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September 18, 2002 In Gold We Trust: The New Money |
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There is widespread belief that gold's recent non-performance was attributable to a stronger dollar, stock market rally, and/or central bank manipulation. While it is true that gold's rise was tempered by the bounce in the US dollar, we believe that gold's nonperformance was attributable more to the fact that gold and gold shares were the only place where there were profits. In fact, our studies show that in the long term, gold is influenced not by transient factors such as central bank musings, but rather as a store of value when investors lack confidence in financial assets. Currently, gold is mired in a tight trading range of $305 to $318 an ounce. After recording a 2½-year high at $330 in June, the pullback is simply a normal correction process. We believe that gold is about to breakout of this trading range and is in the nascent stage of a multi-year bull market driven by a declining US dollar, global bear market and Middle East geo-political tensions. The Dollar Standard For thousands of years, gold has been an integral part of the world's monetary system, providing the backing for money. Gold financed wars and subsequently the rebuilding of those countries. Gold formed the basis for the international monetary system from 1946 to 1971. In the era of the gold standard, gold was a reserve asset and central bankers were forced to adhere to financial discipline. Despite public sales, gold is still the second largest reserve asset held by central banks. The last vestiges of the gold standard disappeared when Nixon severed the link in 1971 and in the process devalued the dollar, ending the right to demand gold for dollars. Gold and the dollar were worth whatever the financial markets say they are. Exchange rates were allowed to float and the US dollar became the underlying standard for many countries. During the subsequent two decades of floating exchange rates, the powerful US economy kept the dollar strong and gold prices low. Gold declined as US dollars were created in abundance without the need for 100 percent backing or redeemability. An excess of monetary stimulus such as eleven interest rate reductions within a year and a half and double-digit monetary base growth also caused a glut of dollars. Ironically, most of those dollars ended up on the balance sheets of foreign central banks, because they too wanted part of the American dream. The US dollar reached a fifteen-year high and dollarization became the norm. Through the issuance of so many dollars, the greenback became the largest asset class held by the world's central banks. This allowed the United States to create the world's biggest bubble and accumulate one of the world's greatest debts. The rise and fall of America's financial strength has left them with too much capacity, too much debt and an economic engine that refuses to turnover. The Americans must now finance a record $450 billion current account deficit and a near record $200 billion budgetary deficit with almost zero interest rates. It took time, but foreigners are now tired of financing America's twin deficits. So far, the flight from the dollar has been orderly but there is no guarantee that it will continue. At some point the dollar collapse will crack the veneer of complacency and lead to a crisis of confidence in the markets. We are concerned that the exodus could escalate since this mountain of foreign-owned dollar securities is extremely vulnerable. The slide in the US dollar comes at an awkward time for policymakers. With a declining dollar, the pressure on the Fed to maintain a sound money policy whilst providing the liquidity to rebuild the economy, raises the inevitable "guns and butter" question. The Fed has created unprecedented amounts of new liquidity in order to soften the impact of the deflationary debt levels without creating real value in the economy. Further, with the Fed keeping interest rates low, it signals that it will continue to subsidize the American way of life with twin deficits. The prospect of another slide or debasement of the dollar lessens the appeal of holding dollars as sound money. Yesterday the dollar's strength dampened inflation; today a falling dollar will revive it and that's hardly a rosy outcome for world financial markets coping with mammoth US deficits. Inflation is caused by the erosion of a currency's value when too much money chases too few goods. It can happen again. And what is to fill the vacuum left by the dollar? Gold, of course. After all it has worked for the last few thousand years. In the new world where markets are secondary to government actions, where markets are illiquid and capital is scarce, we expect gold to regain its status as a store of value. "Sooner or later", wrote Robert Louis Stevenson, "we sit down to a banquet of consequences". The New Money Dollarization is disappearing. After Mexico in 1994, East Asia in 1997, Russia in 1998 and Brazil in 1999, the full faith and credit of the United States is under scrutiny. The malaise that spread to Latin America is just beginning. More recently the Argentinean collapse and the $30 billion IMF bailout for Brazil has lessened the appeal of dollarization. Volatility in the financial markets, an over-valued and over-owned US dollar and forty-year low interest rates have forced central banks to diversify their portfolios from dollars, prompting them to buy euros and gold instead. The Bank of China recently raised its gold reserves to 500 tons, which is only 2 percent of total reserves. Asian central banks hold between 1 and 5 percent of their foreign exchange reserves in gold, while European central banks hold 30 to 40 percent and the US at 55 percent. With over half of the world's foreign exchange reserves in Asian vaults, they are the next big buyers of gold. Japanese investors to date have bought more than 60 tons or