Gold and gold shares have spent the year to date in a corrective mode. The intense investment ardor of 2003 has been succeeded by disinterest and skepticism. Gold shares, which are essentially long-dated options on the gold price, provide the best barometer of sentiment. In 2002 and 2003, the shares outperformed the metal by a factor of 2:1. This year, they have under-performed, with gold up 2% and the shares down 9% (basis XAU as of November 2, 2004.) Investment flows into US gold mutual funds have been subdued compared to 2003 and 2002, and are down more than 60%.

As always, the key investment questions are: (1) where are we on the road map of the secular bull market for gold; (2) are we in fact still on the road or has it come to an end; and (3) what is the condition of the fundamental forces behind the market direction?

To alleviate any suspense, it is our view that we are still in the early stages of a bull market for gold and a bear market for financial assets, including (especially) the US dollar. Our view on (1) ought to dispatch any need to discuss (2), but it might be worth considering what to look for in judging the bull market in gold to be over. In general, the answer to (3) is that the conditions supporting a rising price of gold are not only intact, but, if possible, stronger than ever.

A Brief Review of the Fundamentals

Supply and demand factors remain positive and compelling. One might think that after a five year run in the gold price from $250 to $400+, mine supply would be surging and demand would have receded. In fact, the opposite is true. Mine supply, at 2500 tonnes (metric) seems likely to decline over the next three to five years. This would likely be true even if the gold price traded up $100/oz. and remained on this hypothetical new plateau. Demand is robust.

Gold mining is an intrinsically hardscrabble proposition. It is rarely a good business. Rising costs have more than kept pace with the rising gold price. In South Africa, producer of 14% of the world gold, an overvalued currency has resulted in a declining gold price in local currency terms, contracting margins, and shutdowns of marginal mines. Elsewhere, important cost factors have pinched returns on sales and capital. Energy costs have seriously eroded margins for open pit mine operations worldwide. Equipment and capital goods price increases have drained cash not only for existing operations but raised the ante for new mines on the drawing board. Drill rigs are hard to find, skilled operators even more so, and assay lab backlogs are at record levels. The industry, broadly ignorant of the need to generate returns in excess of its cost of capital, has high graded existing mines, overproduced relative to reserve development, continues to squander capital, and persists in opting for dilutive financings that undermine the interests of shareholders (thereby turning away all but the most speculative investors.)

Poor returns on capital and value-destroying mergers have caused significant cutbacks on exploration spending, which remains 40% below the recent peak of $1. 7 billion in 1997. The efforts of environmental NGO's, emboldened by the financial support of tree hugging billionaires, are adding costs and challenges unknown ten years ago for existing and proposed mines. The lead time between discovery and first output for major new mines is easily measured in decades.

Demand for gold jewelry remains strong despite higher prices. According to Goldfields Mineral Services, global consumer demand rose 11% in terms of tonnage and 25% in dollars in the second quarter versus last year. The Indian subcontinent, the largest market, will purchase 880 tonnes this year, a rise of 10% according the MMTC, the Indian parastatal agency which tracks commodity imports. The pattern of Indian buying, which accounts for 19% of the world jewelry consumption, has been to absorb gold on declines but not to drive prices on the upside. The financial market metaphor would be that of intelligent accumulation. India, though significant in itself, exemplifies the increased appetite for gold that goes along with third world economic growth. Elimination of import tariffs in China and the organization of the Shanghai Gold Exchange promise to activate demand in a potentially large market that has been a non-factor for the past decade.

Central bank bullion bars and new mine output are sold for cash, only to be melted down in refineries and reconstituted into fabricated shapes for jewelry. In this manner, gold disappears into the dowries of Asian families and is no longer for sale. Physical buying of this sort not only absorbs supply, it places gold beyond the grasp of financial traders and issuers of derivatives such as gold linked notes. These traders are the equivalent of gold price bookies, with little idea of the internal fundamentals of their bets, and absolutely no idea of the widening gap between the liquidity of gold traded as paper and the real thing.

There are two factors driving demand for physical gold. The first is the growing prosperity of the emerging world. The second is the rising level of commodity prices, which acts as an important cash flow generator for segments of the globe where derivatives are unknown or distrusted.

