first majestic silver

$XAU Underperformance

December 24, 2004

This article is divided into three Parts:

Part 1- explains why the Gold Shares have been underperforming relative to the price of bullion in recent months,
Part 2- points to some possible implications
Part 3- presents a possible explanation

Part 1

Over the years I have found that there are three criteria which seem to influence both the validity or importance of any particular trendline and/or angle of incline or decline. These are:

  1. A trendline which has a "gap" as one of its points of contact is probably important
  2. The more "points of contact" that you can achieve when drawing your trendline, the more meaningful the trendline
  3. If it is possible to draw other trendline/s, joining other tops and/or bottoms, such that the second, third and nth lines form channels represented by parallel lines, then the more parallel lines you can draw, the more important is that particular angle of incline

With the above in mind, I have hand drawn two sets of parallel trendlines which have common points of intersection, as can be seen from the chart below (courtesy DecisionPoint.com).

The lines A-B and C-D form a channel showing a shallow angle of incline for the gold price that has been in place since 1985. (Of interest is the fact that there was a gap that occurred at point A when the market broke up at that time)

The lines E-B and F-D form another channel showing a steeper angle of incline for the gold price that has been in place since 1999.

In my view the common points B and D are highly significant from a technical perspective, and point B is most significant of all.

Point B represents the "point of resolution" at which it will be determined which of the two angles of incline will dominate. It therefore represents significant resistance to a further rise in the gold price.

Angles of incline can be likened to "cruising speeds" in a motor car on a long journey. Although, as a driver of the vehicle, you may speed up or slow down from time to time to negotiate your way through obstacles and/or differing road conditions, over time your speed of travel will average out as a constant. Some travellers will be comfortable to average (say) 100 km/hour, and others will be comfortable to travel at average (say) 120 km/hour.

B is at a level in the chart above where it needs to be resolved whether the majority of investors (i.e. the market) would prefer to continue into the future at either of the following average cruising speeds:

  1. That represented by the angle of incline of A-B
  2. That represented by the angle of incline of E-B
  3. That represented by a steeper angle of incline than either of the above.

In respect of 3 above, the lines draw on the chart below offer one alternative possibility

Although (probably through a parallax error) they do not appear to be parallel, the four lines drawn above are as close to being parallel as is necessary to conclude that the angle of incline established in the 1977/1979 bull market (before the blow-off) - which was replicated in the 1985/7 bull market; and which has been replicated yet again in the 2002/4 period - may eventually be turn out to be the dominant angle of incline. It is slightly (but not significantly) steeper than the E-B angle of incline.

What are the technical implications that flow from the above?

  1. Barring an exponential blow-off such as occurred in 1979-1981 - which was subsequently followed by a price collapse - a price for gold in the thousands of dollars per ounce seems highly unlikely.
  2. In the absence of "proof" to the contrary, the angle of incline represented by line C-D should be regarded as the dominant angle if, for no other reason, than that it has been in existence for nearly 20 years, as compared with the angle of incline represented by line F-D which has been manifesting for only five years.
  3. Should resistance at point B eventually be overcome, it seems likely that a steeper angle of incline will begin to dominate - which could see the gold price at around $500 - $550 per ounce with one to two yearsprovided there is not an exponential blow-off.
  4. If the shallowest angle of incline should emerge as the dominant angle, a price of $500 per ounce for gold seems to lie several years into the future.

Technical analysis is not a science. As a matter of objective fact, one cannot reduce human behaviour to predictable mathematical formulae if for no other reason than there exists a phenomenon known as "biofeedback". By way of an example of what is meant by biofeedback, I am (as are most people) able to reduce my own blood pressure reading merely by concentrating and/or meditating.

It follows that if a large number of technical analysts are monitoring the market, then their behaviour will have an impact on how the market as a whole will behave. i.e. Those monitoring the system will themselves become part of the system. It is not mathematically possible (as far as I am aware) to develop a mathematical model that will take into account a primary human behavioural action and ALSO an infinite loop of possible behavioural flow-on reactions to that primary action. I guess it might be possible through computer simulation to "model" a ripple effect, but then the very knowledge of the existence of that model will likely render it inaccurate in the future.

