"Historically," says James Dines, The Dines Letter, "Both the Dines Gold Stock Average (DIGSA) and Dines Silver Stock Average (DISSA) have been bearish in Octobers, 82% and 77% respectively. DIGSA was up 4 and down 18 times, while DISSA was up 5 and down 17 for the past 22 years." According to Dines, Octobers are usually nearing a good time to buy on declines, before their seasonally bullish first quarter.

"The pullback in gold and gold stocks affords us another opportunity to buy gold stocks on sale," says Lawrence Roulston, editor, Resource Opportunities. He is of the opinion that the gold price will trend higher. "Exactly the same fundamental forces that have taken the gold price from $250 an ounce to the present level are still very much in force, says Roulston.

Patrick Heller, editor, Liberty's Outlook, www.libertycoinservice.com a monthly review of precious metals and numismatics, thinks we are still in the early stages of the next bull market and says the overall trend is definitely up. Heller had the following comments on gold's rise and the dollar's decline in his newsletter, Liberty's Outlook.

"There are myriad reasons for the price of gold to rise on its own merits - decreased supplies from mines and central banks and increased demand from investors and jewelry buyers have made multi-year shortages even more extreme in the past couple of years.

Those factors have been driving the gold price, now up more than 50% in the past 31 months!

However, the strongest underlying support to higher gold price sin the past three months has been concern that the building pressures against the value of the U.S. dollar may cause it to crash sooner or later. In the past month, for instance, there was a high opposite correlation between the rise or fall of the dollar against the Euro - 0.8 out of a maximum possible of 1.0 for perfect correlation. When the dollar fell, gold has risen, and vice versa.

The U.S. dollar is already down 8% against a weighted average of world currencies since early 2002. We are just seeing the beginning of this trend.

As one of my analyst friends recently said, "It used to be the dollar was the safe haven and now the dollar has fallen off its throne, and gold is the new safe haven."

This trend will continue to have a strong impact on the price of gold in coming months. Let's review the background before projecting into the future.

How Did Things Get This Way?

The United States has the world's largest economy by far, even though it does not have the largest population. This higher wealth per capita was made possible by an economy freer of political distortion and control than any of the other major developed nations.

This economic strength and long-term stability (the United States is the only nation in the world where all of its coinage from 120 years ago is still legal tender!) has resulted in the U.S. dollar being highly desired by foreign governments and investors. Governments hold a quantity of foreign exchange so that it can help manage (in theory, at least) the value of its domestic currency. Foreign investors formerly held dollars to seek safety from the value of their assets, denominated in local currencies, depreciating.

(A prime example comes to mind. When the financial crisis hit Southeast Asia in 1997, Indonesia's rupiah dropped more than 75%. Yet those Indonesians holding gold were able to avoid much of the financial hardship and misery.)

The strong economy made it possible for the U.S. to extend massive amounts of credit beyond its borders. In 1980, the U.S. was the world's largest creditor nation.

That has all change in the years since. Being able to create U.S. dollars simply by printing paper and trading it to other nations for tangible merchandise encouraged massive imports into the U.S. As consumption soared, the U.S. turned into a net debtor nation by the late 1980s.

Still, the U.S. could largely ignore this shift. It has the world's largest and most liquid stock and bond markets. It can borrow in its own currency simply because it is the world's reserve currency. Even when times are hard in the U.S., economic turmoil in other countries almost always seems to be worse.

Advantages such as these allow the U.S. government and private sector to borrow more and at a lower interest rates than anywhere else in the world.

This spending spree is having a disproportionate effect on the world economy. The Economist recently reported that, since 1995, almost 60% of the cumulative growth in world output has come from America, which accounts for only 30% of world Gross Domestic Product (GDP). Domestic demand has risen in the U.S. at twice the rate of other rich nations during this period.

Another way of putting this is to say that the world has become too dependent on the U.S. economy to bail out everybody else.

This presents the current dilemma.

Where are we now? What will it take to change? How bad is it going to get? What can you do about it?

The Current Dilemma

Where are we now? After the stock market crash in early 2000, investment spending collapsed in the U.S., but consumer spending held steady.

American consumer indebtedness is growing twice as fast as incomes.

The "Official" Federal budget deficit has soared to 4% of GDP for the current fiscal year. It was in surplus just three years ago.

The current annual U.S. trade deficit has ballooned to about $500 billion per year. We import 50% more than we export. This trade deficit is up to a record 5% of GDP!

Foreign private investors, sensing forthcoming weakness in the dollar, have reduced their new investments in U.S. paper assets other than bonds to less than American investment overseas.

The prime foreign purchasers of U.S. debt are the governments of Japan and China, who buy dollars as a means of subsidizing their own exports.

Current net debt to foreigners is up to 25% of GDP, compared to being a net receivable of 10% of GDP in the late 1970s! This level of debt is higher than what forced some Latin and South American nations into financial disaster in the 1980s. Although this percentage is still lower than many other rich nations, at current trends the percentage will rise to 40% by 2007 and 60% by 2013!

At current interest rates, America pays approximately $4 billion per year on net debt to foreigners. However, today's low interest rates will not likely continue to attract sufficient additional credit. Rising debt and higher interest rates could lead to net interest costs to foreign creditors of $150 billion by 2007. Thirty-five fold increase in 4 years? Yes, that is not a misprint.