three times more than in the first seven months of last year. In a subtle announcement, Malaysia and a handful of other Islamic countries plan to use gold dinars to settle bilateral trade from mid 2003 so as to reduce reliance on the US dollar. According to Islamic law, gold dinars have a specific wealth of gold equivalent to 4.22 grams of pure gold and its value is around $42(US). To be sure, the trillion-dollar lawsuit against the Saudis in the United States will accelerate this trend. It has been reported that since 9/11, Middle East investors sold up to $200 billion of US assets of an estimated $1.2 trillion in dollar securities. With the economic case for a strong dollar gone, and little room for fiscal stimulus, we believe that we are on a threshold of a lower dollar, stocks and bonds. Gold is a winner in this environment and cannot be printed, does not default, or threaten to default. The lack of confidence in the financial system and the specter of another Iraqi war are pushing gold prices up. Investors are seeking an alternative and gold has emerged, not only as a store of value but also as a new standard. Indeed our bullishness has been based upon the overdue decline of fiat money and the reestablishment of gold's role as the basis for a monetary standard in a world lacking an anchor. Gold cannot be created like fiat money. Even Fed Chairman, Alan Greenspan called gold, "the ultimate form of payment in the world". Gold- the Alternate Asset Class Throughout history, gold has reacted inversely to other asset classes including the Dow Jones Industrial and the S&P 500. Gold will become an important part of a balanced portfolio. It is the safest possible asset, its intrinsic value unaffected by central bank musings or the world's politicians. As the US dollar falls, the gold price usually rises. The prospect of years of recovery from the bubble years suggests gold is a good alternative to stocks and the dollar. In 1985, the US dollar fell 35 percent against a basket of currencies. Gold went up 66 percent from $300 to over $500 per ounce in the same period. To date, gold's performance is up over 14 percent, better than an 11 percent decline in the Dow Jones, 18 percent fall in the S&P 500 and outperforming other currencies this year. We believe gold has begun its second leg of a multi-year bull market that will see $375 per ounce near term and $510 per ounce next year. Gold has finally reasserted itself as a savings and investment vehicle and will appreciate further against under-performing currencies, bonds and stocks. Gold's return to a safe haven role caused Morgan Stanley's global strategist, Barton Biggs, to recently advocate a 5% weighting in portfolios. Biggs wrote, "this large differential could only be solved by much higher prices, the point is that, it is not inflation or deflation that is the principle driver of gold, but the return from other long-term financial assets, particularly equities." Mr. Bigg's view is that capital returns reached a zenith a year and half ago, and the stock and bond outlook will lag that of gold. Debt, debt and too much debt Today, personal savings are too low, and corporate and household debts are too high. Mortgage debt stands at 7 percent of household discretionary income. Debt problems are of concern as consumer credit outstanding rose at 5.9 percent annual rate in June. Household, corporate and credit debt is now almost $30 trillion or 2.9 times GDP. There are also increased numbers of consumers defaulting. For example, the shares of Capital One, the US credit card group tumbled 40 percent after Federal regulators ordered it to increase its reserves by $240 million, to cover potentially bad loans. Credit card companies wrote off $4.9 billion in bad debt in the first quarter of this year, up from $2.6 billion during the same period, according to the Federal Deposit Insurance Corporation (FDIC). The rise and fall of the telecoms have overshadowed the dotcom crash. Telecom debts exceed $1 trillion. And, the industry is at the center of the accounting scandals following WorldCom's bankruptcy, the biggest in corporate history. As in Japan, the telecom debacle will take years to recover and the hangover consequences must be dealt with. First, the oversupply of capacity built during the bubble years must be brought inline with demand and second, the mountain of debt must be reorganized. History shows that a prolonged period of uncertainty looms, as the excesses in the system in capacity, consumption and debt is worked down. The US trade deficit ballooned to $37.2 billion in June, up 3% from $36.1 billion in April. The threat of deflation has been raised due to the sluggish economy. Interest rates cannot go below zero and the Fed has already reduced interest rates eleven times to fortyyear lows. For some time we have argued that the Americans have entered a Japanesestyle deflation. Asset bubbles are part of our financial history. From tulips to telcoms, investors have experienced the climate of both fear and greed. We have experienced the greed, now the fear. The Japanese experience suggests that the Fed is fighting yesterday's war. Although, deficit spending has slowed the Japanese economy's slide, it has not reversed it. Bush and Greenspan are repeating the same mistake. Between 1995 and its peak less than six years later, the capitalization of the US stock market rose by $12 trillion. Now with a deflated stock market bubble, almost $4 trillion has disappeared. While the numbers are large, it should be remembered that the overall US economy is only about $10 trillion, so a $4 trillion loss has a dramatic deflationary effect. In Japan, the Japanese appetite for gold increased 500% from a year ago as investors worried about the nation's economy and the safety of their banks. Following the hangover, Americans too might find gold's role as a hedge is a good thing. The War On Wall Street Two years ago, investors were willing to believe anything, today there are prepared