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USD Teeters, New Lows Imminent

Today's Highlights:

  • Bearish breadth expands against greenback
  • Gold bears fail to focus on USD as driver
  • The outlook for the dollar is related to real return expectations
  • What else haven't the markets considered
  • Gold equities factor $310, could be a buy now
  • Barrick dances around market's demand

Gold prices could be set to turn up again.

You couldn't tell by Monday morning's selloff on the TOCOM (Tokyo Commodities Exchange) overnight, and the action in gold shares recently. But after watching the major US stock averages stumble early in the session, witnessing a firming of silver and base metals prices, and observing fresh slippage in the US dollar, against currencies broadly, we're set to get right bullish on the metal in the short term (we've been less bullish in the short term since the day gold prices reached our $390 target).

After consolidating for the past month, the Swiss Franc surged to new highs Monday, followed by the Euro - though the new high is more marginal there. The US dollar index has been consolidating its sharp 2002 losses over the past 30 days, also, but currencies such as the South African Rand and Australian dollar continued to soar throughout. Both made new highs against the greenback again Monday - the Rand gained nearly 2% to new 2 year highs, while the Aussie rose 1% to new 3 year highs.

Last week, the Canadian dollar no doubt finally turned heads when it reversed a three year bearish sequence by breaking out of an intermediate chart bottom. Monday it also traded to more than two year highs.

In Japan, the Bank of Japan shocked most pundits last week when it chose a traditionalist to replace BOJ chief Hayami, who's stepping down this month, over an inflation targeter. The move was no surprise to us.

Obviously, a central bank can't really be independent of its government, but it still has to put up the facade (of independence). If it doesn't, confidence in the currency and market system deteriorates more quickly. Many economists argue that deliberating a devaluation in currencies is a legitimate stimulus to real economic activity. I suppose we haven't shipped enough of them off to any one of the numerous developing countries still pursuing backwards inflationary policies as that. They should know better.

Anyway, whether it is deliberate or not, it is entirely possible that one aim of dollar policy is to undermine foreign currency purchasing power by promoting inflationary policies such as (yen) weakening or quantitative easing, abroad.

'Sure, free trade, great, but you should weaken your currency to subsidize your export sector... make more money that way you fellow capitalist you.'

I know, it doesn't sound like anything US policy makers would stoop to. So why is that advice then plastered all over the financial press?

Who knows what the idea of reform is in Japan, or what the US' role is in it, but if it's to make for a sounder or freer market system of production, the idea of weakening the yen is, well, wrong. Besides, the dollar's too weak. The market won't allow it. That was the verdict that yen bear (reformist) Shiokawa, Japan's finance minister, admitted to after last weekend's G7 meet. So after being held back over the past six months by rhetoric, and despite new lows in the US dollar index, the yen too is finally on the verge of a major breakout.

The breadth of the move against the dollar is on the rise, and it appears to be gaining momentum. If the Yen manages to break out of the prospective two year (head & shoulders) bottom, the development would be very bearish for the US dollar. Maybe that was behind the Dow's forfeiture on Monday, to a degree.

The US dollar index has had trouble bouncing during its consolidation. It hasn't in fact. And the fresh bullish momentum in the currencies it is composed against now argues for new lows in this index. Further weighing on the dollar is the renewed weakness in stock prices as well as falling yields over the past month.

Gold Bears Fail to Keep Focused on the US Dollar
Last week, stock bulls were excited about a strong durable goods number and upward revision in fourth quarter GDP that implied a rebound in manufacturing. However, Monday's release of the ISM index (used to be the NAPM - National Association of Purchasing Managers) for February dampened that enthusiasm, because it contracted to 50.5 from 53.9 in January, well below forecasts exceeding 52.

In terms of measuring economic activity in the first quarter, this is an early indicator, though stuff like this never moves markets all by itself. What may be more important for investors is Friday's February employment report. Weekly jobless claims figures have looked dismal all month long, though who knows what the magicians will do to the monthly number.

At any rate, the chalk marks (chart activity) remain bearish for most equities around the world - except parts of Asia perhaps. The bears look set to take back all that the bulls have gained since 1996/1997, in both the Dow and the US dollar. The US averages look very shaky, and a look at the components only makes us more bearish. The Dow looks ready to take out October's low at 7200, which would be a new almost six year low. The significance of it is whatever you might attribute to leaving behind the 1998 low.

In this teetering backdrop, gold prices should reach our $425 - $450 medium term target easily by the first half of 2003. We could be right on the edge of just such a move. But much depends on just how much of the decline in the dollar index has been factored by the move in gold to $390 during February.

