Storm Watch Update
DOW 10,000 VS. GOLD $300
by Jim Puplava
www.financialsense.com
February 15, 2002

Tools of The Technical Trade

Technical analysts refer to them as support and resistance levels. A support level is a price level at which declining prices stop falling and move sideways or upward. It is a price level where there is sufficient demand to stop the price from falling. A resistance level is a price level where a security’s price stops rising and moves sideways or downward. It indicates an abundance of supply. Because of this, the security may have difficulty rising above this level. We also see is both short-term and long-term support and resistance levels that alert investors to trends in the marketplace. These are two very important tools that technicians follow to discern turning points in the financial markets.

There is no greater example of this principle than the current charts of the Dow Jones Industrial Average and the price of gold. Both charts indicate the current battle between paper and physical assets. Since reaching its peak back in January 2000, the Dow has been on a downward slope in what has become a bear market for stocks. Since that time, the Dow has made many attempts to rally, first above the 11,000 mark, and now the 10,000 level. The 11,000 benchmark didn’t hold for very long. The new psychological level has become 10,000. This level is very important for investors and the financial markets for it represents the hope of a recovery. Even though other indexes like the Nasdaq and the S&P 500 have fallen and lost more ground than the Dow, for the vast majority of investors and U. S. citizens, the Dow is an important symbol of America’s economic strength. The Dow is also the most widely followed stock index around the world. If the Dow is okay, then the American economy is believed to be okay.

The Consumer/Investor Confidence Game

In many ways, the Dow has become the key to maintaining consumer confidence. As long as it remains close to the 10,000 level, consumers can hold on to the illusion that we’re okay and that better times lie ahead. Keeping the Dow at or close to 10,000 is part of the confidence game that is now being played in the financial markets. If the Dow falls below that level, as it did following the terrorist attacks on the Trade Center in September, then hope dims and can quickly turn into fear. That is why there was so much intervention into the financial markets by the Plunge Protection Committee during the fourth quarter of last year. Wall Street and the media began to immediately talk about a Fed-induced recovery. The markets rallied strongly on nothing more than hype. Earnings for corporate America during 2001 turned into a profit implosion. Profit margins and earnings hadn’t fallen this drastically since the Depression of the 1930’s. As the tally comes in for last year's fourth quarter, it now looks like profits fell 23.9%. Analysis of potential profit sources going forward doesn’t look that good either. Wall Street has been steadily raising its earnings decline numbers for the first quarter; while at the same time, they are raising profit projections for the second half of the year. The consensus is for an earnings recovery of more than 17% for 2002. This means we’re back to the second half recovery scenario. For the last three years running, all bets have been on the second half recovery, which has never taken place. Now investors are told that earnings will be up by more than 17% for the year. For those targets to be reached, corporations are going to have to do some very heavy lifting during the second half of the year. You might say their efforts will have to border on the miraculous.

Illusive Earnings Plays, Pro Formas, Write-Offs, and Recalculations

None of the major companies reporting earnings so far are talking about potential miracles in the second half of the year. Even with financial publications now reporting pro forma earnings instead of the bottom line, the efforts to reach those targets are going to have to be Herculean. What we do know at this point is that due to accounting changes, it is now estimated that companies will write-off close to $1 trillion in impaired assets from their balance sheets this year. These write-offs will be shown in the numbers that follow profits from operations before you arrive at the bottom line. These charges are going to be so horrific, it may be one reason that publications like Barron’s will no longer compute P/E ratios for the three major indexes based on bottom line numbers anymore. Many of the companies that went on an acquisition binge during the boom years of the 90’s are now in the process of writing off many of those paid-for-assets. Howard Schilit, in a recent Newsweek interview said the next big thing in accounting will be coming from those companies that grew their bottom line through acquisitions.

Unmasking The Numbers

The problem for Wall Street and their partners in the financial media is how to maintain the illusion of prosperity going forward. It will mean changing what is reported and how it is spun for public consumption. I’ve written in the past about the danger of accepting pro forma numbers as a reliable benchmark for a company’s financial health. This week I’ve written about pro forma economic numbers. However, the confidence game is getting harder to maintain. Each day there is another earnings disappointment, accounting scandal, currency mishap or bankruptcy that makes it more difficult to keep the prosperity illusion alive. The consensus forecast for recovery this year is based on a debt-strapped consumer going even deeper in debt to support consumption. Despite periodic episodes of spending, such as the fourth quarter jump in auto sales, it now appears that the consumer has begun to retrench.