While third world jewelry demand sops up nearly all newly mined gold every year, investment demand also shows signs of awakening. Investment demand for gold as an alternative asset has been dormant for twenty-five years. Awakened, it has the potential to swamp the supply of physical gold, which in financial market terms is similar to a micro cap stock.

We estimate that the market cap of global gold to be approximately $1 trillion at current prices, assuming that all central bank gold is for sale. Since all central bank gold is not for sale, the real market cap is approximately half of this figure. Global financial assets approximate $70-$75 trillion. Even a small diversion of .1% from financial assets into gold would equal 2 years of mine supply. It is a trade that can't be done at current prices. (Check out our math in the Appendix)

It will be interesting to see what becomes of the new gold ETF (Exchange Traded Fund) proposed for New York Stock Exchange listing. The ETF must be backed by physical gold, to be held on deposit with HSBC in London. It is our belief that, in time, the ETF will tap investment demand that has until now steered well clear of the sector. An ETF launched in 2003 in London has achieved a market cap of $739 million, and is backed by 1.8 million ounces (as of October 19^th). A NYSE listed gold-backed security, in our opinion, will be more widely accepted. It will be followed by listings on other major markets.

Conservative investors, both institutional and individual, have shied away from mining stocks for good reason. They are risky and speculative, even if they do provide dynamic exposure to rising gold prices. Institutions loaded with overvalued equities and bonds would do well to consider the non-correlated benefits of even a small commitment to physical gold, for the sake of their beneficiaries who will need spending power twenty to thirty years from now. Individuals and institutional portfolio managers may well come to consider the ETF as a more effective way to protect capital than by simply raising cash. The ETF has the potential to add several hundred dollars to the gold price, over time, because it will facilitate access to gold for a broad range of investors previously excluded due to inexplicably archaic mechanisms.

And what of central bank selling, the long-standing hobgoblin for gold investors? In short, there are signs that overt official sector selling may be abating. Although the new agreement governing central bank sales (Central Bank Gold Agreement, March 8, 2004) permits 2500 tonnes to be sold over the next five years, only 1900 tonnes has been spoken for. The UK has completed its sales and Swiss have a residual of 130 tonnes. Netherlands has a small residual of 65 tonnes from its original program of 300 tonnes. According to Goldfields Mineral Services, it is "highly improbable that, in practice, close to two thirds of this quantity would be mobilized for sale" over the next five years.

Central bank attitudes towards gold appear to be warming. There is official sector buying in the Persian Gulf. Argentina has purchased 40 tonnes of gold this year, possibly as defensive move against aggressive creditor actions outside the country. Official sector antipathy to the dollar is spreading. A scathing review of the "dollar hegemony" by Oleg V. Mazhaiskov, Deputy Chairman of the Russian central bank is undoubtedly on the minds of others who feel more constrained to speak freely:

"The world has come to a paradoxical situation in which the creditor countries are more concerned with the fate of the dollar than the U. S. authorities themselves are. Thus, the evolution of the U. S. dollar's reserve role in recent years has given ground to some quite pessimistic forecasts, based on rational economic theory. No wonder that the number of people who have held assets in dollars and now wish to diversify them partly into gold - the traditional shelter from inflation and political adversity - is steadily growing." (June, 2004)

Central bank supply, required to balance the market at current levels, is waning. Increased investment demand, a wider appreciation on the constraints of new mine supply, and a decline in central bank selling are the stuff of a compelling commodity story. But, there is much more to this story than the pedestrian summation of supply and demand factors.

Enter Beardsley Ruml

The DNA of financial instability is embedded in human nature. Manic highs, gut wrenching lows, expansive assumptions as to future returns, catatonic withdrawal into risk avoidance, a predisposition towards optimism or skepticism all originate in the psyche. They are magnified, reinforced, and institutionalized by crowd behavior. The ebb and flow of the tide of credit reflects the rhythmic cycling of popular beliefs and fears over decades. The credit cycle explains how the mythic business heroes and investment icons of one year are transformed into the laughingstock and felons of another. It cannot be harnessed by econometric exactitude to suit the aims of public policy, because it is a fundamental expression of humanity at work in the financial marketplace. Still, for most politicians, the lesson learned from the 1930's depression was that an expanded government role could modify market outcomes to benefit society.

