There’s Gold in This Missive

Gold has been much in the news these days. It has reached new price highs in dollar terms, which probably says more about the dollar than it does about gold. But we still see lots of people with a desire to hold gold. Why? First of all, gold is supposedly a store of value. During times of crisis, lots of folks almost automatically turn to gold for a piece of their savings. This has always fascinated and mystified us. (This is the whole tuna fish and shotgun shell argument. For those who have not heard that one, in the worst case scenario, which the gold bugs seemingly always think is right around the corner, gold will be valued no matter what. We argue that canned tuna will probably be more highly valued while shotgun shells, with the appropriate appliance to put them to good use, will be even more highly prized.) This is a kind of self-fulfilling prophesy. If enough people have the same knee-jerk reaction to buy gold, gold will go up regardless of the cause.

Okay, we’ll grant that so long as that knee-jerk reaction is dependable there is no sense in arguing with it. But, is there any real fundamental reason to own gold in portfolios? It is a dandy diversifier, like most commodities. It can work as an inflation hedge, like most commodities. So, why not just buy commodities?

Gold is a dense, heavy, malleable, shiny metal that is good for very little save dentistry and jewelry. It is a fine conductor of electricity, but then so are silver and copper and they each cost a lot less. So, there are few industrial uses for gold, save jewelry and dentistry. This means that gold, once produced, doesn’t get used-up. It sticks with us more or less forever. According to the National Geographic, all the gold that has ever been mined world over is about 161,000 metric tons (worth roundly $6 trillion at today’s price). Roughly enough to cover a football field to a depth of about 6 feet. Nearly half of that gold has been mined in the last thirty or so years, as gold production skyrocketed after the huge price run-up in the 1970s. Maybe there are a couple hundred Troy pounds stuck in this or that tomb of some forgotten prince, but probably not enough to make a serious difference to the total. Of all that gold, only about 30,000 tons or so is ‘official’ gold owned by this of that central bank or multi-national organization.

Much gold is produced as a by-product of copper or silver production. More is produced in dedicated gold mines. The by-product production will continue even when gold prices drop while high-cost, dedicated mines tend to stop producing. Some of the biggest recent finds in places like northern Canada or in Mongolia or other harsh environments have high production costs that may make it difficult to maintain profitability if the price were to fold. Back in the 80’s and 90’s, as gold prices fell from $800+ an ounce to $200+ an ounce, gold production fell from over 40 million ounces a year to barely 25 million due to high-cost operators deciding to stop production. Today, we produce nearly 60 million ounces a year, with about a third of that coming from high-cost facilities (Canada, Nevada, Siberia, etc.). The point being that gold isn’t that scarce.

Most gold mined today is in deposits with density of less than 5 parts per million. The gold is in alluvial deposits in old sea beds or lake beds and is mined by an open pit method. The ‘ore’ is brought to a pit where it is exposed to arsenic and the gold will bond with the arsenic and is then leached out with water. The gold/arsenic is then refined to eliminate the arsenic, which is then recycled to the next batch of ore, while the tailings are cleaned and removed. At this rate, these mining operations need to process two tons of ore to retrieve one ounce of gold. In most ‘hard rock’ mining, the concentration of gold in the ore is more like 60 parts per million or a heckuva lot more.

We think what we have here is an emerging bubble. The problem with bubbles is you don’t know when they are about to pop. This one could inflate for a long time before it finally caves-in (a little mining humor there), it could double, triple or quintuple first. But, when this many people all agree that something is bound to go up, it seldom does for very long. A reviving economy in most parts of the world would argue that the classic purpose of holding gold has long since passed. If the point is that gold will reward in times of stress, those times are likely over. So, unless you feel there is a point in the not too distant future where the economy and civilization in general is going to come crashing down, gold has probably seen its day. (There is still time to get your shotgun shells and tuna, which can still come in handy in a vibrant economic period.)

The other reason to own gold is as a hedge against inflation, right? First let’s ask what inflation? We have not yet experienced any serious inflation in this cycle, or the one before and yet gold has risen from under $400 an ounce to $1000 an ounce a couple of times before this. During the last great wave of inflation in the 70’s, gold went from less than $100 an ounce to over $800 an ounce, better than an octuple. If we get massive inflation (which we feel is a distinct possibility), then maybe all this hoopla over gold might appear reasonable. But, now there are other ways to hedge against inflation. First, you could invest in strong currency countries, like Switzerland, China, Japan and others. Wait, we’re doing exactly that right now. Or, one could own commodities that we are using up and so need to keep getting more and more, like copper, zinc, soybeans (no wait, we can make all the soy beans we need if we are willing to forgive something else, like beef), or molybdenum. Oil would seem to be a better inflation hedge as it is in fairly tight supply and according to many folks we are actually running out of it, rather than building the supply of it at a rapid pace.

