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The Case for Gold

by Doug Casey


TIME FOR GOLD?

In May 1996, Casey advised getting out of natural resources, particularly mining stocks and precious metals. He saved his readers a lot of grief as the whole mining/precious metals market tumbled disastrously, but now....

"It's time to buy both gold and silver bullion (or coins) in size, and with abandon. It's also time to buy into the junior mining shares. Sure they could lose another 25%, even after the mauling they've had. But the chances are better they'll gain 500% over the next couple of years. I'll take those odds."


 

I've always been a gold bug, believing that the dollar should be redeemable in something specific, and not just be a floating abstraction (an "IOU nothing" from its issuer). But I haven't always been a gold bull, because the metal is also a commodity that can go down as well as up against other things.

But at this point I feel we're about to go into the most violent monetary crisis of modern times (whew, I really hate saying such inflammatory things, but you've got to call them the way you see them). Gold -- and silver, for a different set of reasons -- is headed into a major bull market. And gold stocks, which have just bottomed (off 70-95 percent), are likely to move over 1,000 percent in the next few years -- something they've done, cyclically, a half-dozen times in the last 30 years.

See if you buy the basic rationale. International Speculator will have a strong focus on the gold stocks in the months to come.

A short case for gold

I figured the bottom for the gold market in this cycle was about $275; it turned out the absolute bottom was $252, put in during July 1999, when the Bank of England announced it was going to sell up to 415 tonnes (13.3 million ounces), or 60 percent of its reserves, over the next few years. But to see the metal explode upwards by over $60 late that year took me as much by surprise as anyone. It wasn't that it happened; that was inevitable. It was the exact timing, a factor which is always unpredictable. Things you expect to happen usually take longer than expected; but once under way they tend to evolve much more quickly than you expected.

Estimates are that world demand for gold is 50 percent higher than annual production of 3,000 tonnes, and that's been the case for years. The deficit has been funded by gold loans from central banks, abetted by forward sales of some mining companies.

Central bank selling, in itself, doesn't bother me. I have a low opinion of central bankers, IMF functionaries, and government economists of all stripes, maintaining that they're exactly the same people you'll find working for the Post Office, except that they come from better families and went to more prestigious schools. The fact they dress in Armani suits and fly first class on junkets where they decide how to spend your money doesn't mean they're smarter or harder working than their fellow government employees at the Post Office, just luckier and better connected. Indeed, I'd sooner trust my mail carrier with the decisions they make; at least he actually does something productive with his time, and his head hasn't been filled with all manner of economic rubbish.

In any event, the facts are that central bank selling has been a major factor in the gold bear market being both as long and as deep as it's been. The central banks of Australia, Argentina, Canada, Belgium and Netherlands have each sold almost all their holdings. The Swiss are cleared to sell 1,300 tonnes (42 million ounces), the IMF 300 tonnes (9.6 million ounces) and the British have sold most of the 415 tonnes in question. But that's only part of the story, because the central banks have been making gold loans for over a decade. The rationale for them, of course, was that they could earn perhaps 1, 2 or 3 percent on an asset that otherwise earned nothing. The rationale for the borrowers was equally compelling: Borrow at 1, 2 or 3 percent, sell it (helping drive down the price) and pay back the asset later, at lower prices. It's been an excellent game to play for almost 20 years. But when the market turns, many players are going to get caught short.

Pretty much the same thing as with the carry trade in various currencies; i.e., borrow currency X (paying 3 percent interest), sell it, buy currency Y (earning 7 percent interest), capturing the 4 percent difference, plus perhaps a big capital gain if currency X goes down in the face of huge selling. Do it on heavy margin and make 50 percent per year. Unless and until something goes wrong, as happened with long-term capital a few years ago.

Unprofitable short positions are doubly dangerous, presenting counter-party risk; they can bankrupt both the borrower and the seller. I suspect more and more traders are going to start closing them out, buying back gold sold at higher levels. Just as the bear market [in gold] fed on itself, the bull market soon will. And entirely apart from the long-term fundamentals, short covering alone could be absolutely explosive. The decision of European central banks to stop lending as well as selling gold will alone put a lot of pressure on the shorts. Meanwhile, new ounces are being discovered much less slowly than they're being mined; exploration budgets of mining companies have cyclically collapsed to less than one-third of what they were a few years ago. And many mines are high-grading to maintain current cash flow, which will compromise them in the future.

What will set off the next up-move in gold? It could be a panic in the stock market. Perhaps a surprise bankruptcy. Maybe a war. It's a safe bet something will go wrong when most people think we already live in the best of all possible financial worlds.

