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February 18, 2005

Contending Gold Perspectives
by Adam Hamilton

Like probably every other major market move in world history, the bull market in gold is generating ever-increasing interest. Not surprisingly though, while the raw price data is absolutely indisputable, there are a myriad of varying opinions on whether gold is going higher or lower and why.

Differences of opinion on the markets are fantastic and ought to be celebrated, not feared. Investors and speculators have a natural tendency to feel threatened when others advance opinions contrary to their own. Instead these differences should be viewed as priceless learning opportunities. The more perspectives from which we can view any market, the higher the probability that we will make the right trading decisions.

Differences of opinion also make markets. If everyone felt the same way, we would all be buyers or all be sellers and there would be no counterparties with which to trade. The markets would grind to a halt! In addition, a mono-opinion market culture would be extremely dangerous, breeding stupendous bubbles as everyone tried to buy and shockingly brutal crashes as everyone tried to sell.

The diversity of opinions is the spice of the markets, creating a thriving intellectual wonderland that truly is the ultimate marketplace of ideas. Personally I am always excited to learn about different market opinions, whether aligned with or contrary to my own, as studying them inevitably deepens my own understanding of these fascinating markets in which we sojourn.

I am launching this new series of essays in the spirit of this marketplace of ideas focused on gold specifically. Rarely do 48 hours of my life pass by without subscribers and clients writing me and saying something like, "Adam you say gold ought to go higher in the years ahead but [Insert Name Here] says that due to [Insert Reason Here] gold is going to [Insert Outcome Here]. What do you think about this?"

My hope is that this series of essays can provide a forum to critique and analyze contending gold perspectives. I want to do this with a gentle spirit, trying to foster mutual understanding rather than sowing the seeds of conflict among competing schools of thought. I have immense respect for everyone playing in the challenging market arenas, whether I happen to agree with their worldview at the moment or not.

Since I will be analyzing ideas and technical approaches advocated by other analysts and speculators, I think it is only fair that I subject my own ideas to the glaring spotlights first. Since 2000 I have been an outspoken gold bull, unapologetically long-term bullish. I have written countless dozens of essays on gold and have been blessed with great realized profits trading this gold bull to date.

On the very trading day before gold carved its multi-decade secular bottom in early April 2001 I concluded an essay with, "History, economic fundamentals, and logic dictate gold is amazingly undervalued and due for a monstrous rally. My capital will be ready for the coming gold rush!" The next day gold briefly fell under $257 but has never looked back since.

My gold worldview is long-term bullish as I believe gold is in a massive secular bull market that ought to gallop higher for many more years, perhaps a decade, before it fully runs its course. As in all other bull markets in history though, this long-term bull has been and will continue to be punctuated by periodic corrections as prices flow and ebb, taking two steps forward before one step back to regroup.

Why do I believe gold is in a bull market likely to run for many years yet? Please allow me to briefly outline 10 major reasons. I have also hyperlinked in some previous essays that explain some concepts in much greater detail if you would like to dig deeper to understand my bullish outlook on gold.

1. Supply and Demand. The ultimate arbiter of any price is supply and demand. When demand exceeds supply, prices are forced to rise. The rising prices work on a chronic supply/demand deficit from both sides, providing an incentive for producers to increase production while providing a parallel incentive for consumers to decrease consumption. Eventually the rising prices bring supply and demand back into equilibrium where production and consumption are balanced.

In gold's case, its global demand is growing much faster than its global mined supply, so the only economic resolution for this deficit is higher prices to bring supply and demand back into balance. I'll discuss the reasons why gold's demand is rising below, so for now let's focus on why its mined supply just cannot rise fast enough to meet demand growth.

Unlike almost every other business, gold mining is totally dependent on highly local geology. Obviously you can't build a gold mine unless there is gold to mine! Since gold is so scarce in the natural world, it is very difficult to find a site with enough gold to mine economically. And even if you manage to find such a site after endless exploration, you are totally at the mercy of local and national governments, all of which are corrupt and love to extort profits from captive mining ventures.

And if you manage to find a suitable gold-mining location and can jump through all the flaming bureaucratic hoops, you still have to raise tens or hundreds of millions of dollars to build roads, put up buildings, sink the shaft, and buy the necessary capital equipment. And even if you somehow manage to secure financing, it still takes several years at best to spin operations up to full speed.

So not only is gold mining an extremely tough business plagued with geological quirks and government harassment and enormous up-front capital costs, but even if you can overcome all of these stellar hurdles you won't be selling any of your gold for years. Thus, no matter how high the gold price travels, it will literally take years for producers to find new deposits to develop, mine, and sell.

