Gold Forecast

John Mauldin | Thoughts from the Frontline
March 1, 2002

Today we are going to think about what lies in the future for the yellow metal -- that barbarous relic:

GOLD

. Long time readers know that I am no gold bull. Indeed, I have been bearish to neutral on gold for over a decade. However, a number of economic trends are causing me to re-think my position. I believe the case I lay out is one you will not have read from the usual gold bug suspects. I even give you a new way to play the gold market that should do well for you even if I am wrong.

But first, I can't help myself. I HAVE to make a few (hopefully brief) comments on the massive amounts of data that came out this week, supporting my theme of the Muddle Through Economy.

Lies and Statistics

Under the heading of lies, damn lies and statistics, I was rather surprised by the growth in home sales. The headlines shouted that existing home sales grew by an amazing 16% in January. All-time record highs, we were told. "Clear evidence of the coming economic rebound and the resilient American consumer."

Something just didn't feel right, so your intrepid analyst decided to look a little further. Sure enough, the economics team at Morgan Stanley uncovered a statistical quirk. It seems home sales actually fell from December to January by 17%, from 404,000 in December 2001 to 336,000 in January 2002.

But in the world of seasonally adjusted numbers, this counts as an increase of 16%, because it is more than expected for this time of year. A little seasonally adjusted salt turns down 17% into up 16%. I need some of that salt for my bank account.

Indeed, January sales were compared to previous Januarys, but the culprit might not be the ever resurgent US consumer. January sales generally are down because it is cold in January and no one gets out to look at homes on the weekend. The unseasonably warm winter (the warmest in 105 years) has people out and about and buying.

Stephen Roach speculates, "Since the heat wave limited the downside, the hocus-pocus of seasonal adjustment produced an extraordinary spike. But what the statisticians giveth, they must taketh -- the so-called seasonal factors always average out over the course of the year. All it takes is for the weather to return to normal -- and the seasonally-adjusted figures will fall like a stone. I reckon that will also occur this spring."

Now, I must admit I was surprised as well by the revised estimates of growth for the 4th quarter of 2001. We are now told the economy grew in the fourth quarter by 1.4% on an annualized basis. I seem to remember writing that the number would be revised down, as they usually are. The stock market and the cheerleaders loved that stat, and I got a few teasing emails and calls. How can we be muddling through if the economy grew so much?

There is more to that number than meets the eye. Consumer spending was up a sharp 6%, 12 times what it normally is during a recession. Roach tells us that 86% of this rise is attributable to durable goods purchases like automobiles. These were sales which moved forward in time as a result of 0% financing and low inventory reducing prices. Roach feels this will contribute to a "double-dip" recession. He makes a good case.

I still think that we just muddle through, though. There are a lot of good things we can point to. The purchasing manager's index is up. In fact, the PMI numbers this month were positively bullish. If capacity utilization is up soon, as I suspect it will be, I think those timid souls who went to the sidelines with me in the fall of 2000 can start to think about equity investments again. As I will go into it next week, the recovery is starting right on time

Productivity is up, even as Europe, our chief trading partner, is slowing into recession. This quarter will see some growth as well. Things are just not that bad.

The problem is that the normal things which spur an economy into 5-6% growth rates after a recession are not going to do so this time. Consumer spending and housing never fell from their highs, so there is no room for them to rebound. About the best we can hope for is they stay high. I should note that new housing construction fell 14.8% in January, which is somewhat worrisome. Capital spending, the third force which should put us into a boom, is simply not there. With capacity utilization at a 20 year low, there is little incentive to spend money to increase production capacity.

These numbers have the combined effect of suggesting a slow and weak recovery.

Which is precisely what Alan Greenspan said in his testimony before Congress. The U.S. economy is "close to a turning point," and should begin growing at a slower pace than after previous recessions, he told us. "An array of influences unique to this business cycle, however, seems likely to moderate the speed of the anticipated recovery," he said.

