Gold and Dow Scenarios

Whilst I was channel surfing on foxtel, and reading the West Australian TV supplement on Saturday, I came across the inspiration for another article concurrently. On the golden years special (1980), the hit from The Vapors, "Turning Japanese" graced the TV screen, and after flicking further through the TV guide, I cam cross an ad for Emirates (airline) as opposed to being bombarded with it from Mick Malthouse at every Collingwood post match conference. The main thrust of the ad was based on the airline finally to Perth, with the heading, "A reputation for Gold, A lot like Western Australia". Here we have three major aspects of the financial word, the Middle East, gold and of course the real threat of the US "turning Japanese"

The inflationary-deflationary see saw is now heading towards deflation in the eyes of a number of analysts and this could well have negative implications for gold during the initial deflationary period. I have read various arguments that put forward a case for every type of "flation", and I would expect a flood of new buzzwords to emerge once we finally move away from a low inflationary environment into something far more sinister. For many in the US the thought of the country's economy following in the footsteps of Japan could well be more of a bad dream then reality, however there are some alarming similarities emerging, despite the arguments supporting the US banking system and doubts over a "double dip" recession.

In terms of gold, there are a number of potential scenarios that could emerge relative to the broader financial system. I have noted that many gold enthusiasts, whilst loyal to the cause are actually quite nervous that their investments could be affected in a severe stock market shakeout and have questioned being essentially overweight in the sector.

I must admit to being somewhat apprehensive of where things are heading, despite the fact I remain extremely bullish on the medium and longer-term prospects of precious metals.

THE DOW JONES FRIEND OR FOE?

In early March this year, I wrote a paper for clients, "Valuing the Dow Jones, the case for revisiting 6000", after looking at each of the 30 components and taking their respective P/E's, yields and growth prospects into consideration. I also looked at how an acceleration of the downtrend in the DJIA could affect investor's attitudes towards stocks, and how the selling pressure could snowball. Despite the fact the market bounced at 7532, and we now have calls that a market bottom is in place, I am sticking to the target, and feel that a new "bear market" rally of some strength and duration could actually assist in the process.

A more serious correction could well occur when complacency enters the market, and a number of bearish analysts switch camps in the belief that they were wrong, through the fear of being left behind in the next chapter of the raging bull market.

POTENTIAL SCENARIOS FOR GOLD

One of the major factors that could have ramifications for both the broader market and gold could well be US military action against Iraq, however to an extent the shock value of such an event has been removed, however within the event there could well be a number of associated issues that prevent a quick resolution and escalation of the conflict should such action occur. My preferred scenario is for the continuation of a grinding bear market in both the DJIA and $US, whilst participation in the gold sector continues to prosper along with the share prices of the producers and explorers upon the release of positive results. This situation would be ideal, as market risk is slowly removed, and whilst near-term volatility could well still be dominant it would provide an ideal environment for precious metals investment.

If I knew what was going to happen, or had a magical chart that would point me in the right direction I certainly would not be sitting here penning this article. The best strategy I can come up with is to prepare for each potential scenario, and ensure that some liquidity is maintained to benefit from near-term weakness in precious metals equities.

Scenario 1: DJIA drifts lower along with $US, whilst the POG edges higher

As indicated earlier this is my preferred scenario, and provides an excellent foundation leading into 2003. I would expect the continuation of strong up days in the DJIA and further volatility in the POG, however the dips would provide excellent buying/trading opportunities. This scenario could also provide the impetus for a shift in investor psychology towards gold, and a gradual build up as opposed to a bubble could well be the ingredient for a more sustainable gold bull market.

Scenario 2: DJIA rallies sharply till October/November, Gold remains range bound with the bond market under pressure

In terms of longer-term buying opportunities this may be of some benefit, however having another DJIA bubble forming could well prove dangerous to gold equities as in a dash for cash down the track they will be harshly treated. In terms of market risk, there could well be sharp spikes in the juniors on exploration results, however I would expect they would be short-lived without the POG catalyst.

Scenario 3: DJIA rallies sharply, taking the POG with it whilst the bond market eventually falls over

This scenario would be similar to 1987 in terms of the formation of a mining bubble that could well bring down the DJIA. Those that are able to sell into "irrational exuberance" will invariably do well in this scenario, however bull markets have a nasty habit of turning prudent investors into green-eyed monsters, and the danger in this environment would be similar to the final month of the Nasdaq bubble. The environment for junior explorers would be ideal, and I would expect a flood of new listings and joint venture announcements. Could well provide ideal buying conditions once it the bubble subsequently bursts.

Scenario 4: DJIA crashes in the short-medium term, along with $US, whilst the POG rises in a flight to hard assets and cash

Despite the POG rising, gold equities would be dumped along with other sectors of the market. Shortly after the event I would expect calls similar to 1929 where all is well in the economy. For those with high liquidity levels this would be ideal, as once hopes of a major bounce in the DJIA are dashed I would expect gold and gold equities to strongly outperform the broader market. This event would be somewhat damaging to gold enthusiasts that are essentially "fully invested".

Scenario 5: DJIA trades in a tight range, $US eases, POG slightly higher

This scenario would be somewhat similar to what we have now, and gold stocks would be reactive to short-term fluctuations and exploration programs. I cannot see this continuing in the short-term, as there are far too many outside influences that could alter the current climate and quickly.

Scenario 6: DJIA collapses, $US dives, and the economy enters a deflationary depression

This scenario would be very ugly on a political, social and economic scale, and looking at events in history there is really only the 1932 scenario where gold performed strongly. (Homestake Mining). Not my idea of fun, and hopefully the doomsday predictions of some will not come entirely to fruition. The inflationary cycle that follows could be positive for gold and equities, however I do not really want to find out.

Scenario 7: DJIA grinds lower, inflationary pressures emerge, and the gold price rallies

This could well set up a 1995/1996 style run in gold, where the price exceeded $400oz, before the Reserve Bank of Australia decided to offload some gold, and collapsing investor sentiment towards the sector led to the creation of the shells that were to become the darlings of the dotcom boom. This scenario could well be ideal during the small rate window of opportunity (between significant tightening), and lead to a brief but somewhat enjoyable rally in PM's and commodities.

EXTERNAL THREATS AND FACTORS

• An escalation of conflict in the Middle East, and India/Pakistan and importantly the US and England against Iraq.
• The collapse of a major US financial institution.
• Detonation of the "derivatives time bomb", where gold enthusiasts suspicions are justified.
• Assassination of a key political figure.
• A major natural disaster in the US, Japan or Europe.
• Collapse of the worldwide "housing bubble" with significant falls in coastal areas of major cities.
• China and Taiwan along with the influence of the US.
• Escalation of economic problems in South America.
• Accounting discrepancies emerging on a worldwide basis, and increasing investor distrust in the efficiency of the stock market.

The environment for gold investment is showing tentative signs of dramatic improvement, however enthusiasts should be wary of the risk factors associated with a collapse of the stock market and the advent of social and political unrest. Whilst the mood amongst gold investors appears to be cautiously upbeat, there are no guarantees that even a rising gold price would lead to strong rallies in gold equities.

No sex, no drugs, no wine, no women
No fun, no sin, no you, no wonder it's dark
Everyone around me is a total stranger
Everyone avoids me like a cyclone ranger

                  (The Vapors, Turning Japanese)

For some reason I seriously doubt this will occur regardless of where gold heads and whether or not we get that "double dip" recession leading into a deflationary depression.