The Coming Bull Market in Gold
Part 2

Recent Comments on Central Bank Gold Activity

German Finance Minister, Theo Waigel "Germany will not sell one ounce of gold." Jean Pierre Patat, French Central Bank "Several central banks which had sold gold from their reserves now feel there is no longer an advantage to selling more bullion as any advantage was outweighed by the loss on remaining reserves from reducing the gold price." "It seems the market is more influenced by psychological phenomena than central bank gold sales." "Concern that European central banks will sell large portions of their gold reserves are 'devoid of substance'". Japanese Prime Minister, Hashimoto "Exchange rate instability might encourage Japan to sell some of its US Treasury securities holdings and buy gold." Shunjiro Karasawa, Member of Japan's Lower House of Parliament "Japan's gold holdings are far too low compared with other major countries." Masaaki Nakayama, Member of ruling Democratic Party "Excessive dependence on the U.S. dollar and sharply smaller gold reserves are my growing concern."   Alan Greenspan, Chairman, Federal Reserve "The extraordinary decline of the price of gold is in small part the result of central bank sales."   German Polls show that: Germans believe that property or precious metaIs will represent better investments than cash savings following EMU.   Swiss polls show that: A referendum to reduce gold reserves would be defeated.

Other factors which could have an important effect on gold are the future of the EMU and a decline in the U.S. stock market.

Effects of the EMU on Gold

1. Widely accepted that the Euro will be a soft currency. - Unlikely that European central banks will want to soften it further by selling gold. - Bundesbank wants a stronger Euro. 2. German people will not accept a weak Euro. It can be strengthened with greater gold reserves. 3. Investment firms can arrange the purchase of any gold Europeans may want to sell in an orderly manner. i.e. Purchase a call option on any gold central banks want to mobilize. 4. Asian central banks will have fewer alternatives for investment of their $600 billion of reserves.

Even if the EMU happens, it is generally accepted that the Euro will be a soft currency. It is therefore unlikely that the Bundesbank will allow it to be even weaker by selling gold. Actually, we might be surprised to see an overweighting of gold as the least onerous method of strengthening the Euro. The EMU appears to be an unpleasant brew, concocted by the Eurocrats and administered to a, so far, inattentive public. The French want a shorter work week and a higher minimum wage. The Italians refuse to reform their pension system where a large percentage of the country is considered disabled and eligible for a pension.

Finally, when and if EMU happens, there will be few alternatives for Asian central banks to invest their reserves. Gold will have to be considered for a more prominent role.

Effects on Gold of a U.S. Market Decline

1. A U.S. market decline, this time, would likely affect U.S. consumption. Also, the dollar would decline as foreigners sold shares and bonds. 2. Without the U.S. as the consumption junkie for the world, European and Japanese economies would weaken further. 3. EMU would come under pressure as more expansive policies would be desperately needed in Europe. 4. Serious disruptions in European debt and currency markets would occur. 5. With the Swiss trying to debase their currency, there would be few alternatives to gold. 6. Gold, already in deficit with producers and speculators short, could rise dramatically. 7. Gold shares already at bear market bottom prices should rise substantially. Also, as money flowed into more defensive investments i.e. gold shares, the funds flow would dwarf the small market capitalization of all gold shares.

We are faced with the simple fact that, as the stock market and dollar continue to be strong, gold is rejected as an investment vehicle. As the following charts show, gold has the most negative correlation to the stock market of any asset and is now at an all-time extreme undervaluation relative to the Dow.

When the stock market declines it will weaken consumer demand which will have a significant impact on fragile European and Japanese economies. As the economy softens in the U.S. the Fed will no doubt lower interest rates which will result in a declining dollar, but even more important, we will probably opt for a weaker dollar to strengthen exports at the same time as other countries want weaker currencies to stimulate their exports. Competitive currency devaluations should begin a major bull market in gold. The basic supply/demand deficit will then come into play resulting in even greater strength in gold. There is also a strong relationship between dollar strength and gold's weakness.

Based on gold's gross undervaluation relative to the Dow, gold's price being far below its 26 year mean and all the factors previously mentioned, at the very least there is a solid case that the current 12 year low in gold, or 20 year low adjusted for inflation, makes a very good entry point.

Turning to gold shares we are looking at the lowest valuations since the bottom in 1992. The reason to own shares relative to bullion is that they offer much more leverage. Typically the shares have three times the percentage move that bullion has. Actually, the juniors and high cost producers tend to do much better than that.

Market Capitalization of Gold Shares is Small

1. Estimates of worldwide gold share total market value is under $50 billion. 2. Estimates of available "float" are below $30 billion. 3. Even assuming a 20% increase in shares as a result of financing in a strong gold environment, any serious interest in gold shares would dwarf the available supply.

