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GOLD AND SILVER REMAIN UNDERVALUED

To the disbelief of many, the U.S. dollar continues sinking to new lows. Many analysts and investors have been thinking someone would step in to support the dollar near its all-time low on the U.S. Dollar Index at 81.8 reached back in 1995. Today the index closed at the new low of 81.57, with the dollar exchange rate for the euro at $1.332, Swiss franc at $.876 and the Canadian dollar at $.845. Mainstream market analysts are mostly playing it off as a good thing that will make our exports more competitive and work to inflate our way through the federal budget deficit and trade deficits. Most Americans don’t seem to be alarmed much by the falling dollar; after all, with Mr. Greenspan virtually endorsing a lower dollar, how could it be all that bad? The Fed has been advertising higher interest rates and the spin right now has interest rates moving higher due to an improving economy, not because of a falling dollar. Today the stock markets are getting happy with the prospects of an improving economy based on the ISM report and got an extra boost as energy prices declined with higher than expected inventories.

The day opened with a positive report from the Institute for Supply Management showing their factory index rose to 57.8 from 56.8 in October. This was the first increase in the manufacturing index since July and came in stronger than expectations at 57.0. The employment index also rose from 54.8 to 57.6. The report said consumer spending increased 0.7%, but incomes only rose 0.6%, which means consumers either went into savings or increased their borrowing. Consumer sentiment has been in steady decline, so we’ll just have to see if the spending will remain at a high rate. We already had a warning from Wal-Mart that sales are running behind plan for the first week of the holiday shopping season.

The ISM report was enough to get stocks headed into positive territory, and got an extra boost when the Energy Department said crude inventories gained by 849,000 barrels and distillate inventories (including gasoline and heating oil) grew by 2.3 million barrels following the expected build of 1.5 million barrels. By the end of the day crude was clobbered for a huge loss of $3.64 (7.3%) a barrel to close at $45.52, with gasoline falling 6.5% and heating oil down 6.3%. (This won’t last with a falling dollar.) The lower energy prices were well received by Wall Street sending stock prices higher across the board. By the end of the session the Dow Jones Industrial Average added 162 points to 10,590, the NASDAQ Composite moved 41 points higher to 2,138, and the S&P 500 closed in new high territory for the move by adding 17 points to 1,191. I’ve been expecting a near-term correction for stocks, but they just don’t want to come down! Me thinks reality will set in for stock investors shortly after the first of the year when fourth quarter earnings come out. This re-election rally feels like the “sentiment war rally” that took stocks higher in 2003. I’ll need to see stronger earnings in January to believe it.

Higher interest rates will put additional pressure on stock prices, as bonds with higher yields become more and more attractive. The higher interest rates should work to contract price to earnings multiples for stocks. Remember that the P/E ratio for a stock is the inverse of the stock’s yield. The P/E ratio works well as a relative number because it reflects stock prices for each dollar of earnings. A stock with a P/E of 15 would have a return of one dollar for every 15 invested, or 1/15 = 6.7%. To get the total yield for a given stock, just add any dividends to the “earnings yield.” The markets have been sporting historically high P/E multiples and the high multiples have been justified by low interest rates.

Thirty-year Treasury Bonds are currently yielding 5.0%. The current P/E for the S&P 500 is 21.1 and the dividend yield is 1.57%. Using the reciprocal of 21.1 we get 1/21.1 = 4.74% plus 1.57% dividends equals a total yield of 6.31%. Stocks are yielding 1.3% more than bonds, which reflect the additional risk for stocks over bonds. To convert the bond yield to a P/E ratio just flip it over and divide .05/1 = 20. A bond yielding 5% is comparable to a stock with a P/E of 20. Now for illustration, let’s assume long-term interest rates move up to 7%. Now divide .07/1 = a comparable P/E of 14.3.

As interest rates rise, P/E multiples must come down to keep the relationship between stocks and bonds intact. There are only two ways stocks’ P/E’s can go down: either earnings must increase or the stock price must move lower. As multiples begin to contract with higher interest rates, just ask yourself if the P/E’s will come down due to higher earnings or lower stock prices. I do not believe stock earnings will keep pace with rising interest rates, therefore stock prices should move lower. So far as I can see, the best hope for stocks going into 2005 would be earnings growth via inflation that would coincide with the artificially low interest rates we have today.

In the mortgage arena rates are already starting to move higher. The Mortgage Bankers Association reported 30-year fixed rates moving from 5.64% to 5.78%. Overall, the MBA application index fell 5.8% with the purchase index down 0.6% and the re-finance index down a much bigger 12.3%. Mortgage re-financing has been drying-up since the peak back in May of 2003. This should put a damper on demand for high ticket items during the shopping season. Auto makers are already cutting back.

I’ve been watching the bond market very closely for a break lower in price ushering-in the higher yields, but it’s not happening…yet. Most recently money has been moving out of the longer maturities and going into the shorter end. As I write, the 30-year bond is down 0.2% and the two-year note is up 0.1%...not a big move, but clearly favoring the safety of shorter maturities. I guess all I can ask myself, is how much longer we will be able to stay at 40-year low interest rates with inflation heating up and the dollar on the ropes. I expect the bond market to crack lower (make special note to read Martin Goldberg on this topic tomorrow), but it hasn’t happened yet. I told Martin today it looked like bond prices are still in an area where they can be “rescued” to keep a lid on interest rates. Technically bonds are breaking down, but we’ll have to see if the PTB’s can pull another rabbit out of their hat, salvaging bonds and real estate in the process.