Gold mined supply is therefore very inelastic (unresponsive to price) and highly constrained over anything short of a half decade or so. Today's higher gold prices will take at least several years for producers to respond to, and only after these producers believe that this bull will be persistent enough to make a big bet on it. The rate of mined gold supply growth will not grow very fast in the coming years for these reasons.

2. Long Valuation Waves. The general stock markets move in great 33-year cycles known as Long Valuation Waves. For the first half of these cycles, like from 1982-2000, stock valuations and prices rise in massive bull markets. But in the second half, like from 1966-1982 or 2000-20XX, stock valuations relentlessly mean revert back down to long-term averages. We are in this brutal valuation wave winter today.

While stocks make horrible long-term investments during the latter half of these Long Valuation Waves, thankfully commodities and hard assets thrive. Commodities also move in roughly third-of-a-century cycles over time, but they tend to oscillate 180 degrees out of phase to the equity valuation waves. Thus, secular commodities tops like in the early 1980s coincide with secular equity bottoms. And secular equity tops, like 2000, coincide with secular commodities bottoms.

Our current Great Commodities Bull launched in 2001, just after the secular top in the general stock markets after a mighty equity bull lasting for half of a 33-year valuation cycle. Market history is very emphatic in demonstrating that the 17 years after this parallel commodities bottom and equities top should be great for commodities but very poor for equities. This precedent suggests commodities should be strong and equities weak for another decade or so from today.

And indeed commodities capital investment was neglected for two decades prior to 2001 so production is low while demand is skyrocketing, particularly out of Asia. Just as with gold specifically, for commodities in general constrained supply growth accompanied by accelerating global demand guarantees higher prices.

Why languish in a secular stock bear when your investments can thrive in a secular commodities bull? As more and more investors come to realize this, their demand for gold and other commodities-related vehicles will only grow greater and greater. We may as well bet on the horse most likely to win in the next decade!

3. King of Commodities Investments. Out of all the ways to invest in a Great Commodities Bull, gold is the single easiest and safest. Physical gold is easy to buy, requires no upkeep, and a great deal of wealth can be secured and stored in a relatively trivial volume. Unlike many other major commodities, physical gold is not perishable and can be stored indefinitely. Gold has always been the ultimate commodities investment.

For pure investment purposes, every other commodity falls short of gold. You can hide $1m in gold coins in an old unused pipe section in your house and no thief will find it in a million years. If you buy $1m in wheat though, you will have to purchase land and bins to store it, and insects and humidity could wreck it in less than a year if it isn't stored perfectly. Oil may be the king of commodities in general, but try to get zoning permission to build a giant tank to store $1m worth of crude oil in your backyard!

Silver is ultra-volatile and one of the greatest speculations in history, but it is inferior to gold as a store of wealth. In addition to its brutal gut-checking price volatility, its value-to-volume ratio is vastly lower than gold's. $1m worth of silver weighs far more and takes up a great deal more room than $1m in gold. For investors wanting to deploy capital into the secular commodities bull, gold is the most logical choice today just as it always has been.

4. Ultimate Alternative Investment. Some investors will buy gold to ride the commodities bull, while others will buy gold to escape the equities bear. This distinction may seem subtle, but it is very important. Gold is a natural destination for equity flight capital since it is the ultimate alternative investment in world history.

Mainstream financial investments are virtually all intangible paper. All of the stocks and bonds we own, even all of our bank accounts, are ultimately nothing more than someone else's promises to pay. If these promises are not honored, then the stocks and bonds are worth no more than the paper on which they are printed. During the descending half of Long Valuation Waves, after enough years of punishment investors' confidence in paper assets wanes. Remember the 1970s?

Gold is the ultimate alternative investment because it is tangible. It is a real physical asset that has intrinsic value in and of itself, never dependent on someone else's mere promises to pay. Since gold is fully independent from the paper financial system and its underlying fragile web of promises, it has long been perceived as the most ideal safe haven when investors flee paper.

Interestingly, as equity flight capital bids up gold prices in the years ahead it will create a virtuous circle that attracts even more capital. Gold, like all investments, becomes more attractive to more people the higher it goes. This is contrary to normal supply-and-demand profiles, where demand becomes lower at higher prices. In gold's case investors bidding up its price end up putting it on the radars of even more investors, who bid it up further and accelerate the cycle.

5. Relentless Fiat Currency Inflation. Speaking of paper, every national currency on the planet today is pure fiat, just paper monopoly money backed by nothing but faith in the issuing government. Since today's monetary supplies have no roots in reality, governments can and do grow money much faster than the underlying pool of goods and services on which to spend it. The US dollar has not been backed by gold since 1971.

