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Taylor on us Markets & Gold

The Paper (Financial) Markets

October 5, 2002

Bullish Markets

The Giant Sucking Sound

Actually one point we would like to make that we think Mr. Gross has still not focused on, but which Dr. John Whitney and now finally Stephen Roach of Morgan Stanley is focusing on is that one of the major reasons why the U.S. companies are in trouble is because of an exceptionally overvalued U.S. dollar. We know this is true because capital intensive bulk commodity products (as opposed to labor intensive products) are pushing American producers out of their own markets. There are virtually no cost advantages for the Chinese on these products since they use the same kind of capital intensive production measures as the U.S. uses. And then they have to ship these heavy products half way around the world through a couple of canals which is a very costly process. The only way these products can force Americans out of their markets is by way of an overvalued dollar, which in effect is a major tax on American consumers. - the only explanation is that the dollar is much too strong. Moreover, the Chinese currency is pegged to the dollar so that even when the dollar declines in value vis-à-vis the Euro or Japanese yen, there is no return to a trade weighted fair dollar as far as China is concerned. And so we are hearing the giant sucking sound that Ross Perrot warned us about.

So why don't we hear about an overvalued dollar as a solution to our problems? I believe it is because the policy makers of America no longer care about America. What they are working very hard to accomplish is a one world government. And judging the apparent elimination now of legislative bodies, which are now subject to court rulings, how can anyone deny that we are no longer a republic, but an emerging dictatorship?

- GOLD - Gold Bullion remains bullish and I continue to believe we are in the very early stages of a multi-year bull market in gold. The spot price of gold at $321.60 is above the 20-day moving average of $319.72, the 50-day moving average of $316.67 and the 200-day moving average which is at $305.72.

We really need to get through about $330 to see higher prices taken out. In the mean time, a moderately rising gold price is allowing some of the major mining companies a chance to unwind their hedge positions before an explosive rise in gold springs forth. In any event, we would much rather see an orderly rise in the gold price. After building such a long term base, the gold charts are looking exceptionally healthy.

- GOLD SHARES, as measured by the XAU on the other hand have been displaying some weakness. As of the close of business yesterday, the XAU was at 67.16, just slightly below its 200-day moving average of 68.01. You will recall earlier in this bull market, the gold shares were leading gold bullion. I believe the current slow down in the shares may simply be a correction of the shares which had gotten ahead of themselves and gold bullion. Of course, we take it as a given that intervention in the XAU is definitely a possibility by some of the gold bullion banking firms who hate gold at the very core of their being. After all gold is to bankers what a nun is to a whore house. Gold and the nun are both a deterrent to deceit and dishonesty. The critical support level for the XAU is at about 55 which was reached back in July and 50 reached in November 2002.

Bearish Markets

- STOCKS as measured by the Dow and the S&P 500 and virtually any other broad based index you care to name is bearish and showing considerable technical weakness. Both the Dow and the S&P are not only substantially below their all important 200 day moving average but also very far below their 20-day and 50-day moving averages. And both are very close to long term support levels. For the Dow that support level is at about 7500. For the S&P 500 it is at about 800. A decline by either or both of those indexes would likely mean a very substantial and possibly a very quick decline to much lower levels. I still think it is possible that we could see 5000 before the end of this year on the Dow.

- THE DOLLAR - as measured by the U.S. Dollar Index is at 107.16 vs. its 20-day moving average of 107.36, its 50-day moving average of 107.52 and its 200 day moving average of 111.01. There has been a great deal of intervention in this market. Unlike gold, the government does not deny that it manipulates the currency markets from time to time. So why don't they acknowledge they are doing it with gold too? Because if the markets understood that the gold price was lower due to intervention rather than natural market forces, the private sector would begin betting against the government. In the end, the markets will win any way. And we think the early stages of the bull market in gold is evidence that the time of gold price fixing by the Fed and other central banks may be near at hand. And when policy makers are no longer able to manage the gold price, they will also likely lose control of the currency markets too because what we are talking about here is systemic risk. Gold is the money that is outside of the fiat money system and hence the place to be given the growing vulnerability of our dollar based global fiat money system.