A Different View of Historical Gold Prices

Yesterday I got frustrated watching gold and silver take a beating with the dollar hitting new lows. I increased my frustration when I looked at the performance of the gold and silver mining companies relative to the metal prices. Gold took out the resistance around $430 and moved to new highs while the HUI Gold Stock Index has failed to make a new high. I’ve been touting silver for quite some time and it blew through the $8 mark today with the December contract closing at $8.05 an ounce. The cautionary note comes when we see the silver mining company stocks closing slightly lower. Many of the gold and silver analysts have been calling for a correction that hasn’t happened yet. They are now at the point where they are “wishing” for a correction so they can buy their positions back. Frankly, I think a correction would be quite healthy for the metals right about now to build a strong base as we continue higher…but it doesn’t necessarily mean it’s going to happen. Much will depend on the political posturing for a falling dollar and what the other countries do in response. Right now I’m thinking we are going to see a short and shallow correction before we move up again. I believe the pull-back will be shallow because I keep up with the reports from LeMetropole Café that have been pounding the table on the strength of the physical market, especially overseas. We have just entered the delivery period for the December contracts, so I’ll be watching to see if there’s a big run on physical, or if the contracts are rolled forward.

To fix my frustration yesterday, I decided to quit watching the screens and do a little study on historical gold prices adjusted for inflation. I’ve sliced and diced the value comparisons for gold and silver comparing them to the CRB index, foreign currencies, gold/silver ratio, Dow/gold ratio, gold/oil ratio, and on, and on, and on…  This time I decided to look at average annual gold prices going back to1970 and adjusting each year’s average by the CPI to see where it should be today based strictly on inflation with no respect given to the supply/demand fundamentals. The following table is what I came up with:

It was very constructive for me to go through this exercise because it calmed my frustration with the conclusion; it’s just a matter of time to see higher prices. The study showed me once again that gold, and by extension, silver are still undervalued. To backtrack, I pulled the average annual price from Kitco’s historical data and used the “Inflation Calculator” at www.westegg.com/inflation/ to arrive at the inflation adjusted price for each year (extended to 2003). Please note the inflation calculator uses the CPI data as the measure for inflation and it is widely accepted that the Consumer Price Index understates the true rate of inflation. Also, these numbers do not include inflation for 2004. That being said, I consider these numbers to be on the conservative side.

You must know by now I am quite bullish on the precious metals sector, so consider my optimism when I say the most important number on the data table is the average inflation adjusted price for the twenty-year period from 1975 through 1994 at $645 per ounce. This would support the claims of some analysts that the natural clearing price for gold based on supply and demand should be in the range of $600 to $750. As I recall, Frank Veneroso calculated the natural clearing price to be around $650 an ounce a couple years ago. Since gold and silver have been held back below their natural clearing prices for so many years, we should see an overshoot of the clearing prices by a long-shot before the market settles back to where it belongs, but that’s probably five to ten years from now.

I believe the twenty-year period from 1975 to 1994 is more representative of the true picture than the thirty-year window of the data table. I threw out the first five years because that was the time the gold price was adjusting from being loosely fixed at $35 an ounce. We ran up some huge debts to pay for the war in Vietnam, and then President Nixon decided to roll-back the gold cover clause that backed the U.S. dollar allowing foreign governments to exchange excess dollars from trade for gold at $35 per ounce. Charles deGaulle was actively exchanging excess dollars for gold until Nixon cut him off. In the end, it looks like the war on terror will have many parallels to the war in Vietnam with its subsequent carnage for the dollar and U.S. assets. (Bond prices crashed straight through the Seventies until the long-bond was yielding roughly 15% in the early Eighties, and don’t forget the stock crash of 1973-74.) They diluted the dollar in the Sixties and tried to hold it all together, but it was more important to create (borrow) more money to fight the war and spend on entitlements.

In the calculation to arrive at $645 gold, I also threw out the last five years because that was the time (1995) the Clinton/Rubin team began to implement the “Strong Dollar Policy.” Part of the strong dollar policy was a suppression of commodity prices along with a focused effort to keep the gold price subdued. You can go back to study Gibson’s Paradox by Lawrence Summers to understand why central banks want to keep a lid on the gold price as it relates to interest rates and the dollar. It has already been revealed by Paul Volker that the big mistake made back in the Seventies was simply that they did not sell enough central bank gold to keep the price from taking-off and throwing up all the red flags that the dollar was in trouble. The powers that be are doing their best to heed Mr. Volker’s words, but in the end their efforts will be futile as they always have been throughout history.

One other thing to note on the table is that I bolded all the inflation adjusted prices above $450 an ounce since that’s been the ballpark price recently. Note the 20-year window again from ’75 to ’94. During those twenty years there were only two years the inflation adjusted price was below $450. We still have a long way to go for this big bull market in precious metals and declining values for fiat currencies, especially the U.S. dollar. The rise for gold and silver will certainly NOT be a straight line up, but will most assuredly be filled with some exciting volatility. Silver blasted-off for a gain of nearly 4% today, but most of the silver mining stocks closed lower. The non-confirmation from the equities implies we have a near-term correction to deal with, but I’m not convinced the pull-back will be deep enough to take profits now hoping to buy the shares back at a lower price.

For all you gold and silver bulls that happen to be out of the market, I hope we get the brief pullback to get you some good entry points and for me to re-load the heavy leverage positions. It won’t be easy to trade the metals because it’s not simply straight-forward fundamentals and technicals, but rather mixed with politics and international posturing of foreign currencies. Political haggling over currency rates will make the unpredictable more probable…linear thinking in a non-linear world will not work moving forward. Time to think out of the box…Expect a discontinuity in the financial markets and prepare as best you are able!! We are in uncharted waters with the entire globe operating on fiat funny-money. Next year should be a wild ride!!!

Have a Great Evening!

Mike Hartman

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