Gold Market Update

The gold market came to life during the eight trading days through Friday, rising $ll.90 to $280.50 an ounce. Both volume and open interest, which had declined to historical lows, rose with rising prices. Despite mysterious selling from time to time on several days, gold closed at or near its daily high. Conspiracy or not, there are forces whose interest is to have an unnaturally low gold price be maintained. In our view these forces will be overwhelmed provided the investing public senses the urgent need for gold to protect against increasing currency volatility and turmoil. The following is an assessment of why this may develop:

1. The world has been operating for eighty-seven years with an increasingly undisciplined monetary system, leading to an enormous credit expansion. On top of a bloated credit structure, corporate debt expanded 60.8% during the last five years. Financial debt, the source of proliferating speculation, almost doubled. Something similar happened in the 1970s, but much of that debt was inflated away. Even in the bubble economy, debt has not been inflated away. This was also true in the shorter and more restrained bubble of the 1920s and its aftermath. Debt doesn't matter until it matters, and then it's all that matters.
2. (2) The two remaining bubble areas are real estate and the U.S. dollar. Real estate is the most debt laden major sector of the economy, with both the owners and their creditors highly leveraged. Government Sponsored Agencies, involved in at least 40% of residential real estate loans, operate with a 97% debt to total capital ratio, a ratio that would make even highly leveraged banks flinch. Average home owner equity is at a record low and loan to value now approaches 100% for new mortgages. Home prices, like the last bull phase of the Nasdaq, have been reported to be rising exponentially, but rumblings are heard. Silicon Valley is obvious, but watch the heavy industrial and financial centers. Commercial real estate has its own problems as Monday's Wall Street Journal duly noted.
3. For years, the U.S. Dollar has defied the gravity of a growing current account deficit by attracting huge amounts of foreign capital. New direct investment has already shriveled, making the dollar dependent on highly mobile portfolio flows. Corporate debt issuance, which appeals to yield seeking foreigners, was a record in the first half, but will likely slow to a trickle in the second. It is no secret what a persistently weak Dow might do. Argentina, with its absurd currency board is a wild card. Possible contagion of a debt default and devaluation has been debated endlessly. The case for contagion is that, unlike the l997-8 crisis, the world is close to recession. US and European recessions, renewed fiscal difficulties, a weak dollar and a disinclination by the United States to intervene would not bode well for currency stability. Already Singapore and Taiwan are in recession, others are close. The risk is that these nations could throw their vast foreign exchange reserves into the market, hoping to support their currencies and economies.

Who would this hurt the most? The industry and banks of Spain, a euro nation, are heavily committed to Argentina and Mexico and so are U.S. banks. Mexico, despite its strong currency and stock market, is showing troubling signs of a current account deficit and faltering economy, which would be exacerbated by a U.S. recession and lower dollar. Treasury Secretary Paul O'Neill said recently: "The hot money may have to take a bath". Once we learn who supplied the hot money, a cold shower may be more appropriate. It goes without saying that neither the euro nor the yen are suitable to replace gold as a haven from a falling dollar.

Confidence is the key. Benjamin Disraeli defined confidence as "Suspicion asleep". Here is an example. On August l7th the New York Times reported that the Bundesbank painted a gloomy picture for consumer spending, machinery and equipment, exports and construction. The same day The Financial Times headlined: "Bundesbank Upbeat"' referring to next year's forecast. Next day the White House forecast 3.2% economic growth next year. The truth is, however that "is" still means "is" and "may be" still means "maybe". But the best example of suspicion asleep was Marco Polo's description of the creation of paper money which he first saw in China in 1271 AD: "All these pieces of paper are issued with as much solemnity as if they were of pure gold. A variety of officials write their names and put their seals on the paper. The chief officer smears the seal with vermilion and impresses it on the paper so that the seal remains printed on it in red. The Kahn each year creates a vast quantity of the money which he exchanges for gold and silver, so that the great Kahn has more treasure than all the kings of Europe."