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AGE Gold Commentary is our regular report analyzing trends in precious metals and rare coins. We monitor domestic and international markets and extrapolate from our 30 years in metals to place current events into a hard asset perspective. View archives.


1/24/2007: Calm before the storm

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Greetings from American Gold Exchange. In this edition of Gold Market Commentary:

Precious metals overview 2007
Gold: Back to the 1970s
Bernanke: 'The calm before the storm'
Classic U.S. gold coin update
Recommended classic U.S. coins

Precious metals overview 2007

After the first three weeks of 2007, precious metals remain range-bound in what can best be described as choppy and volatile trade. Because our world has become so wired, and information now travels the globe in milliseconds, metals prices are increasingly influenced by the news of the moment. And since gold and silver have more than doubled in price over the last three years and are likely to do so again, they have attracted the interest of investors, speculators, and money managers around the world. Volatility is the result, and we've been seeing quite a bit of it lately.

In our last update, we described how gold decoupled from oil last fall after moving in tandem for several years. This trend continues: gold has firmed up in price over the last 30 days while oil has continued to decline, down 13% in the past two weeks and around 30% from its recent peak. These losses come despite the seasonal increase in demand during winter, threats to supply caused by Russia shutting down its pipeline to the west, and Venezuelan President Chavez's recent talk about nationalizing his country's oil industry.

Last week on NPR, an analyst was queried about oil's recent, counter-intuitive decline. His response was illuminating, not simply about oil but any commodity, including gold. The minute oil leaves the ground, he said, it is owned by the financial markets, so every oil shipment around the world is traded several times before it reaches its final destination. In the last three weeks, many traders in hedge funds, investment banks, and ordinary pension funds have lost their appetite for oil. Speculators who had previously seized any excuse to pump money into the oil market are now using any excuse to get out, despite increased winter demand and recent geopolitical events pointing to higher prices. With any market, once speculative momentum develops in either direction it can take a while for fundamentals to win out and return the market to a more rational course.

Tidal waves of speculative money move around the world in seconds these days, lifting the markets du jour for a time and then crashing them back to earth despite fundamentals that might otherwise chart a slower and steadier current. Oil, gold, and other commodities are especially prone to such speculative volatility these days. Last spring, for example, gold surged quickly over $730 because speculative momentum pushed prices past their natural equilibrium points, a little too high, a little too fast. Oil seems to be reacting now the same way gold did last spring.

As the gold chart above indicates, the last twelve months have been volatile, indeed. Between 2002 and 2005, gold gained at a steady pace from around $300 to $450 an ounce. Then, beginning in fall 2005, hedge fund managers and speculators worldwide started piling into the market. By spring 2006, speculative momentum took over, driving the gold price to a new generational high of $730 in May. Of course, speculators can exit a market as fast as they enter, and that's exactly what happened last May and June when the gold price dropped below $570 on profit-taking. It's been consolidating in choppy trade between $580 and $650 since August.

In hindsight, it seems pretty clear the gold market simply got ahead of itself in a speculative frenzy. And the surprising strength of this premature up-spike was the reason why its ensuing correction was so strong, and why the market has been unusually volatile since. Today, those short-term speculative excesses have largely dropped from the market, and gold is tacking higher on solid fundamentals once again. While the recent bias has been towards the upside, we think the gold market will remain range-bound for the time being. However, gold is up $20 in the last two trading sessions, reacting to oil moving higher and the dollar moving lower, and may test upside resistance at $650 soon.

Recently, silver has been choppy and volatile within a trading range of $12.00 to $14.00. In December 2006, silver pushed over $14.00 for the first time since spring 2006 but failed to hold those gains.

Although silver was lagging gold in price appreciation early in the bull market, it's been playing a fast game of catch-up over the past 18 months. In 2002, silver was under $5.00, and it remained under $8.50 until fall 2005, when it began a dramatic surge to as high as $14.75 in spring 2006. Like gold, it dropped severely in May and June when speculators and hedge funds lost interest. Since then, it rebounded nicely and consolidated with most of its gains intact, but the consolidation process has been very choppy, as the chart shows. Now silver seems to be steadying once again and building a base above $12.50.

The current silver price is two to three times its average price from the mid- to late-1990s. If it follows gold’s lead, and we believe it will, silver should eventually double or even triple its current price to trade in the $25 to $40 range. Some analysts are calling for $100 silver in the future. Although this figure seems too high to us, we see big gains in store for silver, nonetheless.

The current platinum chart is one of the most erratic we’ve seen in decades. Platinum remains the most highly valued precious metal and the most volatile, so we continue to shy away from it. We've been trading precious metals since 1980 and we've never seen platinum so highly valued relative to other precious metals. At current prices and with such volatility, it's not really a buy-and-hold metal; so we recommend acquiring platinum only on extreme weakness. If possible, put trailing stops on your position. We continue to favor palladium over platinum because it offers similar scarcity and industrial applications, but at one-third the price and with much less volatility.