It is in the context of social engineering that the removal of gold from its historical role as the official basis for money, the substitution of fiat money as the foundation for the international credit system, and the consequent mispricing of gold must be understood. Thirteen years after President F. D. Roosevelt suspended private transactions is gold, the Chairman of the New York Federal Reserve penned an article for American Affairs titled "Taxes for Revenue Are Obsolete." Beardsley Ruml, advocating the elimination of the corporate income tax, observed:

"The necessity for a government to tax in order to maintain both its independence and its solvency is true for state and local governments, but it is not true for a national government. Two changes.... have substantially altered the position of the national state with respect to the financing of its current requirements.

The first of these changes is the gaining of vast new experience in the management of central banks. The second change is the elimination, for domestic purposes, of the convertibility of the currency into gold. "(American Affairs, Jan. 1946)

In these few sentences, Mr. Bruml anticipates the 60-year transformation of the Federal Reserve from a traditional central bank into a central planning agency. Bruml, as did many other post war leaders, mapped out an intellectual framework for interventionist economic policies designed to eliminate the pain of bad economic outcomes while presumably allowing for open-ended upside. From that point on, the only thing that has changed is the evolution and perfection of technique. Ruml could never have imagined the gyrations by which the future Fed would slay any and all dragons threatening financial stability. Writing gold out of the monetary script, foreshadowed in these remarks, was the magic formula by which the levers of credit would be transferred from the markets to the politicians.

The US dollar, freed from the constraint of gold backing in 1971, became the pliable foundation for international credit. It rose geometrically in quantity to become the essential fuel of global economic growth. Owing to surfeit, it is on the brink of global distrust. Because of its pivotal role, few dare to speak of it honestly as did Mr. Mazhaiskov. That is because it is more widely held, it seems, than Internet stocks at the top. Those with large positions can ill afford to point out its shortcomings. Global trade has been lubricated by universal acceptance of the currency. Our Asian trading partners, needing dollars to finance their own economic growth, find it convenient to ignore the risks of dollar devaluation. However, Fed officials seem to be siding with Mr. Mazhaiskov. George McTeer, outgoing President of the Dallas Fed, said on October 8^th, 2004: "theoretically, some day...the flows will turn against us and there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar." This is quite a statement from a regional Fed president. It is amazing that it was all but ignored in the press.

What is a dollar worth? It is too bad that there is no obvious answer. As we have seen, many thoughtful observers have suggested, and very persuasively, that it is overvalued and that this overvaluation is unsustainable. Some counter that the dollar's value in terms of alternative currencies has been fairly stable, but closer examination of the yen and euro leads to troubling questions as to their intrinsic worth. In a world of fiat currencies with no objective basis for value, the potential for economic misjudgments seems limitless.

The value of one single, solitary US dollar is impossible to determine. Purchasing power parity, exchange rate versus other currencies, and purchasing power as defined by the consumer price index do not hold the answer. All three benchmarks are flawed. These valuation measures are subject to tinkering by governments to suit their policy aims. We have suggested as much in "The Real Value of a Dollar" (2/14/04), as have many others:

"In the absence of a gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold." (Gold and Economic Freedom, by Alan Greenspan-1966)

The inability of players in the economic realm to judge the value of the unit of exchange categorically leads to mistakes and imbalances that must be rectified in due course. Fundamental analysis of return on investment, whether for family savings or corporate spending, is meaningless in the absence of an objective and fixed unit value of return, or numeraire . Economist David Ricardo reasoned that a fixed and objective unit of account was essential if "one wish(ed) to make interlocal or intertemporal comparisons (in the) problem of measuring value". For multinational producers of goods in China destined for the United States, a critical factor governing the return on capital, which cannot be known today, is the future exchange rate, which dictates the number of dollars returned for a product sold. While there is always exchange rate risk in cross border trade, the risk would seem especially pronounced in the case of China, which seems to be the universal justification for almost any investment proposition.

Imbalances must proliferate in the absence of an objective standard of value. Credit is extended and capital committed based on artificial suppositions. Asset values are marked to market on the same false pretenses. Returns are illusory; the security of credits a fiction. It is the sort of thing that can only happen, unchecked, in a regime of central planning.