When money supplies grow faster than underlying economies, soon relatively more money is bidding on relatively fewer goods and services. This increase in money supply is, of course, the scourge of inflation. Inflation is a diabolical and immoral stealth tax imposed by governments on their unsuspecting populaces. Ordinary people work hard for a lifetime saving money, but when they retire they find that their money will buy a lot less than it did back when they were saving.

As more and more investors perceive the dire threat of inflation to their families' futures, they will naturally migrate into gold. Gold keeps pace with inflation, buying roughly the same amount of real goods and services regardless of currency in circulation. In the 1920s one ounce of gold would buy a decent men's business suit at $20. Today one ounce of gold at $425 will still buy the same grade of suit, while the original $20 in paper won't even buy lunch!

While paper money supplies tend to grow by 5% to 8% annually in the First World thanks to irresponsible and unaccountable central bankers, the newly mined physical gold supply rarely exceeds 1% a year in growth. This stable and very low growth rate is why gold has been the ultimate form of money for six millennia now. With fiat currency growth rates far exceeding the gold supply growth rate, it is inevitable that relatively more paper will chase relatively less gold, bidding up its nominal price.

6. Negative Real Rates. The first corollary to fiat inflation is today's brutally low or negative real rate environments, where bond investors either break even or actually lose purchasing power by the mere act of lending out their hard-earned capital. When the rate of underlying inflation exceeds the nominal interest rates available in the markets, bond investing becomes a losing proposition.

Free markets hinge on the crucial concept of mutually beneficial transactions. The bond markets are where savers, who consume less than they earn, meet up with debtors, who earn less than they consume, to consummate capital transactions. True free-market prices of this money, or interest rates, provide a reasonable return to the saver and a reasonable cost to the debtor, a mutually beneficial transaction. Interest rates should always be set by the free markets instead of the abomination of the Fed.

But with today's artificially low interest rates, it is nearly impossible for bond investors, savers, to get a fair return on their capital. If they can only earn 3% on their capital but inflation is running 4%, then they actually lose 1% of their purchasing power every year. They are punished for being savers, something Greenspan and his minions absolutely revel in for reasons that escape me. It is saving that should be encouraged and debt that should be punished if a nation truly wants to grow its wealth!

As such, when central banks artificially manipulate interest rates too low bond investors gradually pull out of the rigged market. Since they can't beat inflation in bonds, they gradually migrate into gold so they can at least maintain their purchasing power. Negative real rate environments are one of the most bullish scenarios imaginable for gold investment demand, since it drives capital out of bonds and into gold.

The Long Valuation Wave winter will drive exasperated equity investors into gold, but the unfair and artificially gutted interest rates will drive fed-up bond investors into gold. It is foolish to allow a central bank to force savers to subsidize wanton debtors. The savers may as well just buy gold to ride out the inflationary storm and say to heck with the debtors taking advantage of them.

7. Central Banks Always Lose. Of the roughly 150,000 metric tonnes of gold thought to be mined in all of world history, today central banks control about 20%, 30,000 tonnes. Since central banks rightfully consider gold to be a threat to their dishonest fiat regimes, investors sometimes fear central bank intervention in gold. Surprisingly though, central banks are probably the worst institutional gold traders in world history.

One of the most foolproof indicators that a secular gold bear is ending or a secular gold bull is getting underway is central bank sales. Like the Bank of England's recent fiasco of dumping gold at a multi-decade bottom, for some reason central banks tend to sell at exactly the wrong time. Central bankers, amazingly enough, are human too and subject to the same greed and fear as all speculators. It is only at the end of long demoralizing bears when they start believing Keynesian propaganda that gold is a barbaric relic and think about selling.

And when they do sell, usually near multi-decade bottoms, their gold sales are always very temporary in impact. The only way to control a global price is to put a gun to the head of every buyer and seller of that particular commodity on the planet. 120,000 metric tonnes of gold, or 80% of world supplies, are not controlled by the central bankers. Investors buying and selling this vast majority of non-official gold ultimately determine world prices through their supply and demand. The central bank tail can't wag the bull for long!

Betting against central banks on gold is the ultimate contrarian gold play. In the early 2000s they were selling aggressively and remember what happened? Did gold go from $255 to $200? Nope! Instead it went from $255 to $455 despite the heavy central-bank liquidation. Expecting central banks to seriously hinder a secular move is like expecting a bureaucracy to be efficient, a very low probability bet. They are all talk with very little if any long-term leverage in gold.

8. Information Free Markets. For all of human history until 1995, large organizations like governments had a vast advantage over individual investors when it came to information. But since the World Wide Web started growing popular outside of academia in the mid-1990s, the inherent information asymmetry working against individuals has vanished. Today a cheap PC and broadband grants you information-gathering capabilities vastly superior to those of entire empires in world history.