Back in the 70’s, at the height of the inflation trauma that was the 70’s, the Hunt Brothers (oil gazillionaires from Texas) tried to corner the silver market. Their activity drove the price of silver to $50 an ounce from about $8, still nearly triple the current price 30 years later. They failed largely because price and supply of most goods is inversely related. Higher prices reduce demand and increase supply. Take corn. A couple of years ago, there was supposed to be a shortage of corn due to demand from the ethanol industry. The price jumped up to over $4 a bushel. But, farmers planted corn from fencepost to fencepost and despite a couple of floods and a couple of droughts, produced enough corn to overwhelm the market and drove the price down to under $2 a bushel. The same thing happened to the Hunt Brothers. When the price of silver got high enough, people melted down their silverware and sold it, heirloom bracelets went into the pot as well. Silver came out of the woodwork when the price got high enough. The Hunts misjudged just how much silver there actually was and how it would respond to higher prices. The same thing could easily happen to gold.

There is the argument that the emerging middle class in China or India could absorb a huge amount of gold because culturally gold means wealth to them and the more wealth they have the more gold the buy. But, the higher the price, the less they can afford, the inverse of the parable above – higher prices reduce demand, not increase it.

Then, the argument that with the dollar slowly ebbing as a reserve currency around the world (and we’ve ranted about how this argument is at least exceptionally premature) gold would be the next best reserve currency. But, before gold could be adequate as a reserve currency, the value would have to go up to maybe $5000 an ounce, maybe more. At that point, dollars would be worthless and gold would be the only currency worth having. As a reminder, gold is not money anywhere anymore. There are few governments who would be willing to accept the monetary discipline of a metallic-based currency. Once you’ve had fiat money, no government wants to give that up. It is like a drug, a very good drug.

So, is this a bubble? We think so, an early bubble which may have a ways to go. We wouldn’t be surprised to see gold double before this is over, maybe do more than that, but it is a bubble. There is no fundamental reason why gold should have any specific value. Just about anything more than the cost of production might be a valid price, but even below the cost of production can pertain for a long time due to the unique situation in gold’s case where a decent percentage of all production is a by-product of mining something else. As in most bubbles this is rising mostly because people are in agreement that it always has and always will rise. People who are embracing this are looking backward at a time that has past when fear drove investments, not fundamentals. This is just a bubble and bubbles burst and we’re not chasing this bubble.

Economic News (we’ve discontinued the Good News section since most of the economic news seems to be good news these days, maybe not this week so much.)

GDP was revised to ‘only’ 2.8% growth in the third quarter from the initial guestimate of 3.5%. Our comment at the initial report was that this would get revised downward largely due to the elements of growth that the Commerce Department at first reported. Consumption was revised downward as was business investment. The argument continues that without government stimulus spending there wouldn’t have been a positive number at all. This is true in a mathematical sense, but by the same token that was the whole point of the stimulus exercise in the first place. The government goes out and spends regardless of the ability to raise sufficient revenues to cover its tab because the rest of the economy is weak and can’t maintain its spending. This is the crux of Keynesian economic policies. At the same time, we have monetary policy going great guns trying to push the cash out the door to stimulate spending and investment. One or the other will probably work. What we probably should fear is that both will work at about the same time and send us into overdrive.

Existing home sales lurched upwards last month much to the surprise and chagrin of the economics forecasting community. In a brazen example of rearview mirror phenomenon, most forecasters were expecting a very modest report on existing homes while in fact they got a barn-burner. Existing home sales rose by 10.1%, not the couple of percent gain to flat number widely predicted. The median sales price slipped to $173,100 from September’s $174,900. Both numbers are more than 8% below the comparable month last year. Unlike the prior week’s report on housing starts, this report is helped by lower prices and the flood of foreclosures on the market. So, a lesson here that not all housing statistics are necessarily going to move in lock-step.

Case-Shiller Home Price indexes were reported and they were up. S&P, which owns the Case-Shiller indexes now, has revised the indexes going back over the last 24 months, so the data don’t line up the way they used to. The gain in the third quarter, ended September 30, 2009, was a gain of 3.1%. That is the same increase that was reported for the second quarter. Home prices are back to the levels seen in the third quarter of 2003 according to the statistics.