to trust nothing. Now that the swamp has drained, investors are looking for scapegoats. They are blaming everybody but themselves. While the analysts and investors were calling for more growth, few investigated at what expense that growth would come. Greed made investors gullible. No one can protect people from themselves; no regulator, no central banker, no analysts, and no policemen. Investors bought into the "new economy" ignoring basic tenets, such as price earnings multiples and valuations. While there is no denying that there were abuses to the system and these should be punished, we should not assume that the system itself is broken. We are not here to defend capitalism or the wrong doer, but to point out that every bubble has a downside. It's the same old story, whether it was Bre-X, tulips, or the South Sea bubble. Bubbles are a fact of life; it's the remedies that keep changing. We cannot protect every investor from themselves. To be sure, it will be repeated again and again. Witchhunt On Wall Street " In the very midst of the collapse, five of the country's most influential bankers hurried to the offices of J.P. Morgan & Co. and, after a brief conference, gave out word that they believed that the foundations of the market to be sound, and the market smash was caused by technical rather than fundamental considerations and that many sound stocks are selling too low." The New York Times, October 24, 1929. There has been little commentary against the witchhunt on Wall Street. While we applaud the indictments and the effort to penalize the crooks, the constant attacks on Wall Street to root out the evildoers will do little to instill investor confidence and thus provide the needed base for higher markets. To rid the house of termites, one does not demolish the building, when you can bring in an exterminator. Demolishing the building also leaves you homeless. Indeed, regulators should study new rules, close loopholes, and eliminate conflicts. But, this War on Wall Street does little to eliminate the current abuses or crimes. Karl Marx must be rolling over in his grave... what he could not accomplish with a revolution; Enron, WorldCom, and Martha Stewart have with simple greed... thrown a shadow of doubt over capitalism. Congressional investigators are scrutinizing the central role that Wall Street played in the bubble. Regulators are looking at analysts' behavior, the various "structured" products and the multitude of roles that the banks played by giving large amounts of credit to the select few. We believe that much of the problems can be linked to the repeal of the 1933 Glass-Steagall Act by the Clinton administration that allowed commercial banks to merge with investment banks. While regulators are erecting new barriers, the market itself should be educated in the "tied business" practices of the Street and the wisdom of seeking more independent advice. Investors should not blindly accept advice particularly from an investment bank that may have multiple roles. The question should be asked, what is the independence of that advice? It's not all about the analyst; it's about the system. In such an environment, the Street should support and allow the reemergence of the old-fashioned independent broker. But alas, the Street seems to prefer simplicity and one-stop shopping, ignoring recent lessons, and the lessons of the thirties. Caveat emptor. Recommendations Gold stocks significantly outperformed bullion in the first leg to $330 per ounce. Typically, the shares led bullion on the pullback. We believe that the second leg will see bullion outperforming the shares until gold moves above $330 per ounce. Investors are expected to be cautious until there are clear signs of a breakout. We continue to advise an over-weighted position in gold stocks. Over the past year, the mostly unhedged mid-cap gold companies outpaced the senior producers who are mostly hedged. The unhedged mid-cap producers provide 100% of the upside but coincidently provide superior growth in production, reserves and potential. The challenge for the big cap producers is to replace more than two million to five million ounces that are produced annually - it's easier for the smaller mid-cap producers to replace depleting reserves. For that reason we continue to like Agnico-Eagle, Goldcorp and Meridian Gold. Among the big caps, we like Newmont and Barrick but note that the new Kinross will be a strong performer in the future. Given the recent pull back, the gold producers are better buys compared to the exploration juniors. We would be more buyers of the producers than the exploration vehicles here. However, we continue to recommend our portfolio of Top Ten Juniors, which includes Crystallex, Eldorado Gold, Claude Resources, High River Gold, Iamgold, Miramar, Repadre Capital, Northgate Exploration, Philex Gold and St. Andrews Goldfield. Given the problems in South Africa, we believe North American producers will command an even bigger premium. And, as investors become more concerned about the downside risk of the Dow, gold stocks will continue to outperform. Finally, much has been made about the declining supply of mined gold and the lack of major discoveries. While mine supply of gold is likely to decline, we do not subscribe to the 30% forecasted drop due to the mining industry's propensity to keep old mines running. The old Macassa Mine for example has changed hands more times than a Las Vegas blackjack dealer and is still open. Of more significance for investors is the lack of world-class deposits such as Goldstrike or Eskay Creek since much of the near surface deposits have been depleted. In the latest quarter, gold producers are aggressively unwinding their hedges, through deliveries into contracts, closeouts or actual buybacks. The Australian producers have reduced their hedge books by 8 percent or 1.75 million ounces to 22.6 million ounces in the quarter while gold output fell 8 percent. AngloGold bought back 2.4 million ounces but