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December 03, 2004

Behold Gold's ETF
by Adam Hamilton

Late last month I was researching the new gold exchange-traded fund in preparation for discussing its ramifications in the new December issue of our Zeal Intelligence newsletter. As I gathered information on the gold ETF, I was appalled to learn of its generally hostile reception within the gold-investor community.

When this new gold ETF went live a couple weeks ago I was ready to jump for joy in the streets! I have literally waited years for this day and truly believe the gold ETF will ultimately unleash massive new gold demand from traditional stock investors. The gold ETF will be absolutely crucial in broadening gold's investor participation so it can transition from Stage One to the vastly more profitable Stage Two.

Yet, after reading the Web forums and every commentary on the gold ETF I could find in recent weeks, one would think the AntiChrist of Gold has arrived. Gold investors are not only blaming the gold ETF for the poor HUI leverage, never mind the indisputable fact that the HUI was struggling for months before GLD launched, but even claiming it is a vast conspiracy to liberate capital from gold investors and use it to actively short gold, hanging us with our own ropes.

In order to address this troubling sinister interpretation of the gold ETF, I would like to journey back in time to early October 2002. Way back then gold had yet to break decisively above the $325 Maginot Line, and the ranks of contrarian gold investors were only a small fraction of today's. Back then we looked at the dazzling prospect of a gold ETF as a savior for gold investment demand, not a menace.

The following prose was penned by me and originally published on October 1st, 2002 in our 10/02 ZI letter for our subscribers. My goal in sharing these two-year old thoughts publicly for the first time is to attempt to rekindle excitement about the dawn of the gold ETF. Dear friends, years ago we anxiously awaited this very day with awe and wonder, like kids on Christmas Eve!

The dawn of the gold ETF will be a huge blessing for this secular gold bull, not a curse.

*** Begin 10/02 ZI Excerpt ***

Inflation in the Information Age

The world has never witnessed anything remotely like the Information Age before. No one alive today can even start to comprehend the ultimate impact it will have on human affairs, including the organization of governments, taxation, and money. Finally we the tax cows can communicate directly without being censored by the tax farmers, and the potential for revolutionary change is extraordinary.

As increasing numbers of citizens of countries around the world begin to ask the crucial question "Why do the costs of my life's necessities keep rising ever higher every single year?" many will hop on the Web seeking answers. Search-engine technology will lead them to websites discussing money and inflation, and the insatiable spark of the lust for more knowledge will be kindled.

As hardworking ordinary people educate themselves using information technology and start to understand why their savings are worth less and less each year, Keynes' "one in a million" who really understand will gradually grow to one in ten. These legions of newly enlightened citizens will start telling their friends and neighbors, who will be inspired by their spirit of Renaissance-like knowledge and will head to the Web themselves to learn more. An info-revolution is born!

Just as you sitting on your patio with a fully-loaded 12-gauge riot shotgun will deter most any common thieves, citizens armed with the knowledge of inflation will deter government theft by subterfuge. If you know your house is about to be robbed, you can prepare ahead of time to head off the coming theft at the pass. You stay home, turn on all the lights, and load that fearsome shotgun up with 00 buckshot! The same principle is equally powerful with inflation.

Theft by inflation is only fully possible if you are holding the particular fiat currency that your government issues. If you live in the States, you can only be fully plundered of your hard work and labors if you are holding dollars. If you live in Europe, you are only fully subject to stealth inflationary predation of your savings if you hold euros. Yet, and here we come full circle, you can inoculate yourself from all inflationary taxation by merely owning gold!

Just like a Venetian merchant of 700 years ago who committed his surplus labor to gold ducats, every hardworking citizen today can do the same. Like every other tax cow, when you hold gold you are still subject to direct taxation by your tax farmers, but gold liberates you from the much more serious and dangerous indirect taxation of inflation. By avoiding stealth inflationary taxes, people are once again free to be motivated to work hard, to spend less than they earn, to reach financial independence, and to ultimately achieve wealth.

This concept is certainly not new to you longtime gold investors, but you have to understand that you are the ultimate contrarians on the very vanguard of the new revolution. You are Keynes' ones in millions! I am confident the amazing communications technology of the young Information Age will gradually awaken legions of normal hardworking citizens around the world to the horrific dangers of inflation. Knowledge is power and knowledge now travels at the speed of light for the first time in all of human history.

Gold's Oppressive Transaction Costs

As the money information revolution gathers steam, more and more people will realize they are facing a second tax if they hold their savings in a pure fiat-paper currency. They will discover that if they convert some of their savings into gold today, any amount of gold will buy at least roughly the same amount of real goods and services 20 years from now as it will today. They will give themselves an effective large tax cut by refusing to allow their savings to be confiscated over time by inflationary stealth taxes.