Consumer Confidence as reported by the Conference Board was higher. That came as a bit of a surprise to the typical economist who basically forecasts what has just happened until that changes. But, the gain to 49.5 from 48.7 the month before isn’t anything to cry hallelujah about.

Consumer sentiment slipped again to 67.4 from 70.6 in October. A survey in early November had seen sentiment fall to 66, so this reading is an improvement from that. Maybe we’ll see further improvement in the future. But, this does emphasize that there are differences between the questions and analysis of these two surveys.

Consumer spending grew 0.7% in October according to Commerce Department statistics. The gain had been forecast as only 0.5% by economists who once again are looking in the rearview mirror instead of looking forward. Household income also rose by 0.2%. This too was higher than most economists had foretold.

New home sales gained 6.3% due mostly to a large increase in sales in the South. While most economists were looking for a drop in new home sales, the large increase in the largest sector of the country offset declines most everywhere else. This reminds us that not all the empty homes are where we need them. The South is a growing region while the Northeast generally isn’t.

Weekly Stuff

The week ended badly, but that still wasn’t too bad. The major US stock indexes were anywhere from largely unchanged to down about 1% for the small caps. Foreign indexes were hit far worse, developed markets and emerging markets both down about 2+%. The combination of nothing to get really excited about in economic numbers, the anticipation of Black Friday retail activity and then the sudden, glaring announcements from Dubai on Friday took what might have otherwise been a modestly good week and made it into a blah week.

From the vantage point of this morning, we can tell that Black Friday was a non-event. There were huge lines of people shopping but they didn’t spend any more than they did last year right in the height of the financial consternation last November.

Bond markets were mixed with the higher rated sectors doing better and those exposed to emerging markets and lower rated debt doing poorly. The dollar was down, which ought to have helped foreign markets, but the near crisis atmosphere in Southwest Asia leaked into other markets.

Real estate markets weren’t as badly shaken as one might have at first guessed. The focus of the Dubai World collapse is on their real estate operations and that might have been enough to scare a lot of folks into stepping back from commercial real estate again, or at least convinced a few daring shorts to step into the fray. But, it seems that things were rather calm instead.

Commodities were also mixed with energy prices off a smidge, but then energy demand is on the cusp of its strongest quarter of the year, seasonally. Gold was up, see above for any rationale. Several metals and grains were off on the outlook for somewhat weaker demand than was previously foreseen.

Okay, who can spell Dubai? Who can locate Dubai on a map? Who ever heard of Dubai before last Friday? What the heck is going on in Dubai? Why does it matter?

These and other good questions probably won’t be answered in this week’s missive. To be honest, we can spell Dubai, we can locate it on a map of the Persian Gulf region just south of Iran across the straights of Hormuz tucked in the middle of the Gulf Emirates. It is the second most important of the Gulf Emirates after Abu Dhabi. The state decided to invest some of its enormous oil wealth in upgrading other parts of the economy and so spawned Dubai World to make investments in other parts of its economy and also around the world. The Government of Dubai owns Dubai World, but as we have just discovered, does not guarantee its debt.

Dubai World has requested a standstill agreement with its creditors for debt maturing over the next 18 months. The thesis goes that Dubai World can’t meet all of those debt maturities and either needs access to other funds (swapping one unhappy creditor for a happier one) or time to let cash flow accumulate to pay-off its debts. The general numbers floating around are that Dubai World owes about $60 billion, yes, billion with a B. There are other Dubai-related debtors, like Dubai Ports, that might or might not get wrapped-up in this thing, which would bring the total to over $90 billion. It is too early to say whether that will happen or whether some parts of this would be able to stand apart.

Dubai World got in trouble, as most everyone else has gotten into trouble lately, by taking on debt to speed the acquisition of stuff. In their case that is huge palm-shaped man-made islands in the Persian Gulf and the City Center development in Las Vegas and other things that somehow needed doing. The implicit support from the government of Dubai didn’t hurt their standing with investors. But, that implicit support isn’t going to get them out of this problem. The government has made it clear that they are not guaranteeing the debt. The only backstop they have is their equity holding.

Is this the next shoe to drop in the great credit unwinding? If so, it’s a mighty small step, but given the bearish tendencies of the investing public these days, that’s all it might take to give us our long-awaited correction to this fabulous bull market. Stay tuned, our guess is that all things Dubai will stay in the headlines for at least another week.

Have a great week.

Karl Schroeder, RFC

Investment Advisor Representative

Schroeder Financial Services, Inc.