Gold’s Role in Protecting Your Wealth

We have identified the need for a fund in an area that is under-served and as yet largely unrecognized.

The time has finally arrived that an undeniable need to protect your assets from the irresponsible creation of fiat money, has reached unprecedented proportions. For the first time in many years, the odds have shifted strongly in favor of gold investments and similar commodities, despite ongoing attempts to discredit gold, particularly in the U.S. Among the most important changes we have seen recently are: a growing contingent rejecting the U.S. dollar as a flight to safety; the reversal of gold companies from hedging forward, to not hedging forward, and furthermore removing present forward hedges; and a winding down of Central Bank sales just as the returns of gold and silver leasing recently exceeded the returns on holding short-term U.S. securities.

While we consider these three the most important near-term catalysts, there are others. Gold production will likely be down this year with no expected pickup, barring substantially higher prices. From a technical analysis perspective, South African gold stocks, which are largely un-hedged, recently broke out of 3-4 year chart patterns on huge volume. The Enron debacle has raised concerns of the investing public over accurate disclosure and accounting, inappropriate and excessive use of debt, and financial reporting that can no longer be trusted to present on an economic basis how a company is truly performing. JP Morgan, which is by far the largest player in the gold derivatives market with nearly an 80% share, has recently had the credit agencies looking over their shoulder for a possible debt downgrade. If this were to occur, it could cause the need for some of these derivatives to be unwound. There have been allegations that for the past five years there has been a conspiracy to suppress the gold price as part of monetary policy and efforts to calm the markets during periods of distress, such as the Russian debt default. With the inadequate regulation of the gold markets, it has been claimed in a lawsuit that some of these gold market players have created paper gold shorts to the tune of five times the amount of existing physical gold in the world. In effect, in a short squeeze, gold would be un-coverable. Whatever the outcome of this trial, market forces will eventually take gold prices where they truly belong. One key to focus on is that jewelry demand alone has exceeded mine supply for many years, and the discrediting of gold as a financial asset has helped to suppress its price. We’ve reached a point where this discrediting is of little importance as the central banks of the world, particularly in the US through the actions of the Fed, are rapidly discrediting their paper money.

We have had two recent instances of currency instability and responses, which were uncharacteristic of recent times. In Argentina, attempts to put off an inevitable devaluation have only prolonged what was destiny. The peso has plunged since freely trading, and is now putting additional pressure on its trading partners and neighbors, likely to result in competitive devaluations eventually. In Japan, we have a similar drifting down of the currency, which should eventually affect the entire region. Last year’s 16.4% increase in the monetary base along with near 0% interest rates have had little to no effect on the economy, lending, or prices. With deflation running at a 4% annual rate in Japan and government debt at 140% of GDP we have a good look at what America’s similar policy responses will yield. A contagion of competitive devaluations could result in trade wars as happened in the ’29 crash. A telling response to a sliding yen, which seems even obvious to the general public, has been the refusal of a larger portion of the public to seek refuge in the dollar this time. The authorities in Japan have decided to discontinue their FDIC-like insurance on any deposits over $75,000 as of April. The Financial Times has highlighted stories of Japanese citizens going to the bank, withdrawing all their money and purchasing gold. While gold is no longer thought of as money in the U.S., it is in Japan, as well as India, China, Korea, and South America. In the long history of the world, the acquirers of gold were the next great powers of the world. What is it that attracts these nations to gold and why have they shunned the dollar? We will take a look at some of the things that may have put off these foreigners’ view of the dollar.

A very puzzling occurrence over the past decade in the U.S. has been the total disregard of basic fundamental economic theory by economists, in favor of their collective fascination with the consumer, consumer confidence, and unabashed and addictive monetary stimulation. It seems the most widely disregarded economic principle is: that it is impossible to create more capital than that which is available through savings. The woeful condition of the average American consumer, whom recently spends more than he earns, makes America’s historically low savings rates seem like the good old days. This has gotten to such an extreme that if the average American’s savings rate were to return to the average of the 1980’s it would knock about 2% off of this year’s GDP growth. This, at a time when consumer debt has reached $7.9 trillion, 22% of disposable personal income and up from $3.5 trillion at year-end 1989. During the “boom” year of 2000, the U.S. generated over $2 trillion of new debt while nominal GDP rose by $400 billion. In effect, for every $1 added to GDP, $5 was added to debt, higher by far than the 2 to 1 ratio of the late 1920’s. This buildup in debt to sustain profits is constantly being eaten away by higher and higher interest charges. Even after a dozen cuts in interest rates, the relief is barely sufficient to slow the pace of economic decline.

When people consume less than they make, they are, in effect, by saving, providing for the factors of production, which create jobs, income and permanent capital formation, resulting in an ongoing return to the economy. The wealth effects of realized capital gains, which have been said by some to offset the non-existing savings, have had quite the opposite effect: rather than increasing the capital stock, they have gone to excessive consumer spending. Additionally, the increased commitment of capital to the high-tech sector causes additional problems. High-tech investments have had a history of short replacement cycles, involving high depreciation charges, not only detracting almost immediately from earnings, but also not providing the job creation and multiplier effects of more traditional capital formation such as building new factories. In reality, high-tech investment effects are skewed much more to a consumption-type of activity rather than a capital formation activity. In retrospect, the U.S. has been selling its factories to foreigners to pay for its over-consumption and at the end of the day is left with depleted consumable items.

