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.
11/14/2007: Gold rallies above $800
In this issue ofAGE's Gold Market Commentary:
Gold rallies above $800 Gold rallies above $800
Classic U.S. gold coin rising
Subprime II: Recession at the door?
Fed's dilemma: Deflation or inflation?
Dropping dollar good for gold
Gold rallies above $800
Since breaking out over $700 an ounce in early September, gold has surged over $800, its highest price since 1980, driven largely by a precipitous fall in U.S. dollar relative to other currencies. Despite growing fears of inflation, the U.S. Fed's decision to drop interest rates in an effort to revive the plummeting U.S. housing market was the primary catalyst for the dollar's nosedive. In addition, massive losses by investment banks, in round two of the subprime fiasco, have created a credit crunch that's harming businesses and undermining faith in paper assets of all kinds. As we expected, gold is the big winner in this unfolding scenario.
The dollar's decline has helped to fuel the highest oil price ever, with oil approaching $100 per barrel in recent weeks. The last time oil and gold surged to record highs, in the late 1970s, oil peaked at $36 a barrel and gold at $850 an ounce. In today’s inflation-adjusted dollars, that would equal oil at $100 and gold at $2,100. So, while the dollar is hitting lows unseen since the 1970s (parity with the Canadian dollar, for example), and oil is nearing its 1970s inflation-adjusted price, gold clearly has a lot of running room to reach its all-time high in today’s dollars.
Classic U.S. gold coin rising
Silver, platinum, and palladium have also surged in price, and classic U.S. gold coins, having lagged the metals like usual, are now starting to catch up. Coin buyers are suddenly overwhelming dealer inventories. Once gold surpassed $800 an ounce, new buyers began entering the market in droves.
Listed above in our Hard Asset Scorecard are prices for the four traditional precious metals plus the classic U.S. gold coins we recommend as portfolio builders. As you can see, prices were steady between July and September, but once the subprime crisis hit in earnest they ramped up significantly. We're pleased that three of our top recommendations have showed especially impressive gains: $10 Liberty coins in MS64 rank first, up 45%; $20 Liberty coins in MS64 rank second, up 36%; and our Power Pair #1 ($20 Liberty, Pre-1900 in MS62 plus $20 Saint-Gaudens in MS63) rank third, up 29%. Fundamentals remain excellent for these classic U.S. coins and we expect more gains to come.
At AGE, our focus has always been on finding the best value for our customers in the current market. Last summer, $10 Liberty coins in MS64 were substantially lower in price than $10 Indians in MS64, despite being much scarcer, so we urged our customers to buy them. That recommendation proved an excellent one, gaining 45% in a scant four months and leading the pack, while $10 Indians in MS64, which started at higher prices, have under-performed. In addition, the $20 Liberty coins in MS64 and MS65 were clearly oversold last summer, trading at levels much lower than we thought proper. We knew these to be great coins at great prices so we highly recommended them. Now they've risen by 36% and 29%, respectively, with more gains in sight. We make our recommendations based on continuous analyses of pricing trends and almost thirty years of experience in the market. We're happy so many of you were able to profit from them recently.
We’re off to the next major coin show in Baltimore today. Our classic U.S. gold inventory is the lowest it's ever been. We need to buy aggressively at this show but our expectations are low because very few classic coins are currently available, even on the wholesale market. This real scarcity is one reason why we're so convinced that more gains are likely in classic U.S. gold coins, despite possible fluctuations in the underlying gold price. There's much greater demand than supply in the U.S. gold coins market right now.
Our current classic coin recommendations in this market are:
U.S. Peace silver dollars in Brilliant Uncirculated (BU) condition — A best buy in bulk silver. These rolls of 20 classic silver dollars from the 1920s are extremely cheap today, undervalued by 10% to 30% in the current market. They receive our highest recommendation.
Power Pair #1 — Two of our best gold portfolio builders, paired for savings. Pre-1900 $20 Liberty (MS62) + $20 Saint-Gaudens (MS63). Low cost plus excellent leverage to a rising gold market. Better than bullion for bulk gold investors.