Our target for the Dow is 6000 on a break through October's low, plus or minus. Our target for the dollar "index" is about 91. Gold should break through its 1996 high of $425 on such moves, which incidentally, would almost complete the medium term objective of gold's December break out from what many believe to be a five year double bottom - if it were a true double bottom, the implied objective is actually closer to $450.

That may sound conservative to some gold bulls. It is in our view too. It's certainly not as aggressive as our long term (approx.. 5 year) target - $2000.

  Author's Note: the war premium is a marginal "behavior," not unrelated to the fickle outlook for the dollar. I don't buy the idea it can be calculated. We only ever use it to describe the focus of a particular trade. In other words, it could be considered a description of human action.

Individuals can be rational until they're thrown into a group situation. Point being, that a group has to be considered in terms of the whole rather than the sum of its parts... as though it were one individual for instance.

Whether it's rational or not, on some days, this market (crowd) discounts the impact of the war outlook on things. The discussion of a war premium, however, should go no further than describing the focus of activity.

Moreover, as is typical during the early stages of any bull market, there is still widespread media and industry skepticism / criticism of the gold arguments. Most of them sound like this: gold is overvalued due to the speculative war premium.

Few of them ever note that gold essentially forecast the US dollar's breakdown last year, probably because their eyes were off the correct ball. But also, probably because few of them would like to imagine the consequences of further dollar weakness at this point - higher inflation/interest rates, and lower stock valuations.

First there was the Barron's article entitled "Fool's Gold" in mid August 2001 where the author made the case that gold was only up due to the Argentina crisis that summer, and that it was overvalued as a result. Then 9-11 happened and gold went down.

Interestingly, the bull market peak in the dollar index occurred just one month before the Barron's article showed up. The long awaited dollar reversal was at hand we wrote in July of that summer. In fact, gold had already begun its ascent in the spring of that year. Barron's had it wrong. Gold wasn't up because of Argentina. That was driving it only at the margin. Gold prices were already forecasting trouble ahead for the dollar.

Before you knew it, Japanese traders were loading up on gold futures, while producers such as Anglogold began buying back their bearish hedge position.

The next round of verbal assault - by the bears - came one year later in June (2002). Analysts at Barclays called what was happening in the gold market a bubble, as if they were experts on the subject (of bubbles) or something. All year long last year, one political conflict or another was cited as driving gold demand. Recently the rows with Iraq and North Korea have been pinned for gold's glitter.

It stands to reason that if all these unpredictable, unconnected, exogenous things drive gold higher or lower each time they occur, investing in gold must be unpredictable.

However, what the bears fail to understand is how all that news always only impacts gold prices (or any asset price for that matter) at the margin. The core driver is the deteriorating outlook for the dollar, which happens to be a little more predictable, and to an extent, also responsible for the series of events that often fuel buying at the margin, unbenownst to many in the crowd at the time perhaps.

The Outlook for USD = Outlook for Real Returns
The United States economy requires the influx of a large amount of foreign savings each year, or demand for the dollar, in order to sustain the current account deficit at today's exchange rates.

Historically this meant higher interest rates as this demand moderated. But in the nineties we saw it wasn't simply yields that determined exchange rates. We learned that even speculative stock market gains could increase the dollar's foreign currency purchasing power. So the model had to be adjusted.

What we've come up with is that the outlook for the dollar is determined by changes in relative capital market "real return expectations," which we refer to as the dollar's investment premium if it's a currency, or it's liquidity premium if it's discussed in the context of money.

Since expectations for future returns on any asset are in part determined by past performance, it took one year for Wall Street's bear market to translate into a weaker dollar, and it was postponed also because commodity prices fell during 2001, which sustained the argument for improving real returns, at the margin, if only superficially.

In 2002, it all came together for the dollar's bear market - falling performance expectations for US equities, deteriorating earnings outlooks, falling bond yields, and accelerating commodity (or real) prices. All of that implies falling "real return expectations." Then, towards the end of last year, the FOMC continued to lower yields, despite the dollar's newfound weakness, commodity prices continued to soar, and now, finally, those gains are making themselves evident in the government's published inflation series - CPI/PPI.

The US Dollar's Shrinking Liquidity Premium

The case for a bear market in the dollar is gaining momentum again now after a short hiatus last month. The only real chance the dollar has is that either the Dow rallies enough to improve demand - at the margin - or that gold and commodity prices continue to correct.