The consumer is living on borrowed time and borrowed money and there is no new savings to fund capital formation. The consumer has been consuming the equity in his home at a record pace, dropping equity from an average of 70% to 55%. Another effect of this consumption has resulted in tremendous trade deficits for the U.S., not only capping domestic prices by importing deflation, but also diverting spending away from U.S. factories to foreign producers. Capacity utilization in January was down to 74.2%, its lowest level in 18 years. The U.S. is as dependent on foreign countries to reinvest their profits into U.S. financial markets, as an emerging market economy is dependent on foreign capital. Increasing use of leverage to sustain profits and consumption has resulted in a decline in profits which is structural not cyclical, as interest and depreciation charges mount, with little to no offsetting pricing power. Interest paid by non-financial firms rose from $392.7 billion in 1997 to $521.9 billion in 2000, while depreciation rose from $493 billion to $606.9 billion, respectively. Those awaiting the anticipated V-shaped recovery will be either sorely disappointed or fooled again by the many confidence games being played by the media and the government. The latest example is the change in “Barron’s” in the statistical section showing PE’s based on operating profits rather than reported profits. The change moved the trailing PE from 42 to 28, still ridiculously high in any case.

Potentially the biggest threat to the dollar, and possibly making for the best case for investment in gold and hard assets, is a little known government adjustment to economic statistics that I recently learned of through the work of noted economist, Dr. Kurt Richebacher. It is called hedonic price indexing and its manipulation of governmental economic statistics borders on fraud, and at best misrepresents economic performance of the U.S. relative to its trading partners and therefore currency exchange rates. Since 1986, government statisticians decided to adjust recorded actual sales prices of computers to account for additional memory and computer power. At first the adjustments were not so great, however, between 1995 and 1999 computer prices declined by an average 24% per year while power and memory soared. The distortions to GDP growth are almost undecipherable, and unspoken of by the many economists that waltz through the media shows such as CNBC. Between 1995 and 1999 corporate investment in computers rose by 10% in nominal terms but by 45% in dollars, adjusted by the hedonic price index. This provides huge additions to GDP and particularly productivity, accounting for the “productivity miracle”. The reality is that the phantom GDP results in no sales, no cash flow, no earnings, and no one’s purchasing power. The “miracle” is how they have kept this fraud from the public’s attention for so long. Fixed business investment increased $387.5 billion between 1997-2000, which accounted for 36% of real GDP growth, however, measured in current dollars, it rose by $193 billion or only 12% of nominal GDP growth. These are huge distortions, particularly considering that this adjustment is only made in the U.S., thereby making the U.S. economic performance compare much more favorably than it otherwise would to foreign economies, boosting the value of the dollar. During the peak of the high tech mania in the second quarter of 2000, annualized GDP growth of 5.3% would have been 1.3% in European terms. Germany’s annualized second quarter growth of 1.1% would have been 4.4% in American terms. It seems strange that we never see these differences reported by the media. Clearly the premium the dollar trades at in exchange markets is based on a lot of fluff. Another example was the switch to classifying software as a capital expenditure rather than an expense, qualifying it as an addition to GDP, which has been running at an annual clip averaging about $225 billion or over 2% of GDP.

The Enron debacle has marked the birth of a new era. Investors are questioning accounting and fraud of companies, and when these economic adjustments are more widely understood, investors may totally lose confidence in the government’s statistics, the stock market, and ultimately the dollar. Corporate insiders stop at nothing to beat earnings estimates by a penny to enrich themselves with stock options, with strike prices that are shamelessly lowered even faster than the plunging stock prices. IBM and GE recently announced intentions to disclose more in company reports. The announcements dropped both stocks further. Could it be that investors are already aware of what they may find? Fuller disclosure is only good if there is nothing left to hide. It is time to protect your assets from the dollar’s day of reckoning. The timing can be difficult but the arrival is assured. The key is to be prepared.

There are other ominous signs for the dollar. Despite the bubble in 2000, total domestic profits of U.S. non-financial corporations dropped from $504.3 billion in 1997 to $491.8 billion in 2000. Without the contribution from foreign subsidiary profits, the decline would have been much worse. Record debt was issued in 2001, with corporate debt of $5 trillion. With corporate and consumer saving non-existent, who is buying all this newly issued debt? The answer would seem to be leveraged financial players practicing the carry trade and foreigners, both ominous overhangs for the dollar. Credit spreads are at levels suggesting danger. World central bank reserves are now composed of 76% dollars and over 2/3 of dollars reside outside the U.S. Foreigners own $6.4 trillion of U.S. debt, including 38% of government debt. A listed derivatives market of $19 trillion and an over-the-counter derivatives market estimated at $90 trillion, overshadow the $13 trillion U.S. stock market. J.P. Morgan alone, is said to be involved in between $30-$40 trillion in derivatives with its equity exposed at a $700 for every $1 of equity rate. Money has been growing at somewhere between 5 and 10 times GDP growth. The U.S. is growing its money faster and faster with little effect. You can increase bank reserves, but you can’t make banks make bad loans, therefore money velocity plunges. The U.S. has resorted to all kinds of manipulation such as; discontinuing the 30-year bond, and suppressing the gold price, to mask irresponsible monetary policy to kick-start the financial markets and hopefully consumption, but little has worked. Efforts to hold down the gold price will ultimately fail, and on a grand scale, because we are seeing real physical buying worldwide. The taking of physical possession of gold is the one thing that the rumored paper shorts will not be able to overcome. While we have seen the long-term case for gold building, there are too many factors mounting that can come to a head to not be there now. While it is possible that it could take some time more before things come to a head, we do not believe it will take long.

History is filled with examples, France in 1800, Argentina in 1943, of countries abandoning currencies backed by gold in favor of fiat paper money. The ensuing downfalls are also well recorded. We are at but a moment in time, yet it never ceases to amaze how the lessons of history are so easily forgotten. The opportunities ahead will be many, the key at present is to protect. Never before in history have financial risks been higher.

Richard J. Greene

Managing Partner, Portfolio Manager

Thunder Capital Management

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