Gold Market Letter for November 2009

Gold Market

The financial crisis is now a year behind us and so far with very little inflation (which won’t last long) it is unusual for gold to be acting so robust. Usually when one sees a stock or a commodity going up when most of the usual reasons for its normal price behavior are absent, it signifies new, powerful and unknown force(s) have entered the marketplace.

There are four new forces that were not present in past cycles: 1&2) Central Bank and Sovereign Wealth Funds buying bullion discreetly and in an orderly fashion. With the recent Indian purchase of 200 tonnes of IMF gold this force is now out in the open. The fact this was not done covertly and undercover is very unusual. It is also very bullish, as it implies that other central banks are going to be doing the same thing. 3) Financial Institutions and money managers who have never invested in gold are buying gold as a small percent of their portfolio as pure monetary insurance. These three buying forces should be long term and steady investors. They will not be price sensitive buyers. They will look at gold for the long term in a way that quarter to quarter performance conscious money managers or traders do not. They will buy gold as insurance against the follies of governments including their own. They are also the deepest of pockets and could easily accumulate as much gold each year as is annually mined or disinvested by traders and scared retail sellers. 4) The last force is a hybrid of the old standby “gold bug” crowd and represents a new retail crowd outside of and distinct from the old line street wise buyer in India and China or hard money person. I call this force the nickel and dime force. It means that all over the world (in a hundred or more countries) small amounts of gold are being bought by people because of the unnerving events of the last 18 months. The buyers of this gold are people from the highest to lowest income tiers. Collectively they could swamp even the institutions with buying power.

The largest jewelry retail market in the world, India, has significantly reduced gold imports. Taking up the slack is investment demand that is not readily defined. Therefore this slack, in my opinion is coming from the above four areas.

U.S. Economy

Turning to the U.S. economy, it appears that things have stopped getting worse (except unemployment) and that we may have seen the bottom. It doesn’t mean boom times ahead but it could mean a stagnant/sideways economy that could last a long time or recover slowly. The 2010 Congressional elections are going to be very competitive as the country is in a huge all out liberal/conservative war. Congressmen know that middle of road voters will usually vote their pocket book and in a close election the economy becomes the supreme issue.

If the economy is bad and their district is doing badly they will do badly. Therefore there will be tremendous pressure on the Fed (from the 435 Congressmen) to stay loose for at least another 12 months. The Fed should comply, not only to bail out the many banks that are still in bad shape but because they are now under scrutiny from HR Bill 1207 which demands the Fed to be more transparent. The Bill has a lot of support from both liberals and conservatives. This means the Fed is going to be under a lot of pressure to play ball or else.

Recent economic reports could be signaling a bottoming out process and slow recovery: Manufacturing Index – although still negative has had 6 straight months of improving stats. Building permits and retail sales (still in negative territory) have at least leveled off the last 9 months. Last but not least, Gross Domestic Product, which crashed in the 3rd & 4th Qtr. of 2008 and the first Qtr. of 2009 was down only slightly in the 2nd Qtr. and up 3.5% in the 3rd Qtr. These are stats that are saying, “It’s bad, but not as bad as it was.”

In the last ten years the Consumer Price Index in the United States has increased from 166 to 224. This means that if you were a retiree and had savings in August of 1999, you have experienced a 35% reduction in purchasing power. The Fed and the established political machine in Washington (includes Republicans and Democrats) have been operating a paper money system since 1934, and this abuse of monetary policy has become increasingly worse. The recent financial turmoil that almost took down the global banking system necessitated creating more money and credit in unprecedented amounts. (The U.S. money supply is up 20% in just the last year). The next 5 years will be very inflationary here and abroad and will drive gold to new highs.

Problems That Could Arise

The three areas that could present big financial problems in the future are: 1) State governments are mostly in horrible financial shape and could require massive federal bailout funding. 2) European banks are more leveraged today than our banking system was during the crisis. This is a simple measurement of their tangible assets (real stuff) versus what they have lent out or invested. The US major banks that were in trouble were leveraged 45 times (up from 18 times in 1998). The major Euro zone banks are 55 times leveraged. 3) The commercial real estate market in the U.S. needs a recovery and quickly. If not, this huge $3.5 trillion arena could face even more severe credit conditions and bankruptcies. Interestingly, all roads lead to printing more money to bail out the country’s problems. This is bullish for gold and the mining sector.