Gold is the only perfect destination on earth for capital to avoid inflation. The natural "inflation rate" for gold is only on the order of a percent or two a year. This means that the total world gold supply consistently grows by only 1%-2% each year over centuries through normal mining because gold is so incredibly scarce in the natural world. Contrast this to real estate, a much less desirable inflation refuge, as the number of houses and amount of livable space often explodes up by double-digit percentages every year. Only gold has an unblemished six-millennia record of retaining its raw purchasing power through every conceivable environment.

Newly enlightened people tired of paying the second inflation stealth tax will not commit their entire portfolio to gold, and they shouldn't per diversification theory. We continue to advise our private consulting clients today that everyone should have between 5% and 20% of their total liquid assets invested in physical gold. The coming legions of newly aware inflation refugees will probably allocate a similar percentage of their savings to gold. Obviously this will all vastly boost gold investment demand and lead to much higher gold prices, yielding truly legendary gains for today's early-bird contrarians with capital already deployed in gold.

Yet, a significant problem will arise as folks attempt to apply theory to their reality. The coming inflation refugees will be familiar with stock trading, but not the countless nuances of the gold markets. By definition, since these people learned about predatory inflation and its golden inoculation on the Web, they will be information-technology savvy.

Here at Zeal LLC, my partners and I happily use Datek as our primary brokerage for short-term speculations like our equity-index options. It continues to blow my mind how efficient and effective it is for trading. I can trade any conceivable US stocks or equity options almost instantly. On an average trade, Datek blasts out the finished trade confirmation via e-mail less than 5 seconds after I order the trade. Often the executions occur under 1 second after my orders are entered via the Web.

The technology is truly awe-inspiring! In addition to being fast and always working perfectly, it is very inexpensive. Datek charges $9.99 to trade a limit order of up to 5000 shares. If you bought 5000 shares of a $20 stock, your effective commission would only be 1/100th of 1%! While Datek happens to be our favorite online brokerage for speculative accounts, it is certainly not unique. Other brokers offer similar instant trades at fantastically low commissions.

The coming wave of tech-savvy inflation refugees will be used to and demand this level of service, performance, and cost structure from their brokerages. They will want to think about gold and own it 5 seconds later. Delays in financial services in the Information Age are not acceptable.

Most of you reading this letter have already liberated some of your precious savings from inflationary predation by buying physical gold. You know the drill. While it isn't hard to buy gold, it certainly would never be considered efficient, instant, and inexpensive today. If one lives in a city, one has to jump in their car, drive down to the local coin shop, hope the merchant has whatever gold coins they want in stock, haggle on price, buy the coins, and drive all the way home. It can take many hours just to buy gold!

Gold can also be purchased on the Net, but it is also inefficient.  One has to first find a reputable and honorable dealer, then call or use the Web to order the gold, and then wait a week or two for it to arrive. Compared to buying a stock online, buying gold is like getting teeth pulled. And we haven't even discussed the looming sticker-shock yet!

On Datek you can buy $100,000 of stock for $10. In addition to Datek's trivial commission, you pay a small fractional price over the current stock bid price, the ask price. For argument purposes, let's assume this market-maker's spread is $0.05 on each $20 share. At 5000 shares, this adds up to a total bid-ask spread of $250. For a total cost of $260 you can plow $100k into an equity of your choice.

Gold, on the other hand, has horrendously high transaction costs. Your local coin dealer must buy his gold from a wholesaler. He probably pays 3% over the wholesaler's cost. Hopefully the wholesaler bought near the spot price so his cost was reasonable. The wholesaler has already paid the bid-ask spread on gold from whomever he bought it from, so this is already included in the new gold price.

Then your coin dealer, like any good capitalist trying to feed his family, has to raise his gold prices high enough to pay all his overhead and still make a profit. Let's conservatively assume another 3%. If there is a 1/2% bid/ask spread in gold plus a 3% wholesaler markup and another 3% retailer markup, the total transaction costs for buying physical gold are 6.6%. If you want to shield $100k of your hard-earned savings from inflation by buying gold, you are looking at not only spending hours to do it, but paying a huge $6600 for the privilege!

Unfortunately this example is in line with reality today. If you are aggressive and shop around you may be able to get total transaction costs whittled down to 3%-4% on $100k of gold, but 6.6% is probably what the average inflation refugee will run into. At this point our whole inflation-refuge model starts to fall apart as many new gold investors will probably throw up their hands in disgust and walk away after experiencing sticker-shock. $260 for $100k in stock or $6600 for $100k in gold. Yikes!