British Sovereigns in Brilliant Uncirculated (BU) condition — George V design. The most popular of all European gold coins. A great opportunity to build your core gold holdings with scarce, historic gold coins at near bullion prices. Better than bullion!
Now that precious metals and classic U.S. gold coins are surging in price, where do we go from here? Let’s look at the latest charts, beginning with the U.S. Dollar Index Chart.
As you can see on the two-year Dollar Index chart above, the buck has plummeted like a stone in the ocean since September 1, 2007. In our September update we told you we’ve never seen an environment riper for a major U.S. dollar drop, and that’s exactly what happened. While we anticipated a substantial slide, we did not expect the degree to which the world would suddenly shed dollars. Seldom does a currency fall so sharply without undergoing a rebound, and that's what the dollar is doing now. This short-lived bounce will cause the precious metals prices to pull back somewhat. But the trend remains your friend, as we like to say, and the trend for the dollar remains distinctly down while the trend for precious metals is definitely up.
The chart above puts the current dollar index value into historical perspective. Looking back as far as our available data go (June 1, 1983), you can see the dollar index has never been lower than today, and it looks to go even lower. The subprime losses have yet to be fully disclosed and we believe they will ripple through the markets for months to come.
Oil is now trading just off its highest prices ever. When oil doubled its normal trading range, rising from around $30 to around $60 per barrel, the media were unusually quiet. Now, however, the inflationary aspects of $100 barrel oil are being talked about everywhere. The double whammy of a weak dollar and record oil prices is just beginning to ripple through into the pocket books of U.S. consumers. Gasoline in the U.S. is likely destined for over $4.00 a gallon, and prices for everything we import will continue to rise as the dollar erodes. While the U.S. government barely acknowledges the growing inflationary pressures, consumers certainly feel the pinch. This price pressure will only escalate as the dollars continues to fall. This economic environment remains the most bullish we've ever seen for precious metals and classic U.S. gold coins. We expect the bull market to continue for several more years, at least.
The two-year oil chart shows current support levels at $90 and just under $86 per barrel, as indicated by the green support lines. Upward resistance is indicated by the red resistance line at the latest price peak of $96.70. Please note: If you compare the rise in the oil price from September to the decline in the dollar for the same time frame, the two trend lines are almost identical inversions of each other.
Gold has made dramatic gains in the last 60 days, surging over 25% higher in a few short months before entering a mini-consolidation phase. Any time precious metals surge like they have in the past two months, a profit-taking pull-back is inevitable. We are now in one. This is a healthy part of the cycle because it shakes out some of the speculative froth, allowing a base to form at higher levels, from which further gains can occur.
Gold seems to be settling into a trading range from $795 to $820. While it could drop as low as $760, we believe it cannot stay below $800 for long in this economic environment. The chart above shows the current support levels for gold, as indicated by the green support lines at just under $790, at $760, and at $735. Upward resistance is indicated by the red line at the latest price peak of $837.50. The blue trend lines indicate the extended consolidation phase gold underwent following its May 2006 peak, and the subsequent break out this fall.
Today gold has moved back over $800 into the $810 to $820 range, showing excellent resilience in the face of recent profit-taking. The last two trading sessions have seen it rise quickly from the low $790s, demonstrating that buyers are ready to support the market just under $800 now. The dollar remains the key to further gold gains, as we explain below. We believe the yellow metal will eventually move over $1,200 an ounce and perhaps as high as $1,800 per ounce. While these heights might not be achieved in the current cycle, a move above $850, the previous all-time high, remains a distinct possibility, and perhaps even a test of $1,000 an ounce.
Following gold’s lead, silver, broke into new, higher territory in this cycle. The blue trend lines indicate the May 2006 to August 2007 consolidation phase, and the subsequent breakout this fall following silver’s abnormal dip under $12.50 in August. The green line at $14.60 indicates support and the red line, at the latest price peak of $15.54, indicates upward resistance.