By way of a tangential discussion, let's focus on the period from mid 1997 to mid 2003 in the first chart above.

Market analysts have made much of the fact that there was an escalation of Central Bank interference in the gold market that started to manifest in 1995. In this context it could be argued that it was this artificial tampering that caused a breakdown of the angle of incline C-D. It could be further argued that, when the price of gold rose once again to penetrate above line C-D in mid 2003, that represented the point at which the Central Banks withdrew from their day-to-day tampering, and "normal" market forces began - once again - to manifest.

Conclusion

Given that the market is objectively merely in the process of deciding - for the moment - whether the gold price will reach $500 - $550 per ounce in one, two or more years, the gold shares which have been factoring in a gold price of around $540 per ounce using discounted cash flow techniques will likely under-perform for some time until the gold price catches up.

PART 2

Sometimes, human behaviour tends to be extreme. Many people see things in "black" or "white" - This kind of mindset will conclude that if there is not going to be horrendous inflation that will take the price of gold to $3,000 per ounce, then it must be that there will be a bear market in equities that will cause the entire world economy to fall into a black hole; and deflation will take the price of gold to zero. Such arguments - because of their tendency towards extremism - can safely be ignored.

The fact that "many" people see life in terms of black or white, does not imply that "most" people are extremists. In fact, the lowest common denominator of human behaviour is apathy. Most people prefer not to think at all. Indeed, the extremists are typically also not thinking clearly. They just think that they are thinking J

In recent months there has been a slew of articles arguing that interest rates were going to rise. Indeed, even Mr Alan Greenspan himself confirmed that this was likely to happen.

But let's think about this for a moment. How likely is it that the Chairman of the US Federal Reserve would publicly give bond traders the green light to position against the bond markets in order to capitalise on short sales as the bonds fall in response to interest rates that he was virtually "guaranteeing" would rise?

In fairness, I need to be honest here and admit that, until recently, I was of the view that the S&P was destined to fall as low as 300 because it had broken below the neckline of a Head and Shoulders formation that is clearly visible on the following chart between 1998 and 2003.

Objectively, the recent move of the S&P to a level that is above both the left and right shoulders probably negates the breakdown of the neckline, which can now be argued to have been a "false breakdown". Alternatively, it can be argued that this was not a Head and Shoulders formation at all - even though the volume patterns confirmed that it was.

So, how is it possible for the US interest rates to rise significantly if the US stock markets are not going to "collapse"? Answer, this concurrent state of affairs is not objectively possible. Either interest rates will only rise modestly (if at all) so as to allow the equity markets room to breath. Or, the equity markets will need to negate there false break "up" following a negation of a false break "down", and they will fall significantly whilst interest rates rise. (Such convoluted behaviour seems to have a low associated probability of occurrence)

In recent months there has also been a slew of articles that have been anticipating a US Dollar "collapse".

But surely, if the US Dollar were to collapse, then interest rates would have to rise to protect the dollar? And if interest rates indeed did rise to protect the dollar, would not this cause the US equity markets to collapse?

Well, the technical evidence seems to support the conclusion that:

  1. The gold price is not about to "scream" upwards
  2. The US equity markets are not about to "collapse"

What about interest rates themselves? What do the charts tell us?

There is no doubt in my mind from the following chart that the long dated bond yield has stopped falling, but does this necessarily mean that it has to rise strongly from here?

Note how since 1989 the PMO has tried six times to rise above the zero line and has failed. Note also how much congestion there is at the 5% - 6% level. Is it not possible that the long bond yield can enter into a long term sideways or trading pattern that bounces between 5% and 6%? If so, how much damage is a 1% rise in interest rates likely to cause? Answer: Probably not a huge amount of damage - either to the equity markets, or the bond markets, or the property markets; or even to the US Dollar itself.

Let's now turn our attention to the US Dollar Chart.

Again, there seems to be a significant amount of "fear and loathing" amongst the extremists that the US Dollar is about to "fall out of bed".

