2005 Outlook: The Elusive Climax
At the outset of 2004 we thought that it would be a tough year for gold shares as we felt they were too far out ahead of the gold price trend by the end of 2003; we thought that the bear market rally in the broader averages (S&P 500 and the Dow Industrials) was topping and would roll over in 2004; we expected gold prices to rally further but that the gold price advance was nearing the end of the first phase of a great bull market, pending a blow-off scenario; and we wrote that the US dollar (FX) would try and bounce, but fail. As it happened, our gold share call (for the averages) was on the money. So was our currency forecast. Our gold price call was half right because the higher high in 2004 didn't happen quite like expected. Our emphasis on gasoline prices was clearly correct, and my US$50 target for oil prices was achieved.
The stock market call was going right up until about half way through the year.
Our accounts were generally up for the year but my own account was up only marginally due to the small (15%) allocation to a bearish position against the S&P 500.
I would also be critical that we did not participate in the derivative commodity-related sectors, like the energies, utilities, and real estate and income trusts - derivative because the economic and financial arguments driving the gold trend are typically the same ones driving those trends. Had we not been so bearish on the stock market (generally) in 2004 we would have done better.
Naturally, investment plans aren't just made at the outset of the year. Our outlooks have changed (though not discontinuously) throughout the year. Our commodity targets have mostly been made except in gold. And the only forecast I'm willing to make in the US dollar this year is that there will be more volatility, and that at the time of writing the low for 2005 has yet to be seen. But, this is related to our gold forecast.
The conventional view on Wall and Bay Street today, we get the sense, is that the government has engineered a text-book neo-Keynesian style soft landing; with the help of some deficit spending and inflationary stimuli, the economic bust following on the down turn in 2001 was not as bad as the gold folks and perma-bears thought it would be. People want to believe it so bad that, although they are more cognizant of the inflation than they were the same time last year, they are still willing to put faith in the "data" published by the same government that is resorting to untenable policies and modes of creative accounting in order to paint it.
Moreover, although the inflation case is more apparent today, it has different competing ideas - the deflation case would be contrarian today indeed. But so is the inflation case. Its acceptance has grown begrudgingly - show me the data!
The more popular themes driving the markets today include: 1) China - in terms of its increased demand for resources, currency policy, and the controversy over jobs; 2) Global recovery (as the US recovery spreads) is causing other competing sources of growing demand for the scarce resources - oil and copper usually cited; and 3) Productivity is so strong in the US economy that despite it all, there is still no inflation and it's causing wide spread job losses. These premises, or competing stories, are fallacious at worst; dubious at best. But they are consistent in inference given a year in which gold underperformed most assets, most commodities, and even most foreign currencies - despite new 17-year highs against the US dollar making it four back to back years of steady advances... the best the market has seen since the last bull market.
It is undeniably a bull market move (what bear market rally has ever dragged out 4 years?!) but its progression was and still is stealth, perhaps if only because these other themes dominated the market's psychology - they distracted it, if you will.
For, all those results that are celebrated by Wall Street today could be equally achieved by aggressive resort to a policy of inflation (easy money in the passive sense), and just as mistaken. What's more, some of them can only be explained by inflation, which is worrisome because that means they aren't real. The consequences of "artificial" stimulus are that it is temporary, usually works opposite to intent, and causes the market mechanism to misfire. But it is fun while it lasts; an opium for the people (Mises).
This is not the place to spend much time on revealing too many fallacies since it's only a summary view of our position. But it is important perhaps to mention that productivity is a force which generally creates new jobs and pressures prices. Moreover, economic growth only causes prices to rise to the extent that the growth itself is a monetary phenomenon; if money supplies were fixed for instance, the growth of the market economy to include new countries (like China and Russia) would result in an increased demand for both, commodities AND money - they would offset each other.
But the way it is now, only commodities are scarce.
Moreover, in general, more goods would be produced for which prices would fall because they would be more abundant than money. Economic growth is productivity. By definition it causes the opposite effect on the "general price level" from that which monetary factors do. In other words, if the general price level was flat in a given period it would be a poor analysis to conclude that it meant there was no inflation.
It could easily mean that the effects of inflation offset the effects of productivity, and instead of falling prices they were flat. Needless to say, this is precisely the mandate of the Federal Reserve Board when its members refer to the concept of "price stability." Of course, there is no way to measure the "general price level." It is a conceptual tool and the attempts to quantify it as representing a loss in the purchasing power of money are misleading on theoretical grounds, and also directly in practice because of the extent to which they are played with by statisticians. The same goes for productivity.