Net foreign direct investment peaked at 1.6% in 2000, but has turned negative now (that is, that foreigners are pulling out of the U.S. more than others are sending in). In the mid-1990s, a survey by The Economist found that global investors included about 30% of U.S. dollar assets in their portfolios. That percentage is now up to about 54% of global equity investments and 50% of global bond investments, leaving less room for future increases. From 1998 to 2001, about 80% of new investments by global investors went to purchase American assets.

All of these problems are worse, both relatively and in absolute terms, than they were in the 1970s, which ended with the price of gold climbing to $800 and silver to $50.

What will it take to change?

Strategy #1: The rate of increase in imports will have to fall to 4%, half of the average rate of increase since the mid-1990s. U.S. exports will have to jump up 11% per year, which is 50% higher than the trend in the past 5 - 10 years. If both of these happened simultaneously, that would not eliminate the trade deficit, it would merely hold it at around $300 billion per year.

Strategy #2: The U.S. economy would have to grow more slowly than the rest of the world.

Strategy #2: The U.S. dollar would have to fall in value relative to other currencies.

How bad is it going to get?

There are enormous difficulties with any of the above strategies. A Federal Reserve study in 2000 found, for instance, that imports into America rise 1.8% for every 1% increase in spending. In contrast, a 1% increase in spending elsewhere in the world only translates to a 0.8% increase in American exports.

There are many more problems than simply changes in spending patterns. For instance, the Chinese government is piling up huge foreign exchange reserves, now holding the second largest total after Japan. Normally this would suggest that China's currency is undervalued relative to the dollar. However, the Chinese economy is in precarious shape despite its rapid growth. Anywhere from 25 - 50% of domestic debts owned to Chinese banks are worthless. Any shift in currency value, which discourages Chinese exports, would make this problem even worse, and could easily lead to a financial collapse there!

For the U.S. economy to grow more slowly than the rest of the world would mean a near standstill on technological innovation, which just is not going to happen.

So that leaves strategy #3, a falling U.S. dollar. That is easier to accomplish because free markets can make adjusts relatively quickly and simply. But how much will it take to get back into some kind of international equilibrium?

The dollar rose by more than 80% from 1980 - 1984 and peaked in 1985. By the end of 1987, the dollar had fallen by 54% against the German mark and Japanese yen. The slide was finally arrested with significant multi-government intervention to support the dollar.

This time, the most optimistic estimate of how far the dollar must fall from current levels is 15 - 20%, but even that would only bring down the current trade deficit from 5% of GDP to 3%, higher than almost any time in American history before the last few years.

Ken Rogoff, the chief economist at the International Monetary Fund (IMF), thinks it will take a dollar decline of 35% to bring the balance of trade into balance. Analysts at Goldman Sachs and Deutsche Bank think that declines of 40 - 50% will not be enough to bring trade into balance.

If the dollar decline happens slowly over several years, a financial collapse might be avoided. But I don't think that the markets will wait that long.

Which means that there is a high risk of a quick fall in the value of the U.S. dollar sometime in the next year or two. When quick drops happen, they almost always overshoot.

What could happen in the U.S.? Conservatively, I think there is at least a 25% possibility that the U.S. dollar could fall at least 75% within the next two years. The risk of a dollar crash and subsequent financial meltdown are not negligible.

As the IMF's Rogoff recently commented, "The world is set to jump off the top of a waterfall without knowing how deep the water is below."

By the way, when the value of the currency is falling, inflation is just about guaranteed to take off.

What Can You Do About It?

The best protection against a collapse in the dollar is to shift out of dollar-denominated assets into those that do not depend on the value of the dollar.

Tangible assets have historically been the best protection against currency crises. Among them, gold has traditionally been the asset of choice. It helped many Indonesians in 1997 and may help many Americans in the not-too-distant future.

Silver and rare coins are also worth considering, though their values are influenced by a number of non-monetary factors. Still, for the safety of diversity, I recommend some silver along with gold for most everyone. Carefully selected rare coins can serve well both in a financial crisis and take advantage of the current boom in the rare coin market.

When even the IMF reports that the dollar is overvalued as it did a couple weeks ago, it is long past time to add to your gold and silver holdings.

I do not expect it to take long for gold to pass $400. I also think we are still in the early stages of the next bull market. It won't move in a straight line. But the overall trend is definitely up.

Will Silver Shine If The Dollar Falls?

Some of the investment money fleeing a falling dollar will be directed towards tangible assets. Of that, I expect most will go into gold bullion-priced forms and lower premium numismatic gold coins.

Some will also flow into silver, not because it has a major presence in financial markets today but because it has a past track record as a financial asset.

At today's prices, less than $5 billion of silver is mined each year and available inventories are limited to about $5 billion. Somewhere between $30 - 40 billion of gold is mined every year, with available inventories of around $50 - 100 billion.

The market for silver, compared to gold, is so small that even a small shift toward silver will have a huge impact on prices. So, while I think most of the financial activity will happen in gold, silver could rise by a higher percentage than the yellow metal."

15 October 2003

Source: The Bull & Bear Financial Report, PO Box 917179, Longwood, FL 32792. Readers are invited to visit the web site at www.TheBullandBear.com and sign up for the free E-newsletter, Bull & Bear's Resource Investor newsletter.