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Goldman, Gold, And Dollar's Influence on The Price of The Yellow Metal

This essay is based on the Premium Update posted on April 23rd, 2010.

When gold declined last Friday we were not caught by surprise and neither were our Subscribers. Based on our technical analysis, we gave you a heads up two weeks ago when we said that gold was ready for a decline before resuming its upward climb. But sometimes news can rattle the market, which is what happened Friday when gold hit an air pocket and dove $25 in a few minutes to move very close (or slightly below) the levels mentioned in our Friday update.

While it is always the sell order (or rather a large amount of them) that causes a dramatic move, and one should not automatically assume that one single event is responsible for it (without giving it a second thought), in this case it seems that the immediate cause for the decline was news of the Securities and Exchange Commission's (S.E.C.) civil fraud charges against Goldman Sachs.

You might be scratching your head wondering why such an event would affect the price of gold? Intuitively, one would reason that since gold is a hedge against financial-sector risk, gold would shoot up in reaction to such news instead of diving down. In times of uncertainty, investors turn to gold as a hedge against inflation and unforeseen crisis, gold being one of the very few asset classes that is not someone else's liability. But Friday, investors lost their risk appetite and dumped all commodities in favor of the U.S. dollar.

The full story of what happened with Goldman Sachs is complex and the media hasn't done a great job explaining it. In a nutshell, the S.E.C. is charging that Goldman created and marketed securities based on a group of subprime mortgages that were deliberately designed to fail.

Why would they want to do something like that?

Obviously somebody was going to make a lot of money from it. That someone - as it is expected - was the super-savvy hedge fund firm of Paulson & Co, the world's third largest hedge fund. According to the S.E.C., Goldman failed to disclose to investors the role played by Paulson & Co in the construction and design of that particular security. Paulson & Co helped choose securities for this investment and then wagered (successfully) that it would fail. In other words, Paulson & Co, worked with Goldman to pick the assets that went into the security, allegedly choosing the riskiest. Then, Goldman sold these securities to its clients, who readily bought because of their triple-A rating. (Someone should look into how they got this triple-A rating.) Mr. Paulson then placed bets that the security would lose value.

We took a look at the Goldman Sachs website, specifically at a section called their "business principles." There were 14 listed. Let's look at the first and the last. The first says: "Our clients' interests always come first." (I guess they meant the BIG client, like Paulson& Co) The last principle says: "Integrity and honesty are at the heart of our business." (No need to comment on that one.)

Paulson & Co said its role in helping to design a mortgage-linked deal sold by Goldman Sachs Group Inc. was "appropriate and conducted in good faith," according to a letter sent to investors.

If you're still wondering what all this has to do with the price of gold, we're now getting to that part. Obviously anyone sharp enough to see the coming of the subprime fiasco and intelligent enough to make billions of dollars from it is one savvy investor. Further proof for us at Sunshine Profits that John Paulson is one smart dude is the fact that Paulson's firm is one of the world's largest investors in gold. His holdings of the SPDR Gold Trust (GLD), valued at $3.6 billion, make his firm the largest holder of that ETF -- representing 15% of his portfolio. Among his other top ten disclosed positions is the AngloGold Ashanti LTD (NYSE:AU) gold mining stock. His ownership of that stock totals $1.7 billion and represents around 7% of his holdings.

Even though Paulson & Co. was not charged by the S.E.C., the sheer mention of the firm in connection with the suit against Goldman was taken to be negative news for gold.

The thinking might have been that investors in Paulson's hedge fund may rush to redeem their shares in the fund, thereby forcing it to sell some of its gold holdings. That argument does not make sense. First of all, most hedge funds require at least a 30-day notice to cash out. Even if the deal Paulson made wasn't exactly ethical, it still made his investors a spectacular bundle of money and the S.E.C. did not press any charges against him. So where is the risk for his investors?

Even if, for the sake of argument, many investors would rush to the exit doors to redeem their shares in Paulson's hedge fund, and as a result the fund would have to sell some of its gold holdings, how would that affect the precious metals market?

Writing this week for Marketwatch, Mark Hulbert crunched some figures.

"For argument's sake, let's assume that Paulson's gold holdings, both physical gold as well as shares of gold mining companies, represent a total of about 30% of his overall investments and are worth around $10 billion. Let's further assume that 10% of the investors in Paulson's fund suddenly get cold feet and ask for their money back.

Given my assumptions, that would lead to the sale of $1 billion of gold and gold shares -- or 0.37% of the total worldwide market cap of gold mining companies and gold owned by ETFs. Not exactly good news, but not particularly momentous, either -- especially since hedge fund investors typically can't get their money back immediately but have to wait a while after indicating their intent to redeem."

Even though it seems that the Goldman-linked SEC case caused the price of gold to dive last Friday, we believe it was only a catalyst to the technical correction that we predicted was coming in any case. We wrote in the last two Premium Updates that gold, which rallied to a four-month high of $1,170.70 on April 12, was poised for a technical correction. So, it seems to us that the Goldman news most likely just triggered an exit opportunity for short-term traders to lock in profits. If we look at the large picture, a blip like the Goldman Sachs story won't make a difference in the long-term inevitability of the gold bull market.

We found it interesting that upon hearing the news about Goldman Sachs, nervous investors would dump gold for dollars. We have written in previous Premium Updates about the mountain of debt accrued by the U.S. government and what it will mean for the long-term value of the U.S. dollar.

Speaking of the U.S. dollar, let's take a look at the current situation in the USD Index (charts courtesy by http://stockcharts.com.)

US Dollar Index

In our previous report we wrote the following:

There has been only a very small reaction to the USD weakness. Gold has recently been consolidating and this means that these may move a bit lower before the bottom is in. This holds true for silver and other equities as well.

We felt that the USD would move slightly higher but that its weakness would cause relatively little downward pressure on the precious metals sector. This is exactly what happened over the past seven days as the USD approached its March highs but gold did not respond by moving close to its recent lows. The same held true for silver. So, although the recent decline might have appeared huge on a day-to-day basis, taking a broader perspective reveals that on a relative basis very little downward movement occurred in the PM markets.

This is a very positive sign for PM's as the USD is one of the key drivers for PM prices and the rally seen this week had little negative effect on PM's. We are bullish at present although we do not expect immediate upward movement in gold, silver and mining stocks.

The USD is approaching a resistance level at the 50% Fibonacci retracement of the 2009 decline as well as a previous stop. This may hold this rally in check. However, the PM markets remain strong. Even if we do see another increase (which we don't expect at this point), say to the 83 level, though unlikely, we do not expect a severe decline in PM prices. The USD will eventually, in our view, move lower. This will in turn cause the PM prices to rise strongly as there will be no downward pressure from the USD when its decline begins. Whether this happens in one week or two is unclear at this time but we believe that the decline in the USD is in the cards sooner or later.

Summing up, based on the analysis of the U.S. Dollar Index, we remain bullish on gold, silver, and mining stocks in the medium term.

The USD rally is likely to slow and soon come to an end. Gold, silver, and mining stocks, having shown strength during the recent USD rise, are poised to surge upward once the current USD rally ends. Should the USD rally continue in the coming week, expect continued minimal declines in the PM sector as its strength continues to hold prices in patterns similar to recent weeks.

To make sure that you are notified once the new features are implemented, and get immediate access to my free thoughts on the market, including information not available publicly, I urge you to sign up for my free e-mail list. Sign up today and you'll also get free, 7-day access to the Premium Sections on my website, including valuable tools and charts dedicated to serious PM Investors and Speculators. It's free and you may unsubscribe at any time.

Thank you for reading. Have a great and profitable week!

 

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