Market Watch - June 25, 2003

A Hike In The Price Of Gold Is Unavoidable

GOLD Yes or No?

In last month’s Market Watch the following appeared:

We have written a lot about gold and the fact that gold is in a bull market, up over 40% the last few years, while stocks are in a bear market. It is important to watch gold because an increase in the price of gold means a decrease in the value of the dollar, the currency that supports all of the world’s economies, and the primary reserve currency used to settle international debts

Our national debt has increased 13.6 times and gold has increased only 3 times in value the last 30 years. In 1973 our national debt had approximately 7% gold backing and in 2003 our national debt has only 1.5% gold backing. If our 2003 national debt had 7% gold backing, the current gold price would be $1,716 per ounce. It is mathematically difficult to see how gold will not continue to reach higher levels.

Commercial banks have mandatory capital requirements imposed upon them by the Fed. Mandatory capital means permanent capital that may not be removed, like common stock equity and long-term debt. The reason for those requirements is that the primary business of banks is to take deposits and make loans. Loans use a bank’s cash. The more long-term capital in the financial structure of the banking institution, the more of a cushion exists in the event unusual numbers of depositors withdraw money at the same time. The more long-term capital in the banking system, the more it is in balance and less subject to withdrawals of deposits that can throw the system out of balance and create harm throughout the entire economy. A comparison is this: the more equity one has in their home, as compared to debt, the less one is at risk to default on the mortgage.

What’s this have to do with gold?

Gold as a percentage of our money supply can get out of balance, too, because gold is the “equity” of the monetary system. Our government would have us believe gold is an archaic relic that is meaningless and valueless. What makes gold valuable is its limited supply. A limited supply is an implied discipline upon spending as long as gold is the bedrock of a country’s money supply. For example, in the 1930’s, gold convertibility had a ratio of 1 to 1. For every amount of currency outstanding there was an equal amount of gold backing the currency. Today there exists in the M3 money supply 100 times more in paper currency than in our gold supply. A ratio of 100 to 1 today, as compared to 1 to 1 sixty years ago, is a posture of tremendous risk.

With little gold backing, there is nothing to prop up the dollar’s value in the event other countries loose confidence in our currency. By “releasing us” from the bondage of gold, the federal government has been able to tremendously expand the central government because the government has had its own spending restraints substantially reduced. Under the gold standard, a cumulative federal deficit, and the consequent debt of $6.4 trillion, could not exist. The dollar to gold ratio is tremendously out of balance which, from an economic point of view, can only mean one of three things:

What has happened so far is number 3.

What Are The Capital Requirements For Commercial Banks?

The Fed has minimum commercial bank capital requirements for money center banks as follows:

Tier 1 Capital must be at least 6% of assets and must be equity.
Tier 2 Capital may equal up to 50% of total tier 1 capital and may be debt.

All money center banks’ capital positions far exceed the above minimum requirements of 9%. If the Fed were required to have the same minimum capital requirements (gold to M3 ratio) it imposes upon banks it regulates, gold would be selling at a minimum of $3,800 an ounce! (Based upon US gold inventory of 8,200 tonnes, M3 of $11 trillion, and gold at $380 per ounce.)

Gold Facts And Recent History

Let’s examine some interesting facts:

1.The DJIA to gold ratio was 1 to 1 in 1887 (meaning one ounce of gold could buy the DJIA); the ratio was 18 to 1 in 1929 right before the crash; 2 to 1 in 1932, and 1 to 1 in 1982. It peaked at 45 to 1 in 2000 and currently stands at 26 to 1.

2. All of the gold known to have been mined in history is 216,000 cubic feet, which would cover a football field and be only 3-1/2 ft. high!

3. In 1939 the US had in it’s vaults 60% of the world’s monetary gold, or about 36 million tonnes (page 324, Bernstein’s The Power of Gold).