Gold in the Information Age

Interestingly, the same Information Age technology that can liberate ordinary people from ignorance about money and inflation can vastly reduce the transaction costs burdening gold. It seems odd at first, but bleeding-edge 21st-century technology combined with the legendary Ancient Metal of Kings is a perfect marriage. One wondrous innovation that already exists today that is growing in importance is the use of digital gold as a transactional currency. I penned an essay on digital gold earlier this year called "Gold in the Information Age" that is available on our website.

Visionaries like James Turk (www.GoldMoney.com) are redefining how gold is used in commerce. Digital gold enables global trade to be easily settled in gold. Physical gold is centrally stored in secure vaults and 100% gold-backed encrypted and irrevocable rights to this gold are the actual digital currency changing hands over the Internet. E-Gold's slogan says it all, "Gold itself, circulated electronically." Digital gold is probably the biggest innovation in money since the introduction of the Venetian gold ducat in 1284 and is likely to vastly change the landscape of global trade in the next century. It is not the only gold innovation!

What if Gold Mated with a QQQ?

Last month in these pages I said, "[Newmont President Pierre Lassonde] launched a bombshell and mentioned that he is working together with Chris Thompson and the World Gold Council on a new gold instrument which could take 500 to 1000 tonnes of gold off the market annually, which would be an impressive increase in overall demand estimated at 4000 tonnes per year."

"Coming from an unabashedly bullish gold legend running the biggest gold mining company on earth, these comments are super exciting. It will be interesting to see what Lassonde and Thompson come up with in a new gold instrument!" Thanks to an astute CBS.MarketWatch.com reporter, and our backchannel sources around the world, the veil on the WGC's new gold project has been removed.

The WGC is working to create an exchange-traded fund (ETF) security for gold itself! I have to admit that this announcement has made me more excited about owning gold and gold stocks in the coming years than anything else I have recently seen.

This seemingly obviously simple innovation, the marriage of gold with advanced trading technology, could fundamentally alter the core balance of power in the gold markets forever. Rather than governments and central banks having the initiative and attempting to control the gold price, tens of millions of individual investors and speculators worldwide could wrest control away from socialist 20th-century dinosaur institutions! The gold world may never look the same again if the WGC can pull this off.

Perhaps my great zeal for this revolutionary announcement can best be communicated by a diversion into QQQ-land. Just like us, many of you are actively trading the QQQs themselves or options on the QQQs. "QQQ" is the symbol for an ETF that tracks the elite NASDAQ 100 stocks. While it would be extremely complicated and take huge amounts of money and time to individually buy each stock necessary to build and maintain a custom-designed portfolio that perfectly tracked the NASDAQ 100, the QQQs do all the work.

An investor or speculator can easily trade a QQQ in their online brokerage stock account just like any other stock. Commissions for trading are trivial, as I described earlier. Since its introduction on March 10th, 1999, fatefully exactly one year to the day before the legendary NASDAQ 2000 bubble top, the QQQ has taken the financial world by storm. Today the "Cubes" often command the top spot each day in terms of actual daily trading volume.

On September 27th for example, the QQQs traded 92m shares, more than any other stock in the world. At a $21 close, this is the equivalent of almost $2b changing hands in one day. At month's end, the NASDAQ reported that there were 734m QQQs outstanding. The net assets in the underlying ETF trust were a staggering $16b!

Unlike a typical mutual fund, the ETF has an extremely low expense ratio as well, 0.2%. Owning the QQQs is far cheaper than purchasing a standard NASDAQ 100 index fund. The QQQs have become so immensely popular because they are efficient, inexpensive, easy to trade, and they allow speculators of any size to place bets on the NASDAQ 100.

Before the introduction of the Cubes, only futures traders could directly play the NASDAQ 100. Futures accounts are cumbersome though. They are expensive, demand a steep learning curve, and carry margin requirements. In addition, many futures trades often carry the risk of unlimited losses. It is a very risky and highly-specialized game.

The QQQs bypassed NASDAQ 100 futures and brought the power of speculation to the people. Even though they were down 36% in 2000, 33% in 2001, and are off 47% YTD due to the NASDAQ bust, they remain the speculation vehicle of choice for many of the world's index traders.

Buying and Selling Gold Efficiently

Just as high transaction costs made NASDAQ 100 trading difficult for individual speculators, gold trading is tough for small players today. Gold futures are very risky, bear the danger of margin calls, and each contract only covers a limited time horizon before it expires. Most ordinary folks rightfully want nothing to do with the futures markets, shutting down this avenue of gold speculation for them.