Today silver has risen again to the $15.00 level (not indicated on this chart), and should settle into a trading range from $14.75 to $15.50 in the near term, with the bias towards higher—perhaps much higher—prices. We continue to believe silver has the potential to move over $20 an ounce on this cycle, with consolidation occurring just under $20 once that move is made.
Silver, platinum and palladium remain far more volatile than gold. The market is treating gold today both as a commodity and a currency. The other precious metals remain squarely in the commodity category, and are much more affected by global fluctuations in demand for their industrial uses. Any fears of a recession would further reduce their industrial demand, and are more likely to put downward pressure on these metals than on gold. In its role as currency of last resort, gold is more likely to rise in price as a safe-haven for investors fleeing falling equities and other deflating assets if recession arrives.
Platinum has undergone the greatest price swings over the last two years, as the chart above clearly indicates. Because most of our investors are buy-and-hold types, and because platinum has been so expensive and volatile relative to gold, we've side-stepped the platinum market in favor of the other three precious metals. Platinum should enjoy support at the $1,400 mark and upward resistance at the $1,485 mark in the near term, as indicated by green and red lines.
Following the May 2006 peak and the October 2006 bottom, palladium enjoyed the steadiest upward trend of the four precious metals. However, that trend line broke last summer when palladium sold off sharply, and then rebounded nicely. In the current market, palladium should enjoy support at just over $365 and resistance at $390. Based on the latest chart, we recommend buying palladium aggressively on any dips below $365. We would not advocate taking profits until palladium moves well over $400.
Subprime II: Recession at the door?
Before getting a major bounce yesterday, the stock market had taken a pounding in recent weeks, with the Dow plunging more than 360 points in one day on two separate occasions. A second wave of subprime losses is hitting banks and financial institutions, and fears are growing that the fallout will be more protracted than initially thought. Merrill Lynch, Citibank, Morgan Stanley, Barclays, UBS, and Washington Mutual are all facing billions of dollars in write-downs because of subprime exposure, and the crisis is far from over. "What were once just concerns about credit have graduated to a full-blown panic," said Kevin Giddis, managing director, fixed income, Morgan Keegan & Co.
These huge new losses are stemming in part from so-called Structured Investment Vehicles, or SIVs, bundled debt structures that are essentially a form of institutional carry-trade. SIVs enable large-scale investors to take out short-term loans and invest the proceeds in complex, high-yield products linked to bundles of loans. Many of the components in these bundles are subprime mortgages combined with higher quality debt. Rating agencies like Moody's have given these questionable bundles AAA ratings, enabling them to be sold into large investment houses with the veneer of safety. Just as the housing market was dependent on subprime borrowers, the structured-debt markets were dependent on subprime investors. Both were too reliant on borrowed money, and suffered when their ability to borrow was taken away.
SIVs have been especially attractive to hedge funds, which need to deliver outsized returns to cover the high fees they charge. Most hedge funds obtain their finance from investment banks, however, with 60% of hedge-fund assets handled by three big banks. In addition, hedge funds own the same assets as the banks' trading desks. This means that when the hedge funds are forced to sell, the trading desks are likely to lose money, and therefore the investment banks themselves are hit with huge losses. As blue chip financials fell face-down in their subprime messes, the Dow soon followed.
One of the major fears about the renewed subprime and credit crises is that they could drag the U.S, and perhaps the world, into recession. Certainly, the outlook looks dim for the U.S. housing market and borrowers who took out subprime loans. Two million subprime foreclosures are on the horizon by 2009 if home prices continue their downward spiral, according to recent congressional report by the Joint Economic Committee. More then $71 billion in housing wealth will be destroyed and states will lose $917 million in property tax revenue.
But all consumers are worried and getting more worried about the economy. According to a survey released last Friday by Reuters and the University of Michigan, consumers' view of current economic conditions has been lower only once during the past 15 years—when the United States invaded Iraq in 2003. "Sentiment readings are now out of the caution area and into the danger zone," wrote Robert Brusca, chief economist at Fact and Opinion Economics. "Things do seem to be unraveling a bit faster."
