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December 17, 2008

Gold Looking Up Again
by David Chapman

Gold bugs are a pretty resilient bunch. Even as the price of gold collapsed from its March 2008 highs just over US$1,000 to the depths of the October lows near US$680, the chat rooms and the gold bugs' websites kept up the mantra. They are in a small minority in the market but their small size belies the noise they are able to make. The cheerleading is led by the Gold Anti-Trust Action Committee (GATA - www.gata.org), a group that has long held that the gold market is manipulated.

Whether or not there is gold market manipulation is not for us to determine. Our mantra has always been that gold is money. It has a 3,000-year history of being used as currency. The first gold coins were struck in Ancient Greece ca 700 BC. But Gold is also a commodity, an investment, and as jewellery an object of beauty. It has been known as an asset of last resort. Stories abound of people fleeing oppression and dictatorships, leaving possessions behind but being sure to take their gold. Gold and precious metals are a negatively correlated asset class to traditional financial assets. Gold has been both an inflation hedge and a deflation hedge and it provides diversification in a portfolio of financial assets.

All the gold ever mined totals about 155,000 tonnes. Assuming all of it still available, it has a current market value of about US$4.2 trillion (at US$850/oz). Central banks hold some 29,000 tonnes and private investors another 24,000 tonnes. That accounts for about US$1.5 trillion. It is believed that the central banks of the world may have leased and sold upwards of 15,000 tonnes. Many countries such as Russia, China, India and others have stated intentions to diversify more of their currency reserves into gold.

Gold's market value of about $4 trillion is dwarfed by the world's capital markets, which are estimated to be somewhere between US$170 and $180 trillion. The gold markets, and all other precious metals markets, are very small compared to global capital markets.

The Gold market is also small when compared to money supply. In the US, M1 is $1.5 trillion and M2 is $7.9 trillion. M3 has been variously estimated to be between $13 and $16 trillion.

If a mere one per cent of the world's capital markets were shifted into gold, the reality would be that there just isn't enough gold in the world to even remotely satisfy such huge demand. The world produces about 2,500 tonnes annually from mines, and that number has been declining each year throughout this decade. That is only about $68 billion at today's prices. US money supply has increased in the past year alone by $157 billion (M1) and $562 billion (M2) - 11.5 per cent and 7.6 per cent respectively.

We also saw declining production in the 1970s; it wasn't until the 1980s that mine production finally began to rise again following a decade of rising prices. We don't expect to see rising mine production again until sometime into the next decade.

Since the secular bear market began in 2000, gold and the precious metals stocks have been a clear outperformer.

* Includes price gains plus coupon
** Average yield of auctions. Investors may receive considerably less.

While all asset classes except government debt instruments have suffered in 2008, gold and silver and the precious metals stocks as measured by the Gold Bugs Index (HUI) have clearly outperformed this decade. But not only that; their outperformance has been consistent during periods of financial stress and underperformance in the broader market. That includes both the periods of inflation (the 1970's) and deflation (the Great Depression).

Our first chart is the current decade. Since December 31, 1999 the Gold Bugs Index (HUI) has gained 298 per cent versus a decline of 22.4 per cent for the Dow Jones Industrials. That is the good news. The recent collapse has been a little harder on the PM stocks. To date the Gold Bugs Index has fallen 42.6 per cent from its highs of March 2008 while the DJI has fallen only 36.7 per cent from its October 2007 highs. (These measurements are from high weekly close to the current market close.) But the rebound has also been impressive: the HUI is up about 75 per cent from its October lows while the DJI is up only about 11per cent from its November lows.

Flash back to the inflation years of the 1970s. We don't have an index from the period but we do have Homestake Mining (HM). For the decade, HM was up 465 per cent. Add in 1980, when gold peaked at $850 and HM peaked at $22, and HM was up over 1,000 per cent. The DJI by contrast was up a mere 3.7 per cent from December 31, 1969 to December 31, 1979. Even adding in 1980, the DJI was up only 20.8 per cent. Gold itself rose from $35 to $850, a gain of over 2,300 per cent.

The 1970s was a decade for the commodity assets. The traditional investment vehicles of financials, industrials and others went nowhere. Many investors were wiped out in the collapse of 1973-74. But for those that held Gold or gold stocks they were duly rewarded. Gold is an inflation hedge.

HM had its best move from 1970 to 1974 and topped out at about the same time as the DJI was bottoming. For the next several years HM went sideways to down, and it was only after gold soared to $850 and had its first sharp correction that HM moved to its all-time highs. Indeed while the highs of 1980 were taken out marginally in 1987, 1990 and again in 1994, the move above those highs was not even $1. After topping in January 1994, HM collapsed over 80 per cent to lows in 2000. It was eventually bought out by Barrick Gold (ABX-TSX) in 2001.