Gold Mining Stocks

The precious metal mining sector should one day explode to the upside for the same reasons that have been staring investors in the face for a long time

Mining is one of the few industries where many of the best of breed professionals do not want to work at a major company. The industry lives and dies based on geologists and engineers. Geologists find the metals and the engineers build the mines and infrastructure. The geologists or “mine finders,” have vastly better compensation if they create their own company and do away with the layers of corporate management that must approve exploration budgets. Consequently, thousands of these risk taking professionals with seed capital from venture funds embark to find large economic deposits around the globe. Most fail. But the ones that do discover and develop quality properties reap rewards in the $10’s of millions versus an $80,000 salary working for a major mining company. Because the best and brightest are independent and flexible, approximately 85% of all new mines coming on stream are because the initial discovery was made outside of a major company.

The majors therefore can rely on this professional army of risk takers to be at the forefront of the discovery cycle. They wait and pay $100 million to billions for a proven and developed property. Our job is to find companies that have already found and proven up metal deposits that would be prime candidates for a takeover. Since the gold industry produces about 80 million ounces each year, the industry has to replenish these reserves each year with viable new deposits. This is very difficult, especially for the larger producers. Hence consolidations and takeovers are numerous and expected to grow as gold demand increases in the years to come.

Gold stock investors should be very wary of small unknown companies and exploration companies should be considered very high risk. Committing most of your gold allocated funds to quality companies in production as a core position and also having some trading positions is a good idea. It allows you the insurance of gold in the ground and also allows you to take advantage of the high volatility that is probably coming our way in the gold sector for the metal as well as the miners.

United States Politics

The U.S. political scene is more antagonistic than any time since the Civil War. The fight is held in place by two abstractions - benevolence and liberty, both high quality human concepts. Political wolves on both sides of the aisle use bad economic policies to make believe they are trying to “attain” these concepts to keep constituents happy but fail with misguided programs.  Many programs are illogical and intellectually dishonest in my opinion. Most of our government policies and 90% of U.S. spending is for welfare (benevolence) or warfare (liberty).

We are a welfare-warfare nation. In spite of this, the U.S. is the greatest nation on earth and responsible for saving mankind from tyranny the last 70 years (Nazi Germany, Imperial Japan, Soviet Communism). We also have spent more money defending Muslims (Kosovo, Kuwait) than all the Muslim countries together. Our private sector donates 2-3 times more money to natural disasters outside the U.S. than all the governments of the world combined. Private individuals are what keeps this country going. We are a great nation slowly being destroyed by tax and monetary policies that are politically motivated.

Economic mismanagement has prevailed too long and now the chickens are coming home to roost. Most advanced countries have made too many commitments bailing out the banking elites and pandering to voters who want more from their governments. The overused answer to economic problems (caused in the first place by printing money) has been…. to print more money. The future is obvious and gold is responding.

This country has problems stemming from big government which will eventually hurt many people who do not protect themselves financially. The Department of Agriculture has 86,000 employees (outside of the Forest and Parks Service); none of them grow anything. The Massachusetts Medical Society reports that 25% of all medical expenses are to avoid lawsuits, by doctors prescribing unnecessary “preventive tests” and prescriptions, wasting $200 billion per year, enough to give all the uninsured poor in the U.S. a $5,000 health insurance grant.

Our leaders are more interested in getting elected than really helping people. As long as these unworkable and wasteful government programs continue, gold and the mining stocks are going to be the best insurance and a good investment for a portion of your nest egg.

Some Lies about the Gold Market

1. Gold will go opposite to the stock market. Not true. During the last big move in gold 1978 – 1980 the Dow went from 810 to over 1,000 while gold went from $200 to above $800. Many times they go the same way for the same reason….mo’ money in circulation.
   
   
2. Adjusted for inflation gold should be above $2,000. These are numbers based on using the unreal and unsustainable highest gold price in 1980 and then adjusting it for inflation from 1980. Why not use 1978 gold or 1981 gold? Gold based on prices going back over 200 years is a better idea and therefore should be around $900 - $1100 depending on what numbers one uses. But this is only the U.S., the rest of the world is buying gold. China has increased their money supply by 29% in one year! India 15%. These people know what’s coming. Much higher inflation globally and if you add 10% compounded to $1,000 for 3 years you get $1330.
   
   
3. Gold should not be going up because there is little inflation. Not too bad an argument. But money supply increases today create inflation tomorrow and the gold price is discounting this future expectation. But because the entire global banking and monetary system is so suspect, over leveraged and held together by paper printed or money created out of thin air and called currency, the inflation rationale may not even count any more! How is that for outside the box thinking? What counts is the entire system is suspect! It could collapse. Gold is something that will keep its medium of exchange value if the system ever goes under (which I do not think will happen, but many people do).

The Next Few Months

My first thought is to tell you – don’t worry about it. Gold will be volatile and could as easily go to $1200 next month as $950. I suspect that $1,000 is going to be the new floor. The most important thing is the trend is going up and many years from now it should be a lot higher. Don’t lose sleep over the gold price. Also the Indian gold purchase is very significant and expect other countries to join the gold bandwagon.

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