Sliding consumer sentiment readings like these are typical when the economy is entering recession. Purchases of major appliances and automobiles, generally a good litmus test of the health of consumer spending and the overall economy, are both in a serious downtrend. The percent of consumers with plans to buy a major appliance in coming months dropped to its lowest level in more than two years. And last week General Motors said its third-quarter loss ballooned to $39 billion.
So it comes as no surprise that more and more economic pundits are deeply concerned about the possibility of recession, with many calling January to March of 2008 the dangerous quarter for a sharp slowdown. Douglas Holtz-Eakin, former chief of the Congressional Budget Office and now an expert on the U.S. economy at the Peterson Institute for International Economics, told MarketWatch last week that his "gut tells him the economy might be weaker at the moment than the economic indicators show." The key factor, he said, is that business confidence appears to be weakening sharply. The current economic situation reminds him of the slow recovery in 2002. As the economy exited a recession then, the fundamentals improved but job growth remained weak. It turned out the hidden factor was that businesses stayed in a sour mood even though the recession was over. The fact that business confidence is now at the same low level as 2002 "gives me reason to be more nervous than I otherwise would be," Holtz-Eakin said. (Read more.)
In a sign of waning business confidence, the U.S. manufacturing sector was barely growing in October, burdened by the slowdown in housing and credit, according to the Institute for Supply Management index last week. Considered one of the best early gauges of the economy's strength, the ISM surveys corporate purchasing managers for their up-to-the-minute take on business conditions at their firms. The ISM index fell to 50.9% from 52% in September, weaker than expected. As long as the index stays over 50%, the economy is considered to be expanding. If it falls below 50%, the economy is contracting, which points toward recession. The index has been above 50% for nine straight months, but it's been declining for four straight months and is now hanging by a thread above 50%. The economic expansion has nearly stopped.
Even Ben Bernanke is beginning to sound the alarm about the economy. Last week Bernanke said he expects the economy to slow "noticeably" from the third-quarter growth rate and remain sluggish in the first half of 2008. He also admitted that inflation is becoming a substantial threat, noting that prices for crude oil and other commodities have risen sharply in recent weeks and that the dollar has weakened in foreign-exchange markets, both of which erode purchasing power. Glad he noticed!
Fed's dilemma: Inflation or deflation?
The Fed and other central banks are surely to blame for much of the current credit crisis and its spillover into the wider economy. After years of loose monetary policies, asset valuations are over-inflated, especially in housing and stocks. Between 1997 and 2006, according to the S&P/Case-Schiller national home-price index, American house prices rose by 124%. And other countries were even frothier: Britain was up 194%, Spain 180%, and Ireland $253%. But only in the U.S. were so many subprime loans made to buyers with low incomes and poor credit histories. And along with housing, the Dow swelled to a new record high of 14,198.10, before falling 8.53% in the subprime sell-off of recent weeks.
With so much easy money available, the appetite for risk was similarly inflated. Debt and risk became a way of life, and why not, when every leveraged investment seemed to pay off handsomely, regardless of risk, and home values only went up? But squarely in the middle of the cycle sat the central banks, with easy money policies creating excess liquidity and encouraging it all.
The recent reduction in interest rates gives a clear indication of the Fed's current priorities. Faced with a choice of protecting assets values from deflation or running the risk of increasing inflation, they opted to prevent deflation—in other words, to keep pumping more liquidity into the housing and stock market bubbles. The two largest assets owned by most Americans are their home and their retirement account, mostly held in the stock markets. Both stocks and housing have been the big winners in the era of easy money, and valuations have inflated immensely. By dropping the federal funds rate, the Fed sought to provide relief to sagging values in both areas, with the hope that consumer confidence, currently at a multi-year low and dropping fast, would revive an economy that's quickly slipping into a coma.