We have often heard that gold and gold stocks are only an inflation hedge. Well, if the evidence of the 1930s is worth anything, it is also a deflation hedge. In 1933 Gold was revalued upward from a fixed price of US$20.67 to a fixed price of US$35, a jump of 69 per cent. The US carried out a confiscation of gold at the same time. But those holding gold stocks were able to weather the storm of the Great Depression.

During the 1929 stock market crash HM fell 30 per cent as the DJI was falling roughly 50 per cent. HM actually did quite well, as most mining stocks fell 50 per cent and more during the famous stock market crash. But as the DJI began its long collapse into July 1932, HM started a long rise.

From the top in September 1929 to the bottom in July 1932, the DJI lost some 89 per cent. HM rose 44 per cent during the same period. July 1932 marked the bottom in the Great Depression for stocks, and from there to March 1937 the DJI rose 371 per cent. But HM also rose 343 per cent to its top in February 1936. Over the 1930s HM was up 507 per cent while the DJI lost 38 per cent. Gold is a deflation hedge.

During the financial panic of 1937-38 both HM and the DJI fell sharply. HM topped in February 1936 and to its bottom in October 1937 lost 35 per cent. The DJI suffered far more, losing 47 per cent from its top in March 1937 to the bottom in March 1938. All commodities fell sharply during this time. Two years later, in March 1939, HM topped out for the next 30 years. (Gold was fixed at $35/oz for the whole of that time.) While Gold and gold stocks were relatively static after that many other commodity prices and the underlying stocks continued to rise through the war years before topping out in 1951.

We are showing our chart of HM and the DJI for 1929-40. We thank www.sharelynx.com for providing us with the data for HM all the way back to 1890. We are also showing a chart of HM from 1901, and gold prices below also from 1901. As Barrick Gold took over HM in 2001, we have adjusted the prices to reflect HM and ABX as one.

Our chart of the Dow/gold ratio dating back to 1900 shows the unique relationship between the two. Over the past century there have been three great periods where you wanted to own stocks and two great periods where it paid to own gold, and by extension gold stocks.

Today we are in the throes of the third great period to own gold. In August 1999 the Dow/gold ratio hit 45:1. Today it is 10:1 and it continues to fall. The huge broadening triangle that has been forming over the past 80 years seems to be telling us that the ratio could once again fall to 1:1 or lower.

Does that mean gold at $2,000, $5,000 or $10,000 an ounce? The DJI at 2,000, 5,000 or 10,000 at the same time? We don't know, but our long-term chart of the Dow Jones Industrials also looks ominous. (Again, thanks to www.sharelynx.com for providing data all the way back to 1800.) Note the huge channel that has been forming on the DJI since the 1930s. Parallel lines off the 1929 highs and the 1937 lows appears to have caught the tops near 12,000 in 2000 and over 14,000 in 2007. The bottom of the channel is scarily down below 4,000.

But before grabbing the razor to slit your throat, we drew another parallel line off the 1937 highs: that today comes in around 8,000. We note that the DJI spent years below the line, finally crossing above it in 1993 for good. So it may very well be that we will now spend years above the line. But if our 1:1 Dow/gold is right, then gold might rise to $8,000 to equate with the DJI.

Naturally this is speculation, but gold bugs must be salivating at the thought. After reaching over $1,000 for the first time this year, gold suffered a sharp 30 per cent plus setback. Precious metals stocks suffered even more. Since reaching lows in November, gold prices have begun to rise again. This is of course a positive development. After all, as the monetary and Treasury authorities go into overdrive to bail out the economy and dropping money from helicopters and cutting interest rates to zero, the probability increases that they will once again create a bubble. At the same time we are going through some serious deflationary price drops, as seen by the sharp fall in the Consumer Price Index over the past couple of months. So we have deflation on one hand and the groundwork being laid for inflation on the other hand.

But if there is one thing the authorities fear, it is deflation. They will do whatever they have to do to prevent deflation. Our charts through both the deflation period (the Great Depression) and the inflation period (the 1970s) prove that investors were wise to have exposure to both gold and the PM stocks during both periods of financial stress. Today once again we are going through a very trying period, and not being exposed to both gold and PM stocks seems to us to be downright foolish. Yet in looking at the numbers, the vast majority of the capital markets have little if any exposure to the sector. In this environment that may just be their route to bankruptcy. Many are already there. The choice is yours. Can you afford not to own gold?

Note: Chart created using Omega TradeStation. Chart data supplied by Dial Data.

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2009 David Chapman

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