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Gold Market Update

December 28, 2001

The dollar gold bullion price during the last two weeks resumed its upward trend, which began last April, closing on Friday at $278 an ounce, 1.4 % above our last Update. Due to the weakness of other currencies, gold's price has been strong in all currencies as well. Significantly, the yen fell to a new three year low against the dollar, and the gold price made a three-year high in terms of the yen. Japanese gold investors were rewarded!

Gold mining shares also performed well. The Philadelphia Gold/Silver Stock Index (XAU) was 4% higher than two weeks ago. The Financial Times African Gold Mining Index climbed 80% above its low a year ago due partially to a 36% fall in the South African Rand against the dollar during that period.

Argentina announced it would suspend payments on its $155 billion foreign debt, the largest sovereign debt default in history. The politicians in congress there roared their approval. Creditors-beware when an economy becomes disorderly!

Here are four more reasons why we like gold mining shares as portfolio diversifiers (in addition to the ones in our last Update):

First, many economists and investors expect an upturn from the current recession later in 2002. Indeed, there are signs that the economy may be "bottoming out". However, although some adjustments have already been made, the correction of many remaining imbalances in business and household debts, stock prices, plant capacity, saving and consumption and record current-account deficits and corresponding record private sector financial deficits built up during the great speculative boom of the 1990s may take longer than currently expected. Reductions in cash flow, employment and sales may force a slowdown of debt growth and even lead to a contraction of debt. Aggregate demand, which has been partially supported by credit growth, may accordingly fall further below "potential output". Additional time may be needed to restore balance and long-term sustainable growth in the economy.

Second, household debt may be excessive and vulnerable to a weakening economy because household budgets are stretched so thin. Household debt was $7.6 trillion (100% of disposable income) on September 30, 2001, having risen at an average 7% annual rate since 1991. It even rose at a rate of 8.8% in the second and third quarters of 2001 after the recession began. No one knows how long debt will grow faster than income, but a slowdown in consumer credit growth may be reached sooner than expected. Debt-servicing costs as a percent of disposable income have grown close to previous peak levels. Refinancing has repaired balance sheets, but they are still weak. The percent of personal savings to disposable income fell from approximately 9% in the early 1990s to last year's record low of 1%. If households were to scale back their borrowing and spending to a more normal level due to low confidence and rising unemployment, a prolonged recession might not be avoided.

Third, business balance sheets became further leveraged during the 1990s. "Off balance sheet" financing became popular. From cutbacks in the early 1990s the annual debt growth rate climbed to over 10% in the late 1990s. It was approximately 6% in the second and third quarters of 2001 after the recession began. While net interest payments rose during the latter period, corporate profits fell, thus increasing risk. Business earnings may be further impaired during a prolonged recession due to falling sales, excess capacity and competitive price-cutting. The over-investment in productive capacity may take more time than expected to reach the needed scale of adjustment for profits and investment spending to turn upwards on a sustainable basis.

Fourth, although stock prices are below their March 2000 highs and profits have fallen, valuations remain high and risky. The long-run average price/earnings ratio was approximately 14, consistent with a real return of 7%. Currently, the Datastream measure of total market p/e is 23, down from a peak of 33 in April 2000. Stocks are also high as a percentage of GDP. The risk is that a prolonged recession might reduce profits further. Historically, the profit annual growth rate bears a close relationship to the GDP growth rate. Investor expectations of high profit growth rates could be eroded, resulting in lower price-earnings ratios and higher equity premiums valuations.

A medical study in France during the early twentieth century suggests that gold is an effective treatment for rheumatoid arthritis.
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