Achilles' Heel

September 22, 2000

When Achilles, the mythological hero of the Trojan Wars, was a baby, his mother attempted to make him immortal by dipping him in the sacred river Styx. However the heel by which she held him remained vulnerable. Many years later he was killed - by a wound to his heel.

For some 3,000 years these Greek myths have kept prudent people on guard – wondering where they were vulnerable. Today we are still wondering. Our fundamental assumption is that we have had the biggest bull market in history. Therefore we can expect the biggest bear market in history in due course. This will trigger the biggest depression in history.What triggers a stock market collapse? Throughout history it has always been some seemingly minor event that ushered in a new world. A tea party in Boston. An Archduke gets shot. People sell their dollars. Of all possible investment scenarios, the international value of the dollar is the most likely Achilles' heel of America's prosperity.

The current boom is maturing. The yearlong rise in interest rates is gradually having an effect. Thus the early signs of economic slowdown are at hand. Investors sigh with relief because it reduces the risk of a further rise in interest rates. It prevents the economy from overheating. It might even reduce the risk of inflation as fierce competition keeps prices down. But in these highly leveraged times, a small slowdown can lead to a substantial decline in earnings. Hard times make servicing debt disproportionately difficult. Income drops, but debt service remains fixed. Personal bankruptcies today are near record levels, credit card defaults are high, but nobody knows how high is too high. Personal savings are near zero. Corporate debt defaults have made new records worldwide. Yet as long as foreigners hold our debt and stocks, as long as they feel both that the dollar is the safest currency and that America is a relatively good place to invest their dollars, the market might stay up. This proposition has got to be the focus of the Federal Reserve Board. As long as investors feel their wealth is reasonably secure in the stock market, they will manage to muddle through.

Actually a major worry for all remains inflation. There is little question that the consumer price index understates the inflation rate. Being retail priced, it is a lagging indicator. First of all the true inflation rate is not the price of a basket of consumer goods, but rather the rate of increase in the money supply. This is the true leading indicator of inflation. The broad definition of money, M-3, is now running 9% ahead of last year. The Monetary Base is running 6.5% ahead. Total Fed credit, which is the amount of money the Fed deposits in the government's checkbook, (and is therefore a proxy for government spending) is running 7.5% ahead of last year. These figures are down from their highs, but anyone who tells you there is little inflation just is not looking at the facts.

There are those who say that there is little inflation because productivity has increased. That is certainly partly true because the personal computer has increased productivity. Another reason is because we have shipped all the low-productivity, manual jobs overseas to low-wage countries in Asia or South America. Both of these factors are gradually becoming non-recurring. They are more behind us now than ahead of us, so productivity increases should be harder to sustain from now on.

The Bureau of Labor Statistics has an "adjustment for quality", so that what you and I call an inflated price, they call a better product, and thus the price has not inflated! Auto prices have risen about 8% per year since 1940, but looking at the Consumer Price Index, you would never know it. After all, it has all been quality improvement. But if auto prices have increased faster than incomes, isn't the difference inflation?

As a rule of thumb, the true inflation rate generally runs about 3% to 4% more than the stated rate in the CPI. That is at least partly why interest rates in 10-year treasury notes are now running about 6.0 %.

After the obvious energy inflation, we have to worry about wage inflation for several reasons. Unless Fed policy slows down the economy so much that this no longer becomes a problem, the tight labor market can only raise cash wages in due course, as business competes for help. Furthermore, health care costs have been rising for a few years. They have been increasingly passed back to employees. However as competition for workers increases, the employer once again will have to absorb health-care costs, as well as pay higher wages to get the right help. This can only inflate prices in due course, or failing that, decrease profits. Increasing competition will probably bring on the more of the latter.

The American people have a high frustration tolerance. As long as nobody rocks the boat, it looks like the inflation problems, the debt problems, the earnings problems can be tolerated. It even makes one believe that Alan Greenspan will bring us once again to a soft landing. Of course that is the false sense of security that occurs in the early, denial stages of an evolving bear market. If Mr. Greenspan had started raising interest rates a long time ago, the stock market would not have become so overpriced in the first place. A soft landing simply precedes a hard landing.