The misdirection of capital flows in the current global economy is illustrated by the US trade deficit, the US budget deficit, the 46% holding of US treasuries by foreign investors, the lack any credible attempt to deal with future entitlement claims, the pattern of aberrant behavior in housing finance and the resulting bubble in housing prices, the disconnect between shrinking bond yields and rising commodity prices, negative real interest rates, the overweighting of financial stocks in the S&P 500 (20.1%), the bloated 38% share of total after tax profits generated by financial firms, multi-year interest free new car loans, the reckless pursuit of yield in the junk bond market, the continued overvaluation of equity markets, the inundation of the hedge fund sector by capital flows desperately seeking returns, over utilization of convergence strategies, the paucity of returns for investment strategies across the board, the buildup in corporate cash, the excessive indebtedness of the American consumer, and the glut of golf courses, casinos and SUV's. This is only the short list.

The Treasury Department reported on October 18, 2004, that net monthly capital inflows from the rest of the world declined for the sixth time this year. The 50% decline in net private investment from a year ago was more than offset by a rise in Asian central bank buying. Few would disagree that the obvious support of the dollar by foreign central banks has a finite life. These are bad signs for the currency, but the financial markets appear to exhibit little concern. The chart below shows that foreign private entities have drastically reduced their purchases of US paper, and that central banks have more than taken up the slack. Private companies and investors, not constrained by policy objectives, are turning in their dollars to their central bankers in exchange for local currency. Once, they held onto the marginal dollar for its appreciation potential. Foreign central banks, on the other hand, are dutifully fighting the market to keep their currencies undervalued to the dollar.

How will the exit of the dollar play out? There are thoughtful arguments on both sides of the issue of deflation versus inflation. A serious erosion of the dollar's international exchange value will force the US to become self-financing. Our trading partners do not need to reject the dollar outright but merely to reduce their buying on the margin as has been the case over the last several months. As of this writing, the trade-weighted dollar is at the low end of its range of three years. The dollar has been against the ropes before and has managed to rally. It will probably rally again, but within the context of a well-established downtrend. Aside from a countertrend rally, a probe to new lows would trigger higher interest rates, lower equity market valuations, and higher inflation, as the President of the Dallas Fed has observed.

Dollar weakness could prove stimulative to the economy in the short run as our hollowed-out industrial base is called upon to produce what we can no longer afford to buy abroad. Corporate earnings might rise sharply amidst a contraction of valuations. In short, this would be something of a replay of 1970's stagflation triggered by the unwillingness of foreign bankers to finance our deficits in 1971 and again in 1979 in the absence of interest rate and exchange rate adjustments. The difference between the 1970's and today is that the magnitude and proportion of our foreign indebtedness is far greater.

The all too popular bearish view of the dollar deserves a contrarian response. The deflationist camp notes that there is global overcapacity owing to direct investment driven by the well-known arbitrage of labor rates between Asia and the developed economies. Wages and prices are capped as long as our Asian trading partners choose to finance our debt at current exchange rates. The misallocation of capital on a grand scale has been financed by a buildup of debt on an even grander scale. The debt position functions as a synthetic short against the dollar, which will drive up its international exchange value as business returns falter because excess capacity drives prices lower and forces widespread repayment of dollar-denominated debt. A flight to safety results in miniscule government bond yields, exploding credit spreads, and imploding capital markets.

Beware that the preponderance of bearish opinion on the dollar at this moment could signal a conviction-shattering rally. The obvious peril to the dollar may have been sufficiently discounted for the moment, or may still be too distant to preclude a fake out countermove.

To many, the possibility of a rising gold price in a deflationary setting is unlikely. For example, in a recent article titled "Gold is not Signaling Inflation or Deflation...Yet" published October 18th by Bianco Research LLC, the writer states that:

"Gold's nominal price changes are a function of the relationship between the expected rate of inflation and the short-term interest rate costs of carrying inventory, plus or minus changes in the supply/demand balance."