Clearly, whether they say so or not, the Fed is deeply concerned with the possibility of deflation—the whirlpool of major assets like housing losing their value in a self-accelerating downward spiral. Deflation kills economic growth and goes hand-in-hand with recession. The most common way to fight deflation is through lowering interest rates. But there's a fine line where deflation is defeated without generating the unwanted consequence of hyperinflation due to currency devaluation. Right now, the Fed seems to think inflation is the lesser of two evils. But the piper must be paid and the bill is coming due. The dollar is losing on the world market and this will cause monumental inflation down the road, which will only increase the gold price.
To make the issue even more complicated is the fact of stealth inflation hiding under asset bubbles and the exploding money supply. We've been talking for more than a year about the extraordinary rise in global liquidity in recent years, the inflationary ramifications of this sea of easy money, and the strongly bullish consequences for the gold price. While the short-term cash crunch may be eased by lowering interest rate, infusing billions into the global banking system, and staving off deflation in major assets like housing and stocks, the longer-term excesses in money supply will be far, far harder to control.
The globe remains swamped in money, and lowering interest rates will only raise the flood. According to Mary Anne and Pamela Aden, the money supply in Russia is exploding at a 51% rate; in India at 24%; in China at 20%; and in other emerging markets at an average of 21% annually. In other words, developing markets are pouring money into the global supply at a rate of three times that of developed nations (except the U.S., which is increasing M3 at a 10% rate). When you consider that these same developing nations now account for 60% of global GNP, and growing quickly, you begin to see the inflationary tidal wave cresting on the horizon and rapidly approaching land.
Increasingly, however, economists are questioning the price index method of tracking inflation, primarily because it takes into account neither the expanding supply of money nor the asset valuation bubbles (stocks, housing prices) that have directly impacted consumer pocketbooks in recent years. Charles Goodhart, of the London School of Economics, and a former member of the Bank of England's Monetary Policy Committee, thinks the debate would shift if inflation were properly measured. Monetary growth is more likely to go with rapid rises in asset prices than with inflation in goods and services. “If inflation is (incorrectly) measured to exclude all asset-price inflation,” Mr Goodhart concludes, “then the links between money growth and (true) inflation may be understated.”
If money supply is taken into account, we're already in a condition of extremely high inflation, which has been showing up in asset valuations rather than price indices. The Fed's policy of easing monetary policy to prevent deflation, then, can only prove to be extremely inflationary down the road, regardless of what the price index says today. Despite the moderate price index numbers, people's cost of living is already soaring. Most households are suffering from a vicious combination of higher food and energy prices and the skyrocketing cost of health care. Because so many commodities—oil among them—are valued in dollars worldwide, their prices rise when the dollar falls. While a weak dollar increase the price at U.S. gas pumps, it reduces the price for international consumers whose currencies—euros and the Canadian dollar, for example—are appreciating against the dollar. In other words, when the dollar is weak, oil goes on sale everywhere else in the world, which increases demand and raises prices even higher.
The rule of thumb is that gasoline prices rise 2.5 cents for every dollar increase in the per-barrel price of oil. Heating-oil costs also climb with crude-oil prices but can vary widely based on refining costs and supply. Prices are already on track to jump as much as 50% for the 8.1 million households—mostly in the New England and central Atlantic states—that use heating oil to warm their homes, according to MarketWatch. And to make matters worse, weather experts are expecting a considerably harsher winter this year than last.
So high oil prices, whether we like it or not, are likely here to stay. At an annual energy conference in London three weeks ago, experts made the case for oil prices above $100 for the foreseeable future, largely because of depleted reserves, and the difficulty in extracting oil from current reserves, and years of underinvestment by the industry. Sadad I. Al-Husseini, an oil consultant and former executive at Aramco, Saudi Arabia's national oil company, gave a particularly downbeat assessment of the world's oil outlook. The major oil-producing nations, he said, are inflating their oil reserves by as much as 300 billion barrels. These amount to hypothetical reserves that are "not accessible and not available for production."