Gold is the ultimate free-market asset and currency and thrives in eras when information flows the most freely. Today's Information Age is witnessing the greatest free-flow of information in world history, far beyond the wildest expectations of empires past. Thanks to the ease of learning about anything instantly from your own home today, governments can only pull the wool over the eyes of its citizens who willingly choose to remain ignorant.

Today investors around the world can easily learn about monetary history, stock-market history, gold, the immoral stealth tax of inflation, and countless other crucial core topics essential to long-term wealth building. Thanks to the Internet governments no longer have a monopoly on monetary truth. Investing in gold is the inevitable outcome of learning more about the treacherous history of markets and money, not to mention government.

The dazzling Information Age is also facilitating the rebirth of private 100% gold-backed currencies, this time in the form of digital gold. Why store your transactional money in the form of rapidly inflating fiat when it could be stored in digital gold and hence never losing purchasing power? As gold-backed digital currencies gain popularity, demand for physical gold to back them will continue to grow.

9. The Rise of Asia. With China destined to become the next superpower while the West wanes, the locus of global economic might is shifting to the Far East. Unlike Western cultures like us Americans who are brainwashed into thinking of gold as a barbaric relic, inferior to paper assets, Asian cultures still have strong affinities for physical gold. A great example is Indian families storing wealth in the form of intricate gold jewelry.

As Asian citizens and investors grow wealthier, their traditional love of gold will ultimately lead to huge amounts of capital shunted into physical gold as they diversify their investments. As Asia's hard work leads to greater affluence, its per capita gold investment consumption will utterly dwarf that of the West. While an average (read non-contrarian) American investor may have less than 1% exposure to gold, an average Asian may want 10% or even 20% of his or her portfolio invested in gold.

Even if the average Asian remains poorer than an average American in an absolute sense for another couple decades, the combined effect of hundreds of millions of newly-liquid investors buying small amounts of physical gold could be staggering. I suspect that if Western central banks are dumb enough to dump their entire 30,000 metric tonnes of gold in the years ahead, the awakening Asian giant will collectively swallow it all up without even breaking a sweat.

Asia is probably the single biggest gold investment demand story in world history. It should ultimately dwarf US equity flight capital and US bond flight capital and could very well lead to the biggest gold boom the world has ever seen.

10. Technical Proof. The only sure way to understand true underlying supply and demand fundamentals is by observing price action over a secular period, at least several years. If global gold demand is really growing faster than global gold supply, then the gold price has to rise. There is simply no other economic alternative in a free market! And make no mistake, the gold market is free until every single buyer and seller on Earth can be physically coerced by a single entity.

The chart below shows our awesome secular gold bull to date, the proof of the pudding. For about four years now, a secular time span, gold demand has exceeded gold supply driving up prices. If it was the other way around, if supply, including central bank selling, exceeded demand, this would be a downward-sloping bear trend.

Gold has climbed higher in US dollar terms for four years in a row now, with annual percentage gains noted on the X-axis. Bull to date the Ancient Metal of Kings is up 77.4% as of late last year. Gold's long-term support lines have held rock solid for its entire bull, running parallel with its strong upward-sloping 200-day moving average. Gold has carved five major higher interim highs and five major higher interim lows, an unmistakable secular bull fingerprint.

This gorgeous secular gold bull chart would never have happened if gold demand was not growing faster than gold supply in the last four years. Nor would it have happened if the rampant central bank selling since 1999 was anything more than a temporary nuisance. A multi-year secular trend is beyond argument, as it reflects bullish underlying supply and demand fundamentals for gold.

Conclusion. I hope these quick macro thoughts help clarify why I remain long-term bullish on gold. While whole books could be penned on each of these 10 major reasons why I am bullish, I hope the general flavor was communicated here.

Now that I have a baseline established and my biases are exposed and on the record, I am looking forward to delving into contending gold perspectives in future essays in this series. Other gold bulls believe other things and there are even prominent gold bears today forecasting new multi-decade lows in gold. All of these perspectives are valuable to analyze and provide worthy pursuits to diligent students of the markets.

If you are with me in the long-term bullish gold camp and are interested in actively investing in this gold bull, you may wish to consider subscribing to our acclaimed Zeal Intelligence monthly newsletter.

My partners and I have been painstakingly analyzing virtually every publicly-traded gold company over the past four or five months and are starting to delve into our extensive work with gold juniors in the upcoming March newsletter. Few speculations offer greater leverage to gold's bull-market gains than the very best junior miners!

In the meantime, it is in the best interest of all serious students of the markets to consider perspectives contrary to our own. Even if we reach the conclusion that a contending gold perspective is lacking in some way, the mere act of studying and thinking about it will increase our own understanding. And the more we understand, the more successful our trades ought to be!

Adam Hamilton, CPA
Zeal LLC.com

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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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