June 29, 1998 – Investing requires taking action based on a calculation of probabilities, not certainties. And right now the probabilities suggest that the bottom for Gold has already been reached. By implication, we can conclude that a new bull market in Gold is beginning right now. Hard to believe? Well, yes, frankly it is hard to believe, but that is already reason number one.
(1) Bullish Consensus. Bull markets end when most everyone is bullish. Bear markets end when most everyone is bearish. We have now had very low bullish consensus readings four times over the past year – 18% on July 7th with Gold at $318.10, 18% on December 4th at $286.50, 16% on January 12th at $278.30, and 19% on June 15th at $284.60. Any reading in the teens is unusual for Gold, and in the past has generally marked the beginning of a new bull market. Four in-the-teens readings over one year are unprecedented. This extreme level of bearishness signals that a turn is at hand.
(2) M3 Growth. M3 continues to grow at an alarming rate. The annual rate was 11.1% in the week ending June 15th, another 13-year high (see the chart in Letter #225). The Dollar is being debased, which inevitably results in reduced purchasing power brought about by inflation and/or a collapsing Dollar foreign exchange rate, which is bullish for Gold.
(3) Treasury Intervention. For the first time during the Clinton administration, the Federal Reserve, acting for the Department of Treasury, intervened in the foreign exchange markets to sell Dollars. In this case, it sold Dollars to buy Yen. Treasury Secretary Rubin has been adamant in his defense of a strong Dollar, stating that a strong Dollar is in the best interests of the United States. He of course is correct. But now things have changed. At this time, it is still uncertain why Mr. Rubin took this action, but rumor has it that he was over-ruled by the President. By this line of thinking, Clinton wanted his trip to China to go smoothly, so he placated the Chinese by buying Yen, thereby taking pressure off the Chinese to devalue their currency in an attempt to remain competitive with the Japanese. In other words, political considerations ruled over sound monetary practice, never a good sign for any fiat national currency. This action will cause money to flow away from the Dollar, and Gold along with the Swiss Franc and possibly the Deutschemark will be the natural beneficiaries of the demise of Mr. Rubin’s strong Dollar policy.
(4) Japan. The Japanese economy and banking system are on the verge of collapse. Importantly, the price of Gold continues to rise in terms of Yen, and is now probing over-head resistance at ¥42,000 per ounce. A rising Gold price acts much like a barometer, signaling bad weather ahead. The rising Yen price of Gold will further frighten Japanese bank depositors about the state of the Yen and the insolvent nature of the Japanese banking system, so they will act to further withdraw funds from the banks. Bank runs and/or bank ‘holidays’ have to be considered a real possibility, and given the interlocking nature of the world’s banking system, problems in Japan will have worldwide ramifications, all of which will be bullish for Gold.
(5) Asia. The comments above regarding Japan apply to most of Asia. Even though the banking systems of Hong Kong, China, Thailand, Indonesia, etc. are not as important to the global banking system as are the Japanese banks, failures and bank runs in these countries will have worldwide ramifications, and bullish implications for the Gold price.
(6) Derivatives. While on the subject of Asia, bank derivative exposure should be mentioned. For example, the $20 billion bail-out of the Indonesian economy and its monetary and banking system has been delayed. The reason is that derivative exposure not heretofore known has increased the potential need for funds to at least $30 billion, though at this stage, no one really knows the total loss. And as the Indonesian economy continues to slide into an abyss and as the Rupiah sinks along with it, these losses continue to grow. The derivatives losses in the other Asian countries are also mounting rapidly, particularly in Japan and Hong Kong. These losses will add to the growing fear about the insolvent nature of many Asian banks, which will cause depositors to take money out of the banks and convert it into safer vehicles – like Gold.
(7) Currency Depreciation. Many currencies around the world are collapsing. There are different reasons for the collapse, but they have a common thread. These currencies are all fiat currency and therefore rely upon only one basic prop – confidence. And right now confidence in these currencies is collapsing, from the Baht to the Rupiah to the Yen to the South African Rand. For example, the Rand has depreciated by nearly 20% over just the past few weeks. Investors learned a few years ago from the Mexican Peso that once a currency begins to depreciate, it tends to fall ‘off a cliff’, like the Rand is doing now. And investors also know that Gold appreciates in local currency terms as the currency collapses, making a flow of money from all of these countries into Gold inevitable. By the way, the Peso and most Latin American currencies are near or at new record lows, so more currency bad news can be expected immediately ahead.
(8) Currency Instability. After a period of relative calm, exchange rates are again becoming more volatile. Rapid moves of several percentage points within days or even hours are once again occurring. This instability is not good because it causes an increase in awareness of the fragility of most monetary systems, which in turn causes fear to rise. This fear causes people to act, and they typically do so by reducing uncertainty as much as possible. They sell currencies and buy Gold.
(9) Fear Index. The Fear Index of the US Dollar is at 1.37%, a record low. Never before has confidence in the Dollar been this high. Given all of the developing economic, financial and monetary problems throughout the world and in particular, also given the demise of Mr. Rubin’s strong Dollar policy, it seems safe to conclude that the present extremely high level of confidence is unsustainable. Fear will soon be rising, along with a rising Gold price, particularly as the stock market falls.
(10) Stock Market Top. The stock market is looking very toppy. It is already a high risk market because of the extreme level of overvaluation, so if its momentum (which is the only thing it has going for it) now also starts to fade, then look out below! Falling stocks will increase the level of fear, which will in turn increase the flow of money into Gold.