Palladium's trading range has been moving higher in recent months, from between $305 and $325 last fall to between $320 and $345 today. We expect palladium to continue building its base over the next few months and then move substantially higher with gold and silver. How high can palladium go? Back in 2001, it briefly pushed over $1,050 in a speculative frenzy driven by a major U.S. automobile manufacturer. While that price seems too high a target, we expect palladium to hit $500, perhaps even $750, before this bull market ends. If Chinese automobile manufacturers begin using palladium in catalytic converters, our predictions may prove very conservative. Time will tell. Buy palladium on weakness and continue to add to your position while it remains under $350 an ounce.

Gold: Back to the 1970s

Today, gold is in a consolidation phase that looks strikingly similar to one it went through in 1975 and 1976, and which set the stage for its historic climb from $105 in 1976 to $850 in 1980.

From 1971 through 1973, gold gained by more than 100%, rising from around $40 to $105 an ounce. In 1974, it gathered even more momentum, climbing above $180 on the back of burgeoning inflation for a one-year gain of 80%. In other words, gold more than doubled in price between 1971 and 1973, and then nearly doubled again in 1974. In 1975 and 1976, things settled down. Gerald Ford took over the presidency with his famous WIN (Whip Inflation Now) buttons. Watergate and Vietnam had ground to their ugly finishes, and gold fell sharply on profit-taking before consolidating with most of its gains intact.

Under Jimmy Carter, inflation reasserted itself with a vengeance. Iran dethroned the Shah, seized our embassy in Tehran, and pulled the U.S. into a Middle East quagmire that weakened our reputation abroad and our economy at home. All the while, oil prices and interest rates escalated.

The gold market really caught fire in the 1970s for three main reasons. First, Richard Nixon took the nation off the gold standard, which allowed the government to print far more dollars than there were ounces of gold in the treasury and laid the groundwork for the horrible inflation that plagued the decade. Second, the Arab oil embargo created supply problems (remember those long lines at the gas pump?) that drove up prices around the world, and helped to plunge the U.S. into recession. And third, the combined effects of the Watergate scandal, the dismal end to the war in Viet Nam, and, especially, the Iranian hostage crisis, created a crisis of confidence in U.S. leadership that forced investors to look beyond the U.S. dollar and equities markets to financial safe-havens like gold.

So let's review: record oil prices, rising inflation, runaway money supply, Middle East quagmire, and crisis of confidence in U.S leadership. Do any of these conditions sound familiar today? We’ve all heard history tends to repeat itself. The last time all these factors were so forcefully present in the market, the gold price multiplied 20-fold, skyrocketing to its all-time high of $850. And, as you can see below, the gold chart that's been developing since 2002 is almost identical in shape to the one in the 1970s that led to record prices.

If our 1970s analogy holds, and we think it will, gold has a second, explosive rise in store for us. Based on the important factors such as a weakening dollar, enormous national debts and deficits, growing inflation, rising global conflict, and exploding international demand for commodities, we believe gold will climb above $850, above $1,000, and ultimately set a new high somewhere between $1,200 and $1,800 an ounce. Will it be a steady, measured climb to those prices? Not likely, in today's world of hedge funds, ETFs, and web-driven instant speculation. In the immortal words of Bette Davis in All About Eve, “fasten your seat belts, it’s going to be a bumpy ride!”

Bernanke: "The calm before the storm"

Even the Chairman of the Federal Reserve is beginning to sound a little desperate about our federal deficit. Addressing the Senate Budget Committee last week, Ben Bernanke warned of serious consequences to the U.S. economy if plans are not put in place to pay for the government's future spending obligations.

"If early and meaningful action is not taken," he warns, "the U.S. economy could be seriously weakened, with future generations bearing much of the cost." (See Bernanke: 'Calm before the storm' in federal deficit.)

A surge in tax receipts pushed the deficit down to $248 billion in fiscal 2006—the smallest gap in four years. However, Bernanke dismissed this reduction as merely "the calm before the storm," a temporary respite before what could become a real catastrophe on the horizon if we do not get our financial house in order.

Spending on entitlement programs, such as Social Security, Medicare and Medicaid, will begin to climb quickly over the next decade as baby boomers retire, he told the Senators, which will lead to rising budget deficits and even higher levels of federal debt. By 2030, entitlement obligations will rise to 15% of gross domestic product, from roughly 8.5% in fiscal 2006, according to the Congressional Budget Office. Without steps to reign-in entitlement spending, Bernanke concluded, a "vicious cycle" may develop in which large deficits lead to rapid growth in debt and interest payments, which in turn would add to subsequent deficits. The effects on the U.S. economy will be "severe."