4. Today the US has in it’s vaults 8,200 tonnes, believed to be about 25% of the world’s monetary gold supply.

5. The total stock market value of all of the gold mining companies in the world is currently 85 billion dollars, roughly equal to the current market value of Philip Morris Corporation.

After the Bretton Woods Agreement in 1944, the dollar essentially replaced gold as the standard of value in world markets. The rest of the free world economies were broke in 1943-1944. The US economy was picking up because we were making military hardware. The allies felt the war would eventually be won because of US production. Since the allies’ gold reserves were inadequate to support their need for arms made in the US, the US was able to impose upon the world something else we manufactured: dollars. Dollars replaced gold for purposes of settling international trade imbalances. This was a huge coup for the US. After the war dollars were used through grants from Congress (the Truman and Marshall Plans) to build back up the world’s industrial output. By 1971 the amount of US dollars overseas was so huge that many countries began to discuss redemption of their dollars for US gold, but only France acted. This caused President Nixon to stop convertibility of gold upon demand and allow gold to float freely from $35 an ounce, which did two things:

1. It increased the value of the US, and every other countries, monetary gold supply;
2. It caused the price of gold to exceed $800 an ounce by 1982.

Because of the rapid increase in the price of gold after Nixon denied further convertibility for settlement of international trade imbalances, the currency agreement of 1975 allowed the US treasury to sell gold bullion on public markets in order to “stabilize” the dollar. With gold going up, like today, the dollar was going down. The increase in supply of gold on the public markets to stabilize gold’s price would depress the price of gold. Eventually this plan got the price of gold to under $200 an ounce, but it substantially reduced US gold inventory. Congress will now no longer allow the Fed to sell any of our existing 8,200 tonnes to further “stabilize” the market.

How To Invest

Gold is historically way undervalued. It is important to realize a dramatic increase in the price of gold is probably unavoidable over the next ten years. For investors who believe gold will increase in value, here are some ideas: Newmont Mining (NEM) and Barrick Gold (ABX) are the two largest, and best managed, gold mining companies in the world. Two gold funds that have performed well recently are First Eagle SOGEN Gold Fund (FEVAX) and Tocqueville Gold Fund (TOCQX). For those investors who want to own gold bars or gold coins, go to the periodical section of the local bookstore and purchase Coin World’s current edition or go online to www.coinworld.com. The advertisements in Coin World will provide interested investors with many opportunities to purchase gold (and silver) at the most competitive prices. The US one ounce gold eagles, and one-ounce silver liberty coins, are minted by the thousands. They are in great demand by investors who want to hold physical gold and silver because they are the most liquid gold and silver investments in the world.

Conclusion

Statistics indicate the minimum price for gold should be $1700 and that price levels of $3000 to $5000 an ounce are not unreasonable. Remember that an ounce of gold was equal in value to the DJIA just over 20 years ago. It can happen again – the stock market must go down, and/or gold must go up, for these levels to be realized. Most proponents of conservative economic systems believe one should have 10% of their assets in gold and silver. Should there be a reevaluation of gold from these levels to a price that represents an historical balance in the gold to dollar ratio, the gains from gold ownership would be enormous. Furthermore, currently there exists no investment that has the economics associated with it that could give the investor a greater gain over the next ten years than ownership of gold and silver.

Carpe Diem!
George Rauch
June 25, 2003

A short primer on gold can be obtained at www.gold-eagle.com. Click on “editorials”, and then click on “Research Archives” to get to the list of authors. Particularly important articles are written by Alan Greenspan; Alex Wallenwein’s Gold Will Rise – And Stay There; Alex Wallenwein’s Forget Trading Gold - by Physical! and Hans Sennholz’s Why Gold? Each of those authors has a potpourri of additional interesting articles. Highly educational articles on that sight are written by Stephen Roach (Wall Street’s best known analyst); Richard Russell, who pens the oldest financial newsletter in the country and whose track record concerning the direction of the market is unparalleled; Bill Bonner, John Mauldin and John van Eck, all highly regarded gold experts.