December 2003
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Metal Heads Up

Metal Heads…It has been some time since we have formally addressed gold in a discussion, at least in more than a passing or tangential manner.  To be honest, we’ve been afraid of simply parroting the plethora of gold related information floating around the darker corners of the investment community these days.  But as we try to think in broader terms, this “plethora” of information is certainly far from mainstream or consensus thinking.  Although we cannot state this in an unequivocal manner, we have the very strong feeling that most mainstream investors have very little awareness of global currency movements, outside of what they hear regarding China bashing at the moment.  Most mom and pop investors have very little understanding of money and banking, monetary and fiscal policy actions of the present relative to historical precedent, and very little appreciation for our trade and budget deficits relative to prior period experience.  All eyes and media attention seem to be fixated on the movements of the major equity indices this year, despite the fact that many highly visible gold stocks have outperformed the major equity averages by a mile.  Moreover, the run in a large number of junior gold's this year alone has put many an internet stock to complete shame in terms of outperformance.  Yet across the broad investment landscape, the bull market in gold remains relatively hidden while in plain view.  The same really characterizes the larger precious metals complex.

Trying to keep this discussion as simplistic as possible, we prefer to think of gold in the current environment as being driven by two basic phenomenon.  One shorter term and one longer term.  From a shorter term perspective, gold is keeping score regarding, and is reflective of, one of the greatest credit bubble environments ever experienced both domestically and in good measure internationally.  Although the greatest global source of credit creation has been and remains the US economy, the credit bubble/reflation campaign is truly global in context at this point.  Lending in an on fire economy such as China has been almost parabolic over the last year-plus.  The Chinese authorities fully realize what is happening and have currently taken baby steps to cool it down.  The current Japanese monetary base has likewise gone straight north in nature over the last few years as the Japanese have finally taken the advice of folks like ourselves (the US) and have created an environment of significant liquidity, basically supercharging the already accommodative trajectory of their burgeoning foreign exchange reserve position.
       

The bottom line is that we are smack in the midst of one of the greatest global reflation campaigns of our lifetime.  This campaign directly involves money creation (credit creation), deficit spending, and currency manipulation.  Academic concepts not front and center in the living rooms of mom and pop America.  And gold sits quietly in the corner keeping very detailed notes on this whole escapade.  

The second phenomenon we believe will be very important in terms of the ultimate longevity and height of the bull market in precious metals is the evolutionary track of the global economy.  This is so long term in nature that we believe its day to day influence on gold is imperceptible.  That may also hold true for time measured in months and years.  But as we try to look ahead decades, there is a very good chance that we sit at a significant inflection point in terms of the balance of global economic power.  Again, looking across centuries, it is clear in hindsight that economic power in the 19th century was centered in Europe, particularly the UK.  As we moved into the early 20th century, the British pound was the de facto global reserve currency of the time.  But at that point a new emerging economy was beginning to flex its economic muscles and make its mark upon the global economic landscape.  That "emerging economy" was the US.  In not too short a time (measured in decades), the US economy overtook Europe and the UK in economic mass with the upshot being that the US dollar ultimately wrestled global reserve currency status out of the hands of the British pound.  At the time, the dollar's legitimacy was unquestioned given its then backing in what was the true global monetary standard - gold.  The unmistakable forward marching of the global economy certainly created more than a fair amount of confusion and significant change in its wake.  That change included world wars, international trade disruptions, depressions, etc. and a transition of significant economic power to the then emerging US economy from Europe and the UK.  Within the long term context of the economic evolution of the planet, do we again stand at a key pivot point?  Without sounding un-American or unpatriotic, what are we to make of the current emergence of the Asian economic bloc over the last few decades?  An emergence that is clearly accelerating as we speak.  More importantly, what's to come in the next few decades and beyond?  From our point of view, gold is clearly responding to and anticipating the potential for large magnitude shifts in the global monetary and economic landscape as we move further into the 21st century.  Potential global economic change of such depth that it may occur only once a century.

