Point Of Recognition

October 29, 2007

There is often a moment in a major market move where public perceptions of the item suddenly change and the feeling is something like: "Yup, this REALLY is a bull market!" or "Yup, this REALLY is a bear market!" This is sometime called the "Point of Recognition".

Gold and the US Dollar seem to be experiencing something of this nature right now, except that gold is being recognised as being in a bull market and the US Dollar as being in a bear market. The Point of Recognition generally occurs about midway through a major move, and is a useful guide as to the remaining length of the move underway. Very often the Point of Recognition is seen as a large gap on the chart of the item.

Data updated to 26 Oct 2007.

In this chart of the COMEX Gold price, a gap occurred Friday 26 October 2007 and with gold trading in Asia at around $790 in morning trade on Monday 29 Oct 2007, another gap may be formed in USA trading today (29 Oct 2007). There is little doubt that the perception of gold has changed in the past week and one can sense the new sentiment of "Yup, this is REALLY a bull market" has emerged in the market place.

If we saw the midway gap on Friday 26 Oct 2007 at $777 on the Gold COMEX Futures, we can estimate that the current up move should take the gold price to around $900 without any significant corrections on the way. This is calculated by deducting the starting point of the move at $647 from $777, giving a figure of $130. When $130 is added to the midway point of $777, we get a target of $907.

There are still sceptics around, people pointing to sentiment indicators that suggest that gold is over-bought. Numbers such as 92% bulls are suggested as a reason why the gold market should turn around and correct. The fact is that in a real bull market, sentiment numbers can (and often do) remain extremely extended for considerable periods of time. People who rely on these over-bought/over-sold indicators may find that they miss a major opportunity or, worse still, suffer burnt fingers.

The Point of Recognition appears to have come about due to an increasing awareness of the economic crisis that has developed and the safe haven properties of precious metals. The world is facing a truly unprecedented series of global events, the consequences of which will represent the single most important factor impacting investment decisions from now onwards.

We cannot understand the present or make practical, useful, forecasts without knowing where we have come from. Some historical detail is imperative. The following few paragraphs are extracted from an article by Richard Duncan in the September issue of FinanceAsia and they explain the historical perspective succinctly and extremely well:

Flaws in The Dollar Standard

The Dollar Standard is the most appropriate name for the international monetary system that evolved following the collapse of the Bretton Woods System in the early 1970s. The principal flaw in The Dollar Standard is that it has no mechanism to prevent large and persistent trade imbalances between countries. Consequently, the deterioration in the United States' current account deficit has gone unchecked, recently reaching nearly 7% of US GDP. The countries with a trade surplus with the United States have been blown into economic bubbles. Japan in the 1980s, the Asia Crisis countries in the 1990s, and China today are examples. Moreover, as the central banks of the United States' trading partners have reinvested their dollar surpluses back into US dollar assets, the United States itself has also been blown into a bubble. In short, the US current account deficit has destabilized the global economy. That was the theme of my book, The Dollar Crisis: Causes, Consequences, Cures (John Wiley & Sons, 2003, updated 2005).

Before the breakdown of the Bretton Woods International Monetary System, international trade balanced. Subsequently, however, the gap between what the United States bought from the rest of the world and what the rest of the world bought from the United States began to steadily expand.

Under a Gold Standard, or the quasi gold standard Bretton Woods system, such large trade deficits would not have been sustainable since the US would have had to pay for its deficits out of its limited supply of gold reserves. However, the willingness of the United States' trading partners to accept payment in dollars instead of gold meant there were effectively no limits as to how large the US trade deficits could become. This vendor financing arrangement allowed much more rapid economic growth around the world than would have been possible otherwise. The larger the US current account deficit became, the more the United States' trading partners benefited.

When the foreign companies selling product in the United States took their dollar earnings home and converted them into their own currencies, it put upward pressure on those currencies. The central banks of those countries intervened to prevent their currencies from appreciating so as to preserve their trade advantage. They intervened by creating money and buying the dollars entering their countries. In this way, the exporters were able to keep their export earnings in their domestic currency and the central banks accumulated large foreign exchange reserves.