It isn't intelligible to quantify. And while most people are still likely to write those objections off - since why else is everyone using this data (GDP, CPI, PPI, Productivity, etc.) without a second thought - there are those that will not because their fundamental veracity cannot be denied... those that refuse to be fooled by it any longer.
This camp is growing, side by side with the gold bull. To it, the Keynesian model of government intervention for the benefit of the short term at the expense of the long term has been long ago discredited, and the fact that it is still practiced is the consequence of the program of certain interests and general public ignorance.
The truth of the matter is that this boom is obviously different from the one that it is designed to replicate (1995-1999). There is clearly more inflation than productivity (the Fed of 1994 has turned into the Fed of 1971); the US dollar is falling, rather than rising; the government can't even pretend to keep its books balanced; there are deep-seated structural problems in the labor market (caused by inflation, malinvestment, and what is called capital decumulation); and prices are more clearly rising instead of falling as in most REAL booms. Something is clearly wrong in Denmark but the gold story has been delegated to the back page even though it is the only one that sheds light.
The gold price advance is as stealth as ever. But that should change in 2005 as we expect the untenable nature of the boom to reveal itself.
The premise is a pent-up increase in interest rates. Since everyone expects rates to go up now, I'll only forecast that they will rise to the high end of current prognostications.
In other words, we expect them to rise faster than most participants do. We believe that the bond markets have put in a long term top (last year) and that the first bear market leg of many to come will occur in 2005. All central banks are expected to lag those developments as they occur in the market first; if it were otherwise my gold outlook wouldn't still be so bullish for the short term.
As we've said to clients over the year, we believe that the scope of the current gold price advance is to push the Fed into action - which is another way of saying that the Fed won't act as it should until the gold story gets the attention it deserves.
It's possible that even bond yields won't really start rising until gold prices begin behaving like oil had in 2004; but this is all the more reason to remain bullish on gold: the current position of interest rates is inflationary all along the curve.
Until that changes, there is little scope for downside in gold.
However, this doesn't mean that gold is likely to fall if rates go up. The relationship is historically opposite - gold price moves precede interest rate swings (10 year bond yields) by up to 2 years. It is likely indeed that gold will continue to advance until the Fed itself (and/or other key central banks) actually targets it, or inflation.
If the central bank is hiking rates gradually on account that the economy is back on track, yet at the same time is continuing to provide the "stimulus" for an artificial boom, it is just more of the same; and no reason for gold not to continue to advance.
In summary, we expect to see a stronger year for gold in 2005 than in 2004 - as it rallies in all currencies, against most of the commodities, and relative to most paper assets (stocks & bonds). My current target is $500 if it occurs in the first quarter. If it doesn't occur until the last half of the year as has been typical in the last two years of the advance then that target will probably be higher.
Whenever it occurs, it is the nature of the move that will reveal to me whether and to what extent the form of the subsequent correction will take. We have been looking for signs of a primary correction (a correction to the trend that began in 2001 which would be greater than the 15% intermediate corrections experienced so far) for a year.
However, the character of the advance to date has continued to be bullish - this is said in relation to the level of sentiment, the quality of the market's structure (see COT's), and the technical chalk marks made to date. What we're looking for in gold is for the slope of the main trend to pick up, in a parabolic climax, to mark the end of the first primary sequence as most all commodities tend to; and especially since the reason they have is the very same reason gold is trending up, but which seems so obscure due to the competing fallacies, perhaps. Of course, such a forecast would explain our bearish bond market forecast, and in turn would also explain our bearish stock market outlook which is predicated on (besides rates going higher than most expect) a shortfall in profit growth (real) and a contraction in PE ratios due to 1) falling profit expectations, 2) higher inflation risks, and 3) higher rates. It is all appropriately intertwined.
So much so at the moment that I'd say if our gold price forecast is off then all bets are off on those factors as well. In fact, I'd go as far as saying that they haven't been realized yet because our gold price forecasts continue to fall just short of the mark, which in turn has served to keep the bull market case for gold relatively obscure.
The fundamentals for gold remain as good as they ever have, and the technical situation begs for clarity - if it's a bull 2005 will probably show.