Sleep With One Eye Open...Never since the abandonment of the Bretton-Woods framework in the early 1970's has the US embarked on an economic reflation crusade as significant as what we are now living through.  In fact, one really has to revisit the depression period to find relative monetary and fiscal stimulus as we see today.  Almost three decades of unrestrained monetary inflation have now led up to one of the most significant episodes of money (and credit) creation this country has ever experienced.  As we have chronicled in our subscriber section many, many times, the build up of leverage in the US over the last three decades has reshaped the very face of the domestic economy.  The emergence of the non-bank financial system stateside over the last thirty years has acted to accelerate system wide money and credit expansion throughout the period.  But never in recent history have we ever experienced an environment where growth in money has outstripped growth in the economy to the extent seen in the last three to four years.  In the following chart we have borrowed a concept from Jim Paulsen at Wells Capital management.  What you are looking at below is growth in M3 less growth in GDP presented on a three year moving average basis.  This certainly smoothes out the directional trajectory of the relationship over time, eliminating all the little squiggles and wiggles.  As you can see, current growth in the domestic money supply relative to GDP growth has no precedent over the period measured.  Certainly, growth in money was lagging economic growth from the late 1980's through to the mid-1990's, but this was a period where the velocity of money was going straight up.  It's only when velocity began to turn down sharply in the mid-1990's that the money aggregates began to accelerate very sharply.

With a clearly bullish tilt toward the current economy and equity market, Paulsen poses the question, just where is all of this money going to go?  But with all due respect to Mr. Paulsen, we suggest that perhaps the proper question is, just where has this money already gone?  The chart shows us something that has already happened, not something that is going to happen moving forward in terms of the relationship between money and the economy.
        

Intuitively, we already know where this money has gone.  It has gone into financial assets, real estate and consumption stateside.  It has gone offshore into foreign exchange coffers of our major trading partners and has found its way into fixed investment in productive capacity abroad.  Although one cannot see it precisely in the chart above, M3 growth relative to GDP growth went positive in the middle of 1998, continuing on its near vertical trajectory.  From there on it was a straight up affair.  Interestingly, the almost two decade bear market in gold bottomed almost exactly 12 months later.  Did gold know that an acceleration in one of the most profligate monetary expansions in US history was being born at that very time?  In hindsight, it sure appears as much.

Well if gold did anticipate our current state of affairs back in 1999, it needed to prove to itself it indeed was correct by attempting to test the 1999 low in gold once again in early 2001.  Of course, as you can see below, the early 2001 test coincided virtually precisely with the peak in the US dollar relative to foreign currencies.
        

We won't spend an incredible amount of time on the fact that in the last few years, gold and the USD dollar have been highly negatively correlated.  If there is any mainline or consensus viewpoint out there regarding the metals, it's that gold and the dollar move inversely.  But by inference if nothing else, movement in the dollar is the culmination of global perceptions regarding US monetary and fiscal policy, the US trade and budget deficits, domestic economic growth and the over owned nature of the dollar as the global reserve currency.  Now that the US is tacitly condoning the further depreciation of its own currency relative to other major foreign currencies (as per the message of the G7 meeting in Dubai), this relationship takes on additional importance over the short term.  In the name of potential short term gain (obviously related to reflation and election year timing), the US has now embarked on a very dangerous path in terms of telegraphing to the world that it is willing to openly debase its currency.  The danger, of course, lies in the fact that 41% of total US government debt is in the hands of foreign creditors as of the September month end Treasury data.  Never in US history have we found ourselves in a situation such as we now face vis-à-vis our borrowing of the bulk of the world's savings.

Even the Warren Buffet's of the world have been willing to make the bet with their precious capital that the dollar will continue to decline from here, and perhaps quite substantially.  This brings up another point.  If Buffet believes the dollar will decline from here, then why didn't he buy gold?  The answer, of course, is that he probably could not have purchased enough to make it meaningful to Berkshire without influencing the price in a significant manner.  It's the problem many large institutional investors face at the moment.  Buffet clearly chose large and liquid currency markets to hedge against the dollar.  It's funny, we can remember that in the very early days of the internet, many institutions would not touch internet stocks because the market caps were simply too small.  By the time the peak in the equity market came around in early 2000, the large institutions were fully loaded with then bloated and unrealistic internet market caps.  Will institutions ultimately be willing to load up on gold stocks once their market caps also reach unrealistic levels?  If gold plays out in classic bull market fashion ultimately culminating in some degree of manic action, we'd suspect that is exactly what will happen.  Of course that could be years from now.

As a quick tangent, a number of observations regarding the chart above.  The $400-420 area for gold is quite significant technically.  In addition to being near a big round perceptual number, this area experienced multiple price peak resistance in the early and mid-1990's.  Gold currently encountering this area of resistance is also coinciding with the dollar finding relatively strong price support in the low 90's area.  In the graph above, we have drawn in a potential head and shoulders formation being traced out in the dollar at the moment.  If indeed the head and shoulders pattern applies, there may be more technical "work" for the dollar to complete between 90 and 100 before breaking the potential neckline to the downside near 90.  In the following chart you can see that the dollar is well on its way to retracing its entire bottom to top move of the last decade.
      

