Gold and Debt Reflect Mood Swing

Since September 11th, I have suggested that the investment emphasis was poised for change. This was not based upon the terrorist attack alone, however the new war does serve to accelerate and expand the mood swing. The foundation for our current quandary was poured during the 2000 summer. The exceptional exuberance from our prior decade had saturated the market. Subscribers should recall my initial analysis of The Journal of Commerce shipping columns. A dramatic decline in commercial transport suggested that the economy was rapidly slowing down. My warnings that equities would fall victim to this decline were unrecognized by compatriots in the stock market sector as more bottom predictions made headlines in The Wall Street Journal, Investor's Business Daily, and The New York Times.

The revelation that Merrill Lynch and other big-name brokerage houses gave bogus stock analysis in favor of investment banking divisions was shocking, but logical. These firms hire some of the sharpest analytical minds in the business. It seems clear to me that the same indicators I was examining were under the scrutiny of these other highly qualified analysts. Simply put, the pending economic condition was fairly obvious.

This is not to say that the general public should have known better as Neil Cavuto of FOX News suggested when debating Bill O'Rielly over the Enron debacle. The public is usually trusting. The blame rests squarely with the analysts who violated the public trust.

Interestingly, analysts have been slow to correct the fundamental misdirection. There is still an underlying insistence that all will be well in the weeks and months ahead. Regardless of fines imposed and potential class actions, Wall Street is conducting business as usual...recommending stocks. This seems to be meeting public resistance as reflected by the Dow Industrial's inability to sustain above 10,000 while the S&P 500 gyrates around the "fair value" mark. In the meantime, gold funds and stocks have soared with relatively little fanfare from the analysts. In fact, some say gold is "overbought."

In my attempt to keep my finger on the equity pulse, I interviewed several stockbrokers and financial planners about their current portfolio recommendations. Virtually all believed U.S. debt was "overdone" along with the gold sector. All were looking for "opportunities" in the chip sector and healthcare (inclusive of pharmaceuticals). In the meantime, 10-year notes continued to rally along with gold and related stocks.

We are in a "quality" mood. Even with encouragement from the Federal Reserve and prospects for a 1/4-point rate hike in August, investors would rather be safe than sorry. This flight to quality comes at a seemingly unusual moment. We do not have an inflation problem, yet. Excluding energy, prices have been stable to lower. Labor productivity is up while wages have remained static. Hmmm...what's wrong with this picture?

The answer is, "Nothing." Gold is a hedge against uncertainty. The current uncertainty is not over the value of money (thank heaven), it is based upon alternative investments. There are no alternatives. With money market and short-term yields at historical lows, the only alternatives are investment assets with reasonably assured base values and returns. Within this category, 10-year and 30-year government paper provides liquidity and yield while gold offers the ultimate security.

The gold story is more extensive because it has broad international underpinnings. While our focus is upon the War on Terror, India and Pakistan are bristling. My sources tell me significant gold is being moved to "safe havens" as a precaution. Many from both countries are taking families on extended summer vacations. We cannot comprehend the fear currently sweeping the Subcontinent. At the same time, over 100 metric tons of gold has moved from the Middle East to Indonesia, China, and Switzerland. While this is not a huge quantity, it represents a beginning. My sources indicate an additional 100 metric tons is waiting for a direct buyer.

Despite the trend's dramatic slope increase, there has been no lack of sellers. This rally is being comfortably fed by producers and swap transactions. Thus, any rumor that there is a "squeeze" in gold is unfounded. As with all trends, there are skeptics who envision a return to December lows.

The daily chart shows a classic recovery from a rounded bottom with a three-tiered slope acceleration. Technically, we could see a correction to 31400 or even 30700 without interrupting the interim uptrend. Given the distance already achieved in such a short period, such a correction would be healthful for a market that has remained anemic since the U.K. completed its first auction.

Currency Consolidation Strategy

The last time gold showed signs of life, the Euro was still in planning stages. As the EC weaned itself from gold as an "official reserve asset," many believe there was a concerted effort by central banks to depress the yellow metal in favor of the "all-paper" economy. Whenever there is a currency conversion, confidence is paramount. Any deviation from full faith in the creditworthiness of paper can send a new currency spiraling downward.

I know there have been numerous stories and even a lawsuit filed with claims of conspiracy. The problem with conspiracy theory is that the very pressures applied by the alleged conspirators makes the market. This is to say that Japanese dumping of microwaves to capture market share creates oversupply and drives prices lower and sends U.S. manufacturers packing. Eventually, the intervention fails because the cost exceeds the benefits or the objective is achieved.