Bernanke's warnings are remarkably similar to those voiced by Lawrence J. Kotlikoff, an economist at Boston University, in the Saint Louis Federal Reserve Review last summer. We reported on Kotlikoff's study back in September, but it bears repeating, especially in light of Bernanke's similar comments last week. (See Commodities boom alive and well.)

Like Bernanke, Kotlikoff believes that the exploding U.S. "fiscal gap," or the inability of the U.S. government to meet its current and future financial obligations, is likely to result in devastating consequences for our economy and our overall quality of life. The fiscal gap includes not only our gargantuan national debt, which is currently $8.5 trillion (or $28,423 for every man, woman, and child in the country) and rising, but also the future burdens of Social Security and Medicare to which the government is financially and legally obligated.

According to Kotlikoff, our current fiscal gap measures an absolutely staggering $65.9 trillion. This figure is more than five times the U.S. GDP, almost twice the size of the national wealth, and, significantly, around eight times the "official" national debt of $8.5 trillion. One way to get your mind around its staggering implications is to ask what changes will need to be made to offset it. Kotlikoff's answers are truly terrifying: the immediate and permanent doubling of personal and corporate income tax; an immediate and permanent two-thirds cut in Social Security and Medicare benefits; or the immediate and permanent (and impossible) cutting of all federal discretionary spending by 143%.

Given the reluctance of our politicians to raise taxes or cut benefits, the most likely scenario, he concludes, is that the government will simply print more money. Further increasing the money supply (M3), however, will merely amplify the problem and lead to spiraling expectations of higher inflation, "with the process eventuating in hyper-inflation." Fiscal policies like ours, he says, have created hyper-inflation in twenty nations over the past century.

When all else fails, crank up the printing presses! According to many experts, the U.S. is already plagued by inflation far greater than the reported CPI and PPI numbers suggest, precisely because of an already-exploding money supply. In his recent newsletter, renowned market analyst Paul van Eeden explains that the inflation rate of the dollar as measured by M3 is actually about 10%, far higher than the CPI rate of 3.3% for 2006. (See Paul van Eeden, "A massive transfer of wealth".) Inflation, after all, is a reduction in purchasing power, which is a reflection of the amount of money available to spend. As Nobel laureate Dr. Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomenon. To control inflation, you need to control the money supply."

These unsettling conclusions about inflation and M3 are underscored by Michael Hodges in his superb Grandfather Economic Report series, which we highly recommend to all of our readers. A former multinational CEO and associate of the late Milton Friedman, Hodges is understandably concerned about the consequences of our nation's current fiscal irresponsibility for our grandchildren (hence the "grandfather" in the name). As a public service, Hodges has spent years collecting and crunching hard data about federal debt from official government sources. He makes this information available at no charge on his website simply to educate American citizens about our increasingly dire financial condition. We applaud his efforts.

As you can see in the chart above, the purchasing power of the dollar has eroded profoundly over the last 50 years, and in almost perfect symmetry with the unprecedented explosion of the U.S. money supply. Since 1950, according to the data analyzed by Hodges, the dollar has lost 88% of its purchasing power while the money supply has increased by 3,000%. In other words, a dollar in 1950 would buy only twelve cents worth of goods today! Here are just a few examples of the real-life ramifications of the extraordinary shrinking dollar, cited from The Grandfather Economic Report:

• A postage stamp in the 1950s cost 3 cents; today's cost is 39 cents — 1,200% inflation.

• A gallon of 90 Octane full-service gasoline cost 18 cents; recently it climbed above around $3.00 for self-service — 1,870% inflation.

• A new house in 1959 averaged $14,900; today it's $282,300 — 1,795% inflation.

• A dental crown used to cost $40; today it's $740 — 1,750% inflation.

• An ice cream cone in 1950 cost 5 cents; today its $2.50 — 4,900% inflation.

• Monthly government Medicare insurance premiums paid by seniors was $5.30 in 1970; its now $88.50 — 1,570% inflation.

• Several generations ago a person worked 1.4 months per year to pay for government; now he or she works 5 months.

• In the 1950s, one wage-earner families lived well and built savings with minimal debt, many paying off their home and college-educating children without loans. How about today?

Why this horrendous devaluation of the dollar? Hodges argues convincingly that it was the creation of the Federal Reserve (in 1913), followed by the absence of a gold standard (since 1933) to restrain this Federal Reserve, that enabled the Fed to create limitless new fiat dollars—and therefore debt and inflation—out of thin air.

Alan Greenspan would seem to agree. Speaking before the Economic Club of New York on December 19, 2002, the (now former) Fed chief made the following comments about the relationship between abandoning the gold standard and the explosion of both money supply and inflation:

"It was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, has allowed a persistent over-issuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess." (See Alan Greenspan, "Issues for Monetary Policy".)

