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Two articles that suggest gold is headed much higher

There are two articles in the 31st May edition of Barrons magazine that point to a much higher gold price over the years ahead. The first of these articles is an interview with Ray Dalio entitled "Set Aside Fears of Inflation -- Just For Now".

Ray Dalio is the chief investment officer for Bridgwater Associates, a firm that manages about $75B on behalf of governments, central banks, pension funds and endowments, so his opinions carry some weight. His views are decidedly gold-bullish, not because he is bullish on gold but because he unequivocally concurs with the Keynesian (read: wrongheaded) policies implemented by governments and central banks in response to the financial crisis. Specifically, coming through loud and clear in the article is Dalio's belief that central banks can help the economy by creating money out of nothing (counterfeiting). For example, he says:

"There is a lot of criticism about saving financial institutions and running a big budget deficit, but if the government didn't do those things we would be in a terrible situation. It will be impossible to stimulate that way in the future because politically it is untenable. That's a risk because, between now and 2012, the economy will probably go down again, and it will be important for monetary policy and fiscal policy to be able to be stimulative, and for the Federal Reserve to be able to purchase assets again."

And:

"The English also have way too much debt, but they have [an advantage over the euro zone in that they have] an independent currency and can print money and avert a debt crisis. Debtors with no ability to print money are the ones in trouble."

Moreover, near the end of the article he dispenses with the idea that the large-scale printing of money will lead to an "inflation" problem, as follows:

"The depreciation of the major currencies and the printing of money will not cause a significant general level of inflation anytime soon.

The printing of money will offset the deflation that is coming from the weak demand for goods and services due to weak credit growth. For example, in March of 1933 the U.S. printed a whole lot of money, and that had the effect of converting deflation into modest inflation, but not a high rate of inflation.... My point is, in developed countries there is too much of most things at the moment, and that's creating a deflationary environment. There is too much manufacturing capacity. There is too much labor. There is too much housing stock. As Europe's economy weakens and its debt crisis worsens, the printing of money does not mean that it will produce an accelerating inflation because simultaneously there is also less being purchased, and the surpluses are already causing deflationary pressures. That is why, contrary to almost everybody's belief, I believe the bonds in countries that can print money will be good investments."

To summarise Dalio's view: Central bank money creation will put a floor under the economy, and as far as the general price level is concerned it really doesn't matter how much new money is created as long as there is an output gap.

If highly respected and influential money managers such as Ray Dalio believe that monetary inflation is the way to go then we are a long way from the point where the political tide shifts against attempts to 'inflate away the debt'. This suggests that there will be a lot more inflation in the future and that a much higher gold price lies in store.

The second of the two Barrons articles is entitled "Gold: The Ultimate Fiat Currency". This article makes the correct point that people tend to chase performance, which results in investments becoming extremely popular after they cease to offer any value. Unfortunately, that's the only correct point in an article riddled with misunderstandings and logical errors. We'll only deal with a few of the errors/misunderstandings.

Richard Wiggins, the article's author, argues that gold has become too popular, the implication being that it is now over-owned and therefore at risk of experiencing a large price decline. We agree that gold is a lot more popular today than it was five years ago, but very few members of the investing public currently have significant exposure to gold. To quote Marc Faber:

"Let me shed some light on...[the argument that gold is over-owned]. Every year I attend numerous investment seminars, corporate meetings, and conferences. I frequently ask who among the audience owns some gold. Usually a maximum of between 3% and 5% of the participants own some gold or other precious metals. ...In fact, given all the money printing that is going on around the world I was rather shocked that when I attended recently five different conferences and group meetings with investors I consider to be "sophisticated", prudent, and "intelligent", hardly anyone among them owned any physical gold or silver (usually among 200 people maybe 3 people)."

After wrongly asserting that gold is "over-owned", Wiggins continues:

"The big argument for gold is that all of the money that the Federal Reserve is printing -- 18 years of easy money -- will come back to haunt us at some time when inflation comes roaring back. Yet if today's investors are worried about U.S. inflation, they can go out and sell T-bonds, or buy the euro or another currency and earn interest while they're doing it. Investors afraid of 1970s-style inflation also should be buying Treasury inflation-protected securities."

We agree that a short position in T-Bonds should do well over the next few years, but there are four reasons why a short T-Bond position is not a good substitute for an investment in gold bullion. First, a short position in anything should never be considered an investment. Second, you only need to look at what happened over the past decade to realise that declining confidence in government-controlled money can be accompanied by positive returns for both gold and T-Bonds. Third, by monetising T-Bonds the Fed could ensure that the government bond market failed to reflect the "inflation" threat for an inconveniently long time (inconvenient, that is, for anyone attempting to protect themselves from "inflation" via a T-Bond short position). Fourth, mathematics favours 'longs' over 'shorts', in that the maximum potential gain on a non-leveraged short position is 100% whereas the maximum potential gain on a non-leveraged long position is unlimited.

