Gold Quarterly Review

Gold shares performed well on a relative basis during the first quarter, even though they under performed gold bullion itself which scaled the $1000/oz. threshold on the market panic surrounding the rescue of Bear Stearns by the Fed and JP Morgan. In the aftermath of the bailout, the financial markets have resumed some semblance of normalcy and media pundits are proclaiming that the worst is past. In other words, we are back to business as usual. We disagree and will elaborate below.

During April, the precious metals sector has suffered a sharp correction on the perception that the Fed rescue has once again “fixed”what was ailing the financial markets and economy. As of this writing, gold has retreated approximately 15% since its March 18 high, and could correct somewhat more although probably at a slower rate for a few more weeks. The XAU (Philadelphia Stock Exchange Gold and Silver Sector Index) has given up 19% since its high of 206 on March 14. Again, we believe this correction could extend for a few more weeks. In both cases, itis this type of sharp selloff that sets the stage for a rally to new highs after shaking out weak holders and momentum players who climbed aboard late in the game.

The pivotal event of the first quarter was the “bailout”of Bear Stearns. In reality, the bailout concerned much more than an unfortunate brokerage firm that is soon to be history. As has been widely noted by astute observers in the financial press, JP Morgan and the Fed were forced to act because JP Morgan was counterparty to Bear Stearns on countless derivative transactions. A failure of Bear Stearns would have imperiled JP Morgan and caused a run on the global banking system. As stated by David Einhornof GreenlightCapital at the Grant’s Investment Conference on April 8, 2008,

The government appears to have determined that the collapse of asingle significant player in the derivatives market would cause so muchrisk to the entire system that it could not be permitted to happen. In effect, the government appears to have guaranteed virtually the entire counter-party system. As night follows day, it is certain that in the absenceof tremendous government regulation, this bailout will lead to a new and potentially bigger round of excessive risk-taking.

So, what has changed? Just another government bailout of the murky and little understood derivatives market which has become the principal mechanism by which global credit is distributed. The rescue has bought time but not changed outcomes. For outcomes to change, aregulatory regime must be implemented and this will take much time and acrimonious debate.In the process, credit will be frozen at best and quite possibly continue to contract.

Gold cycles last many years, even decades. The current cycle began officially in August 1999 when gold bottomed at $252. The prologue to this cycle was an unprecedented buildup in credit, culminating in the practice of reckless investing first in dot com stocks and then other NASDAQ securities. The Fed response was easy credit and excessively low interest rates for an extended period. The capital market response to the dot com bailout was an orgy of structured finance and credit speculation which is not limited to the subprime mortgage sector and permeates the financial system, in our opinion. What will follow this most recent bailout is anyone’s guess.

It is the unwinding of previous credit buildups and excesses that fuel investment demand for gold. It was the availability of excess credit that inflated asset values, including housing, and it will be the subtraction of credit that will continue to deflate asset values and generate associated credit losses.

Government policy is faced with an impossible dilemma. First, it could let market forces run their course leading to outcomes that would be politically unacceptable. Second, it could devalue outstanding debt burdens that are weighing on asset prices, including and perhapsespecially housing, by debasing the dollar (inflating). Any doubt that the government has embarked on the latter course should be eliminated by an examination of recent changes in the balance sheet of the Federal Reserve. The once pristine finances of our central bank have been compromised as high quality government securities have been replaced by loans to financial institutions collateralized by assets which those institutions presumably could not liquefy in any other manner.

Market volatility notwithstanding, it is essential to stay focused on the investment rationale for gold. It is a time proven strategy for protecting and even enhancing capitalduring a downward credit cycle.