The exploration shares have been decimated by Bre-X. In case you were on the moon and missed it, this was a $4 billion scam run by a bunch of clowns in the jungle of Indonesia. The only reaI value in this company may be the movie rights.

We met these fellows early in the game and based on some geologists we had confidence in we bought some stock at $3. We felt they had found a few million ounces and the stock could be worth $10. Before we knew it they were talking about 20 million ounces and the stock was $40. We got out. It went straight to $300 as projections reached 100 million ounces with dozens of analysts endorsing these numbers.

The head geologist who, in addition to having four wives and a degree in salting, either jumped or was found pushed out of a helicopter on the way to explain to Freeport, Bre-X's new partner, why the new holes drilled by Freeport found no gold. Actually, the geologist's body was "hard to identify" and there are people who claim to have seen him in various parts of Asia.

At any rate, the $4 billion drained out of the market overnight resulted in some nasty margin calls and the liquidation of the exploration stocks became a waterfall.

This has created incredible values with declines of 75% not uncommon. This was a once in a lifetime scam and a once in a lifetime washout.

As you know, the market is like a ferris wheel, sometimes you are in the car on top and sometimes that car is on the bottom. This time the gold stock car is off the tracks. TVX sells at the price it traded at before it bought and expanded a deposit in Greece which will mine gold at $125 per ounce, generating a cash flow of over $120 million per year starting in three years which is three times the company's current cash flow. Golden Star, an exploration company, has declined over 60% from its 1997 high. It is back to the same price as four or five years ago. In 1992 they had 7 gold projects in various stages of development and no diamond projects. Today they have 36 gold projects and 31 diamond projects.

There are only two reasons to buy gold shares. Either you think the price of bullion is going to rise or you can identify a company which has the potential to expand its reserves at a rate not recognized in the marketplace.

With a worldwide gold share market of about $50 billion, about 1/3 of Intel, and a float well below that, these shares must be purchased before gold begins to rise. That is why the shares rose 30% before gold took off in 1993. Today, gold shares have the lowest relative strength in over 20 years. Also, today you have a clear acquisition emphasis by the major gold companies. Each is on the acquisition trail and when gold starts to move we believe that a corporate takeover binge will unfold. This will reduce this tiny sector even further.

Even if you do not accept the concept that gold is going to enter a secular bull market, you can look at an investment in gold shares on a cyclical basis. Since 1980 the Gold Stock Index (XAU) has made six attempts to break through 150. A move to 150 would be a 50% gain or perhaps twice that in the more aggressive gold equities. This is the first time that the potential launching base has been this high. Should an upside break of 150 occur, there would probably be a dramatic rise in the gold shares.

What we can conclude is that the structure of the gold market is explosive. Not only is there a large and expanding deficit but there is a huge effective short position as well. We have outright speculator shorts, producers which have sold future production aggressively and central banks which have sold calls to earn income.

With Asian central banks grossly underinvested in gold and investment demand in general nonexistent, it is likely that any surprise would be purchases by Asian central banks and investors adding more fuel to the fire once the advance starts.

We can also conclude that the relationship of gold to paper markets is at the greatest extreme in history and gold shares are at valuations seen only at the 1992 low before the major advance. Clearly, both gold and gold bullion are offering extremely attractive entry points.

The trap has been set. With thousands of tonnes sold short by short sellers and producers into an expanding deficit, the short sellers must not only continue to sell short at their current high rate to hold gold down but must steadily increase their short sales to fill the steady expansion of the deficit. The problem arises when the shorts try to cover. The only source of supply would be huge sales by central banks to bail out the shorts.

In the event of a market squeeze, central banks, the ultimate trend followers, would most likely not only not sell, but they would become fearful of losing the gold they had out on loan to short sellers and would call the gold back, which they can do on short notice. That of course would magnify the problem and the worse it got, with a highly inverted lease rate, the more gold would be demanded back by the central banks. As we have mentioned previously, much of the borrowed gold has been fabricated into jewelry so it would be difficult if not impossible to return a significant percent of the gold loaned out by the central banks.

When gold turns up, gold shares, from their current depressed base and with their inherent leverage to the gold price, will be the place to be. Higher cost mining companies and the washed out exploration sector will have the biggest returns. In the past, when the gold share advance began, high cost South African mining companies gained as much as 40% in the first week of the rally.

I've now given you the complete and I think compelling case for gold and gold shares. There is just one more piece of evidence to complete the picture. How many people here think that gold will be over $500 in a year? How many people think that gold will be over $400 in a year? I rest my case.