But let's be objective here. There is significant support at the 80 level which implies two things:

  1. The probability of its being penetrated on the downside is low
  2. Should it break below 80, then the following fall could be steep.

But in the context of equity markets that appear to have a low probability of collapsing at present, and in the context of interest rates which could very well oscillate within a 1% trading range from this point forward, the probabilities favour that the Dollar Index's support level at 80 will hold.

From a gold investor's perspective, if the US Dollar Index support level at 80 does indeed hold, then this can be construed as Good News.

Why?

The answer flows from the following chart of the Goldollar Index (Gold price multiplied by the US Dollar Index)

Note how the resistance line AB commences at a gap (highly significant) and then has effectively 5 points of subsequent contact (also highly significant).

Note how the rising line CD is squeezing the price of the goldollar index into the Apex of a triangle from which a breakout MUST occur within the next couple of months.

A rising trendline approaching a horizontal resistance line is technically known as an "ascending right angled triangle" which, typically resolves itself to the upside.

It follows that if the goldollar index starts breaks up above the resistance level A-B the inverse linkage between the (rising) gold price and the (falling) US Dollar is likely to broken. In turn, what this means is that if the gold price rises from this point, it is likely to be in absolute terms as opposed to relative terms and, it follows further, that the gold price in non dollar denominated terms is also likely to also break up.

A gold price that is rising in absolute terms in both dollars and foreign currencies is likely to have positive flow on effects to gold shares which, in turn, are likely to rise - following the breakout given the above explanation as to why the gold shares have been lagging.

The following chart shows the price of gold in yen and it should be noted that this particular chart has already broken up out of the ascending right angled triangle - implying that the direction of the breakout of the entire goldollar index is indeed likely to be "up"

PART 3

Logically, the US related debts - which are at historically high levels, and growing - are (should be) exerting a downward pressure on both the equity markets and the US Dollar, and an upward pressure on interest rates. Unfortunately - arising from the above analysis - these expectations are not being met and the logic appears to be false.

This begs the questions: Why not? How will it be possible to avoid the anticipated economic consequences of US profligacy dating back to 1982?

By way of context, it is probably important to emphasise that my own background is one of Manufacturing and Venture Capital Investing. For 12 years from 1974 to 1985 I owned and operated factories, and for 12 years from 1986 - 1997 I was involved at fairly senior level in various aspects of Venture Capital Investing. Prior to 1974, I received my training in finance as an Investment Analyst and Portfolio Manager in the Equity Markets.

I therefore have hands-on experience in both Industry and Venture Capital Finance and, in my capacity as a Venture Capitalist, I am trained to think in terms of "Industries" as well as "Businesses".

Whilst there are not many people who will agree with me at this point in time, I have a view - which I have steadfastly held since 1985 (which is the reason I became a Venture Capitalist) that "energy" and "energy related technologies" ultimately drive the World Economy.

By way of example, I recently took the trouble to quantify the size of the world's oil and related industries and was surprised to discover that the combined 2003 revenue of all of the industries that are directly or indirectly related to oil that was around 10% of World GDP of $42 Trillion. (Or over $4 Trillion)

I also took the trouble to quantify the "Multiplier Effect" that flowed from the most recently published levels of World Savings rates and was equally surprised to discover that it is effectively 10X.

It came as no surprise, however, to "prove" that which I have understood intuitively since 1985, namely that 10 X 10% = 100% i.e. The entire world economy is ultimately driven by oil - which has been the primary energy input for generations.

Of course, the answer is not quite as "neat" as that! Of course, the "real" answer is that all Primary Industries added together generate the initial dollar revenue input which, when revenues from manufacturing and services are added, gives rise to World GDP after the effects of the Multiplier have been added.

But let's run with my model for a few minutes more.