Of course, the question is, with gold now at $275, what will happen next? I heavily discount most of the predictions based on what Greenspan or other central bankers are saying or appear to be thinking or doing. In the first place, very few of the pontificating pundits have even met them; even a close friendship with them would likely be of little help in figuring out what they'll be forced to do. And, most important, it increasingly doesn't matter what they do. Even back in 1971 the market overwhelmed the Central Banks when they tried to control gold at the artificially low price of $35. Then the Banks owned about half the gold in existence; now they probably own less than one fourth of the estimated 4 billion ounces above ground. Then the size of national debts was vastly smaller, the volumes of international trade vastly lower, and governments much more able to control their economies. Further, the world financial situation is far more precarious now than it was then.

How high will gold go?

I think a new bull market in gold has started, and not just another cyclical upturn. Even though we've had a half-dozen strong upturns since gold peaked at over $800 in January 1980, it's been a 21-year gold bear market. Each upturn took many volatile gold stocks up from 10 to 50 times in price. But that's always been within the context of a supercyclical bear market. I believe that's over now. We're at the cusp of another supercyclical bull market, like that of 1971 to 1980. In other words, over the last 20 years, any rally was a good time to sell. Over the next several years -- I hesitate to assign a figure -- every sell-off should be treated as an opportunity to buy.

How high will gold go by the time it's over? This is the realm of crystal ball gazing, and I'm not a fortuneteller. I can tell you where gold could go, although this isn't a prediction. If you assume gold is money, and I do, just look at these ratios. I think three ratios make sense, in descending order of importance:

1) U.S. gold to the money supply: M-1, which includes currency and checking accounts, is currently around $1,100 billion; the U.S. gold inventory is supposed to be 261 million ounces. Dividing one into the other gives you $4,214 per ounce if the government were to be able to make each dollar redeemable with a specific amount of gold. If you use the figure for M-2 ($4,562 billion), it rises to $17,480 per ounce. If M-3 ($6,206 billion), then $23,780 per ounce.

2) U.S. gold to U.S. foreign trade deficit: The size of a country's deficit or surplus would be of no consequence in a free-market world, where all currencies were convertible into a fixed amount of gold. It would be a self-correcting phenomenon, reflecting nothing other than cyclically differing preferences to save or consume. Today, however, the dollar is considered a liability of the U.S. government, especially those in the hands of foreigners. At this point, there may be a trillion dollars circulating outside the United States, held by foreign central banks. They're potential hot potatoes that, when the trade balance reverses, as it must, will send domestic inflation skyrocketing. The deficit is currently running at $400 billion a year; at $300 gold, the U.S. supply would last less than a quarter. Based on a cumulative $1,000-billion deficit, about $4,000 gold would be necessary. The situation is quite analogous to that of the late '60s, when a run on the dollar started due to a surfeit of the currency in Europe.

3) U.S. gold to U.S. government liabilities: The official U.S. government debt is $5,650 billion. The government could make good on that with its gold supply at $21,650 gold.

The developing bull market should be a wild ride indeed, however, even if fundamentals like these never come into play. The presumed 30-million ounce annual supply deficit has been building for years, covered by gold loans of one type or another. No one knows with any real accuracy where the world's gold is, or exactly what people are doing with it; there's a lot of conjecture in the numbers. But it would appear a short position of about 400 million ounces, about 10 percent of all the gold in existence, may have developed over the last decade, and the higher the price goes, the more frantic will be the drive to cover it. It's entirely likely you'll see bankruptcies on the part of both lenders and borrowers in the next few years.

And there will be one positive side effect of tens of millions of Americans watching the markets -- or at least the fraction of them that are left after the NYSE and Nasdaq get really ugly. This mob is conditioned to watch any market that's moving, and they're inclined to bet mainly on up-moves. Precious metals will be about the only games in town. And when these folks discover the existence of gold stocks, you're going to see moves that will dwarf those of the late dot-com companies.

I don't know the timing of the next move in gold; but you should use times like these to sit on the bid and build a position. I've been saying that for the last year. This is likely to be the strongest gold market in history, driven by both fear and greed.

Again, nobody knows what gold is going to do tomorrow; but I'm betting that in this cycle it's not just going through the roof, but to the moon.


by Doug Casey
March 15, 2001

Copyright © 2001 by Doug Casey. All Rights Reserved.

Doug Casey is the editor of the newsletter International Speculator, and author of the best-selling "Crisis Investing" and "The International Man."

http://www.dougcasey.com

Reprinted by USAGOLD with permission of Mr. Casey. No further reproduction without permission.

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