Sep 4 2008 8:42AM

Market Update

The  gold price was hammered down 20% over the past month as investors suddenly regained confidence in the U.S dollar. The explicit commitment by the federal government to prop up the two ailing quasi-government mortgage agencies (Fannie Mae and Freddie Mac) seemingly dispelled investor concerns over further damage from the credit crisis that erupted a year ago.

The Federal Reserve has already lowered the interest rate it charges on loans to the banking industry to a level that is less than the rate of inflation.  In essence, those government loans are cheaper than free. The promise of further government freebies for the banking industry was warmly received by investors who seem oblivious to the long-term consequences of the government’s largesse.

The new-found view of dollar invincibility gave at least a few investors enough confidence that they simply bailed out of gold and other commodities that had provided an element of currency hedge.  Like a flock of frightened birds, other investors followed the lead and took flight from gold and other hard assets.

Many of the investors following that lead had little understanding of what caused the flight from gold, or even if there was a good reason.  The attitude seems to have been: “If everybody is selling, then that must be the right thing to do.”

It was less than five months ago, after the implosion of Bear Stearns, when headlines were warning of a complete collapse of the American financial system and a spread of the financial woes to the rest of the world.  All it took to
restore confidence in the economy and in the dollar, at least in this moment, was a belief that the government would provide a bailout. Investors don't seem to realize that in agreeing to prop up Fannie Mae and Freddie Mac, the American taxpayer has effectively taken on another $5 trillion of debt, bringing the total burden to $14 trillion. Investors seemingly don't care that the financial rescue plan is predicated on simply creating more dollars out of thin air.

Like an exploration company that keeps churning out new shares without producing results, the effect of printing massive amounts of new currency must eventually impact the underlying value of the dollar. But, to most investors, that is a story for tomorrow. Today, the system seems secure.

It is all too natural for investors to get caught up in the moment.  Few people remember that it was just over two years ago when the gold price took an even bigger hit, dropping 22% in a month to $567 on June 14, 2006.  At that time, headlines were calling for the end of the bull market in gold, as they do each time after the precious metal drops in value. 

While the headlines were telling investors about the great fall of gold, the precious metal began its biggest move ever, soaring 82% in less than two years.

In June 2006, that massive drop in the gold price seemed terrifying. When you look at the gold price chart over the past few years, that drop which seemed so huge at the time barely shows up on the long uptrend.

While speculators flit in and out of the gold market, seemingly propelled by little more than Internet innuendo, the physical buyers take a far more rational approach to the market.  When the speculators are clamoring to join the upward momentum, pushing gold to record highs as they were last March, the physical buyers wisely stand back from the market.

Once the speculators flee the market in panic, the physical buyers come back, quietly picking up gold on sale. That is exactly what is happening at this moment, with physical buyers providing support for the market as they have after every dip.

There is some confusion about the figures related to the gold market. The volume of gold traded by investors over a year appears to be far in excess of the physical market. As a result, some investors, and even some commentators, attribute a far greater level of importance to investors as drivers of the gold market.

However, one must remember that paper trading in gold involves a buyer and a seller. In simplest terms, a piece of paper representing an ounce of gold is traded many times over the course of a year. Only to the extent that more ounces of gold are drawn into the investment realm do investors impact the gold market.
Clearly, investors and speculators do impact the markets, creating the temporary spikes and pullbacks that are so much a part of the gold market. Physical supply and demand are far more important as long term drivers of the market.

As a basis for this commentary, we have reviewed the factors impacting on supply and demand for gold.  In the next issue, we will present a more comprehensive analysis of the gold market, detailing the trends of the most significant supply and demand factors. For now, suffice it to say that there is nothing to suggest a break from the pattern that has prevailed for the past seven years. Investors who buy on the dips and take profits on the spikes have done even better than those who hold for the long term.

Since the middle of 2001, the gold price has more than tripled.  If the Dow Jones Industrial Average had kept pace with gold during that period, it would now be in excess of 30,000. Instead, the Dow is at about the same level now as it was 7 years ago.

All commodities were hit over the past month as the entire sector suddenly fell out of investor favour. In part, the
renewed confidence in the dollar played through the commodities world. Many of the commodity prices had been pushed up too high, totally out of balance, by investors who had simply jumped on the bandwagon with little understanding of the underlying fundamentals.

We have watched the speculators coming and going from the metals markets now for several years. You can see the pattern in the copper price chart, effectively creating froth on top of the longer term trend. Not surprisingly, when investor sentiment turned against commodities, the related companies were hit even harder. Some are comparing the present situation to 1997, when prices went into a multi-year dive.

The situation now is totally different. At that time, the emerging Asian economies had just tanked. Growth in the so-called Asian Tigers (South Korea, Taiwan, Singapore, Malaysia, Indonesia, Hong Kong) stalled after a currency crisis. China and India had not yet started their ascent. At the same time, a massive amount of new metal production capacity had just come on stream, the result of a huge development boom that went on through the 1980s.

Now, the Asian Tigers are a mere side-show to the spectacular growth in the much larger Asian nations. Mining industry spending in this cycle has been primarily aimed at acquiring existing production, with only modest new capacity having been added and nowhere near enough new capacity in the pipeline for supply growth to overtake demand growth.

The above copper price chart reflects the underlying strength in the metals markets, even as speculators flee the sector. The commentary in the popular press is saying that the metal prices may not increase in the near term, setting a negative tone for investors. However, there is no mention of the enormous value in the companies that hold development assets.

Copper exploration and development companies are still being valued on the basis of a long term copper price in the area of $1.50. It should be clear by now that the price is going to remain well above that level. If those companies have value at $1.50 copper, imagine their value at $3.50 copper. The story is similar for the other metals.

Remember, we are not counting on the metal prices rising further to generate value for investors. There will be huge gains to the extent that the metal prices merely remain above the historic averages. By now, it must be getting clear that the historic averages are merely history.

At this time, the market is obsessed with the near term, and has completely lost sight of the bigger picture. For those with enough patience and courage, the present market offers outstanding bargains


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