Is This Real?
By James J Puplava CFP, December 8, 2003
For gold investors, these are good times. For the third consecutive year in a row the price of bullion has risen and the price of gold and silver equities is outperforming all of the major averages. The HUI is up 74% this year and the XAU is keeping up with the NASDAQ. It has been almost a decade since gold and silver have delivered returns of this magnitude. For many it is hard to believe that the HUI has advanced relentlessly over the last three years rising 515% since January of 2001. Yes, these are good times, but for many in the gold camp, the times are too good to be true. Many believe that this is a new bull market, but many investors have their doubts. This is demonstrated by the high degree of caution in the gold camp. You can read about the caution in the media (this week's Barrons) or you can pick up on the caution in the chat rooms.
I saw this first hand at the San Francisco Gold show last month. For me personally it was my first time attendance at a gold show. The night before the show began I overheard one investor inside the exhibition hall tell another investor how he had been a heavy seller of gold shares the last month. He hoped to pick up shares at much lower prices in the months ahead. The next day almost all of the speakers expressed the view that gold stocks were expensive. Everyone believed that it was a new bull market but just about everyone expressed caution. Some even went so far as to say they were sellers at this time. To those who ply their trade in the gold markets the heavy attendance at the gold show was viewed as a contrary indicator. However, from what I was able to see, the gold show was made up of gold bugs. John Q., Herbie Homeowner, Larry Lawnmower, and Danny Day Trader were nowhere to be found. The attendance at this year's show was three times that of previous years. Yet, it was the same people. One newsletter writer I spoke with said that he was seeing many of the same people from previous peaks make a cautious return. From my perspective rising attendance at a gold show is not a contrary indicator. When regular investment conferences make gold their topic du jour, when CNBC features a daily feature on gold, or when Maria Bartoromo starts following gold IPO's or if Louis Rukeyser's Friday night guests are gold fund managers, I would become worried. We are nowhere near that point and in fact are far from it.
The high degree of caution that I saw at the San Francisco Gold Show has more to do with an industry and investment depression in the metal that has gone on for more than two decades. To many who have waited far too long for gold prices to rise, the degree of caution is understandable, for over the last decade every time gold prices crossed the $400 mark they have either been repelled or contained. A recent example is what happened back in February of this year when exuberance in the gold camp was everywhere. There were widespread predictions that gold would quickly surpass $400. Instead of rising to $400 gold prices fell by 15%. Many feared another repeat of last February when gold broke out to the upside and then quickly retreated. Some feared that this was about to happen again. Then there were the gold charts. Everyone had long-term charts on gold similar to the chart below. As the reader will quickly see the $400 level for gold has acted as resistance for more than a decade. Now that gold has broached that level, many believe that prices wouldn't hold up.
Many investors and newsletter writers I spoke with were worried that this could happen again. The fact that attendance at this year's show had tripled from the previous year only went to reinforce that belief. To many in the gold camp gold prices had risen too far, too fast for most to feel comfortable with present prices. What worried many is that exploration budgets were going up again and a new wave of money was flowing back into junior exploration companies. Many juniors have seen their shares rise 400, 500, and as much as 2,400% this year. The fact that money was moving into the sector again and the industry was flush with cash again was viewed as another sign of a market top.
I came away from the gold conference with a different view. I had been cautious going into the gold show. However, prominent media stories about gold being overvalued followed subsequently by cautious statements coming from several prominent newsletter writers were rapidly changing my view. After witnessing the degree of caution at the gold show I believed that gold prices and gold shares would be heading higher. There was too much caution. The key indicator for me was this weekend's edition of Barron's which featured an article titled "Too Precious." The writer felt that gold shares were getting overheated with gold share prices getting ahead of the bullion prices. The article goes on to make a case for gold shares being overvalued with examples of Newmont, Barrick, Placer and AngloGold.
I take a different view. I would like to make the case that gold and gold shares are far from being overvalued. I begin my case with the price of gold itself. At today's closing price of $407.50 gold is still down 52% from its peak back in 1980. Gold bullion prices have been in a bear market for almost two decades. To say that gold is overvalued simply because it has risen 60% from its bear market nadir of $255 in 2001 is absurd. Back in 1980 when gold was selling at $850 the money supply as reflected in M3 was $1.8 trillion. Today that figure is $8.9 trillion as shown in the graph below. In 1980 when gold was selling at $850 an ounce the supply of money was $1.8 trillion. More than two decades later the money supply has risen by 400% and the price of gold is $450 less than where it was in 1980.
% change on year ago
In addition to a rapid increase in the money supply since 1980 there are no signs of a let up. As the table illustrates money supply growth is growing at a healthy clip around the world. There is slosh of money circulating around globe looking for a safe haven and shelter from monetary debasement. Industrialized nations are engaged in a currency war similar to the "beggar thy neighbor polices" of the 1930's. It has become a game of one-upmanship in seeing who can devalue the fastest. At the same time dollar investors are looking for a refuge from the dollar's steep decline. Gold is once again becoming the center of the monetary universe as the center of gravity switches to other stronger currencies and the ultimate currencies gold and silver.