Of course the most inflated prices in the nation are in the stock markets. This is the one serious threat that remains. I have always believed that over a long pull of time the stock market as a whole should sell for the reciprocal of the long bond yield. In a bull market the price-earnings ratio rises over this number, in a bear market the ratio falls below this number. Because the government is buying back their longest bonds, the 10 year bond is a better guide today of a free-market interest rate. Since 10 year Treasury bonds yield 6.5%, then the Standard & Poors 500 stock average should normally sell for 15.4 times earnings. Today it sells for 29 times, almost twice the norm. You don't have to be a genius to figure out that the averages could drop 50% from here, assuming that current earnings do not decline. If in due course current earnings decline 50% in our highly-leveraged economy, then we are talking about at least a 75% decline in average stock prices.

For the time being, even if we get a stock market rally to new highs, in anticipation of a soft-landing, it should be an illusion. It should amount to a bear market rally, a bear market correction. We have been in a bear market in the averages at least since last January. Of course the technology stocks are off the charts as far as price-earnings ratios go, especially the ones that have no earnings. The dot.coms looked to me like dot.cons when they first went public. Now they have become dot.bombs. Meanwhile investor confidence is reportedly still high, typical of the early stages of a bear market. The public does not realize that the recent increase in volatility is typical of the final stages of a bull market. Most of them weren't here when the last great bull market ended. Those who have lost money in the recent mania may now begin to reduce their consumption expenditures. Imagine the impact on consumption when this spreads to the whole stock market.

Of course the price-earnings ratio falls if interest rates rise. Under what circumstances could rates rise? The generally accepted notion is that if recession or worse comes, interest rates will fall because nobody wants to borrow. If bad times come, the stock market will anticipate it. However, as the stock market crashes, foreign investors will pull money out of our markets. They own only about 10% of our stocks, so it would not seem to make much difference. However where will their net proceeds of sales be invested? They will think that if the market crashes, a depression cannot be far behind. In a depression the government will print money in whatever quantity and form is considered necessary. Hence they will inflate the money supply even faster than now. As the supply of paper dollars increases, the market value of the dollar declines. Thus foreign investors will flee our currency by selling their Treasury Bonds. The Fed then raises interest rates even higher than the inflation calls for, in an attempt to keep foreigners in our treasuries. Of course this simultaneously slows the domestic economy. The Fed is already doing both these things today. After all, foreigners have provided 40% of our government financing. Without their presence in our bond markets, rates would be higher. Once foreigners pull out of our stock and bond markets, they are unlikely to invest in stocks or bonds of their own country. They know that If America sneezes, the rest of the world catches pneumonia. So where are they going to put their money? Why naturally in the only international money you can trust- gold. Gold because it is nobody else's promise to pay. Gold because it is the only store of value and the only medium of exchange that has lasted 5,000 years. It may not pay any interest, but it has little risk of declining to zero. Gold has already declined 67% in the last twenty years. How much further can it decline? It might even represent enormous good value. After all it is selling at 1978 prices! How many assets can you buy at 20-year-ago prices?

Now it is clear why our government is perfectly willing for other central banks to be lending and selling gold. It is the reciprocal of the dollar. It is an alternate currency. It is competition for the dollar. It is insurance against a falling currency. It is protection against an inflated dollar. It is protection against a deflated dollar. The price of gold is a report card on the dollar.Governments cannot print gold. So they try to ignore it. They try to get the media and the public to ignore it. When they issued so-called "inflation-indexed bonds" they refused to index the bonds to the gold price. When central bank lending and consequent selling suppresses the gold price, it supports the value of the dollar. Thus U.S. dollar policy faces a constant dilemma. On the one hand it wants to see the dollar as cheap as possible to be competitive to aid exports. It also helps paying off government debt with ever-cheaper dollars. On the other hand it likes a strong dollar because it keeps the price of imports, and inflation, down. A strong dollar reassures foreign investors who own 40% of our Treasury obligations. Above all, a strong dollar sends a worldwide message that dollar-denominated investments are safe. If that means suppressing the price of gold, the authorities feel that they will cross that bridge when they come to it.Someday will come the day of reckoning. But it is no problem. When the public demands that their paper dollars be convertible into gold, they will simply raise the price of gold so high that nobody will convert...nobody will pay the price of conversion. But the right of conversion will once more stabilize the value of the dollar.