Dropping dollar good for gold
Expensive oil combined with dropping interest rates spells bad news for the dollar but great news for gold. The dollar has slumped more than 20% since 2002 relative to its trading partners, and the pace is accelerating. Several months ago we warned that the subprime fiasco had the potential to torpedo the dollar on basis of interest rate differential, or the difference between the cost of dollars and the cost of other currencies on the world market. Why is it so important? Because it's the most obvious indication of how the world sees the dollar as an investment and whether foreign powers are likely to continue financing the astonishing $9 trillion U.S. public debt.
To maintain the value of the dollar and keep our debt afloat, the Fed must appeal to foreign holders and future buyers of our Treasuries by offering higher relative yields and a meaningful interest rate differential. However, the attractiveness of U.S. rates is expected to decline in 2008 as central banks in Europe and Japan raise their rates, effectively devaluing the dollar in relation to their currencies. The Bank of England hiked rates by a quarter-point to 5.75% earlier this year—its fifth increase; and the European Central Bank, which sets rates for the 13 countries from Germany to Slovenia that use the euro as their currency, has doubled rates over the past 24 months.
"The single most important factor that differentiates the current dollar bear market is the contrasting growth and interest rate landscape between the U.S. and global economies, as most foreign central banks are closer to raising interest rates while the [U.S. Federal Reserve] is forced to cut rates further," wrote Ashraf Laidi, chief currency analyst for CMC Markets. "Thus, going forward, prospects for a dollar turnaround are minimal on structural and policy terms, assuming no growth or systemic shocks in the Eurozone or the U.K.," he said. (Read more.)
If the Fed cuts rates further to stanch the wounds of the subprime credit crisis and stave off recession, it will encourage foreign investors to dump even more dollars. If the dollar loses too much value, these foreign holders of our dollar-denominated assets could easily abandon ship, leaving our stock and bond markets to sink along with the dollar. Indeed, the abandonment of U.S. assets is already underway. China announced last week that it plans to diversify part of its gargantuan currency reserves out of the weakening dollar. Foreign investors have slashed their holdings of US securities by a record amount as the credit squeeze has intensified, according to the latest Treasury figures. The Treasury International Capital report—known as the TICs report— shows that foreign investors sold a net $69.3 billion of long-term US securities in August, the biggest outflow since 1990.
“A truly stunning TICs number, the likes of which I have never seen," said Alan Ruskin, chief international strategist at RBS Greenwich Capital. "There is no way to get away from the lack of corporate bond inflows, the foreign selling of U.S. equities and the countervailing strong U.S. purchases of foreign equities and bonds. The bad news is that [the data] plainly shows how vulnerable the dollar is to a continuation of the credit crunch risk averse environment." (Read more.)
On the other hand, if the Fed is forced to raise rates to maintain an advantageous differential and curtail inflation, the move would support the dollar temporarily but could deal a mortal blow to an already wounded housing market, which, in turn, could cripple the economy and the dollar in the longer term. Bernanke is caught between a rock and a hard place; and he's chosen, at least for now, to go the route of combating deflation at the risk of fanning inflation—perhaps massive inflation—down the road. The dollar is therefore losing the interest rate competition to other major currencies, and the gold price is reaching new generational highs. When all of this monetary inflation finds its way into the price indexes—and it's starting to already—gold will be due for even greater gains because it is the go-to asset during periods of high inflation.
Gold has returned to favor as an international currency in large part because it's not a debt, collateralized or otherwise. Rather, gold has intrinsic value and is intrinsically liquid. Unlike paper currency, bonds, or equities, gold depends for its value on no one's liability; it carries no promise of repayment. Gold is permanent, not a piece of paper with an arbitrary value printed on it. You can’t make more of it by edict or printing press or financial innovation. In this era of instant global transactions, SIVs, and CDOs, it's ironic that the favorite asset of the ancients is showing its mettle. Why? Because you can depend on gold to be exactly what it's been for millennia, a stable store of value in an unstable world. We urge you to stock up now while prices are still relatively low!
Thanks for your time. We'll keep you informed!
Dana Samuelson, President
Dr. Bill Musgrave, Vice President
AGE Gold Commentary
Gold has been on a tear, breaking out above $1,500 and hitting a series of a new six-year highs as slowing global growth ... read more