(11) Formation of the ECB. The European Central Bank has been formed, and we will soon learn what its reserve policy will be. We already know that Gold will have a role to play, which is not too surprising given Gold’s historical role and unique advantage as money. Besides, many central banks are increasing their Gold hoard, like the Russians which have just announced a 10 tonne increase so far this year to 525 tonnes.
And as the Bank of France said recently in its annual report: “Neither the U.S. Federal reserve, nor the German Bundesbank, nor the Bank of Italy, nor of course the Bank of France plan to sell the precious metal.” Consequently, the fear of European dishoarding will be lessened, and along with this decline, people will increasingly move some of their wealth into Gold.
(12) Interest Rates. Key interest rates around the world are out of line, as discussed in Letter #223. Dollar rates are too low. Yen interest rates are way too low. Gold’s interest rate has been way too high. Interest rates are a reflection of risk, and there are basically two types of risk – credit risk and price risk. Gold’s interest rate is well above normal historical levels, and should drop as the credit risk of national currencies becomes more apparent as bank failures (in Japan and elsewhere) once again become a front-page topic. Gold’s interest rate will drop as its price increases, thereby bringing a greater availability of bullion supply into the market. The relationship of various interest rates will return to normal levels, which means the Gold price is destined to rise.
(13) Technical Considerations. There are many positive technical factors, but I’ll group them into one reason. These include the high short position in the precious metals at the moment, the extreme oversold level that has been reached, the length and magnitude of the decline, and that both Gold and Silver have recently held important support (see Page 4 for further discussion of this point). These factors are bullish.
(14) US Trade Deficit. The US trade deficit is ballooning. Record deficits – probably over $300 billion per annum – lie just around the corner. These deficits will weaken the Dollar, which probably already peaked against the European currencies in August 1997. A weak Dollar will increase the demand for Gold, and higher Gold prices will be the result.
(15) Foreign & Domestic Debt. As noted above, the United States is flooding the world with Dollars by importing countless foreign made products and exporting Dollar denominated IOU’s. The United States is the world’s largest debtor country as a result. That is not a good position to be in. Debts eventually have to be repaid, but the ability to repay these debts has to be questioned. This skepticism about the level of debts only increases when one recognizes that it takes ever more debt to be created in the United States to get an incrementally smaller growth in economic activity as measured by GDP.
(16) Gold Production. The output of newly mined Gold is expected to remain stagnant, instead of growing as previously forecast. Long-time readers of these reports know that I do not put a lot of weight on production reports. For example, with 85,000 tonnes of monetary Gold in aboveground stocks that is perfectly substitutable for newly mined Gold, does it really matter much whether or not the miners produce 200 tonnes a year less than expected? In reality, it matters very little. However, the new forecasts of slower production are of some importance for one reason. Declining or even stagnant production gets a lot of publicity, and because it is perceived to be bullish, this news should positively effect investor sentiment about Gold.
(17) Commodity Prices. For most of this year, commodity prices have been under pressure. Crude oil slid because a drop in Asian demand led to over-production. Base metal prices were also hurt by a drop in Asian demand. Foodstuffs were hit by a stronger US Dollar and also by ideal growing conditions so far, particularly in the US. However, the good news for lower commodity prices is behind us. Commodity prices will begin rising from here, which will have a bullish impact on precious metal prices.
(18) Credit Risk. In a period of rising confidence, credit risk is rarely questioned, let alone doubted. However, it is an undeniable fact that not all IOU’s are repaid. Inevitably, some loans go bad, and some promises to pay are not fulfilled. Historically, investor and consumer confidence rises and falls along with such factors as economic output, stock prices, etc. When confidence falls, the public increasingly turns to Gold because it is the only money that is no one else’s liability, and is therefore immune to credit risk. Credit risk has been ignored, even forgotten, since the early 1990’s. That disinterest is about to change. Problems in the banks in Asia, and soon thereafter, problems in US banks being affected by the collapse in Asia, will cause the public to once again look more closely at credit risk. When they do, they will recognize that the level of confidence today in the banking system is ill-founded, so they will respond by shifting money out of currencies into Gold.
(19) Great Value. Very rarely does a bell ring when it comes to investing. But a loud bell did ring early this year when Warren Buffett, the doyen of value investors, announced that he had acquired 130 million ounces of Silver. It was a wake-up call that Silver in particular, and the precious metals in general, represented great value. As a consequence, Warren Buffett in effect announced to the world that the precious metals should be looked at by anyone wanting to acquire an under-valued asset, which is the basic strategy that made him so successful as an investor. Years from now it will probably be clear that Mr. Buffett had picked the bottom of the market to accumulate his precious metal position.
To conclude, it is well known that bull markets end in exhaustion, i.e., all buying has been spent. Bear markets end in capitulation, i.e., the last weak hand has sold. Regarding Gold and Silver, we have seen unprecedented capitulation, as well as unprecedented bearishness.
Things, however, do change eventually, and it now looks like the time has finally come for a change in the precious metals. The many reasons for change are there; the extreme level of undervaluation is also there. These factors provide a potent mix. The result could turn out to be an explosive rally in Gold and Silver in the last half of the year.
A rally in the precious metals? An unexpected conclusion? Yes, but bear markets end when least expected.