Gold Market Update

February 7, 2002

Since our last update, bullion dipped near long-term support levels at $278, but quickly reversed course to end the week with an impressive $3.90 rally on Friday to close at $286.00. A steady trend-line along progressively higher lows has been in place since last April. This price trend is increasing at a 10% annual rate. Meanwhile, the twelve-month gold contango (forward price premium) has hovered around the 1% level since September. From 1997 through 2000 the same contango ranged from 3% to 6%. Any time the price of gold rises at a higher rate than the contango, it doesn't pay to hedge or short the metal because the gold must effectively be bought back at prices above the contract price at maturity to complete the trade. This explains why both producers and speculators are reluctant to hedge or short the metal respectively for the first time in five years. Anglogold announced in their quarterly reporting last Thursday that over the course of 2001 they have reduced their hedge exposure by some 3.4 million ounces (105 tonnes) by delivering into their book without putting on new hedges. The gravy train that enabled the bullion banks to make a windfall by selling short in a declining price environment is over. Credit Suisse First Boston saw the writing on the wall when they shut down their bullion banking business last fall, to the dismay of their clients. Another prominent player in this arena is Goldman Sachs, whose Derivatives and Trading Research Group issued a buy recommendation for XAU calls on January 3rd. Apparently, Goldman feels their bullion derivatives book will be manageable at higher prices.

In addition to the gold-friendly interest rate environment, financial risk is rising around the globe, causing investors to take a fresh look at bullion. According to the World Gold Council, Japanese gold demand was up 54% in the fourth quarter. New limits on bank deposit insurance that go into effect in April have many Japanese wondering if bank failures are imminent. The Nikkei Stock Index dropped below the DOW for the first time since 1957. The Yen is making new lows against the dollar as well. Estimates of the funds required to repair the bad debts of the Japanese banks are many times that of the S & L crisis in the U.S. in the early nineties, perhaps an order of magnitude greater. Meanwhile, as Argentineans suffer the adverse effects of deflation caused by pegging their currency to an overheated U.S. dollar, we wonder how much longer Hong Kong can continue its dollar peg. Another 1% rise in the Trade Weighted Dollar Index will put the U.S. dollar at new 15 year highs.

What makes the recent strength in gold unusual is that it is occurring amid dollar strength - perhaps a sign of the times. Given the well established inverse correlation between the dollar and gold, it has been a puzzle as to how a bull market in gold could develop in a dollar-centric world where most Central Bank reserves are tied up in dollars and, relatively speaking, the U.S. economy is perpetually stronger than any other (although Enron et al and the War may be changing all that). The answer to this appears on the graph below. Since the gold price was freed from government mandate in 1971, it has traded in a series of distinct bands versus the Trade Weighted Dollar Index. When fundamentals and market sentiment reach certain levels, gold gets re-rated and shifts to a new trading range versus the dollar, while at the same time maintaining its inverse correlation. Gold achieved a positive re-rating in 1974 and 1979. These were tumultuous years in which inflation and oil shocks wracked the economy. Gold received a negative re-rating in 1990, following three years of declining bullion prices, as inflation was subdued and the Cold War came to a close. Today, gold continues to trade within the range established in 1990. If dollar strength persists, what would cause the gold price to improve through a positive re-rating? While the well-being of the global economy is currently at risk on several fronts, there are key indicators that suggest that U.S. investors are generally ignoring these risks: 1) the general stock market continues to trade at historically high levels relative to GDP and earnings; 2) consumers continue to borrow and spend at excessive rates compared to past recessions; and 3) the U.S. housing market has remained strong. An event or outcome that causes any of these key areas to enter a significant decline might prompt many more investors to seek alternative ways of protecting their wealth. Gold is one of the few investments that has a history of protecting wealth during periods of heightened financial or currency risk. The positive price trend in bullion and the impressive year-to-date gains by gold stocks (XAU up 15.4% as of Friday) suggests there are a growing number of investors who recognize the merits of gold. Here are some pertinent comments from a recent Barron's interview of a leading small cap portfolio manager: "Gold stocks - which we don't own - seem to be trying to tell you something. .... Any more deflation won't be good. .... With deflation, companies learn only what price they can't sell something for ...... Now we need a little inflation."

In every cubic mile of sea water there is 25 tons of gold