The Fed regards keeping the value of the dollar stable as the key to keeping American prosperity afloat, the key to a soft landing. Part of this policy means keeping gold prices stable or down. It so happens that a lot of gold borrowers, hedge funds and bullion banks, did the job for them. They borrowed the gold at 1-2% interest rates, sold it, and invested the proceeds in other investment operations. I do not believe the government can keep the dollar stable and gold down very much longer. They tried this in 1968 and again in 1971 and each time they failed. The free market was and is bigger than any government. It is interesting to note that governments always seem to sell gold just before it starts to rise substantially. Government is slow to move. It looks back at $850 gold in 1980 and concludes that gold is a depreciating asset, that it is dangerous. I look ahead and conclude that it is opportune. Danger and Opportunity look alike.

The economic slowdown has already started. The rolling crash has already started. Other paper currencies are also weak. The Euro is now suffering a decline of two-years duration because hedge funds and others borrow Euros at a lower rate than comparable U.S. Treasuries, sell them, and invest the proceeds in higher yielding U.S. Treasuries. Already we are competing for funds with higher interest rates in order to keep the money here. The hedge funds, in this so-called "Euro carry trade", will do to the Euro what they did in the "gold carry trade". But all things come to an end.If the euro declines enough, some people will prefer gold. The process will feed on itself.

There is now believed to be a short position in gold somewhere between 7,000 and 10,00 tons. There is certainly no way this amount of gold can be found to buy back such a huge short position, without a major explosion in price. The central banks are now worried they won't get their gold back. Little wonder they try to keep the price down, so their shorts, their gold borrowers, can gradually cover their short positions and deliver back their borrowed gold.

In 1946, the central banks of the world owned 90% of the above ground supply of gold. Today the world-wide stock of gold is believed to be 132,000 tons of gold. Of that total, the world's central banks now own only about 28,000 tons or 21%. If you subtract the 10,000 borrowed tons that they may never get repaid, they can only be sure of controlling 18,000 tons, or some 13% of the world's gold supply. The central banks are selling gold because the hedge funds and bullion banks control the market now. They force the central banks to either sell gold at bargain prices or they will never have enough money to cover their shorts and repay them. If the price of gold rises, they will be forced into bankruptcy and the central banks will never get their gold back.

The central banks do in fact know the difference between paper and gold. They are unlikely to let their gold reserves fall to less than 10% of all the gold supply. That means that the central banks probably will only sell down to the 13,200 tons level. Thus they only have another 4800 tons to sell. It should not take very long to accomplish that. If this line of reasoning is right, it means the central banks will probably not get at least 5200 tons repaid. After a while this possible outcome may dawn on the central bankers and they may lose interest in lending gold. This will do wonders for the gold price. Obviously they cannot sell gold forever. Meanwhile, control of the gold price is gradually passing from governments to the free-market.

In fact one has to wonder if the private banking industry is the root cause of the decline in the price of gold for the last few years. Private bankers realize that they are lending paper of a specific purchasing power. They would prefer to get repaid in similar value. The only way to achieve this is to try to keep the value of paper money stable. In the face of constantly increasing money supply, the only way to do that is to stabilize the price of gold, which measures the international value of the dollar. There is an awful dilemma here. On the other hand, Central bankers would like to see their currency gradually decline in value so as to facilitate repayment of government debt in cheaper money. For both parties, the only way to keep the dollar attractive is to make gold unattractive. Furthermore governments basically do not like gold: they can't print it. You thus have the ingredients of a negative attitude towards gold. It does not require a conspiracy of bankers and governments. It is just a matter of attitude. BUT IT CANNOT LAST VERY MUCH LONGER. The accelerating gold sales indicate that it is requiring ever larger amounts of gold to stabilize or suppress the price gold.Don't lose sight of the fact that the buyers may not be so dumb. They are trading paper for gold. Don't lose sight of the fact that while lots of stock prices have declined substantially this year, many gold share prices have not. That ought to tell you that something is afoot.