That sounds like a description of the Muddle Through Economy. Not too bad, just not a return to the Boomer 90's.

I can't resist. Just one more hidden stat before we go to gold. Buried in the report that the economy grew in the 4th quarter of least year was this astounding number.

The GDP price deflator, a gauge of inflation tied to the report, fell at a 0.3% annual rate in the fourth quarter. That's the biggest decrease since the first quarter of 1952 and followed a 2.2% pace of increase in the previous three months.

Holy predictor of deflation, Batman! I believe I wrote last week (and even three years ago) about this very phenomenon. We are on the verge of watching inflation slip below 1% within a few months. That is not an environment in which the Fed is going to feel the need to put on the brakes and raise rates.

And so, John, you are telling us on one hand that deflation is coming but now you may be turning bullish on gold? Isn't it inflation that is supposed to be good for gold prices? Inflation is one factor, but as we will see, there is another.

Gold as the Great Scale

My long term disinterest in gold stems from the fact that every time gold gets around $300, some central banker threatens, or actually does start, to sell gold. As an investor, I am not interested in investing in something that has an artificial "ceiling" to it. However, the roof might be cracking, so maybe we can see a little ray of opportunity.

First, a little background. In researching this letter, I reviewed a lot of gold studies. Many of them breathlessly predict gold going to $1,254 or some nonsense; or they can confidently suggest their numbers show a fair value for gold far above where it is today, and we only need to buy gold (presumably from them) and wait for the market to agree with their view.

These reports are full of charts and graphs showing the relationship of gold to everything but the kitchen sink. Invariably, they are all bullish relationships. If gold comes back to "trend," on this relationship, it will be at an all-time high.

Most of these relationships are non-existent, in my opinion. The relationship of gold to the S&P 500 or oil or whatever may be interesting, but it has absolutely no bearing on the price of gold. None. Zero. I am reminded of the observation that there is a statistical correlation between the length of skirts and the rise in the Dow. (If there was such a correlation, then Argentina would be the world's most valuable stock market.)

The reason, we are told, that gold has not gone to its fair price, are those nasty central bankers. It is a conspiracy, and we need to put a stop to it.

In my opinion, there is no conspiracy. Central bankers in most countries simply do not like gold. To them, it is an asset from the Dark Ages, one which does not pay interest. In the case of some of the central banks, they need the cash.

To them, gold is not money. Even a firm which has its roots in the gold movement has recently abandoned the fervor of its founder. Nowhere is this more starkly illustrated than in the year-end letter from Blanchard and Company. Blanchard was started decades ago by Jim Blanchard, and was one of the premier gold bullion dealers. Jim was a good friend and business associate, and I miss him as he is now walking streets of gold rather than selling them.

But Bill Bonner tells me that his old company wrote the following: "Effective as of January 1, 2002, Blanchard and Company is changing its business practices and policies in order to limit its exposure to falling gold prices, and recommends to its clients that they do the same. As of that date Blanchard will not maintain inventories of gold bullion or gold bullion products, nor will it market gold to, or solicit gold sales to, Blanchard clients.

"Gold is no longer a hedge against inflation, devaluation of the dollar or falling stock prices," continues the mailing from Jim's old company. "It is no longer a store of value. The very idea of gold's intrinsic value - value that is not dependent upon the actions or promises of any government - is publicly questioned by senior central bankers, and by the heads of major financial institutions."

I believe they and the central bankers are wrong. And clearly the market does as well, or gold would fall dramatically.

Gold is the scale upon which the actions of central bankers are weighed. It is a neutral currency, an arbiter of the value of all other currencies.

If you lived in Japan, you would not be talking about gold conspiracies. You have simply watched gold recently rise 50% in your currency. No wonder mama-sans are buying gold in large amounts. When the leaders of a country clearly declare their intention to devalue their currency, it is time to head for the hills.

Where can you go if you are Japanese and you don't want to lose buying power? Large investors flee into dollars or some other store of value. Smaller investors flee to gold.