That's our call.
The best opportunities in the year ahead in our opinion will thus involve:
- A long position in gold bullion (and gold shares), aggressive to our targets ($500 for gold; 265 for HUI)
- A short position in equities (or perhaps some profit taking in the non-gold commodity related)
- A short position against most bond markets
- A temporary accumulation of T-bills, as cash
There are many ways to structure a strategy around such an outlook - ask your financial advisor. In conclusion, some elaboration on the gold shares: our short term outlook is bullish but on a reduced level (relative to pre-2004) to account for the uncertain intermediate outlook. In other words, if gold prices blow past our targets in February we would expect the equities to participate; but at the same time that would in our current view mark the beginning of a primary sector correction because it would complete the first bull leg. The entry point for a core (long term) gold stock position, on the other hand, is as good as it has been at any time since 2001 - a core position being that segment of the portfolio that is considered long term (i.e. 5 years plus).
The long term outlook for gold is very favorable, and does not require the level of introspection that is necessary to determine its year-to-year prognosis.
This is not the year 2000 when we were pounding our proverbial fist on the table that the next $200 points in gold is up and that the gold shares were the buy of the century. However, the gold story has been far from realized at the same time. The intermediate term (1-year) call is much tougher today but the long term call is as easy as ever. Gold prices are going to make it to US$2,000 plus or minus a few hundred points. The current advance merely represents the awakening of a trend that will take us there; and so we perceive upside at least until the gold bull is no longer so stealth that it defies sun up.
GLD Controversy: Maybe A Case of Jumping the Gun
This update is a follow up to our last editorial - GLD: Incompetence or "Told You So?" - which aimed to legitimize some of the questions being raised by critics of the World Gold Council, Bank of England, and other Participants, Issuers, and Trustees involved with the new StreetTRACKS (GLD) exchange traded gold bullion fund (ETF); and added one of my own - whether it was possible to redeem borrowed shares for bullion to squeeze the market.
A few new facts have come to light which I think are pertinent and may close the chapter on some of those questions at any rate. Whether that's helpful or not, I don't know. I'm sure not everyone will like hearing them. But we believe they are relevant to the matter and heaven knows we want to get to the bottom of it once and for all! As far as that goes, these answers go a long way in settling my own present concerns - though not all the way I must admit (great, now both sides can hate me).
My own concerns with respect to the WGC's new gold product - the StreetTRACKS gold trust (GLD) - stem from an inherent distrust of the cartels and monetary institutions that are in the business of underwriting, managing (market making), and offering custodial services with respect to what may well be one of the world's largest bullion reserves one day. The reason for the distrust is part of the gold story - in other words, these outfits are the same institutions that support, propagate, and help hide the unsound monetary policies that threaten the stability of the entire financial system, and the very reason that we are bullish gold. They are also the very reason that the silence on the gold story is still deafening. In this vain it is interesting that the WGC is bound to a continuous period of silence on account that the ETF is an ongoing new issue.
By most accounts, the Bank of England, the Bank of New York, the WGC, and UBS are highly respected institutions and together no doubt employ thousands of credible employees. Yet their endorsement of this deal is precisely what raises the hairs on the backs of gold bulls and bugs inclined to believe in the view that a concerted suppression of gold prices has been underway for over a decade. In one way or another (i.e. manipulation or not), with respect to the gold story, they are all perceived by the bullish community as part of the problem to begin with. So, now they come clean?
Suddenly, the WGC is no longer the villain that has been underhandedly promoting fashionable gold jewellery as though it were the only reason to buy gold; the Bank of England whose motives for announcing the sale (if not the sale itself) of its own gold are still largely in question is suddenly a credible custodian despite its controversial if not murky auditing procedures; and the large investment banks whose dollar, Fed, and Tbond businesses dwarf, and largely oppose, their gold business are suddenly trusted with establishing themselves as intermediaries in the international flow of gold bullion.
I'm just trying to describe the essence of the problem. And what we've got here is a product which I myself believe is fundamentally bullish for gold demand that is being managed by a group that draws distrust by the most fundamentally bullish of gold bugs.
Consequently, the issue has driven schism in the gold media community.