But the technical set-ups in gold and the dollar are important only for the short term.  Longer term, it's monetary, fiscal policy and economic fundamentals that will carry the story.

From a very short term standpoint, gold is a hedge relative to a declining dollar.  And implicitly a hedge to everything the dollar represents - profligate domestic fiscal and money policy, huge budget and trade deficits, etc.  And we suspect that these forces driving the dollar will continue to drive gold over the very short term.  As it stands right now, gold has made new short term highs relative to the dollar, but that's not yet the case globally in terms of gold relative to major foreign currencies.

Compared To What?...As you can see in the gold chart above, the price of gold has hit a seven year high this year.  Certainly in good part, the dollar isn't just depreciating against foreign currencies, but it is also depreciating against the ultimate global currency - gold.  So for now, gold may be holding more fascination for US dollar based investors and speculators than for other like minded market participants around the planet.  Although gold has hit a seven year high against the dollar, from a very short term perspective, it has not hit new short term highs against other major foreign currencies for now.  Below we present the relative movement in gold against major foreign currencies over the last 13 years.  What we believe is important is that gold has not yet experienced a long term price breakout against any of these currencies.  Ad that includes the dollar.  But in many cases it is very close.  Does the bull market in gold accelerate globally when and if gold makes new decade-plus highs against these currencies?  And what could be more bullish than having something like this occur in relatively simultaneous fashion across multiple currencies?  (Answer:  Not much.)
       

In terms of the Euro, gold has hit technical resistance five times over the last two years and has yet to breakout to the upside.  For Euro based investors, gold has been nothing more than a trade for the past few years.  The big breakout lies ahead, if at all.  For Yen and Pound based investors, there has been a clear uptrend over the last few years, as portrayed by rising bottoms in their respective currency-gold relationships, but no new long term highs as of yet.  Yet these charts tell us that gold has slowly inched higher over the last few years relative to other major foreign currencies.  The message?  To us this says that gold isn't just appreciating against a very weary and overburdened dollar, but is well on its way to appreciating relative to global "paper" in general.  In the interest of time, we've excluded other currencies like the Canadian and Aussie dollars.  The chart patterns are similar to what you see above.  But we believe the Yen, Euro and Pound are especially important in terms of their relationship to gold as these are currencies of mass and liquidity.  

Moreover, gold isn't just appreciating relative to currencies, but relative to equities.  Here in the US, we find the following chart informative.  Below is the S&P 500 from 1990 until the present.  The top chart is price only.  The bottom chart is the comparative performance of the S&P relative to gold.  What we find important is the fact that despite the S&P cash price currently having broken the infamous massive head and shoulders neckline near 950, the S&P relative to gold has not broken this same neckline formation at all.  Quite telling in terms of gold outperforming a broader class of paper, if you will.
      

Again, without regurgitating what is already common knowledge in the gold community, gold is driven not only by greed, but also by fear.  And fear takes many forms.  At this point, we believe gold is in part being supported and accumulated by those interested in diversifying their assets, at least to some extent, away from paper.  Away from fiat currencies and away from equities that are very expensive relative to historical precedent.  Those fearful that the ultimate reconciliation of very significant global economic imbalances will not be without bumps along the way.  Bumps that may impair the unhedged value of those currencies or financial assets for a time.  Although we have no way of knowing, it would seem reasonable to assume that if gold breaks out technically relative to the Euro, the Yen and the Pound, broad global interest in the asset class that is the tangible precious metals would increase significantly.  Especially interest in gold.  That may lie in our very near future.  We'll just have to see.

For now, $400 remains a big round number for gold (specifically in terms of the dollar).  For now, gold has not yet confirmed a break out relative to broader global paper (major currencies).  For now, it's really only those fearful of ultimate global economic reconciliation bumps in the night (as well as pure momentum traders) that are accumulating gold for their own accounts.  For now, most remain blind to the message gold is sending really to the global financial community.  As we mentioned, gold has really appreciated most heavily against the dollar over the last few years.  We consider this very telling and significant given that US dollar based consumers have been supporting the bulk of global trade over the past half decade.  Serious in that gold is sounding an early warning regarding the US currency and economy that has been the global consumer of last resort for long enough to have precipitated a state of global economic imbalance unprecedented in our lifetimes.  Is gold initially pointing to the planet's weakest economic link by appreciating so heavily against the dollar as opposed to gold's current price relationship with other major global currencies?  That's what gold seems to be telling us.  For now, few heed what seems a very simplistic warning.  