Regarding the idea that inflation-fearing investors should buy inflation-protected securities, we'll simply note that these securities only protect against the effects of inflation that the government admits to.

Regarding the idea that investors buy the euro as a hedge against US$ inflation: He can't be serious!

The article ends as follows:

"Only 15% of gold is used as a monetary metal; the rest of it is used as a commercial metal, and that use, particularly as a corrosion-resistant electrical conductor for semiconductors, is declining. Regrettably, it is a soft, semi-useless metal with very few industrial applications.

Gold is just another fiat currency. The only reason gold is valuable is that we believe it is valuable. Ultimately, this gold bubble ends in tears. When and how far gold's price will decline is anyone's guess, but a smart bet is "sooner rather than later.""

He may as well have held up a sign that reads:

"I am totally clueless about gold supply and demand, and I don't know the meaning of the term "fiat currency". Also, it has never occurred to me that the only reason ANYTHING is valuable is because we believe it is valuable."

In conclusion, the first of the above-mentioned Barrons articles is gold-bullish because it reflects a belief that a lot more monetary inflation will be needed to support the economy in the future, while the second is gold-bullish because it reflects gross misunderstandings of gold, money, and what a real "gold bubble" would look like. Such misunderstandings are usually prevalent in the early or middle stages of bull markets, but never near the ends of bull markets. When we get to the stage where the gold bull market is almost complete, almost everyone will understand why the price is rising.

"Austrian"-oriented investment advisors

The Stock Market

The Shanghai Stock Casino

An article posted at Seeking Alpha on 1st June does a good job of explaining the three main forces that drive prices in all stock markets (speculation, arbitrage, and value investing), and why the performance of the Shanghai stock market says almost nothing about the long-term growth prospects of China's economy. Here are the concluding paragraphs:

"A market driven almost exclusively by speculators, and with little to no participation by fundamental or value investors, is not a market that pays much attention to long-term growth prospects. It is driven largely by fads, technical factors, liquidity shifts, and government signaling.

So what does this year's crash in the Shanghai stock market tell us? It might be saying something about the impact of the European crisis on export earnings. It might suggest that liquidity in the system is being driven into real estate rather than into stocks. It may reflect contagion and nervousness about the fall of stock markets abroad.

But we should be cautious about reading too much into it. In fact attempts by Beijing to hammer down real estate bubbles in the primary cities without addressing underlying liquidity expansion may simply push asset price bubbles elsewhere, and this could easily cause a surge in the Shanghai stock markets. But this should not then be interpreted as signaling a surge in the economy.

Shanghai's markets will go up and down, but they are not driven by investor evaluation of long-term growth prospects. China does not yet posses the tools to make such evaluation useful, so be careful about reading too much into the stock market numbers."

Investors and analysts should be careful about reading too much into China's stock market numbers, and should be even more careful about reading too much into the GDP-growth numbers reported by the Chinese Government. China's GDP numbers -- which many people cite to justify bullish forecasts for industrial commodities -- are completely fabricated.

China's economy is probably now in a downturn, but it is really just a coincidence that the stock market is in a funk. At some point over the next few months it is certainly possible that the government will 'manufacture' a new upward trend, regardless of what the economy happens to be doing at the time.

By the way, stock markets in the so-called "developed world" have become far more speculative over the past 15 years. Rather than discounting long-term growth prospects, in a similar vein to China's market they are now driven to a large degree by government policy shifts and central bank machinations.

Current Market Situation

There is nothing new for us to say about the broad stock market. As discussed in the latest Weekly Update, the 50-day moving average looks like a reasonable upside target for the rebound that began last Tuesday. The following chart shows that the S&P500's 50-day moving average is at 1160 and falling.

The beaten-down oil services sector of the stock market, as represented on the following chart of the Oil Services Holders ETF (OIH), is worthy of comment at this time. The OIH has tanked over the past few weeks as the stock market has discounted the short-term costs and the longer-term implications of the BP disaster.

Apart from the environment and the companies that are directly involved with the failed rig that is now pumping millions of barrels of oil into the ocean, the offshore drilling industry will be the biggest loser as a result of the disaster. Amongst the biggest winners will be onshore drilling companies (PDS, for example) and companies involved with the production of oil from Canada's tar sands (SU, for example). On a longer-term basis the uranium sector could also benefit.

Due to our overall market outlook we don't think that this is a good time to be buying the potential winners from the BP disaster, but we expect that a good buying opportunity will arrive by October.