The key major driver in this new bull market in gold and silver is a monetary one. It began with Fed policies to reinflate the financial system and the economy to prevent asset deflation. Since 2000 M3 in the U.S. has grown by $2.3 trillion. Credit and money growth has also been inflated through the issuance of mortgages being underwritten by GSE's such as Freddie and Fannie. The U.S. is in the midst of a credit boom that is unprecedented in history. No other nation throughout history has expanded its money supply, issued as much credit, or taken on more debt than the U.S. Since succeeding Paul Volcker as Fed Chairman in 1987 the hallmark of the Greenspan Fed has been to print, print, and print money. From the stock market crash in 1987, the peso crisis in 1994, LTCM and Russia in 1998, to Y2k in 1999 and to 9-11, the standard recipe for any economic crisis has been to print more money. The result is that the world is awash in an ocean of dollars. The trouble now is that many of those dollar holders are looking to exit the dollar. Most of this money has been going into foreign currencies such as the Euro, the Yen, the Canadian, Australian and New Zealand dollar. However, there has been a small leakage into the gold and silver markets which is where the smart and safe money is heading. In summary, the coming monetary storms is one reason why gold and silver prices are heading higher. The supply of fiat money is almost endless; the supply of gold and silver is not.
The problem for the gold and silver markets is that these markets remain far too small to absorb any significant influx of funds without driving the price of precious metals and precious metal equities higher. The annual market for silver is only around $2.5 billion and for gold it is around $25 billion. The market cap of all the world's gold and silver mining equities is less than $100 billion. In contrast to these small figures the world equity markets are around $25 trillion and world bond markets are over $40 trillion. Over $2 trillion trades each day in the currency markets. Put simply, the paper market dwarf's the bullion markets and there is simply no way that the bullion and precious equities market are capable of absorbing even a fraction of this money without prices heading to the moon. There is an ocean of paper money flowing through the financial system and only a cup of gold and silver. There is nowhere for prices to go but to the moon.
Another factor that has not been reflected in the gold and silver markets is the approaching gold and silver train wreck. Proven and probable reserves for major gold and silver producers have not kept pace with the increase in production. There are many large gold producers today that haven't improved their reserve life from where they were over a decade ago. Large gold and silver deposits are getting harder to find with very few existing fields of sufficient size capable of replacing each year's production of the majors. In order to replace existing production the majors would have to be finding 5 five-million ounce deposits each year simply to keep existing production flat. The majors are ramping up their exploration budgets and have been raising billions in cash this year. However, the time from discovery to the time of production may take as long as 5-7 years. Many experts in the field believe that the majors are unlikely to survive in their present form by the end of this decade. If a major merges or acquires another producer, unless that producer has a longer reserve life, the reserve life of the major remains unchanged. There is only one way that those reserves are going to be replaced and that is through exploration (finding more gold) or through acquiring the reserves of junior exploration companies who hold gold and silver resources in the ground. The significance of this reality is one reason why the high price quality junior mining companies have been going through the roof. This issue will be addressed in a much longer and detailed piece "Pacman, Clicks, and Bricks" coming next week. The important point to understand is that a major supply train wreck is coming to the gold and silver markets soon. (Please see The Silver and Gold Train Wreck for a prelude to "Pacman, Clicks, and Bricks.") This supply train wreck will have every bit as much influence on the gold and silver markets as the monetary storms that are currently gathering force. The supply train wreck is the second catalyst to higher gold and silver prices for both bullion and for equities.
U.S. stock prices rose today led by financial shares amid optimism that corporate profits will accelerate next year. The Dow is only 35 points away from the 10,000 mark with many experts believing that benchmark will be crossed once again this week. Analysts are raising earnings projections for Q4 and for next year. Fund managers expect the stock market to remain buoyant the remainder of the year. Stocks rallied in flag pole fashion led by the futures pit. The Dow advanced 103 points to close at 9,965, a gain of 1% for the day.
Tomorrow the Fed FOMC meets in Washington to decide the future fate of short-term interest rates. There are growing signs of inflation showing up everywhere from higher service prices to rising record commodity prices. The one surprise the markets aren't prepared for is accelerating inflation. We are currently experiencing accelerating inflation in the form of rising asset prices. That inflation is now starting to spill over into the real economy with prices rising in many sectors. The start of the Fed's next monetary cycle is expected to begin by the end of the second quarter of next year. Analysts are looking for the language that accompanies Fed meeting for tell tale signs that the Fed is gearing up to prepare the markets for a change in policy and higher rates. The Fed will have to walk a tightrope and make sure it speaks carefully so that another bond market rout doesn't occur as it did last summer. The Fed is aware that the markets are highly geared; especially the carry trade which keeps long-term rates low. The unwinding of the carry trade is a problem itself. When it unwinds rates will fly upward, not to mention the exiting of dollars by foreign investors.
Volume hit 1.19 billion shares on the NYSE and 1.58 billion on the Nasdaq. Market breadth was positive by 21-11 on the Big Board and by 8-7 on the Nasdaq.
Charts courtesy: www.stockcharts.com, Bloomberg, & BigCharts
© 2003 James Puplava