As the US current account deficit grew larger, central banks created more and more money and intervened on a greater and greater scale each year. In fact, total foreign exchange reserves have doubled over the past four years. In other words, during the course of the last four years, foreign exchange reserves have increased by as much (US$ 2.8 trillion) as in all prior centuries combined. The reinvestment of those dollar reserves into US dollar assets fuelled the credit excesses in the United States that culminated in an unsustainable property bubble there.

It is this sequence of events that has created the vast distortions in the world economy, the vast growth in Debt, Deficits, Derivatives and other acronym challenged pieces of paper. The real estate crisis in the USA, combined with illegal and fraudulent practises in the sub-prime market, has resulted in a situation where global credit markets are caught up in a systemic crisis, possibly the worst ever.

The US is caught between a rock and a hard place. If the Fed does not reduce interest rates, the economy will unravel and massive de-leveraging will occur with devastating consequences. If the Fed does reduce interest rates, the US Dollar will continue to tank, probably at an increasing rate. We already know that the Fed has made its choice. It will abandon the US Dollar and try and save the economy.

Let's be blunt about it: THE US DOLLAR IS IN A DEATH SPIRAL. This is already (and will become increasingly more so) the single most important factor to consider in investment decisions.

Those countries that continue to intervene in currency markets to prevent their currencies from appreciating against the US Dollar will cause their currencies to follow the US Dollar into the Death Spiral.

We are facing the end of the US Dollar Standard in world trade. It is the end of an era that has spanned 36 years and there is no ready-made replacement for the US Dollar as a unit of measurement. The world is facing a period of monetary chaos.

How this will all work out is extremely uncertain. It is possible that the world is facing a debt implosion and a deflationary crash. The background factors for that to happen are all in place. Governments, such as the USA and Britain, have indicated that they are not prepared to accept the pain of a deflationary depression and will do whatever they have to do in order to prevent this from happening. They are prepared to sacrifice their currencies and endure a wild ride on inflation - if that is what is required. There appears to be no middle or "muddle-through" path. An ugly, damaging landing of some description seems to be inevitable.

These opposing forces, Deflationary vs Government Intervention, in an era where the US Dollar Standard is rapidly coming unhinged, leads to an expectation of Hyper-Stagflation as the possible economic outcome.

How does one handle the situation from an investment standpoint? If the deflationary forces do produce a massive collapse despite the Government's and Fed's best efforts, the safest and possibly best place to be is in Government Bonds. If it is the Hyper-Stagflation scenario, one would want to be in tangible assets, "store of value" items, of which precious metals will no doubt prove to be the best and safest haven.

As nobody can be absolutely certain as to the how this major crisis will play out, the prudent and conservative policy is to have something in both camps, adjusting the percentages as time goes by when it becomes clearer which of the two outcomes will prevail.

Money is flooding into US Treasury bonds and into gold, silver and oil. It seems that money managers have passed the "Point of Recognition" and are adopting the prudent and conservative policy suggested above.

Alf Field

Comments to: ajfield@attglobal.net

Disclosure and Disclaimer Statement: In the interest of full disclosure, the author advises that he is not a disinterested party in that he has personal investments in base metal mining shares including Zinifex and Mincor ment. The author's objective in writing this article is to interest potential investors in this subject to the point where they are encouraged to conduct their own further diligent research. Neither the information nor the opinions expressed should be construed as a solicitation to buy or sell any stock, currency or commodity. Investors are recommended to obtain the advice of a qualified investment advisor before entering into any transactions. The author has neither been paid nor received any other inducement to write this article.

Alf Field was born and raised in South Africa. He is a Chartered Accountant by training. Together with a partner, he started his own funds management business in 1970 in Johannesburg. In August 1971, when the USA stopped converting US dollars for gold at $35, Alf perceived a major opportunity to buy large quantities of gold mining shares personally and for clients. In 1979 he migrated with his wife and four children to Australia. He is currently a self-funded retiree who manages his own portfolio. In 2002 Alf started writing articles on gold related subjects, including monetary history, as well as a series of gold price forecasts using the Elliott Wave technique.

The naturally occurring gold-silver alloy is called electrum.