The accompanying chart in the article only goes back to 1997. This sort of thinking equates the symptom of a general fall in the level of prices with deflation but overlooks the root causes and dynamics of a deflationary meltdown. It is easy to think that if all commodity prices are falling, then gold must also. The article later states: "If the price of gold starts to fall more rapidly than the dollar index increases, deflationary pressures exist and an appropriate policy response is indicated." The direction of the general price level cannot be confused an inflation or deflation of credit. Secular credit cycles are beyond the control of central bankers, although central banks can certainly augment the process of credit expansion if they already under way. A general fall in prices can occur quite normally during a period of economic growth that is not deflationary. However, falling prices in a deflation are only a side effect of a general paralysis of credit. The more telling symptoms are very low nominal interest rates, high real interest rates, and failing household and corporate credits. Investor behavior shifts from risk taking to risk avoidance. In a secular credit contraction, such as we are in the midst of at the moment, the gold price rises as a measure of the demand for safety. Central bank attempts to counter the contraction take the form of excessive paper issuance, which for a time can inflate asset values due to surplus liquidity. Ultimately, the market sees these actions for what they are, monetary debasement. While nominal price levels may rise in response, as in the 1970's, economic activity stagnates.

In our view, both inflationary and deflationary scenarios explain how and why the gold price will rise, not only in dollars, but in all currencies. The dollar's predicament allows for more than one plausible outcome. Our contrarian instincts at first guide us towards the deflationary camp, since it seems under-represented in discussions of this sort. But the deflationary camp omits an important consideration, which in our view makes a precise repeat of the 1930's impossible. That factor is best summed up in the notion of Beardsley Ruml: sophisticated central bankers and enlightened government policies can always create desirable outcomes. Disrespect for market outcomes is not limited to central bankers and policy makers. It is integral to the post World War II social compact. Dollar trashing therefore exists not only as a notional last resort for desperate policy makers, but also constitutes an option that would be widely applauded. According to Bob Hoye of Chartworks :

The purpose of sound money has always been to "manage" the ambitions of the state...In 1900, all levels of government were taking only 10% of GDP and the public was skeptical about big government. In the last part of the 20^th Century, the government take was approaching 50% and the public had visions of government as a wish machine. (Address to the Committee for Monetary Reform and Education, October 2004)

Acceptance of the dollar as the global reserve currency is on thin ice. As with any overvalued security, there is no margin for anything less than perfection. In the instance of the dollar, perfection may be defined as uninterrupted and unthreatened economic growth, consensus belief in the same, low reported inflation, stable financial markets, political tranquility, and a restoration of international harmony.

Misguided Faith

What is the explanation for the persistence of investment confidence in the face of transparent danger to the status quo implied in dollar devaluation? Possible answers include wishful thinking, ignorance, habit, selective inputs or a combination. Another possibility is that there is nothing to worry about at all. The five-year rise in the price of gold can be taken as a warning or it can be dismissed. A benign interpretation, non-threatening and consistent with investment complacency, is that the rise is based strictly on commodity related supply and demand factors. It can be argued that gold's dollar price has under performed other commodities, especially oil. In deflated dollar terms, today's $400 handle is only $200 in 1980 terms. In 1980 it peaked over $800, or $1600 in today's money. Gold is simply tagging along in the slipstream of oil, copper and nickel.

The complacent world view holds that financial assets will normally generate positive returns, that the dollar doesn't matter, that the economy is now and always can be wisely managed, and that in old age, sickness, and travail there will always be a government backstop for individuals, businesses and investors. That view appears to be widely shared in financial markets. The notion that the dollar and financial assets in general are in the early stages of a multi-year decline is alien and inconceivable. If it were otherwise, the dollar price of gold would not be $400. It would have at least three zeros before the decimal point.

When does reality sink in?Past behavior of the financial markets suggest that the lags are considerable. Timing markets is hazardous. Let the tape do the talking, as price is always the best educator. A visitor from another planet might hypothesize that investment thinking broadly anticipates financial markets. Reality is quite the opposite. The explanation lies in crowd psychology and human behavior, not rational analysis:

"The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent."

