Gold Market Update

May 17, 2001

Is this what a post-bubble economy is supposed to feel like? Folks are still borrowing and spending, with consumer credit up an annualized 4.7% in March, revolving credit up an incredible 11.7%. Summer tourists are starting to clog the streets of Manhattan. The neighbors are adding on to their house - again. Meanwhile, unemployment reports get worse, real interest rates approach 0%, and debt problems mount. Front page Wall Street Journal this past Friday declared that losses on Telecom debt are expected to rival the losses from the Savings and Loan crisis of the early 90's. The mood in America is surprisingly complacent, with absolute faith in the power of big government to correct whatever problems arise. Not having lived in the U.S. in 1930 or Japan in 1991, I can't say whether the mood fourteen months after the collapse of those historic stock market bubbles was different than today, although I've always imagined it was. When comparing price charts, we find that final stock market capitulation came nearly three years after the peak of both the 1929 DOW and the 1990 Nikkei. Perhaps the worst is yet to come in the post-Nasdaq bubble economy, but if this is as bad as it gets, we can't wait for the next one!

The gold market has improved since our March 23rd update. In the face of a strengthening dollar, bullion broke firmly above its 200-day moving average of $267.85 on Wednesday, May 9th with a $4.90 daily gain. Gold mining shares also moved decisively higher on big volume. Commodity traders saw this as a bullish sign as Comex open interest increased on long buying. Gold has since faded a bit, but held slightly above the 200-day trend line to end the week at $267.90. Outside of technical factors, a global reflation theme was also supportive of gold. On Thursday, May 10th the European Central Bank unexpectedly reduced rates by 25 basis points after stating just two weeks prior that European inflation is too high to allow easing. This, coupled with the widely expected Fed rate cut tomorrow and Japanese plans for "quantitative easing" (a.k.a. printing money), created inflationary concerns in the market.

On May 4th, Bloomberg News continued their ongoing bearish assault on the gold market by publishing a sort of post mortem on gold as an asset class, citing as evidence the decline in gold funds, which, according to Bloomberg, have dwindled by 70 % over the last five years to $1.3 billion in assets. Additionally, many precious metals funds now have large holdings of non-gold equities. We don't dispute that the gold funds have a diminished influence on the gold market these days, however, gold mining company valuations suggest that interest in the gold sector is much broader than generally believed. Gold companies have historically traded at a premium to their intrinsic value. In fact, analysts don't use price/earnings ratios as a basic measure of value because the P/E's of gold companies are volatile and usually at astronomic levels. Instead they use price/cash flow or undiscounted net asset value premiums. For example, based on 2001 and 2002 estimates, gold companies trade at approximately double the cash flow multiples of their copper-producing brothers. Undiscounted net asset value premiums for the gold producers now hover around the 60% level. While this is down from historic levels of around 90%, it is still extremely high when compared with other commodity producers. The reason for the superior valuation is that, unlike copper, two-by-fours, or soybeans, gold has added value as a currency and store of wealth. Gold shares effectively serve as call options on bullion. As the influence of gold funds on the market has declined, others in the broader investment community have bought gold shares, thereby enabling the gold miners to maintain their premium valuations. If new investors viewed gold as a simple commodity, they would never have bought a single share, and the valuation multiples would have collapsed along with the shrinkage of the gold funds. Investors support the high multiples because gold endures as a unique asset class.

Gold is still being mined and refined at the rate of almost 2,600 tonnes per year.