In fact, in most countries of the world, gold is in a major bull market. Gold is up sharply in terms of Euros. The bulk of that rise is the 20% decrease in the price of the Euro, and the rest is the rise in gold in terms of dollars.

King Dollar is Getting Old

Gold has not risen in the US because the dollar has been rising faster, in terms of the rest of the world. When central bankers in Europe sell their gold, they are getting a lot of euros. The incentive is for them to sell, especially if they think the dollar is too strong and will come down over time. And especially if they do not want to own gold.

As the dollar comes down, so will the price of gold in terms of the Euro. If you as a central banker do not want to own the metal, then it is better to sell high. That means now. As long as gold is high in terms of the Euro, there will be pressure from central bankers selling.

For there to be a sustainable bull market in gold, there needs to be a break in the King Dollar. Period.

I have been arguing that the yen is on its way down. No sign of the dollar dropping there. But the yen could be part of the problem in another way.

Many observers worry about the Japanese repatriating their huge dollar investments in US stocks and bonds, causing the dollar to drop, as well as the stock and bond markets. That would cause gold to rise, maybe even sooner than I think. That is possible, but it is not my main concern. Mine is just the opposite.

With the Japanese government committed to a weak yen, it is likely they pursue "reform" so as to not increase the price of the yen. (See past e-letters for more information.) It is just as possible that they inject capital into their banks in such amounts that not only do the banks not need to repatriate dollars and turn them into yen so as to shore up their balance sheets, but that they have excess yen to purchase dollars (and perhaps euros) to hedge against a dropping yen.

This, along with the rest of the world dealing with the huge deflationary pressures running rampant throughout especially Asia, could actually create a stronger dollar - indeed it could be a bubble. We all know what happens to bubbles.

What could be the catalyst for the break in the dollar? The current accounts or trade deficit. I know, I know, the bears have been pulling this one out of the closet every year or so, and like the boy who cried wolf, nothing has happened.

The world continues to buy our goods, stocks, bonds, businesses and real estate to finance our buying binge. It is now running almost $500 billion through the last quarter, according to Morgan Stanley.

They estimate that the trade deficit could be almost 6% of GDP in 2003, which would be 50% higher than ever seen. We would need almost $2 billion per day from foreign sources. This is unsustainable. Just as Amazon.com could not grow their stock to the sky by by borrowing and spending far more than they make, the US will one day have to pay the piper. On balance, the US owes $2 trillion dollars to foreigners, net of our investments overseas. That number has been growing dramatically for the last few years.

At the projected 2003 rate, foreigners would own everything not nailed down in the US in a few decades, which clearly cannot happen. Something will have to give, and that something is either the dollar or a massive reversion in US dollar outflows. We will need to export more and buy less on a huge scale for this to happen.

But the dollar being strong makes international sales more difficult in the face of cheaper competition whose currencies are weak.. And it makes cheap foreign goods more attractive tothose of us with strong dolars. As long as foreigners keep selling us things so cheap, it is hard not to buy. Like I often tell the waitress, take this plate from me before I eat some more!

The question in your mind is, "How far will the dollar fall?" The answer is hard to gauge. There are a lot of variables. One of the biggest is the Japanese. Could we see the dollar rise against the yen and fall against much of the rest of the world? Yes, that is quite possible.

If we do not see a bubble, we could see the dollar drop as much as 20% or so against the Euro and other strong currencies. For a lot of reasons, I rather doubt it goes much further, unless we have another major recession and Europe is in a growth cycle, which is hard to imagine now.

In one sense, 20% is not that much. But a 20% drop in the dollar could mean a rise of gold to the high $300's or maybe even spike to $400.

When does this dollar correction happen? I seriously doubt it happens this year, without some unforeseen external event and probably not until we are well into 2003. But the gold market could begin to smell the drop and rise in anticipation. There is just no way to know.

