When does the Final Shoe Fall on the Complacent Hedger?
by James E. Sinclair & Harry D. Schultz
The most insidious characteristic of the hedge position is that it lulls the hedger to sleep, risk-wise, from beginning to end. It is taught from university to the trading desk that a hedger never abandons the hedge position once taken. Rather than close the position, a hedge is adjusted to circumstances and for the hedger themselves only grudgingly at best. The concept is hammered home to the financial engineer student that not to hedge is to gamble. That once the hedge is established, to even adjust the hedge is to walk slowly into the arena of sinful speculation. It has never occurred to the financial engineer management of gold producers that they are public companies whose profit has been largely generated in recent years by trading gold on the short side i.e., by commodity trading not mining. The commodity trader that doesn't know when to quit will give it all back. The teacher never told them that the secret to consistent profits in the commodity market is demonstrated by the rule "When you make a bunch go to lunch." That means if you have a good run, stop. It has not yet occurred to the financial hedge engineer management of the gold producer that what made them billions of dollars by mistake could lose those billions of dollars by mistake. They must actually believe they are trading/market geniuses in excess of Livermore & Seligman. Those the gods wish to destroy, they first make mad. The greatest market madness is when you become a legend in your own mind as is now prevalent among the financial engineers of gold producer management. Nobody beats the market all of the time except in their mind. Remember the gold hedger didn't get into gold hedges voluntarily. In the beginning, hedging as a strategy was undertaken only to satisfy the demands of a lending bank. In order for the production to be financed as "Non-Recourse" to the gold producer's other assets, the loan had to be hedged for the period of the loan, generally ten years. The bank itself presented the hedge package, which was to be adopted as part of the loan deal. We suspect that the bank was driven at that time primarily by the profit hidden in the hedge-spread for its subsidiary. Then lo and behold, gold declined and the hedge made money. A light lit up in the minds of the hedger and off we went into an extended bear market that endured for 22 years, thanks to continually ever more extreme sales of gold hedge positions. As always, all slick ideas get to the bottom side of the planet Earth last. When it finally dawned on the Australians that there was almost free money to be had from the kindly gold banks, they dove in head first times ten. The Australians, having been the last to find this free money give away game, their timing was awful. The Australians then got a surprising "first" by blowing themselves financially out of the water almost immediately. It is thus no surprise that many of the Australian over-the-top hedgers are now the property of other international major producers. The only surprise is why anyone paid anything for them other than assuming and paying up on the Australian's awful hedge losses.

We now hear two plaintive cries from the complacent hedger. The first and weakest is: we, the hedger, cannot lose since if we are only hedged on 10% of our total gold reserves and a loss on that is offset by the other 90% of our reserves as they grow mightily in value. On the surface that seems correct but it's awfully wrong. You cannot compare hedging to total reserves because short of using a nuclear device (the Soviets tried it in diamond mining and believe us, it bombed) to mine the reserves, they cannot be taken out of the ground any faster than the present operation (usually running near or at capacity) can mine them. Since all financial transactions (that is what hedges are) have to be looked at as financial transactions, their integrity depends on how able the producers can satisfy them by other means. That measure is the size of the hedger's treasury and how much production the hedger has YEARLY. Therefore the true measure of financial integrity can be reduced, for practical purposes, to how many times one year's production that company is hedged. The final fallacy in the plaintive's cry is that the hedge position produces debits and credits but the reserves in the ground financially produce nothing whatever. That is the key to sapping away the producer's cash but they seem not to care, or understand.

How about the hedger that recently called Sinclair "malicious" for revealing these facts? That hedger says we are not a hedger because their hedge book is headed toward being "balanced to even." First, please dear hedger, understand that there is no perfect hedge. If you believe that there is a perfectly balanced no risk hedge, please speak to Saul Stone, who owned a clearing house in Chicago that cleared for a derivative dealer in a perfectly balanced Butterfly (four legs) derivative spread. That hedger went broke big time in the "perfectly" balanced hedge position. Saul paid up the huge loss a client took that did not even belong to Saul. God Bless people of integrity like Mr. Stone. They are few and far between. To the perfectly so-called balanced hedger all I can say is good luck. May the instruments never fail and please have a right of offset in your client agreements with your gold banks for the sake of your stockholders. Only when you have no hedge book are you out of the commodity speculation business and back in the gold mining business. Until then, stop the spin city BS and name-calling.

The Final Shoe is falling
SOON!

We have previously outlined to you what makes the gold market happen in fundamental terms. For gold to establish a trend there need be no other stimulus these than fundamental issues. However for the sake of review we will briefly review.