Overall we think Stephen Roach has properly diagnosed the disease that is at the heart of a growing systemic global risk. Stephen points out how the entire world is dependent on the U.S. to continue living beyond its means. But at some point in time, the pathological behavior displayed by the U.S. will cause it and the entire global economy to self destruct. Dr. Roach is quite rightly calling for a decline in the dollar back toward a fair trade weighted balance. Unfortunately, Wall Street is more concerned about retaining overvalued capital markets for the sake of preserving its own wealth than about longer term health of U.S. markets. As such, there is little likelihood in my view that policy measures to allow the dollar to return to a fair value on the basis of trade will be allowed to take place. Indeed, Dr. Roach noted in a recent essay that he had taken a great deal of heat over the suggestion that the dollar should decline by 20% or so.

Unfortunately this is a game of chicken that not only policy makers but all of us will be victims of. Those who protect themselves by investing outside of the system, will fare better than others. But make no mistake, gold and gold share profits will by no means offset the overall pain we are likely to suffer in the Kondratieff winter that has just begun.


Further information related to the potential for junior mining companies facing the threat of property loss due to gold hedging by joint venture partners with project financiers was provided by James Sinclair at the beginning of this week at With the permission of Bill Murphy of GATA, I am herewith reprinting Mr. Sinclair's comments.

"Let's reason together. As a junior exploration and development company, you have an exciting property. Hedge Hog Gold, a major Canadian producer, likes the property and after a long negotiation you come to a 30% you and 70% Hedge Hog Gold, JV agreement. HHG, the major gold producer, finally finishes exploration and contracts with a major engineering and economic geological consultant to provide a positive bankable feasibility study.

"You, the junior, in your JV agreement with Hedge Hog Gold, the major gold producer & now property manager, as is the industry standard, agrees with the lender as permitted by you to place your 30% and Hedge Hog Gold's 70% of the property up as collateral to the development financing. Financial entities that fund development loans will never fund a fractured asset. 100% of the asset must collateralize the funding.

"In today's world it has become common for financial entities to offer non-recourse funding for mining development projects if the project enters into a derivative hedge that sells all gold production forward, thereby guaranteeing the ability to pay back the loan by locking in the profit for the term of the loan repayment. That term is normally 10 years. Now, you can see why certain companies CANNOT close their hedges, as they are mandated by the loan agreement that provides non-recourse financing. Non-recourse financing means that the lender will not, in the case of a failure to repay, look to any asset of either the junior or the major except the underlying property pledged.

"The problem is that the junior rarely has anything else anyway. Hedge Hog Gold, like all majors today loves non-recourse financing because they have many other projects operating. They do not want the failure of one project to impact any other project. Therefore, the form of non-recourse financing has become almost 100% of the gold project financing over the past six years. This is one of the reasons that hedging has become so popular in the gold mining industry.

Now it stands to reason that the junior in this 30% / 70% JV, who places its property as collateral for the loan package would have 30% of the Derivative Risk. It is the Derivative setting the price of the gold sold for the project, therefore the junior is benefiting from the Derivative part of the loan package, if gold declines. It stands to legal & logical reasoning that you cannot benefit from the derivative placed by the major as part of the loan package and avoid the liability of that derivative.

"The junior benefits in two ways. First, the junior benefited from the loan package itself which built their 30% of plant and mine. Secondly, if gold declines, they benefit from the hedge position. My position is, if gold rises and the Derivative melts down, Hedge Hog Gold is going to look to the junior for 30% of the loss. It is the industry standard that if you receive a cash call from the major that you cannot meet, it triggers a dilution clause, usually to 10% of net profits. In English, 10% of net profits in a JV with a major gold producer = practically no $.

"Therefore in what I have demonstrated to you, any junior gold producer or explorationist in a JV agreement with a major gold producer who is also a hedger probably is in danger of losing their asset to the major.

"You can find out by asking your junior. It may be a revelation to them but they and you need to know. Copy my letter and this answer to a reader in and send it with a polite note asking your gold junior to have their legal counsel read this and check to see if they have this liability.

"Your junior (if it is in a JV with a major as described) may be and probably is exposed to a derivative risk that they do not know about by what is called in law -- a Negative Pregnant. That means the obligation exists, even though not clearly stated in the agreement, because it is simply a provable legal obligation even though it is not clearly stated. I believe in such a circumstance as I have outlined you have? a "Negative Pregnant" therefore the junior has the obligation on the derivative simply by definition. Your junior is obligated to answer your question.

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