,000-feet deep in a South African gold mine, sweating bullets and reaching for a bottle of water. My tour guide, a hardened South African mine executive, seemed immune to the heat.

"Mr. Myers. Mr. Myers!" I could barely hear him above the buzz of the rock drills only a dozen feet away. "You must understand," he yelled into my cupped ear, "the price of gold always comes down to one thing and one thing only. The number of U.S. dollars out there."

I don’t know where he is today, but I bet he has a smile on his face. Why? Because he understands that the world is experiencing the same kind of dollar inflation today that made South Africa rich a generation ago.

Right now the United States is fighting a two-front war – one against terrorism and the other against recession. George W. Bush understands that the economy condemned his father to be a one-term president.

That explains why Washington is doing everything it can to inject money back into the economy and why the Fed frantically cut rates last year. On Jan. 3, 2001, when the Fed cut its key federal funds rate by half a percentage point to 6%, it was because of a slowing economy. The move was the first of 11 cuts in 2001, which slashed the key rate by 4.75 percentage points to 1.75%.

But Washington realizes this isn’t enough. So it is reverting to its old ways, specifically a new round of spending. The budget surplus of 1998-2001 has evaporated. Still Congress is eager to implement the kind of spending that would make economist John Maynard Keynes proud. Congress will inject over $200 billion into the economy this year, and unless the economy begins to turn around soon, that total will grow.

Washington has one final trick up its sleeve – running the printing presses day and night. Of course cash is not really created, or at least not much of it. Instead the Treasury controls the amount of currency by creating more money through loans to banks, which in turn lend it out to businesses and individuals, expecting them to jump on the low interest rate bandwagon.

The adjusted monetary base – also called super money because banks loan it out in multiples – is growing at a double-digit annual rate. In fact, in October 2001 it grew from $614 to $637 billion, one of the largest single-month climbs in memory. Moreover the adjusted monetary base measured just $500 billion in 1998. The addition of $137 billion in just over three years is remarkable.

Zero maturity money stock (MZM) has risen by $500 million, or more than 11%, over the past year. The broad-based measure of money, M3, has risen by more than 10%. And over the past year $20 billion in new cash has been pumped into the system. There is now $540 billion in cash in circulation, double the outstanding cash of 1990. In an ideal world the amount of money would grow lockstep with the economy. But the situation we have here is one where money is growing at a rate five to 10 times faster than GDP. Basic economics tells us that if the money supply is growing faster than the amount of goods and services, we end up with inflation. It is a simple case of too much money chasing too few goods.

If, and this is a huge "if," consumer confidence continues the gains it showed in December, along with the low interest rates available to borrowers, there is a strong likelihood this excess money that has been made available to the banking system will enter the economy. With the shallow growth ahead for this year, expect a greater increase in money than in productivity.

There is a final component to the inflationary argument: the United States is on a war footing. Congress could easily add $200 billion a year in military spending. That would increase defense spending by one-third, from 3% of GDP to 5%. Already supplemental appropriations have raised the original fiscal year 2002 spending level by $47 billion to $363 billion. This would be a reversal of the 1990s when defense spending as a share of GDP dropped from 5.5% around the time of the Persian Gulf War to the inadequate 3% last year.

One of the major reasons inflation has been subdued for the past decade has been the decline in military spending. During the Cold War in the 1960s, the U.S. military budget absorbed about 9% of GDP. In the aftermath of Vietnam, defense slipped to less than 5% of the economy. President Ronald Reagan’s final assault on Soviet communism temporarily increased the defense allotment to nearly 6.5% of national income, but it has been in decline ever since. Looking at the big picture, consider that national defense spending as a share of total federal budget outlays has plunged from 50% in the early 1960s to 15% more recently.

The problem with military spending is that it is not nearly as productive as non-defense spending. One hundred billion dollars spent building tanks does not add to the productivity of the nation the way $100 billion spent on a new dam project or tax cut would. "The military ratchet was the most important single influence in raising prices and reducing the value of money in the past 1,000 years," writes Glyn Davies in his book, A History of Money.

No one would argue that the guns and butter legislation passed by President Johnson during the 1960s had a major part in stirring the inflationary kettle. Of course, the real impact of that legislation took a few years to assert itself.

What experienced investors realize is that there is a time lag between the creation of money and the onset of inflation. Remember that the Treasury makes money available to the banks. Sometimes that alone is enough. Economists call it pushing on a string. But invariably there is a tug at the other end of that string by borrowers.

In the ’70s TV show "Barney Miller," a suspect is brought into the precinct after his wife reported a robbery. It turns out the robber was her husband. He confesses to his wife and Captain Miller that he liquidated everything he could and used the money to buy more gold.

She looks at him with tired eyes. "Maybe you’re wrong, Harvey. Maybe we won’t get war, famine and runaway inflation."

"Stop being such a damn pessimist!" he yells.

A few gold bulls are beginning to think the gold pessimists may finally be wrong. The 1970s were a spectacular time for hard asset investors. This decade could be even better. The reason – the continual decline in the world’s raw resources. Just as big oil is spending less at the drill bit than it is with acquisitions, so too are mineral companies spending less on exploration.