Let's think about that statement for a moment. For 130 years, the net level of prices remained basically the same, which meant inflation was effectively nonexistent. But once the government began to print money without gold convertibility in 1933, and then without gold backing in 1971, it was able to flood dollars into the economy without constraint. The result has been, and will continue to be, chronic inflation.

If Bernanke, Kotlikoff, Hodges, and Greenspan are correct, and if intractable federal deficits and fiscal gaps result in even larger increases in money supply (or "over-issuance," as Greenspan called it), we're likely to see inflation that will make that of the 1970s look tame as a newborn kitten, regardless of what's reported in the CPI. In the mean time, M3 continues to expand apace, "unleashed from the constraint of domestic gold convertibility"; the pile of debt in Washington just keeps getting bigger; and the dollar, as a result, just keeps looking weaker from a long-term perspective.

The economic problems we face today as a nation are among our most challenging ever and won’t be solved quickly. We’ve gone from the largest creditor nation to the largest debtor nation. We consume more oil than any other country, and we are more dependent on imported oil today than we were in the 1970s. Inflation is on the rise and will get worse as the money supply expands further to pay our enormous debts. Our currency is in a major decline, despite its bout of oil-fueled strength over the last few weeks, and the only reason it has not crashed further is there's no clear worldwide alternative—yet. Indeed, the dollar is fast becoming the old alpha male, barely leading the pack. Will the euro usurp its status as the world’s currency of choice, or will the yuan? Or will it be gold itself, as it was for so many centuries?

In any event, gold will benefit immensely from a global transition away from the dollar by becoming a repository for huge amounts of wealth as investors seek safe-haven alternatives. So once again, we urge you to take advantage of today's inexpensive gold market while you still can.

Classic U.S. gold coin update

We recently returned from the first major coin show of the year, the FUN Show in Orlando. As we expected, the overall supply of classic coins on the national market remains wafer-thin. Demand, however, is reawakening after a dormancy of several months following the red-hot coin market of last spring. With almost no inventory buffer now in the market to insulate coin prices during a renewed buying surge, coin prices in 2007 should remain very sensitive to the smallest increases in demand. The price corrections of last summer and fall have set prices for most classic U.S. gold coins well below where they should be, in our opinion. Astute buyers will understand immediately the excellent buying opportunity presented by current prices. Stock up while you can!

Last year's feast-and-famine coin market, which corresponded to the surge and correction in the gold price, indicates that classic coins are now responding to gold market fluctuations more quickly than before, which means investors are chasing the market more than buying on weakness and selling into strength. Some of you have asked why we continue to recommend buying but not selling. The reason is simple: we believe this market has several more years to run, at a minimum, before it reaches its zenith. With so much of the bull market still ahead of us, we strongly urge you to buy on weakness and hold! When we see significant opportunity to lock in your buy-and-hold profits, we'll issue sell signals.

Many of the coins we favor as portfolio builders continue to be 10% to 30% under-priced, in our opinion. When gold breaks above $660, these coins will almost certainly appreciate very quickly and more than overtake the gains of gold. Even if the gold price holds where it is today, our recommended coins should gain simply because they have yet to catch up with the recent gold market rise. The window of opportunity we announced in our last update is still open, but perhaps not for much longer.

Recommended classic U.S. coins

These are the classic U.S. coins we recommend most highly:

Power Pair #1 – An inexpensive pair of classic U.S. double eagles (a P-Mint $20 Saint-Gaudens in MS63 plus a pre-1900 $20 Liberty in MS62) at low premiums relative to gold bullion. Appropriate for conservative investors who like modest leverage to gold and complete financial privacy.

Note: Be sure to ask your Account Manager about our recommended San Francisco Mint upgrade for your $20 Saints in MS63! For just a 5% premium, they offer 20 times the scarcity of Philadelphia Mint Saints, which can mean much greater leverage to a rising gold market.

$10 Indian MS64 – A classic coin that's under-priced by at least 15% right now, making it a great value with superb upside potential. Appropriate for the investor who appreciates strong leverage with modest downside risk.

$20 Liberty MS65 – This blue chip classic U.S. gold double eagle is about 25% undervalued right now relative to its historic premium and its May 2006 price. Appropriate for the long-term value investor who will buy and hold for the greatest rewards.

U.S. Peace silver dollar rolls, BU – The smart way to buy silver. Inexpensive with excellent scarcity for the price.

That's it for now. As always, thanks for your time.

Sincerely,

Dana Samuelson, President and Owner
Dr. Bill Musgrave, Vice President

  

Metal Ask      Change
Gold $1,462.12           $0.77
Silver $16.65           $0.01
Platinum $900.63           $0.08
Palladium $1,881.30           $-6.36
In US Dollars