But that is the reason gold will rise. Not some intrinsic hidden value of gold. Not some relationship with the S&P or oil or silver or whatever. It is that gold is basically a currency play. When the dollar drops, gold will rise in terms of dollars.

How to play for a possible rise in gold? You could of course buy bullion. But the more profitable way would be to buy gold stocks or gold mutual funds.

Profit margins at gold producers will go through the roof and stocks should rise in concert with profits. Of course, gold stocks are highly volatile and speculative.

The problem with buying today is that there is nothing keeping central bankers from selling and watching the price of gold drop back to $270, and watching your gold stocks drop even more.

A New Way to Invest in Gold

Thus, we are back at my conundrum. How do I play in a manipulated market? But if I sit on the sidelines, I will miss the run. Getting into the market, however, exposes me to risk - lots of risk.

My old friend (and former partner) Gary Halbert has found a way. His firm, ProFutures Investments, has found and represents a gold mutual fund timer that is the only person I am aware of who has a long term track record of successfully timing gold mutual funds. The firm is Dorset Financial. Dorset is run by Bruno Giordano, a graduate of West Point, who was a pilot in the Air Force. The firm manages $50,000,000.

Giordano began his program in 1995, and has comfortably more than doubled client money, while the Johannesburg Gold Index is down over 50%. While somewhat volatile, he is nowhere near as volatile as the funds themselves.

He has added value, averaging 14.5% annually for the last five years. He is up 10.5% in February and up 16% so far for this year. He uses the Rydex Precious Metals funds. The minimum investment is low, as well, only $25,000, which is low for an advisory service.

If I were going to invest in the gold market today, this is the way I would do it. I would let Giordano manage my gold investments. Giordano has figured out how to make money in a lousy gold market. It could remain lousy for another year or more. Or it could take off this summer. I don't know. My guess is that it takes off sometime in the future, due to the correction in the price of the dollar.

But putting your gold money with a professional like Dorset gets you in the game with a reasonable chance of making money while you are waiting for "The Big One."

Halbert has put together a thorough analysis of Dorset and Giordano. You can get it by sending him an email with your name, address and phone number to gold@profutures.com or calling ProFutures Investments at 800-348-3601 and asking for the information on Dorset. For the record, I do not make anything from this recommendation.

Halbert's firm is a first-class operation with no pressure and no hype. I should know, I helped build it before starting my own firm. I especially enjoy his newsletters and special updates, and consider him a good source of information.

If you have been thinking about investing in gold or are already doing so, I suggest you get this material and read it thoroughly.

The Politics of Race

I normally stick to finance, but I sometimes feel I must stray. I cannot contain the sense of outrage I feel over the current use of racial politics by Ralph Neas of People for the American Way in trying to stop the appointment of a judge to the appeals court. That Senate Democrats are going along with this is even more outrageous.

Those of you who may have seen the /familyphotos.aspfamily photos on my web site have noticed that my family is more colorful than most. I have two adopted sons who are black. I have less than zero tolerance for racism. When Neas and Senator Edwards use the race card as they are, they are furthering the racial divide in America. They are perverting the very standards of justice and equality that are critical to an America which needs to be healing.

They are cynically using race in a manner that is no different in ethical basis from the Jim Crow laws of the early century. In both cases, the proponents use race to divide and differentiate. Proponents of both Jim Crow laws and the current actions of Neas and company justify their actions with hollow sounding excuses.

I expect no less from Neas. But for the US Senate to allow themselves to be used in so blatant and cavalier a manner is just too much to stomach. If you are from a state with a Democratic senator, consider expressing your displeasure and encourage him/her to reign in the abuses currently going on in the Senate Judiciary committee.

********

Over the next few weeks, I am going to address my concern over the dollar and how it could affect our portfolios. I will suggest some other ways to position your portfolios to benefit.

Speaking of suggestions, take some time this week to call a few old friends and just catch up. It will make your life, and theirs, a lot more enjoyable. It will also remind you that true riches are not just golden.

Your rich in family and friends analyst,

Scroll down for comments.