still has 10.5 million ounces under hedge. Newmont reduced its hedge book by 734,000 ounces in the quarter to under 9 million ounces. Placer Dome will cut its hedging program by 20 percent to 6.8 million ounces but still have 2.8 years of hedged production. Barrick too has also pledged to hedge less in the market, selling half of this year's output at spot market prices. Unwinding the hedges acts as a powerful buying force on the markets in contrast to the sales, which act to depress the price of gold. We continue to believe that producers will buyback additional hedges since interest rates remain low, narrowing the contango. Hedging has become unpopular as investors are concerned about the lack of transparency, the risk potential and the lack of upside. In a well-publicized battle, South Africa is introducing the Black Economic Empowerment Charter that will change the mining industry forever. While it took some time, the government is introducing legislation that will give black people a greater share of South Africa's mineral resources. A government trial balloon proposed that 51% of all operations should be in the hands of blacks within 10 years. The threshold is likely to be negotiated down, but the objective remains. The government has also introduced a new Minerals Bill, similar to Canadian mining companies, which will force companies to " use it or lose it". While the industry could live with that, the Money Bill's increased royalties, the proposed transfer of ownership to black empowerment groups and new "social" costs will ensure that South Africa's gold production will remain at 50 year lows. At the very least, until South Africa sorts out the new rules, there will be uncertainty in the capital markets and South African mining valuation multiples will shrink further. Agnico-Eagle Mines Limited AngloGold Ltd. Barrick Gold Corporation Glamis Gold Ltd. Goldcorp Inc. Kinross Gold Corporation Meridian Gold Inc. Placer Dome Inc. Placer has again extended its bid for AurionGold of Australia. Placer has only accumulated 37 percent due to the resistance by management and major Australian shareholders. Placer has little choice but to extend its bid, because under Australia's takeover rules it would be limited to an incremental and lengthy takeover strategy. Moreover, Placer will not have board representation, which further complicates the takeover. Placer must feel like the proverbial bride's maid and the sorry acquisition record continues. There are repeated takeover rumours about Placer, because the shares have been a laggard performer. Placer Dome shares have been heavily traded. The latest involves a joint bid by Barrick and Newmont. This rumour follows another of two months ago that was floated with Gold Fields and Goldcorp making a joint bid. Joint bids are always difficult and cumbersome. The obvious negatives are Placer's overly large South African exposure, hedge book, declining production and reserve profile. The positives are two million ounces of steady production and a strong balance sheet. We do not put much weight into these takeover rumours and believe that the volume is attributable more to the liquidation of the approximately 25 million shares of Placer Dome received by AurionGold shareholders. There is no question however that Placer's twelve mines would be attractive to different players but tax issues, valuations and rights of first refusal make a piecemeal deal difficult. Nonetheless, any takeover for part or all of Placer is difficult and thus unlikely. What of a friendly merger? We think not, Placer Dome's management makes that unlikely. We thus continue to recommend avoiding Placer due to the declining production profile, maturing mines, accident-prone management and overly large exposure to South Africa. TVX Gold Inc. 
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John R. Ing Disclosures: General Disclosures: This report is approved by Maison Placements Canada Inc. ("Maison") which is a Canadian investment- dealer and a member of the Toronto Stock Exchange and regulated by the Investment Dealers Association. The information contained in this report has been compiled by Maison from sources believed to be reliable, but no representation or warranty, express or implied, is made by Maison, its affiliates or any other person as to its accuracy, completeness or correctness. All estimates, opinions and other information contained in this report constitute Maison's judgment as of the date of this report, are subject not change without notice and are provided in good faith but without legal responsibility or liability. Maison and its affiliates may have an investment banking or other relationship with the company that is the subject of this report and may trade in any of the securities mentioned herein either for their own account or the accounts of their customers. Accordingly, Maison or their affiliates may at any time have a long or short position in any such securities, related securities or in options, futures, or other derivative instruments based thereon. This report is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities discussed herein in any jurisdiction where such offer or solicitation would be prohibited. As a result, the securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. This material is prepared for general circulation to clients and does not have regard to the investment objective, financial situation or particular needs of any particular person. Investors should obtain advice on their own individual circumstances before making an investment decision. To the fullest extent permitted by law, neither Maison, its affiliates nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained in this report. For more information, please visit our website: www.maisonplacements.com Copyright © 2002-2009 Maison Placements Canada Inc. Image rendition and html coding Copyright © 2000-2009 SafeHaven.com ADVERTISEMENTS
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