If the World GDP is (say) $42 Trillion, and the Multiplier Effect is (say) 10X, then to increase World GDP at the margin by only 3% will require additional "primary value" input of only 1/10th of this number = 3% X $42 Trillion X 10% = $126 Billion

For twenty years I have been looking for an energy related industry that would supersede the oil industry which, in terms of mathematical modelling, can be demonstrated to have peaked in economic importance in 1975. As a Venture Capitalist working at senior level inside one of the largest banking institutions in the world I was able to investigate every Alternative Energy industry "contender" that I could find but, until about five years ago, the most likely contender as a substitute for oil eluded me. The biggest "clue" that I had was that according to the same mathematical models the primary contender was likely to be Natural Gas (as opposed to the basket of smaller, less commercially significant "natural" technologies that include solar, wind, hydro)

And then I found it!

In 2000 - after having been actively looking since 1985 - I had cause to investigate in depth an industry that had been established by the Germans during WWII and that had been quietly building a momentum since the 1950s and 1960s. That industry is founded on "gas-to-liquids" technology, which was originally invented by two German scientists by the name of Fischer and Tropfsch.

In brief, by converting carbon materials under extreme heat to carbon gas, and by adding various other gases including hydrogen, it is possible to artificially create a "hydrocarbon" gas which, when it cools, precipitates to become a hydrocarbon liquid that is not only equivalent to conventional fuels and oils but is also "clean" - i.e Free of impurities such as sulphur.

In brief, the technology was originally embraced by Adolph Hitler when it became apparent that there was a risk that Germany would be barred from access to the world's oil supplies if it were to enter a World War. Germany, which had access to abundant supplies of coal, was enabled by Fischer Tropfsch technology to produce "synthetic" fuel and oil.

One reason that Fischer Tropfsch technology had not been subsequently embraced as a world-wide alternative to crude oil was that the cost of converting alternative carbonaceous materials (coal, Natural Gas, farm waste, human solid waste) was too high to allow the resulting product to compete against oil - which until 2000 had been trading at below $25 per barrel (See chart below)

In 2000, the oil price rose briefly above $30 a barrel - thereby making Fischer Tropfsch technology a "contender", but it peaked in 2001 and fell until 2002.

It was only in early 2004 that it became clear that the oil price is now unlikely to fall below $35 - $40 a barrel; and it is now clear that Fischer Tropfsch Technology is "the" most likely contender to replace oil.

Also in 2000 I started to focus on another obstacle to the adoption of ANY widespread energy source as an alternative to oil, and I discovered that the US and European based oil lobbies were fiercely protecting their interests.

Those who were in the industry wished to preserve the status quo, and it is primarily for this reason that the threat of terrorism has been blown out of all proportion. This is not to say that there is not indeed a threat of terrorism, but to effectively argue that the future of all civilization is at risk because some undeniably evil forces conspired to destroy two highly visible buildings in New York seems to me to be "drawing a very long bow". When one puts this attitude together with the developments in Afghanistan and Iraq, and with the shenanigans surrounding the Yukos corporation in Russia, one develops an objectively healthy degree of scepticism that all is not as it seems on the oil front.

In any event, the very existence of Fischer Tropfsch technology - which has been in day-to-day use by SASOL in South Africa for over 50 years - renders oil a strategically vulnerable source of energy in the event of a rising oil price. i.e There is no doubt that oil is now both technically and economically replaceable. As a by- product of its adoption, Fischer Tropfsch technology will also offer an additional bonus: If embraced on a world-wide basis, it will ALSO facilitate a reduction of greenhouse gas emissions.

From the perspective of the oil lobby, something had to be done and, in my view, what was in fact done was that the they convinced the US (and Australian and Russian) Governments to refrain from ratifying the 1997 Kyoto protocols. Of significance was that the main commercial issue behind this decision was that ratification of the Kyoto Protocols would have accelerated a move towards Alternative Energy technologies. In turn, this would imply a concerted move away from oil - and this would certainly not have been in the financial interests of the politically powerful oil lobby. Hence, the failure of the US to ratify. Of course, the reason the US actually gave was "apparently" plausible, namely that the cost to industry would be too high. For this reason, the nonsensical compromise of "trading in carbon emission credits" was invented - to no avail.

