Some thoughts on gold’s steep correction
Gold's taken a downturn recently, but is it a blip on the radar or a fundamental shift in the market?
Not surprisingly, gold’s steep correction has generated some concern for
resource stock investors. So let’s take
a look at the gold market.
I figure the metal "should" be worth something like $1,000 an ounce
now to be in a rough equilibrium with the value of other things the dollar can
buy. That’s an arbitrary guess; there’s no exact method I know of to determine
gold’s real dollar value. If the U.S. dollar were sound, there would be a fixed
amount of gold in the treasury for every dollar in circulation; in the 19th
century, a $20 note was a receipt for an ounce of gold held on deposit, and a
"dollar" was just a convenient name for a 20th of an ounce of gold.
Today, of course, the relationship between the dollar and the amount of gold
the U.S. Government has to redeem it with is so tenuous that it’s completely
academic. But, assuming that the government were just to make good on dollars
held by foreigners—forget about Americans—how high a gold price might be
needed?
First we need to know how many dollars are outside the U.S. Nobody knows
exactly. They constitute the reserves of most foreign central banks and the
de-facto currency of record in dozens of countries for ordinary citizens. The
amounts are almost beyond belief; it’s said that, in Moscow alone, there are more US$100 bills
circulating than in the entire U.S. Could $5 trillion be the number? If so, and
if there are the reported 261 million ounces in the U.S. Treasury, the value of
that gold comes to about $20,000 an ounce. Just to make good on the reported U.S. trade
deficit of $800 billion for the last year, we’re talking $3,000 gold. Forget
about what the numbers would be if you added in the domestic money supply, M-3.
Especially since they don’t even publish it anymore.
But the numbers, at this point, are academic. My basic view on gold is
unchanged. And the fact it had a 37% gain this year, reaching a peak of $725 on
May 12, or has given back 22% since then is meaningless in the big scheme of
things. As I’ve said before, before this market is over, gold isn’t just going
through the roof; it’s going to the moon. And the market is by no means over.
It’s just starting to wake up from a generation-long slumber.
Why did it heat up the way it did? Perhaps the attention of the traders was
drawn to gold by Bush’s brinkmanship and buffoonery over Iran. Perhaps
it was people noticing that gold was a relative laggard among the metals in
this bull market. Perhaps the market was paying more attention to the Russians
and the Chinese, among others, divesting dollars. There is solid evidence that
dehedging by the producers helped fuel the surprisingly strong rally, and that
that dehedging is now slowing.
Likely it was a confluence of these and other factors. Thousands of hedge
funds, most of which collect their 20% profits just to follow the trend, piled
in. As the herd took their positions—especially when the short-term oriented
traders had all bought—momentum slowed, and it went into reverse.
Remember that most of these traders were toddlers the last time gold got
anyone’s attention, back in the 1970s, and so they only know what they’ve been
taught—that gold is an anachronism, a valueless relic. Consequently, they have
almost no understanding of gold’s fundamentals.
Consider, for instance, a primary reason given for gold’s big correction is
that higher interest rates will make gold a less attractive asset. As if there
is some hard and fast rule that says gold can’t move up when interest rates are
rising. But that ignores the clear historical precedence of the 1970s when
interest rates were surging at the same time as gold.
It’s unwise to try picking tops and bottoms in the market. But, the way I see
it, gold has made its bottom as you read this. The fundamentals haven’t
changed; there’s only been a swing in traders’ sentiments.
As for the gold stocks. We’re still in the “Wall of Worry” stage of the market.
The larger public is not involved, and the thin slice that is, is just moving
with the price of the metal. The downdraft has been aggravated by the weakness
in the NY market. Remember, gold stocks do best when both gold and stocks are
rising and worst when both are falling.
My guess is that now, after
losing perhaps 25-30%, the big selling is over. The stocks will drift through
summer, and the game will be on again come the fall. You should use this time
to pick through the wreckage and put in stink bids on the issues likely to lead
the market back.
Although the best indicator is to watch popular magazines, with an eye to doing
the opposite of what their covers scream, there’s still too little public
interest in gold to merit their attention. And it’s too early in the market for
your neighborhood cocktail party chatter to tell you much. Best to use your own
psychology: when you feel bold and enthusiastic, sell. And when you’re fearful
and depressed—like now—buy, or at least line up your targets. Don’t forget how
much higher these stocks are now than a year ago. And remember they’re likely
to be much higher a year from now.
The best recent analogue remains the Internet market. Every time those stocks
sold off from about 1995 on, it just set the stage for an even stronger
resurgence. That’s how this market will play out as well.
Finally, a reminder that volatility is the norm, not the exception, in gold and
silver stocks. It’s very important you only invest in them to the level of
being completely comfortable with a 50% or even 90% loss. That’s not just a
passing platitude, but perhaps the best bit of advice I can give you. Reading
some of the emails we’ve received these last few days, it’s clear that some of
you probably got carried away and so are now panicking. That is never the right
frame of mind, under pretty much any circumstance, but especially when it comes
to investing.
As the gold and silver stocks come roaring back in a month or so, do yourself a
favor and scrape enough off the table to get you back to the point where even
steep losses are unconcerning.
Meanwhile, patience, steady nerves and a focus on loading up on the best of
best at bargain prices will win the day.
Doug
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