-from Silas Marner by George Eliot, as quoted by David Richards in Barrons ( 9/20/04 )

We conclude with ardent conviction, the more so for our isolation, that the dollar's role as the global reserve currency has run its course. The transition to a new basis for international credit will be lengthy and difficult. The repercussions of a transition are not reflected in the financial markets. For this reason, gold is inadequately priced. The best strategy, under these circumstances, is to own as much as possible of what so few have in their possession, physical gold. While gold mining shares will perform well along the way (and should certainly be owned), they are much easier to manufacture than the metal is to extract. The same is true for derivatives, or paper gold. A private banker recently told us how he had protected his clients with gold-indexed notes issued by his employer, and that this practice was widespread in his department. We hear similar stories from Asian and European investors. No institution contemplating gold in four digits would issue such paper.

It is difficult to understand how a fiduciary, charged with a responsibility to protect the purchasing power of beneficiaries, not for tomorrow or next year, but for generations, could avoid inclusion of this asset class. At the very least, it should appeal to the growing numbers of TIPS investors, Pimco for example, who have come to distrust the CPI as a measure of inflation.

Any asset allocation analysis that does not incorporate gold, or that lumps it together with other commodities, is pointless. Since 1990, the correlation between oil and gold has been .108, according to our trusty Bloomberg. The correlation between copper and gold has been stronger at .738. On the other hand, gold showed virtually no correlation with the S&P (.039) or the trade-weighted dollar (-.185), while oil correlated in a moderately positive way (.311) and (.279) and copper in a strongly negative way (-.575) and (-.687). What does all this mean? Absolutely nothing. The Bloomberg data covers only a 15-year span of moderate inflation, a statistically insignificant blip in the context of financial market history. 1930 data, not captured by Bloomberg, would show that financial assets and commodities were highly correlated, since both imploded against soaring gold prices.

When will the bull market in gold, still in stealth mode, run its course? The first step would be a recognition, on the part of the financial media, that a bull market has been in place for some time. The second step would be for the same providers of financial misinformation to predict more of the same and explain why.

Still, much more than a supportive financial media would be necessary to declare that the bullish run in hard assets is history. The essential component of a secular top for gold would be an equivalent low in financial assets. Such lows over the past 100 years coincided with the culmination of a financial crisis eliciting extreme response from the government. In those instances, investor expectations were crushed and remained so for several years. In 1934, the Roosevelt administration increased the gold price to $35/ oz., an overnight rise of 69. 3%, the compensation required to persuade private owners to part with the metal. From 1980-1982, the Volcker Fed increased nominal interest rates to double digits and produced a recession, a feat of political will power that seems unlikely to be matched for several years. With the S&P 500 trading at 19x trailing earnings and yielding 1.7%, optimism reigns. For the government and its policy makers of all party persuasions, it is business as usual. It is not necessary or possible to know the headlines that will accompany the onset of a winter in the financial markets. The passage of seasons is ordained in all things, Beardsley Ruml and his co-visionaries notwithstanding. The peak in the current gold bull market will coincide with the end of the road for elitist social engineering, the government wish machine, and the hoax of unlimited dollar issuance.

Appendix

Unlike other commodities, all the gold that has ever been mined remains above ground. This is notionally correct even if it is not precisely so. Gold does not get consumed in the manner of other commodities. While hard numbers do not exist, most would agree to a rough figure of 150,000 metric tonnes of gold have been mined over history. Of this amount, perhaps half can be considered to be in play in the sense that it exists as financial gold. The rest exists in museums, high-end jewelry, and other artifacts where the usage precludes liquidity in the sense of a financial asset. Of the remaining 75,000 tonnes, approximately 31,737 tonnes are held (or thought to be held, depending on the credibility of central bank financial statements) in central bank vaults. Let's assume that all of it is really there, and that some portion hasn't been swapped or lent into the physical market where it might have disappeared forever into the souks and bazaars of the world.

The market capitalization of 75,000 tonnes of gold at $400 / ounce is $960 billion.

(1 metric tonne = 32,151 troy ounces x $400 / ounce = $12,860,400. )

1/10% of 1% of global financial assets of $70 trillion = $70 billion.

Last year's global gold production of 2,593 tonnes is valued at $33 billion.

Therefore, 2. 1 years of mine supply is equal to a diversion of 1/10% of 1% from financial assets to gold.