The dividing point is that some gold bulls (call them moderates) are willing to overlook the big picture conflicting role of the managers of the fund because of their confidence in the protection afforded by various indentures legally binding all vested parties and the pragmaticism of a paper gold vehicle; while the more distrusting gold bulls believe too strongly that any such "paper" products are but another scheme, which pragmatism doesn't deserve their compromise. But the issue came to a boiling point where one side accused the other of trashing the integrity of the messiah of gold demand; while the other side accused the former of passive acceptance of yet another paper scheme, or promise to pay that it can't fulfill. For their part, the WGC offered no shortage of bait.
The quiet period, the unecessary involvement of the BOE and its related murky custodial structure, as well as the screw up involving the identification of specific gold bars are all things that most of us might think would naturally draw investigation.
The following quote by James Turk well exemplifies this position:
Let me sum up by quoting Chris Powell of GATA: "When the exchange-traded fund reports gold bars with duplicate serial numbers (even if there really are separate bars somewhere), when the fund happily declares that it may not even know the identity of the custodians of its gold, when the fund has a relationship with the biggest and perhaps most nefarious gold-leasing and gold-selling financial institution in the world, and when the fund does not forswear leasing its gold and thereby assisting the suppression of the gold price, investors generally and gold's partisans particularly should be skeptical."
We now understand that two bars can have an identical serial number but post 2002 must have different dates and weights for full identification. Yet the issuers should have known that listing bars in that way without disclosing the full identifying fact (i.e. the identifying year) would ring alarm bells. So the answer is at least incompetence.
To their credit the WGC posted the Johnson Matthey Letter along with the original Gold Bar List but not until after the fact - December 8th. Moreover, although Turk says that couldn't happen at GoldMoney because it "pioneered the online reporting of audited gold bars," and includes the prefix (which the WGC's initial count didn't), when I looked at the way that he lists GoldMoney's bars most of the pre-2002 (JM) bars have prefixes but none of the bars from Johnson Matthey UK were listed with the new prefix system (year, serial). Everything else has a prefix; but the date column, which is separate (any bar with a prefix (most) has this prefix listed in the same column as the serial number) is titled, "date added," not "prefix." This may be a minor point, and since it is a new product there really isn't a generally accepted "way" to do this yet. In any case, there is not enough justification on this basis alone to say that it was anything but a matter of incompetence, and no doubt the issuers would object to that too.
Participants/Dealers Cannot Redeem Borrowed Stock, Legitimately
In response to my question a reader kindly pointed us to the following section in the "participant agreement" at the SEC's website under registration filings which was not included in the prospectus as per our last issue, GLD: Incompetence or "Told You So?":
Section 8. Redemption. The Authorized Participant represents and warrants that it will not obtain an Order Number (as described in the Procedures) from the Trustee for the purpose of redeeming a Basket unless it first ascertains that (i) it or its customer, as the case may be, owns outright or has full legal authority and legal and beneficial right to tender for redemption the Baskets to be redeemed and to receive the entire proceeds of the redemption, and (ii) such Baskets have not been loaned or pledged to another party and are not the subject of a repurchase agreement, securities lending agreement or any other arrangement which would preclude the delivery of such Baskets to the Trustee the third Business Day following the Redemption Order Date.
The entire document can be accessed here: http://www.sec.gov/Archives/edgar/data/1222333/000095013604003776/file003.htm
This basically means that borrowed shares cannot be redeemed; only shares that are owned outright can be redeemed. Of course, it does not escape me that there exists a business in the handling of illegal short sales - of new issues and private placements - which are also not allowed but which we all know (but can't prove) occur nevertheless.
However, such activity can only be done in the shadows of legitimate activity. It can never be the primary activity and so if it goes on in this fund it isn't likely to be on a big scale. Yet, I cannot get past the underlying fact that if anyone can do it (or similar chicanery) on a large scale, the group behind this thing is practically it.
Although there is no good evidence of tampering with the fund yet, and isn't likely to be in the short term, due to the structure of the deal and the institutions involved I cannot categorize an investment in GLD as anything more than a legally protected promise to pay. But, this is a personal subjective view, and in the end the market determines that.
So far GLD has taken the premium away from other competing products; but it's too early to conclude anything - positive or negative. Some of the questions raised are productive considerations; others are perhaps best described as jumping the gun.
For many investors paper gold is the most practical way to go.
And well, if it's difficult for a legitimate group to organize a sounder gold-backed issue as competition for the WGC's product, look no further than the regulatory bodies who make it so burdensome that only the cartel players can do it.