In a way, you can claim the Euro is a conspiracy by European Member Banks to manipulate the money supply. Of course it is. Who is issuing the money? The key is not to complain that the price is artificially low. The market price is always correct. The objective is to take advantage of the intentional skewing between buyers and sellers by selling with the crowd or buying on at more favorable decreasing prices.

The Gold Council makes a point that all portfolios remain unbalanced if they do not have a portion dedicated to hard assets like gold. This is because gold's appreciation potential becomes exceptional relative to conventional investments when paper begins to deteriorate. Just before the rally, members of the Council pledged over $100 million to bolster gold's tarnished image. They would be wise to read the literature on this noble metal. Gold doesn't tarnish.

The most recent double play involves buying gold while selling U.S. Dollars. Gold's appreciation in dollars is partly due to the dollar's fall against other currencies. If there is any doubt, observe the chart of June U.S. Dollar Index (top) to June gold (bottom). Essentially, you are viewing a mirror image. For an Australian buying gold in U.S. Dollars, the appreciation is muted against his or her home currency. However, any depreciation of dollar parity can be offset by buying an Australian Dollar hedge or selling a Dollar Index hedge. Alternatively, one could execute this protective strategy using options. With options, you need a balance between price responsiveness (Delta) and cost.

Gold's popularity among sophisticated investors receives an additional boost from the more direct parity correlation. True to form, gold retains its purchasing power parity without interference from interest rate policy.

In contrast, the dollar is supposed to respond in tandem with U.S. interest rates. When rates rise, the return on U.S. denominated instruments becomes more attractive. This strategic stance was formulated after currency was completely de-linked from asset accounting. During the transition from 1972 through 1980, a rising interest rate was indicative of a defensive stance against a deteriorating currency. It was a warning to flee. Equally important, the strategy when rates were disproportionately higher was to buy the interest-bearing instrument and sell the equivalent underlying currency as protection against deteriorating currency parity. Thus, a "pure" rate of higher return could be achieved.

Today's logic has been turned because currency is a commodity as well as a means for exchange. This confusion and exposure to contrary logic is absent from gold where there is a single purchasing parity assumption and, hence, relationship. We should not be surprised to see gold reemerge as a de facto monetary standard if the Dollar becomes more substantially unglued.

Silver Lining Or Trail?

Is gold pulling silver or do silver fundamentals stand alone? This week's Wall Street Journal covered digital photography (a favorite subject of mine) in Mossberg's "Gadgets" column. The article seeks to "demystify" this increasingly popular technology and essentially confesses to the reality that a 4.0 mega pixel digital image in an 8 x 10" format qualifies for any size enlargement (within reason) without distortion. This medium has come of age and is rapidly encroaching upon conventional film.

Granted, my original prediction for silver's demise was aired on the NBC Today Show back in 1988. I was premature in theory, but correct in my assessment that silver's foreseeable future remained bleak. This opinion is echoed in my book, The New Precious Metals Market. As a "poor man's gold," silver has displayed equal enthusiasm for the long side. I am not one to buck a trend. However, where gold has a substantial horizontal base that includes coins, bullion, jewelry, certificates, closed and open ended funds, and mining stocks, silver is more limited. The efficiency of solvent extraction technology in base metal refining has made silver an increasingly inexpensive byproduct. I am not one to hoard silver bullion. It can tarnish.

The wake-up call in metals has stimulated general interest in commodities. How does the song go? "If I can make it here I'll make it anywhere...It's up to you New York?" Well, metals are traded on the New York Mercantile Exchange COMEX division! Yet, other markets are receiving a benefit. Commodities are about the only place where you can make a positive return. With stocks becoming as volatile and "risky" as futures, why not get the better return from more leveraged financial vehicles?

Strategy

We have been taking advantage of volatility to sell call/put strangles in interest rates, stock indices, and energy. As silver approached $5, I am tempted to sell calls against our futures as partial protection against a correction. At the least, we would achieve the additional profit from current levels to the strike...say 525. We can also pocket the premium. At worst, our futures would be stopped and we would cover the call at the lower price while liquidating the futures.

The same strategy makes sense as we roll from June into August gold. Tomorrow is first notice and we have been holding our long for enough time to be in the top third of the delivery roster.

As I end this week's Report, I simply cannot resist calling attention to the old saying that silver follows soybeans. Hy Maidenberg used to write the "Commodity" column for The New York Times when he wasn't assigned to Latin America. He loved this correlation. I don't want to confess how long ago that was!