With A Telescope, Not A Microscope...In addition to the short term factors mentioned, we strongly believe gold is also looking much further down the road.  In fact, a road the time tested metal has traveled before.  From a very long term standpoint, we believe gold is eyeing the burgeoning Asian economic bloc (China, Japan, India, South Korea, Indonesia, Taiwan, Thailand, the Philippines, Pakistan, Bangladesh, Malaysia, Hong Kong and Vietnam).  As you might know, this bloc accounts for roughly 61% of the world's total population.  A population that is destined to change the course of forward global economics.  It's undeniable that the process has already begun.  But that change will not occur without confusion, frustration, possible military conflict, and a direct longer term redistribution of global wealth and broader economic balance.  None other than Buffet came right out in the November Fortune article and stated that the US is slowly but surely transferring its net worth offshore each and every year under current circumstances.  Remember, he's talking about the the net worth of the nation whose economy is ultimately backing the reserve currency of the planet.  Do you think gold is unaware of this?  Do you believe gold lacks proper telescopic vision?  Perhaps gold is telling us that it is ready, willing, and able to be the benchmark or arbiter of what is surely significant global economic and financial change to come.  And that change will not just encompass country specific economies, but also relative global currency attractiveness and importantly, forward global flows of capital.  Who knows, maybe in fifty years the global reserve currency will be an Asian currency, or a broader Asian bloc currency yet to be formed.  But it just may be gold that comprises the economic and financial transition team as far as global capital is concerned.

Although we are still just guessing at this point, we can envision a multi-decade period where the economic strength of the Asian bloc accelerates, while that of major G7 countries grows tepidly at best.  As we have stated many times, the opportunities for global wage arbitrage at the moment are like nothing we have experienced in what is really the short history of the US.  The global corporate sector will accelerate the process of growth in Asian bloc economies as a matter of their own sheer survival.  If indeed this telescopic view of life is anywhere near correct over the next "X" decades, we can't imagine how gold won't at least play a part in this transition process, let alone potentially be elevated to a higher degree of financial benchmark status.

From our standpoint, these are the two main twin drivers of gold.  Short term it's all about currencies, global trade imbalance, the US government deficit, excessive US household balance sheet leverage relative to history, the rate of change in US credit creation relative to GDP expansion, and the over owned nature of the dollar globally.  But we believe the longer term issues are at least as, if not more important than short term economic, currency and other assorted financial gyrations.  If we are even near correct about the relative ascendance of the Asian bloc countries against the established G7 economies in the decades ahead, the shifting global economy will most likely experience bouts of fear and confusion along the path.  Fear that historically has found solace and comfort in the ownership of tangible assets, primarily the precious metals.     

One last comment.  As you know at this point, we have not mentioned inflation and gold in the same sentence, largely because we have not mentioned inflation.  We will admit that gold does deserve some recognition as a hedge against inflation, but we don't think inflation will be the primary driver for gold short term.  In our eyes looking forward, headline inflation will be a byproduct of relative currency movements ahead as opposed to excessive demand pull inflation driven by hot shot global demand centric economic expansion.  We know that excessive monetary expansion over the last few decades implicitly was inflationary in the academic sense, yet that monetary expansion found its way into an excessive expansion in global production capacity that has acted to keep headline inflation numbers theoretically low.  We're often asked how much is too much in terms of US credit expansion?  In the broad sense, how much is too much in terms of paper creation relative to global tangible assets that ultimately support that paper?  In the day-to-day world in which we live, no one has the precise answer.  Maybe like Greenspan, we'll know it's too much only in hindsight.  Well it just so happens that the current gold bull appears cocky enough to suggest we're either very near or have already reached the "too much" paper point as we speak.  What an egotistical SOB, right?

Bottoms Up...A last few charts we can't help sharing.  For those technically inclined, you know that rounding bottom chart formations can be pretty powerful pictures.  And maybe more so if they occur over a multi-year period at bear market conclusions.  Well, in many of the longer term pictures emanating from the gold complex these days, one just couldn't ask for better representations of rounding bottoms formations.  The XAU just happens to be a perfect example.  Much like spot gold nearing the technically important $400 level, the XAU is concluding its own rounding bottom formation with a trip past its own technically important low 90's level.  As you can see in the chart, nowhere over the last twenty years has the XAU put in any better a bullish formation than it has already completed over the 1998 to present period.
      