When all is said and done, the ultimate fundamental determinant of the price of gold is the public demand for real money. Nobody can say when the public will demand that their paper represent a claim on gold, that it be a store of value. But that day will come when the public discovers that their paper money is not a store of value.

The soviet failure was essentially a failure of command and control economic policies. Yet that is similar to what the Federal Reserve Board is trying to do here. The reigning error is to believe that we can have a stock market correction essentially go sideways like it did from 1966 to 1982. This thinking is typical of the denial that characterizes the early stages of a bear market. Investors don't realize that the 1966-82 correction took place in the MIDDLE of a bull market. Now we are correcting the END of a bull market. THAT MAKES ALL THE DIFFERENCE. The world is awash in dollars that we have sent overseas in our spending binge on imports. At some point, foreign individuals and governments are going to conclude that it is not prudent to be holding so many dollars. The high dollar cannot be an island unto itself in a world of sinking currencies.

Not all governments want to sell their gold. When the French government was recently pressured into selling gold, they sold it to their own federal pension funds! Another distant early warning of things to come is the recent announcement by the Bank of China that they have contracted with Investek to provide them with 15 tons of gold per year for the next fifteen years. That is 7.2 million ounces over the life of the contract. At $300 per ounce that means the Chinese government is creating a public policy of annually selling $2 billion worth of foreign paper currency, sacrificing the interest it could earn for the safety of gold. This is a drop in the bucket in the international currency market. However China has announced that it intends one day to have a gold-backed currency that can become a world-reserve currency.China also recently announced that gold ownership would be deregulated next year. One has to worry about our civilization, when the West sells gold and the East is buying it. After all it was the Chinese who invented paper money. They must know the lessons of history of paper money. Would it not be ironic if a communist country taught the capitalist world the importance of gold-backed currency? There are some forces that even a world power like the United States cannot overcome.

One of the worldwide lessons of the twentieth century is mistrust of government. Gold is a good antidote. It is the only money you can trust on a long-term basis. Gold is the best money that paper can buy. Gold is different from all other money. It is nobody else's liability. Gold does not need any government backing. It is not any governments' obligation to pay. It is independent of government. It is personal freedom. So today there are two moneys emerging: Government paper money as a convenient medium of exchange, and gold money as a convenient store of value. Western authorities will probably wake up in due course to the fact that people need trustable money. We just do not know when. One thing is sure. There is an awful lot of paper money around the world, and very little gold. The market value of all the gold mining shares of the world comprise about 1% of the market value of all stocks. All the above-ground physical gold in the world is currently worth about $1.2 trillion. All the paper money in the world has a face value of about $120 trillion: So small a quantity of gold, so large a quantity of paper money. So small a supply of gold, so large a potential market for it. If gold were to represent 10% of the value of paper money, it would have to sell at 10 times its current price--$2,750 per ounce.

Someday, after sufficient paper currency declines, the world governments will re-discover a brilliant idea: gold backing for their currency. -"Plus ca change, plus c'est le meme." - Little wonder that carefully selected gold mining shares, which are leveraged calls on gold, are very high on our approved list. Two things are true:

  1. Permanent worldwide prosperity cannot continue indefinitely unless we have trustable, stable currency values. We cannot have that without gold backing.
     
  2. The less gold that governments hold, the higher the official price will have to be.
     

We have been living in an unprecedented era. Most people don't realize how unprecedented. Never before in recorded history have earnings increased substantially year after year. What has happened in this greatest bull market in history is a once-in-a-generation thing, a once-in-a-lifetime occurrence. When the public realizes this, they will sell stocks. When foreigners realize this they will sell our stocks and bonds. This process will feed on itself as earnings fall, so the greatest bear market in history must follow from the greatest bull market in. What will bring it all down will be the falling value of the dollar.

Through it all, gold and silver mining securities should serve as survivors' insurance, to say the least. Cash, short bonds, and a little golden dynamite in the portfolio may lead to investment survival.

China is poised to become world's biggest gold consumer.