But in November 2004, something structurally important changed. At the time of the US Presidential elections - when no one (including the world media) was really focussing on the environment, two things of huge significance manifested:

  1. The Russian Government - validated by a signature from President Putin - ratified the Kyoto protocols, ensuring that they would become international law in February 2005.
  2. Ex President Bill Clinton made a public statement to the effect that the time had now arrived when it was important to focus on the environment.

With an oil price at over $40 a barrel, and with Kyoto now being a "catalyst to change" the economic viability of Fischer Tropfsch technology is now beyond question. It is both cheaper and more greenhouse gas efficient to produce oil and fuel artificially than it is to buy and use the "natural" product.

Now let's look at some economic implications of this.

As a rough number the capital cost of installing a Fischer Tropfsch Gas-to-liquids plant is around $30,000 per barrel per day, including gasification equipment.

From an industry perspective, the world oil production is currently running at around 80 million barrels a day.

It follows that if the entire world's oil production capacity were to be converted to this alternative technology (which will not happen overnight) a total investment of :

80 million X $30,000 = $2.4 Trillion (which is less than 6% of world GDP) will be required.

If this amount were to be invested over (say) a 20 year period - by way of conventional profit driven investment, an annual investment of $120 billion would be required.

All by itself, assuming no shrinkage in world GDP as a result of debt collapse in the interim, investment in Fischer Tropfsch technology to produce synthetic oil and fuel would lead to a 3% p.a. growth in World GPD.

Now, for the sake of argument, let's assume that the US invested 26% of this amount (given that it accounts for 26% of the world's GDP) it would invest $31.2 billion a year, which would translate - via a multiplier effect of 10X - to an increase in US GDP of $312 billion a year. At that rate it would take the US roughly 100 years to pay off its $34 trillion debt - provided interest rates do not rise significantly from this point (so as to pop the property and bond bubbles) and provided the US Dollar does not collapse (so as to pop the equity bubble).

In and of itself, a 100 year payback period is not particularly impressive. However, one factor that that needs to be focussed on is that there is reason to believe that the US debt levels may soon top out and begin to fall.

Another important fact on which to focus is that Texaco (a world leader in gasification) is a US based company, and US Engineering companies are likely to benefit somewhat from overseas country investment in this technology as part of overall Fischer Tropfsch technology.

The chart of ChevronTexaco (courtesy Bigcharts.com) shows this company's shares having reached new highs in September (the same month that the Russian parliament voted to ratify the Kyoto Protocol)http://news.bbc.co.uk/2/hi/europe/3702640.stm

Note that the break up of Chevron Texaco was in September, but the oil price at that time was in the process of consolidating

Overall conclusion

The recent ratification of the Kyoto protocols by Russia seems likely to give rise to a shift in the tectonic plates of the world economy - which should enable it to be given a much needed incrementalinvestment shot in the arm.

The recent rise in the oil price - to a level which renders large scale investment in gas-to-liquids (Fischer Tropsch) technology not only viable, but financially exciting - will itself be a facilitator of the move away from oil.

Behind the scenes, the above seems to be a plausible explanation as to why the US Equity markets appear to have aborted their southward journey, as well as a plausible explanation as to why the US Dollar is probably not going to collapse and the gold price is probably not going to explode.

Notwithstanding this, given the lingering and large size of the US Debt levels, it appears that the world has learned a lesson regarding the dangers of "pure" fiat currencies; and the gold price in all fiat currencies seem about to re-enter a bull market within the next couple of months. This bull market seems likely to be within the context of a continuing rising dollar price of gold, at perhaps a slightly higher angle of incline than heretofore - thereby making gold and related investments a practical (broad based) long term investment opportunity.

Finally, the irony of Adolph Hitler having been the person who originally commercialised Fischer Tropfsch technology - which is now sufficiently commercially developed to enable it to replace crude oil as the world's primary source of energy for the next couple of generations; and to reduce greenhouse gas emissions in the process - should not be lost on anyone.

I take this opportunity on this Christmas Eve of wishing you all a Merry Christmas and a Happy New Year.


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