After completing a rounding bottom pattern such as seen above, is the XAU now poised to take out the double top in the 155+ area?  Given the length of time necessary to complete the rounding bottom, it's very reasonable to assume as much over an appropriate time frame looking forward.  In fact when we look at the prior bull market top to recent bottom move in gold itself over the past few decades, we may be just getting started technically.  We mark the top in gold twenty four years ago at $861 and the bottom in 1999 at $251.  Certainly we've shaved off the pennies from these numbers.  As such, Fibonacci retracement levels should approximate the following:
      

It may be worth keeping these in mind as we move ahead.  Clearly we are quite near a Fibonacci demarcation line as we speak.

It's not just spot gold or the precious metals index such as the XAU that have traced out pretty darn picture perfect rounding bottoms.  Industry market cap big daddy Newmont also exhibits this textbook pattern, albeit more advanced in price post the completion of the formation than is the XAU at this point.  Newmont just happens to typify one of the major concerns regarding the gold stocks of late in that generically the stocks appear to be leading the metal.  We find this a bit amusing in that this is exactly what stock markets are supposed to do.  How come not many folks were worried about equities from March through June of this year when they were clearly leading and anticipating the headline economic improvement?   What we also find very interesting in the long term Newmont chart is that despite the peak in cash gold prices in the early 1980's, Newmont continued to trace out a rather well defined bullish channel from the early 1980's until it broke down in late 1997.  The break, of course, coming into the final bottoming for the metal itself in its own twenty year bear market.  From a very long term standpoint, NEM is pushing back toward that long term channel as we speak.  Above approximately $50 and it will have returned to the safety and warmth of the upward channel it clung to for so many years.  Once again, the duration of the prior rounding formation suggests at least a return into the channel is a very good bet, and perhaps well beyond.
        

Finally, as we mentioned above, gold is driven by both greed and fear.  For now, those fearful of current global economic circumstances are finding bedrock anchoring having gold as part of their portfolios.  But the public and mainline Wall Street are really nowhere in sight.  At some point, these two factions may also be gripped by fear - fear of missing out in a bull market.  We'll see.  For now, we still see very heavy skepticism.  In fact, just in the last month we watched a major sell side brokerage firm rip into Newmont.  Basically they tore it apart based on fundamental valuation.  We could hardly contain our giggles.  After all, this is the same firm that has upgraded so many outlandishly valued tech stocks over the past year that we've simply stopped counting.  Apparently fundamental valuations are appropriate for the gold stocks, but for the internets, techs and biotechs, it's all about momentum and the fabled four years in a row now desperate search for a recovery.  We will say one thing, it's comforting to know that despite all the machinations in the equity market over the past four years, Wall Street equity analysts have been able to maintain their sense of humor when looking at sectors, right?

It's no secret that gold and gold equities, along with many other precious metals related issues, have had a super year in 2003 in terms of investment performance.  Can it be repeated in the year ahead?  We only wish we knew.  From our vantage point, we believe it's important to recognize that a fair amount of momentum and "hot" money has found its way into these issues this year.  Especially lately.  Moreover, the move in many a junior gold issue over the last three to four months has all the earmarks of momentum flavor.  We've said this in the past and we'll say it again, if we truly are in a bull market for precious metals, we're still in the early innings.  In fact, if we had our wish, we'd really like to see gold and the stocks consolidate for a time and work off some of the "momentum" that has clearly found its way into the group as of late.  Moreover, in light of gold's relative negative correlation with the dollar, we need to remember that currency markets are the most openly manipulated financial markets on the planet.  After all, in what other component of the global financial market can investors refer to something as generic as the Wall Street journal to get full details on manipulative action?

David Fuller who pens "Fuller Money" out of his London perch has likened gold to the S&P in the early 1980's.  We like that characterization.  From a Wall Street consensus standpoint, it's unloved, uncertainty abounds, and skepticism is the order of the day.  That's usually how it goes after multi-decade bear markets in any asset class, as certainly was the environment for blue chip equities in the early 80's.  We'll be keeping a sharp eye on the technicals ahead, but plan to maintain a healthy commitment to this group as we move forward.  After all, it's unlikely that global financial and economic imbalances will be corrected anytime soon.  Given the path the US is traveling in terms of fiscal and monetary policy, the imbalance hole just keeps getting a little larger with each dig of the shovel.  Moreover, as the global economy plays out its slow motion dance of change, tilting ahead in the direction of the Asian bloc, uncertainty regarding the role of the dollar in the global financial environment will only increase.  These aren't events that will conclude over quarters or years, but rather over decades.  From an extremely long term standpoint, if history tells us anything at all, it is that gold has staying power.  We're simply choosing to practice a little bit of that staying power ourselves as it applies to a commitment to precious metals at this time.