January 1, 2005

Gold Forecast -- 2005
by Michael J. Kosares
Centennial Precious Metals, Denver
Author: The ABCs of Gold Investing - Protecting and Building Your Wealth with Gold

"There were (latest estimates) 116,000 human deaths due to the tsunami. But where were the animals? An Associated Press official flew over Sri Lanka's Yala National Park in a helicopter. He saw abundant wild life, crocodiles, wild boars, elephants, even leopards. Said a hotel keeper who's hotel was destroyed, 'This is very interesting. I am finding bodies of humans everywhere, but I have yet to see a dead animal.' My dogs get spooked before thunder or a big storm, long before I sense it. It seems almost all the animals sensed the coming tsunami and headed for higher ground." Richard Russell, Dow Theory Letters

I foresee two potential scenarios for the gold market in 2005. One involves a see-saw market which culminates with a roughly 20% gain on the year in keeping with the average over the last three years. This would take gold to the $525 level. The other involves a substantial price spike resulting from an uncontrolled deterioration in the value of the dollar. In that scenario, gold would threaten and probably exceed the $600 level. I give the first scenario about a 75% chance of occurring; and the second about a 50% chance of occurring. I do not envision much downside in gold, and if it does fall I expect the recoveries to be quick and complete.

With respect to the first scenario, now that we have three years of history in the currency wars to examine, we can surmise from the market evidence that the G-7 countries have agreed to manage the dollar's fall within a band. In other words, Europe and Japan agree that the dollar must fall, but all parties want the fall to be orderly. What some have missed in their analysis -- and this important to forecasting the gold price -- is that in order for the dollar decline to produce the desired results, it must be engineered over a period of years. It's not like waving a magic wand-- the dollar falls and all's well. In reality, industry will need years of a weak dollar to deliver results.

Note: This analysis does not take into account an exogenous shock like a major gold supply disruption, nor does it take into account a major terrorist attack in the West or negative political event in one of the primary oil producing nations like Saudi Arabia, Iran or Iraq.

The gradualist scenario aside, there is another, much more troubling possibility. This scenario starts with the fact that the manufacturing sector within the United States is in decline and has been for a very long time. The devaluation medicine (weak dollar policy) described above is aimed at buttressing an old economy, one that does not exist on the scale it did when Richard Nixon launched the U.S. dollar devaluation policy in the 1970s. In other words, dollar devaluation might not cure what ails the American economy. The United States could very well continue on a track where exports increase, but imports increase at a faster rate simply because the nation no longer possesses the manufacturing capacity that would benefit from the weaker dollar. This, in fact, would be the worst-case scenario for the dollar. It would signal that the trade and fiscal deficits are likely to continue growing at an alarming rate -- a circumstance that could by logical extension usher in an inflationary depression.

What might this mean for the dollar, gold and the U.S. economy?

First, the obvious weaknesses in the policy could encourage a major speculative attack against the dollar which might send gold well over the $600 mark, and under such circumstances there may be nothing to stop it there. This attack could be launched at any time the way George Soros and friends took down the British pound -- a largely forgotten event which illustrates the power that can be summoned by internationally based capital funds. In other words, the G-7 strategy described above could be overwhelmed by the hedge funds and other powerful speculators who in effect smell blood in the water and move in for the kill.

Second, the United States under extraordinary stress would be likely to lobby G-7 for a wider band in an effort to make the policy work. Such a development would amount to a rewrite of the 1970s and a loud echo of the 1997 Asian contagion experience -- the inflationary depression mentioned above only this time it would occur in the world's largest and most important economy. Under these circumstances, the U.S. economy could disintegrate in waves of stagflation -- rising unemployment, mortgage defaults and bankruptcies coupled with double digit inflation, stock market collapses, financial sector breakdowns of every description (including systemic breakdown) and eroding balance sheets across the boards for both businesses and individuals. In other words, the worst case scenario.

I remind the reader that I favor the gradualist scenario as the most likely, but the economy doesn't always respond to the well-laid plans of the policy-makers. No matter which of the above scenarios unfold, or even if something totally unforeseen should occur (as it has so often in the past), remember that physical gold remains the best defense. These are dangerous times and investors should not delude themselves that somehow this is all going to resolve itself politely and positively. Like the animals in the Richard Russell vignette above, perhaps we should heed the warning signs and seek the high ground.