The sum of our gold outlook then is that the model where gold market moves predict counter moves in the US dollar and same direction moves in the CRB is intact. The correction in gold prices that began early in February probably both reflected the dollar's consolidation over the past month and forecast a correction in the CRB. Gold should continue to lead moves in the dollar. Even in theory, the main concern of gold traders is always the outlook for the dollar - assuming they're trading in dollar terms.

Thus, in light of our bearish outlook for the dollar, the only matter for debate is how high gold is going to go now if the dollar is set to lose another 10% or so, on average this year?

Assuming we're right, you already know the answer. We might be wrong, or maybe we're being too conservative. Only time can tell.

During 2002 gold rallied about $75 while the US dollar index fell almost 20%, and since the bottom in 2001, gold has rallied about $100 while the dollar index's fall is roughly the same at 20%. We might agree that the last 20 point spike in gold prices during January already forecast a bearish resolution to the dollar's current consolidation, but would argue that the aftermath of the potential breakdown has yet to be discounted.

What Else Haven't Markets Considered?
I read Monday that in the event of a US-Iraq invasion, Kuwait might have to shut off up to one third of its 2.1 million barrel daily production rate. What I thought was interesting was the press' take on it. They said that while that may be the case, Kuwait in turn promised to crank production up to capacity at their other wells in order to help OPEC countries flood the (oil) market during a possible crisis.

The problem is that according to a recent report by Merrill Lynch (they're bullish on oil as it happens), they estimate spare production capacity in all of OPEC to be only 2.1 million barrels a day at the moment, placing Kuwait's share of spare capacity at only 30,000 barrels per day (data is from their Feb 21st energy weekly).

My point here is that the media reports I'd read largely omitted that fact, which prompts me to question whether the market has really considered the entire extent of possible supply disruptions in the oil market arising from a US invasion of Iraq, which would just add to the supply problems the market is experiencing as a result of a collapse in Venezuelan oil exports during 2002, which in turn has translated to record breaking falls in reported US oil inventories.

The main downside surprise for oil, and for gold to a lesser extent, I believe is the question few investors might have considered. The US administration has shown determination to disarm Iraq, which perhaps has persuaded investors to accept the likelihood war is inevitable. But the antiwar campaign has been picking up momentum.

Could an invasion be shelved until next year? I don't know. The pundits say no. Still, the prospects bear watching, because I think it would be as much a surprise to the markets as anything else at this point.

It might be more apparent the week after next when UN security council members are expected to have finished voting on the new resolution proposed by US diplomats.

  IMPLIED POG - gold price factored by gold stock valuations in the BGI Gold index (proprietary)
Rate conditions Easy money Neutral money
  15 x C.F.P.S. 12 x C.F.P.S.
Agnico Eagle $365 $415
Anglogold $210 $235
Goldcorp $310 $360
Kinross Gold $275 $295
Newmont $295 $330
Average $291 $327
This model is designed to estimate the approximate average 2003 price of gold anticipated by gold stock investors as they determined the value of the above shares on Monday March 3rd.
• latest quarterly estimates of cash costs of production/ounce providedby the company
• average historic multiples of resultant cash flows per share = 15,thus we use 15 to reflect easy money conditions (i.e. low yields, or discountrates) instead of traditional 8, which is unrealistic in practice
• estimated 2003 production rates are assumed to reflect future production
• value attributed to mine life is excluded in the calculation • Newmont and Anglo's lower values reflect risk premium tied to hedgingpositions
• cash holdings per share were discounted to reflect the premium inthe stock attributed to them
• implied gold prices in the table above reflect the average POGfor any particular fiscal year

Gold Stocks Factor $310/oz.
Gold shares continued their slide Monday. The AMEX Gold Bugs index finally nailed our first short term downside target (the 200-day moving average), and appear likely to head lower for another day or so. However, they could be nearing the end of their countertrend move, particularly if our gold price outlook is correct.

Moreover, our gold share index suggests investors are factoring just a $310 average gold price for 2003, approx.., as of Monday's stock market closings.

That was about the average gold price most gold producers realized in 2002. Meanwhile, the average gold stock is down 20% since February's peaks. Our index is down 10% from its peak.

At its peak values in early February, for instance, Goldcorp's shares implied an average $415 gold price this year (range was $380 to $450). Today their market is saying gold is worth only $335 this year ($310 to $360, see table).

We might take it as a bearish indication for gold prices if the technicals confirmed it with intermediate bear signals in either the leading gold shares or gold itself.

Instead, we are taking it as a sign of too much bearish sentiment during a correction.

Since our outlook for the dollar remains bearish; because the main trends in the gold sector remain bullish; and because bearish sentiment is both relatively extreme and typical, our bet is gold stocks are about to put in a bottom. That's a change in our short term outlook. On February 7th we issued an alert warning for a dip to around the current level in gold shares - a little lower actually.