  1. The dynamic condition of the US Dollar.
  2. The condition of the Current Account in dynamic, not static terms.
  3. The attractiveness (or not) of equities as a storehouse of value in the minds of international investors.
  4. The attractiveness (or not) of the US Federal Debt market, 10-year bonds and 30 year bonds, as a storehouse of value in terms of international investors.
  5. The condition of the general commodity market.

That is the entire gold story. All the rest is noise. It may be important noise but other criteria remains only noise. The trend is made by the fundamental five criteria above. The noise can excite or dull the gold trend but it does not make the gold trend. International political tension is a noise item. The market fight between great position holders is a noise item. If you understand the five criteria of trend then you might not need us. We wish to impart knowledge and our goal would be realized when you do not need us. We have a combined 90 years of experience in gold. It is yours for the reading. Please take it and take it to the financial engineers of the gold producers you are invested in. Please save them from themselves thereby saving yourself and gold as a monetary vehicle as well.

  1. The dollar has fallen to a degree that has taken the world by surprise. It has been hammered. In today's market world of instant price gratification, the price downside is like the person who walks into an elevator only to find no elevator waiting and falls down the dark empty shaft. The dollar has free fallen down the elevator shaft.


  2. The Current Account has dropped into a hemorrhaging deficit faster and further than anyone suspected. It was pooh-poohed in February of 2002 by none other than the US Secretary of the Treasury. The Current Account Balance is a broad measure of US trade and capital flows. It blossomed in deficit in the first quarter of 2002 by 112.5 billion, further building up the mountain of US dollars held by non-US entities, both public and private. Now we step into the theory of up and down spirals. As more dollars flow into international hands in an environment of (number 3 in the gold equation) WEAK EQUITY MARKETS, more dollars flow out of equities internationally into the mountain being created by the Current Account Deficit, and around and around we go. As the mountain of external US dollars gets bigger and bigger and the dollar goes lower and lower the result is that equity market rallies in search of a fundamental bottom are ineffectual at establishing that final market low. That is a down spiral of #1, #2 and #3 of the gold equation.


All is somewhat well as long as WHAT? All is well as long as #4 of the gold equation does not come into play. #4 is the attractiveness of the medium to long term US bond market. We "know" that from a cyclical standpoint, both long term and short-term highs in this market are prone to pass by November of 2002. So here is the answer to WHEN DOES THE LAST SHOE FALL on the complacent hedger? November of 2002 is a time that portends the greatest probability that the grime reaper of reality will knock on the door of the complacent hedger and hold out his begging bowl for all your cash please. Why? Well, that mountain of dollars collecting in the world outside of the financial centers of the US as described in the spiral of #1, #2 & #3 above, finds its last bastion of a storehouse of value, the US bond market, is becoming a loser, and then the dollar would be hammered even harder and faster than what has happened already. Gold would, under that scenario, pass up through $354 like a hot knife through butter. Under this scenario, we doubt, anyone would even see $354 go up in flames, as it would happen so fast. Then gold will be in the $380-400 range and the share prices of the major gold producers still complacent in hedging would be falling.

Therefore the answer to your question of when the shoe kicks the derriere of the complacent gold producer hedger is answered as potentially and very possibly November of 2002.

You ask about the general commodity market's contribution? Every ingredient is like a thermometer reading with five indicators of gold's fundamental strength. Four ingredients can carry number five as neutral. That is the genesis of the prediction of $380-$400 today given in this dissertation as a result of gold fundamental #1 as distinctly with a pro-gold high reading, #2 with a distinctly high pro-gold reading, #3 distinctly high pro-gold reading, # 4 expected in November 2002 to support gold and the final #5 now having come from totally negative to negative/neutral which is not a depreciating item to the gold equation. Number five, the commodity market, will be the ingredient that determines if or not gold moves above $380-$400. We will deal with that in the final quarter of 2002. #1, #2 and #3 took us above the $305 barrier and initiated the mechanism of how and whereby nominal value of $280,000,000,000 of gold derivatives are becoming real value in the marketplace as a product of risk control program buying by gold banks. This has presented gold with the challenge to $354 that is where we stand now.

Until September-October, it is our opinion, that correct action for investors in the gold market place is to buy every reaction, selling 50% of your position into strength & rebuy again on weakness, etc, not fearing the talking heads of mega-nonsense about the transient nature of the gold rally that is being paraded on the financial TV stations owned by Wall Street equity interests in the first place. After October, hold for further opinions from command central at the Schultz/Sinclair golden war room headquarters.


June 26, 2002

James Sinclair can be reached at www.tanrange.com
and Harry Schultz at www.hsletter.com