Gold: Darkest Before Dawn?

On September 28, 2000 Salomon Smith Barney provided a very bullish report on gold titled, "Gold: Darkest Before Dawn?" Major pints made by the report were the following:

1. Long suffering gold investors have all but given up… We believe they shouldn't.

2. We see gold as a three-way battle between supportive fundamentals, central bank liquidity, and bearish supply-dominated sentiment.

3. With greater central bank transparency and lending near its limits, the stage is set for gold's commodity deficit to be felt. Investors will have to step up for any rally to gain traction.

4. Macro themes have assumed prominence, and it is virtually impossible to discuss gold prices without a view on the U.S. dollar. Broad-based growth is the best prescription. A hard landing in the U.S. could be negative…or explosively positive.

5. The fragmented, out-of-favor gold sector is ripe for consolidation. Drivers are an exploration collapse, capital unavailability, and the need to appeal to a broader value-investing audience.

I believe the analysts who have written this report have honed in on the most important issue effecting the price of gold, namely gold leases from central banks.

Unlike the World Gold Council, which has in my view undermined the gold mining industry, the authors of the Smith Salomon report at least kept an open mind. They mentioned the low ball estimate of the World Gold Council of 4,750 metric tons. But in fairness, they acknowledged that higher estimates by Veneroso Associates and others (like GATA) which they say are in the 6,000 to 8,000 metric ton range (Frank has actually talked about a range of 10,000 tonnes to 14,000 tonnes range) are possible.

The report said, "In recent years the gold market has been utterly dependent on ever-spiraling lending growth to plug the gap between sales/scrap and fabrication demand. This has provided the liquidity for producers to sell forward and speculators to go short; taking a longer view, it is important to recognize that when this metal comes out of the vaults it is largely absorbed in fabrication and thus may not be readily available in a pinch."

The report also said, "…..We look to total lending as the single best measure of the aggregate short position in the market. This equates to a minimum of two to three years of world mine production and is simply too large to ever be repaid. The belief that lending is reaching its natural limits and cannot continue to grow at 20% to 30% per year is central to our thesis that the commodity gap matters, and that higher prices will ultimately play a role in re-establishing physical market equilibrium."

There are things in this report I do not agree with such as the notion that gold demand does not rise when its price falls. Especially in the low carat American markets, jewelry producers use less gold in the jewelry when it's the yellow metal rises in price. They may sell just as much jewelry in dollar terms but they use less jewelry by "hollowing out" or pushing more silver or lower cost gold alloys. Dr. Larry Parks (www.fame.org) has carried out a considerable amount of research on issue and I think he is exactly right about the elasticity of gold for jewelry.

I also do not necessarily agree with the authors of this report that the U.S. Government is not dishording gold. Why would we believe our government's declaration of that fact when they refuse to allow our national gold horde to be audited? These same folks do not believe nor do I believe they understand the reasons why the price of gold must be retained at low levels to keep the existing financial system in order.

But aside from these disagreements (which are not unimportant) the Salomon Smith Barney analysts at least are focusing on the most important issue facing the gold markets, namely leasing gold. What will they conclude if, as has been the case with prior bullish forecasts, the price of gold continues to decline and central bank leasing continues to rise beyond the limits believed to have been established by the 1999 Washington Agreement.