By typical I mean in that confidence at the early stages of any bull market is typically fickle, and so is the allure of seemingly logical sounding countertrend arguments in the midst of any correction also typical.

Barrick Dances Around Market's Demand
Still missing from the bullish picture nonetheless is any indication that Barrick is serious about reducing its hedge position, or that Anglo has been back in the market since December.

A New York Times article wrote Barrick up in a bullish light this weekend. But there was no indication by the author that the company is doing anything much different except perhaps their 'splaining how their hedges are different than others.

Our comments, which went out to subscribers by email on Saturday, are published below. They conclude that whether Barrick proponents expense negative changes to its hedge book or not, the market should, has, and probably will continue to.

My question is, who's Barrick trying to fool with this article? Is there something in the structure of their hedges that outright prevents them from liquidating them, besides, well, the fact that futures traders'll probably see them coming from miles away!?!

Edited Weekend Note on Barrick's NY Times Plug: An article about Barrick was published this weekend. In it, the journalist builds the case that Barrick's hedges can be postponed almost indefinitely (so long as the counterparty agrees), and that the company's hedge program has been successful because it has enabled a $65 premium over spot prices in recent years.

The journalist also criticizes Blanchard's lawsuit against Barrick by quoting one lawyer as saying if anyone knew anything about gold they wouldn't blame a central bank or producer for manipulating it because its value is derived by "moves mostly on the U.S. economy, interest rates and inflation."

Duh, and I mean duh... for if not the central banks', whose job is it to manipulate interest rates and your perception of inflation? Well, we think Blanchard and co. is wasting its time in this lawsuit for a few different reasons, and we would agree that producers don't really have an interest in suppressing gold prices. However, anyone with a legitimate understanding of gold prices (I say it pointedly because the press also likes to infer everyone else is stupid) and how they're derived should have no trouble understanding why and how a central bank can manipulate gold prices without ever having to touch the trade - by manipulating your perception of inflation, i.e. what is real and what isn't.

Anyhow, the point I wanted to bring to your attention is this idea inferred by the article that the hedges Barrick maintains are neutral to its financial condition.

First, it's true that Barrick doesn't have to put up any margin if the position goes against it. But this owes to its credit rating, and at $800 gold, for instance, I wouldn't bet this to still be the case if the marked to market value of its hedges grows to a negative few more billion dollars. Over the past one year alone, the company's "unrealized" marked to market value of its hedges have eroded by $1 billion US dollars (from a positive $356 million at the end of 2001 to a negative $639 billion at the end of 2002). That's a little more than US$12 million for each $1 gain in gold prices last year. Judging by Barrick's share price performance in 2002, the market certainly "realized" that swing.

With 20% of its proven & probable reserves hedged Barrick can't fully participate in a gold bull market unless its hedges are systematically reversed. It doesn't matter how the always bullish press slices it.

If the company chooses to postpone delivery into its hedgebook, and gold prices are rising, it might indeed receive a better gold price in the spot market by doing so. However, the marked to market value of their hedges would also continue to deteriorate against its cash position, and should be expensed, thus creating a lower performance picture anyway.

Not expensing negative shifts in the marked to market value of those hedges could only be justified if one excludes the possibility that gold prices stay up once they go up - during a secular economic/monetary bust. In other words, investors would have to assume gold prices will come all the way back down. For, if they stayed higher on average, as they have at each significant revaluation of gold/dollar this past century alone, following Barrick's advice, investors would have to wait 10 or 15 years before they count the loss, by which point, the company might finally acknowledge its financial problems too.

Maybe the journalist community would be surprised then, and they could write bad things about the company in hindsight like they're paid to. But I'd bet the market wouldn't be surprised, and I would be surprised to see any investor hang on long enough to wait for the company to admit its problems. Barrick may have learned how to fool investors, just like the central banks have learned how to fool... most of them... some of the time.

However, at this point, if Barrick really wants to participate in a gold bull market, the company must extend its hedge reduction program aggressively beyond what gold it delivers into it each year.

Anything less is simply like pulling the blinds down over investors' eyes. Barrick's waited out the first $100 leg in gold prices. For all we care, it can wait out the next $1000 gain in gold prices. Our clients'll have plenty of money to pick up the pieces. But we won't buy the stock until the company indicates it's buying 'em (hedges) back!

p.s. if the stock rises following the NY Times article, the question we'd have to ask is whether it's rising because of a new perception of the same problem, or because there are indications that the company is planning to buy back its hedges over and above those that expire in the year.

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