The Metals Economics Group reports that total worldwide nonferrous exploration stood at $5.2 billion in 1997. However, mineral exploration expenditures fell 29% in 1998, 24% in 1999 and 7% in 2000 (final numbers are still pending for 2001). As a result exploration expenditure last year were $2.6 billion, 50% of what they were only three years prior.

It is not hard to see that as current exploration slows down, we could be headed for a supply squeeze on several fronts.

According to a recent report by Global Resource Investments, "Mining is a depleting business and in real life mineral deposits are depleted fairly rapidly while at the same time, discovering new mineral deposits happens only occasionally."

Take copper as an example. The world consumes 16.5 million tonnes each year. However, the biggest copper mines in the world hold 12 to 16 million tonnes of copper. That means that each year the world consumes a major copper mine. And replacing these mines is becoming a tougher proposition. While the world still has considerable reserves, much of it is either of poor quality or in politically unstable parts of the world.

Yet buying up existing copper mines adds nothing to the world’s copper supplies. At some point this fact will result in shortages. This, combined with inflation, will push hard asset prices into the stratosphere.

One of the biggest winners, I believe, will be gold.

John Myers,

for The Daily Reckoning
January 30, 2002 — Paris, France

P.S. After I sold Myers Finance & Energy in the late 1990s, I worked as Mark Skousen’s editor for the newsletter Forecast & Strategies. Not only is Mark an acclaimed economist, he has also published his successful newsletter Forecasts & Strategies for over 20 years.

Mark was one of the people that encouraged me to begin writing Outstanding Investments. Why? Because by 1999 he believed that the market was getting close to a top and that it was better than an even bet that inflation would ignite in the early part of the new century.

"Watch for two things always," said Mark. "The yield on the long bond and the price of gold."

The yield on the long bond – now 10 years instead of 30 – appeared to have bottomed in the summer of 2001. It’s current yield of 5.11% is up from 4.88%. Gold has come off its lows. And rising gold stock prices – which we have been seeing – are often a leading indicator of rising bullion prices.

During crises investors begin protecting their wealth by putting money in real assets such as gold, oil and silver. The principle being that purchasing power will be preserved in hard investments. It is a change in mindset that does not occur overnight: A change from being eager to make money to one of wanting to preserve money.

Ironically, once this metamorphosis takes place, the early investors make far larger returns than they were collecting while they were aggressively in the stock markets.

John Myers, son of the great goldbug C.V. Myers, is The Daily Reckoning’s ‘man on the scene’ in Calgary, John has his fingers on the pulse of natural resource industry profits.

The Enron story marks a new chapter in American financial history, says Paul Krugman in today’s International Herald Tribune. Enron did begin a new chapter – chapter 11. But the book’s storyline is an old and familiar tale.

Economists and financial press hacks seem outraged, as if they had been misled. Congressmen, eager to get their names in the paper, are investigating. So many suits are being filed you’d think Enron had forced its investors to have silicon breast implants.

But beneath the mock indignation is a sordid lust. A few inches down from the Krugman piece, David Broder – who must have just read Edmund Morris’s book on Teddy Roosevelt – urges George Bush to seize this opportunity to "reform capitalism". Practically everyone in the nation believes the myth of the "robber barons." Teddy Roosevelt connived his way into the nation’s heart by pandering to it. Broder would have Bush repeat the trick.

Of course, it is all humbug. There is at least as much corporate chicanery hiding behind the SEC regulations and in the cracks of the IRS code than there was out in the open in Teddy’s day. At least back then, investors expected to be robbed. The smart ones took precautions. The others got what they had coming. What has changed?

What has changed is that the nation now employs a whole army of lawyers, accountants, functionaries and factotems to pretend to scrub away the stain of original sin from the financial markets. Thanks to regulators, lawyers, politicians, and analysts – we are supposed to believe – investors will get what they expect from the financial markets, not what they deserve.

But as long as there are fools who need to be separated from their money, dear reader, people will find a way to do the job. Roosevelt-era soap suds just made investors less wary….and thus, easier marks.

Eric, how did the marks make out on Wall Street yesterday?


Eric Fry in New York…

– The Wall Street witch-hunt is underway and several stocks found themselves tied to the stake yesterday, while frightened mobs set them aflame. After all was said and done, 247 Dow points went up in smoke and 51 Nasdaq points turned to ash. The Dow closed at 9,618.24, while the Nasdaq dropped to 1,892.99.

– Suddenly, everyone is scouting around for companies that might have something to hide. And the hunt is proving amusingly easy – more like an Easter-egg hunt for two-year- olds than a genuine investigation.

– During the fantastic bull market of the 1990s, no one cared which companies might have off-balance sheet financing or whose director might have received a little semi-legal "payola." Now they do.