Gold and the Dollar

Gold

Nothing of significance happened in the gold market during the first half of this week, but the current situation is interesting nonetheless. It is interesting because the US$ gold price is either very close to (within $20 of) a short-term peak, or about to break out to the upside. Something similar can be said about the euro-denominated gold price because gold/euro has moved back to last month's all-time high.

Gold has no chart-based resistance above $1250, so coming up with a target following a sustained break above $1250 would involve pure guesswork. On the other hand, IF a short-term peak is now being put in place then $1080-$1120 is a likely downside target-range and major support at $1000 probably defines the maximum downside potential.

We are operating under the assumption that a short-term peak is close at hand, which means that we are maintaining a large cash reserve and looking for opportunities to accumulate some insurance in the form of put options. If this assumption is proven wrong then we will most likely increase our exposure to junior gold and silver stocks.

Platinum

Gold and platinum have trended in the same directions more often than not over the past 40 years, but their supply/demand characteristics could hardly be more different. Whereas gold's price trend is dominated by changes in investment demand, which are, in turn, driven by changes in the general level of investor confidence in banks, governments and the financial system, platinum's price trend is dominated by changes in mine supply and car production.

The following chart shows that there was a huge near-vertical rise in the platinum price in early 2008. This price rise was caused by the -- temporary, as it turned out -- crimping of South Africa's mine production due to the inability of ESKOM to provide adequate electrical power to the mines. It is quite possible that this supply-shock-related upside blow-off created a secular price peak.

The platinum price crashed during the second half of 2008 and then rebounded strongly from late 2008 through to early April of this year. The crash and the subsequent rebound tracked changes in economic growth expectations.

Economic growth expectations probably began a new downward trend last month due to the triumph of reality over stimulus-induced hope, in which case there is a lot of downside risk in the platinum price.

Gold Stocks

The HUI has been drifting lower relative to gold bullion since last September. The most likely outcome is that this downward drift will continue until around October of this year, at which point the stocks should begin to strengthen relative to the bullion. However, if gold bullion makes a sustained break to a new high in the near future then the gold-stock indices will probably enjoy some immediate out-performance as stock market participants hurriedly discount substantially greater gold-mining profit margins. This is not our favoured near-term outcome, but it can't yet be ruled out.

On a short-term basis the HUI is in a similar position to the June gold futures contract in that it has risen to just below significant resistance. Either a short-term top will be put in place within a few percent of Wednesday's closing price, or an upside breakout will soon occur. We are operating under the assumption that it will be the former.

Speculators looking for ways to hedge long-term exposure to gold and silver stocks could consider purchasing December-2009 put options on Silver Wheaton (SLW) with the stock in the US$19-$20 range. SLW is possibly now working on the "right shoulder" of a "head-and-shoulders" topping pattern.

Support lies at US$17 and then at US$13.

Currency Market Update

A slow week so far in the currency market, which makes a nice change. The June euro has again tested its low (see chart below), but on a daily closing basis there has been almost no movement.

We continue to anticipate a 1-2 month bear-market rebound in the euro, with maximum upside to the low-1.30s and likely upside to the high-1.20s.

Update on Stock Selections

(Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html)

Cardero Resource (TSX: CDU, AMEX: CDY). Shares: 59M. Recent price: US$1.04

CDY is an exploration-stage metal miner with several projects in South America and Mexico. The main metals covered by these projects are iron, copper and gold.

The company has been exploring for metals and making metals-related investments for a long time, and yet it managed to sneak through the entire resource bull market of the past decade without creating any shareholder value. That's a remarkable achievement and suggestive of a management deficiency. Sometimes, however, poor management can lead to assets being priced at large discounts to fair value, and, therefore, to buying opportunities. In CDY's case, there is now such a total lack of confidence in management's ability to create shareholder wealth that the stock market is assigning a large NEGATIVE value to the company's exploration-stage assets.

Our statement that the stock market is assigning a negative value to CDY's projects is based on the following simple arithmetic:

The company has working capital (in this case, cash minus the tax liability associated with an asset sale) of C$62M and investments (shares in other resource companies) worth around C$32M, meaning that it has net-cash plus investments of around C$94M. This works out to about US$1.50 per share, or 33% less than the current stock price. In other words, at the current stock price you get cash + investments at a 33% discount to current market value and you get the exploration-stage projects for free. Furthermore, the most significant of CDY's investments is its 3.5M-share stake in International Tower Hill Mines (AMEX: THM), a junior gold mining company that does appear to be well managed.

We aren't going to add CDY to the TSI Stocks List, but it warrants inclusion in the TSI Small Stocks Watch List.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/