Gold Market Update

September 11, 2002

Hello everyone, this is Joe Foster with a Gold Market Update on Monday, September 9th, 2002. Our next Update will be on Monday, October 7th, 2002.

The gold price improved during the month of August, reversing the downtrend of the prior two months. Gold has gained $12.90 or 4.2% since our August 5th Update to close Friday at $319.90. The summer (June-August) is historically the weakest period of the year for fabrication demand. If past trends continue, gold demand will improve over the coming six months as jewelers replenish stocks during the holiday seasons of Ramadan and Christmas, the Indian wedding season, and the Chinese New Year. Seasonal demand has less influence over gold prices than investment demand, which depends largely on market forces such as currency valuations, interest rates, stock performance, and investor psychology. Japan was an important source of investment demand in the first half of the year, as the Japanese government withdrew their 100% backing of time deposits, replacing it with a 10 million yen ($80,000) guarantee. Many Japanese bought bullion as a hedge against a weak banking system. The Japanese government planned to further eliminate its 100% insurance on all other commercial bank deposits in April 2003. These plans were cancelled in August amid a declining stock market. Last week the Nikkei Stock Index sunk to nineteen-year lows. Japan's banks have large holdings of stocks in their portfolios, which causes market declines to erode their capital base. Some analysts had forecasted another boost to Japanese gold demand leading up to April 2003. While this date has now become a non-event, precipitous declines in the Nikkei and the decision to maintain current deposit insurance levels highlight the precarious health of the Japanese banking system. Against this backdrop, it is likely that Japanese investors will continue to search for alternatives to protect their wealth.

In our last update we alluded to the risk of deflation in the post-bubble U.S. economy. Below is a chart that plots the annual change in the Producer Price Index.

The PPI has now shown year-on-year declines for ten months. Except for a period following the 1998 Asian financial crisis, over the past fifteen years producer prices have never had such declines for more than two consecutive months. What makes this alarming is that the deflation in producer prices comes on the heels of the historic Fed rate cuts of 2001. What more can the Fed do to stimulate business? What will the Administration do?

While the PPI has been contracting, the Consumer Price Index has been growing at a rate of between 1% and 2% per annum.

Despite this, consumers are starting to display deflationary behavior. Automotive sales skyrocketed in October 2001, then again in July 2002 in response to 0% financing. In a nation hooked on credit, the only thing better than debt is free debt. Consumers are learning to wait for price concessions. This has onerous implications for the profitability of U.S. corporations, already having difficulty competing internationally due to the strong dollar, and now facing new price sensitivity domestically. There are no recent examples of CPI deflation in the U.S. and it is too early to tell whether a deflationary period of the magnitude experienced in the 1930's is a possibility. Bank failures rocked consumer confidence in the wake of the 1929 stock market crash. In the modern economy, debt levels are high, but exposure to debt is spread amongst a myriad of financial institutions and corporations, not just banks. Modern policy makers are more proactive than their 30's counterparts. Banks appear healthy, although we believe that their derivatives exposure with a notional value measured in the trillions of dollars poses a risk that is difficult to quantify. While most of us remember the role gold and gold shares played in the 1970's as a hedge against inflation, less well known is gold as a deflation hedge. Prior to World War II, Homestake Mining was the blue chip gold stock of the NYSE. From September 1931 to August 1938, the split-adjusted share price of Homestake rose from $0.49 to $2.65. Excessive levels of inflation and deflation are both symptoms of an economy that is out of balance and a monetary system that is unable to accomplish its goals of stable prices and steady growth. Most asset classes perform poorly under such conditions, whereas gold tends to attract investors globally as a monetary alternative and as a tangible asset with intrinsic value.

According to the Talmud you should keep one-third of your assets each in land, business interests, and gold.