Gold Market Update

The tragic events of September 11th immediately resulted in a capital flight to safety and quality. The price of gold, the traditional store of wealth for thousands of years, jumped approximately 7 % to $290 an ounce. The prices of gold mining shares also rose about 7 %. The prices of both gold and gold mining shares have subsequently made strong consolidations. Growing retail investment demand for coins and small bars has been reported in many parts of the world. The CFTC reported that large speculators increased their net long positions from 64.8 tons in early September to 113.9 tons on September 25th. Gold mining shares continued to outperform the market during the third quarter, as they also did during the second quarter. The Philadelphia Gold/Silver Stock Index climbed 9 % during the third quarter while the Standard & Poor's 500 Index fell 15 %. Gold and gold mining shares, of course, also outperformed T-Bills.

Will gold and gold mining shares continue to outperform the market? No one knows the answer. Briefly, here are our views:

1. Following the September terrorist attacks many economists expect a recession during the next few months to be followed by an upturn next year. However, the extent of the U. S. military action and the prospect of further terrorist attacks have multiplied the uncertainties in a vulnerable global economy. In addition to increased fear and reduced business confidence, profitability and investment spending, the index of consumer confidence dropped 16.4 percentage points in September, the largest one-month drop since October 1990. Declines in the rates of consumer borrowing and spending, especially if the housing bubble bursts, and consequent increases in the personal savings rate and cash holdings, could prolong a period of weak U. S. economic activity and overwhelm the Fed's power to stimulate the economy by lower short-term interest rates. Low or negative real rates could be counter-productive if they cause households to save more. Deflation cannot be ruled out.
2. Even though a bear market has begun, stock prices are still high historically and vulnerable to lower price-earnings ratios and higher equity risk premiums if investor confidence is further eroded. Earnings may be impaired during a prolonged recession due to excess capacity and competitive price cutting. Employment cost increases may be slow to adjust. The quality of earnings may be overstated. The ratio of the Dow Jones Industrial Average to the price of gold has declined from a peak of 42 in February and June this year to 30 currently. It was 1 in 1980. A "reversion to the mean" move could imply that gold could continue to outperform the market for some time.
3. Financial stress, credit risks and term risks have been growing. Corporate spreads have risen, making financing conditions tighter. Spreads on high-yield bonds climbed from approximately 6 ½ % in early September to over 8 % currently and are at their widest since December 1990. Default forecasts have been raised and are expected to be higher next year. International risks are high. The yield curve has risen from around 2 % to over 3 %. The huge U. S. private sector debt expansion may turn out to be excessive and may have to be corrected. For instance, outstanding domestic financial sectors debt soared from $ 35 billion (6.4 % of GDP) at the end of 1961 to $ 8.4 trillion (84 % of GDP) at the end of 2000, up at annual average rate of 15 % a year, well above the real GDP growth rate averaging 3.2 % annually. The cost of servicing this debt could pose an unsupportable burden if corporate cash flow and personal income were squeezed during a prolonged recession. Long-term interest rates could increase if inflationary expectations rose or if capital inflows to the U. S. dried up. A financial crisis may not be avoided.
4. The expansion in business and household debt, plant capacity and consumption during the boom of the 1990s may have been excessive. If so, it may take longer than expected to correct them and restore balance in the economy. Reducing interest rates and increasing government expenditures may be counter-productive. Accordingly, investors may become more risk-averse and seek to preserve wealth by increasing the defensive portion of their portfolios. This could include gold as well as cash and T-Bills. Gold is a default-free and currency risk-free monetary asset. It usually has a negative correlation with equities. A precautionary increase in the investment diversification into gold seems to have begun. This policy could again be prudent and improve a portfolio's overall performance. A relatively small increase in the investment sentiment and demand for gold could result in continued profitable performance for gold mining shares.