– Yesterday, investors "discovered" troubling accounting issues at Tyco, and the stock tumbled 20%. Never mind that both David Tice of the Prudent Bear Fund (and featured monthly in Strategic Investment) and Dr. Howard M. Schilit of the Center for Financial Research & Analysis had warned about accounting irregularities at Tyco more than two years ago. Never mind that Grant’s Investor detailed more of the same several months ago in a story entitled, "Tytanico."

– Yesterday, the company’s accounting "issues" took on a more troubling hue in light of the revelation that Tyco paid $20 million to one of its directors for helping the company land a major acquisition.

– But isn’t this how witch-hunts usually go? One day you’re singing in the church choir and the next day you’re suspected of cooking up an evil brew. The difference in this case is that there are not too many choirboys heading up American corporations.

– My friend and renowned short-seller, Jim Chanos, made the cover of this week’s Barron’s as, "The Guy Who Called Enron." Jim has made more than one very timely call in his career, as the Barron’s story points out. More interesting however, is the fact that he has been warning for years that public companies often misrepresent their financial health.

– In a Grants Interest Rate Observer story that is now nearly 4 years old, Grant quoted Chanos remarking, "There is a lot of fudging going on. Companies will do anything they can not to miss somewhat aggressive earnings estimates when the penalty for missing by a penny or two is, in some cases, to see a high P/E multiple cut in half. That is the corruption…But everyone has gotten used to the nudge and the wink about the abilities of companies to massage the bottom line through a variety of subterfuges and artifices, so there is not even a slight disappointment."

– Yep, sounds like corruption to me…and now these winks and nods are coming under long-overdue scrutiny from investors. Clearly, the Enron story and its ramifications for the stock market are far from over. In fact, for folks like JP Morgan Chase, the ramifications might just be beginning.

– A shocking Wall Street Journal article relates that Morgan’s intimate relationship with Enron included transacting numerous bogus trades with one of Enron’s infamous partnerships, known as Mahonia Ltd. The trades did serve a financial purpose however: to create a tax-loss for Enron and to produce large fees for JP Morgan.

– Enron is the new "asbestos." The number of claimants that will be lining up to seek "recovery for damages" might keep J.P. Morgan’s litigation team gainfully employed for years.

– Meanwhile, J.P. Morgan shares got hammered anew yesterday, falling more than 6%, as the bank’s serial disasters continue. "Born Under a Bad Sign," the 1960s song by "Cream," seems to describe JP Morgan’s current predicament.

– Yesterday, we found The Morgan trapped in the gruesome wreckage of yet one more financial disaster – Global Crossing Ltd. This new era telecom, which spent five years and $15 billion building an undersea fiber-optic line and thousands more miles of redundant telecom capacity, filed for bankruptcy protection. And yes, J.P. Morgan is on the hook for about $200 million in loans to the bankrupt telco.

– Maybe Morgan’s recent string of disasters has nothing to do with bad luck, but everything to do with hubris. Certainly, Morgan’s bankers would not be the first to mistake a bull market for personal genius. Unfortunately, when the inevitable bear market arrives, "genius" is shown to be something wholly other.

– It’s an age-old lesson, folks, that even the highest-paid bankers forget: an imprudent loan is an imprudent loan, no matter when it is made. An expensive stock is an expensive stock, no matter when it is bought. The best investors make good loans and buy inexpensive stocks…or they do nothing at all.


Back in Paris…

Poor George Gilder. According to TheStreet.com, he owned only two stocks at the end of 2001. The first month of the new year is not even over and one of them has already gone belly up.

*** Global Crossing was one of Gilder’s favorite stocks. Back in 1999, Gilder wrote that the company "has a truly cosmic position as the supplier of the missing element that
completes the global [Internet] system."

*** The missing element was then…and now is in more ways than one…underwater. Global Crossing announced, back in ’99, a plan to lay 88,100 miles of cable, connecting five continents, 24 countries and 170 cities. At the time, Global Crossing was the leading contender in the "great race for broadband supremacy."

*** As recently as May of last year, Gilder was still hallucinating about winning that race.

"The Telecosm will still prevail," he wrote, "and investors who understand its dimensions will be able to spurn the catastrophists and prosper from the largest opportunity in the history of the world economy."

*** As it turned out, it was a race to insolvency. Global Crossing shares once sold for $61…representing $80 billion (Enron was only $66 billion at its peak) that investors thought they had. Now, they have next to nothing. In this new chapter of a very old story…investors – both at home and abroad – must be wondering how much their remaining shares are really worth.

Until tomorrow,

Bill Bonner

P.S. Easy Al Greenspan has been doing everything within his power to stave off investor disgust. But, eleven rate cuts and a plethora of "coupon passes" have had little effect… except to flood the system with cash.

"In fact," suggests John Myers below, "in October 2001 it grew from $614 to $637 billion, one of the largest single-month climbs in memory. Moreover the adjusted monetary base measured just $500 billion in 1998. The addition of $137 billion in just over three years is remarkable."

John suggests there is always a bit of a lag between the opening of the money spigots and…and, er, what’s this? Inflation? No…More below…

The Daily Reckoning