On the other hand, the gargantuan transaction costs of physical gold make short-term trading of gold coins all but impossible. If the gold ETF flies, it would solve both these problems at once and open up a vast new audience for gold.

With a gold ETF available, one of the new wave of inflation refugees could easily buy gold in seconds for a trivial commission using their existing brokerage accounts. Granted, electronic gold is no substitute for physical gold in one's own possession as the core foundation of a prudent portfolio, but ETF gold is a great starting point for gold rookies.

Hardworking tax cows who are tired of the second indirect tax the government tax farmers are secretly levying on them through inflation would finally have a quick and easy means of leveling the playing field. They could buy shares in the gold ETF as a first step and be protected from the inflationary ravaging of the dollar. This wouldn't kill coin dealers either, as there is no substitute for actual gold coins in one's own immediate physical control. As gold ETF investors become more knowledgeable as time progresses, many of them will probably augment their electronic ETF gold with actual physical-gold purchases later.

In addition to the long-term gold inflation shelter a gold ETF could provide for everyone, it would also be the perfect vehicle for speculation. The QQQs are so popular today not because people want to hold them for years, but because they want to trade them! If gold itself could be traded via the ETF in an ordinary brokerage account, the increased interest in speculating in gold could be tremendous. In addition, just seeing the symbol of the gold ETF alone quoted everyday would spawn great gold awareness.

The Birth of a Golden Leviathan Cometh

Just like the QQQs represent shares in actual NASDAQ 100 stocks, the gold ETF would represent true fractional ownership of real physical gold. Although no specifics are available yet, a gold ETF would create an enormous new channel for physical gold demand. As investment and speculation demand for the gold ETF rose, the trust underneath the ETF would have to buy more physical gold in the open markets.

This gold would be stored in secure vaults with reputable companies. Each ETF share for example, if it cost $50 would represent $50 in real gold stored somewhere. Chris Thompson, former CEO of Gold Fields and now Chairman of the World Gold Council, "If it's backed by the gold council and there is a big, recognizable gold depository involved, it will be a big success."

In Australia Newmont President Pierre Lassonde recently said the gold ETF could increase gold demand by 500-1000 tonnes annually. This number is enormous and could fundamentally alter the gold scene as current global demand is believed to be 4000 tonnes on fresh mined supply of 2500 tonnes.

If a 1500 metric ton annual natural gold deficit increased to 2500 tonnes (5000 tonnes total demand), the gold price would have to soar to attain stasis in market-clearing equilibrium again. If the gold ETF grows as large as the QQQ trust is today, $16b would take an impressive 1531 tonnes of gold out of circulation at $325!

Additionally, all gold ETF demand would feed a virtuous circle which spawns even more gold demand. As the gold ETF rises in popularity, more physical gold will be purchased by the trust. The trust will take in dollars contributed by shareholders and spend these dollars to buy gold. Eventually, if demand is high enough, the ETF alone selling dollars to buy gold could push the gold price up. This will create even more demand for gold investment and speculation worldwide!

For as long as there has been commerce and government, citizens have struggled to protect their hard-earned savings from inflation. The combination of the limitless resources of the Web educating tens of millions of people about money and inflation and an efficient gold ETF could lead to an unprecedented grassroots gold boom.

The best information we could obtain this month indicates the gold ETF could become a reality as early as spring 2003. Gold and gold-stock investors should get ready and strategically deploy capital ahead of time before the new wave of popular ETF-driven gold demand descends upon the world.

*** End 10/02 ZI Excerpt ***

Hopefully revisiting the wonder and excitement inherent in the dawn of the gold ETF back when we first heard about it will put today's doubts and fears into proper perspective. It is natural to fear change, but this is a glorious change that is almost certain to help the gold cause, not hurt it.

If you are interested in learning more about the new American gold ETF, GLD, we just published a brand new December Zeal Intelligence newsletter exploring it a couple days ago. Titled "Behold Gold's ETF 2" it is the long-awaited sequel to the two-year-old thoughts shared above.

This current ZI letter analyzes GLD, from the mechanics behind it to how it will interact with physical gold to how it may affect other gold-related investments and speculations. Please subscribe today to get the true scoop on GLD!

While some folks oddly believe GLD is some type of nefarious Machiavellian plot to cripple our gold bull, I still feel as excited about it as a kid on Christmas Eve! The dawn of the gold ETF is ushering in an entirely new era in our secular gold bull and I can't wait to reap the resulting legendary profits.

What a wonderful time to be a gold investor and speculator!

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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