The latest personal income figures show that even though personal income rose last month, the level of spending isn’t keeping up with income growth. What we do know is that personal consumption has dropped from an annual rate of increase of 5.9% at the beginning of the year to a more recent rate of 1%. Even their spending has been confined to bare essentials. The consumer is tapped out. Debt levels remain high and only look good when compared to the net worth in real estate and stock holdings. This may be another reason why Wall Street and Washington are worried about the stock market. The Fed’s interest rate cuts have kept a floor underneath the stock market and have kept the economy from going into a deep recession. But what comes next? Will it be a surge in capital spending or another consumer-led debt binge that propels the economy forward, or will the job have to rest on the shoulders of government?

The Greenspan Put

Washington and Wall Street are facing a real crisis in confidence. The accounting scandals, the bankruptcies, the implosion of foreign currencies in Japan and Argentina, and now Venezuela are making it more difficult to keep the coming prosperity illusion alive. The entire confidence game now rests on only one last remaining support pillar which is the stock market, and in particular the price of the Dow. Despite a major pullback from January 2000 and March of 2001, there still remains a significant bubble in the stock market that has yet to be deflated. Investors have been lulled into believing Mr. Greenspan will keep a floor underneath the market. This is the support level I am referring to in the graph of the Dow above. This is the famous "Greenspan Put" (a fixed price level which insures against a decline). The stock market as reflected in all major indexes is selling at extreme valuation levels. The trick for Mr. Greenspan is to gradually deflate the bubble in the market over a period of time so as not to create a panic with investors. So as the graph above illustrates, what we have seen is a stair-step decline in the Dow from above 11,500 to 11,000, and now 10,000. The Fed is trying to engineer the unwinding of the bubble in a series of declines that can hopefully be spaced out over several years instead of steep plunge as occurred in 1929 or 1987.

Rising Gold Prices Threaten Confidence

So far, the confidence game has worked. But now the Fed has another problem that it may not be able to contain. It represents the most serious threat to the confidence game. It is the rise in the price of gold. When the price of gold starts to rise, it threatens the public's confidence in financial assets. Gold’s rise spells t-r-o-u-b-l-e for the financial markets. As the graph of gold below indicates, the price of the precious metal has wakened from a decade-long slumber. Since hitting its nadir of $255 an ounce in February of last year, the price of the metal has been on the move. There have been several attempts at assaulting $300 over the last four years, but the price of gold could not hold at that level. It met up with its resistance level at $300. There were brief attempts back in March ' 98, September '99, January 2000, and three attempts in 2001. Each time gold hit $300, heavy selling by bullion banks, institutions or hedge funds knocked the price of the metal down. However, the battle for confidence has now decidedly turned in gold’s favor.

4 Reasons for a Probable Gold Rally

There are several reasons that the latest rally may signal the turning point in what has been a multi-decade bear market for gold. There are four significant forces that have now aligned themselves in support of gold. These forces are 1] the storm front that is building in the economy and the financial markets around the globe, 2] the battle over hedging in the gold markets by producers and bullion banks, 3] the record level of low interest rates, and 4] the crisis in credibility in the financial system.

1] Storm Fronts on The National and International Horizons

I have written at length in my Perfect Financial Storm Series about the crises that are now unfolding in the financial markets and in the economy. They have also been highlighted in weekly Storm Updates. Suffice to say that not a day goes by without another crisis erupting somewhere around the globe in the financial markets, the economy, or with the currency of the world's major economic powers. We’ve seen major bankruptcies from Enron, Kmart, to the more recent Global Crossing. The Argentine Peso, the Euro, the Japanese Yen and now the Venezuelan Bolivar have all plunged to record lows. Stock markets around the globe are now in their third year of descent and the major G-7 economies are in recession. It could be argued that some countries like Japan and Argentina are bordering on depression. The Nikkei is at a level that is slightly above or equal to the Dow Industrials - something we haven’t seen for decades.

Argentinean Peso	Euro
Japanese Yen	Venezuelan Bolivar
Source: x-rates.com

All Eyes on Japan
Everywhere you look around the globe there are growing signs of panic. You have a full blown economic crisis in Japan that has gone beyond dismissal. This is a crisis that the markets can’t ignore. We’re not talking about a third world country. Japan is the second largest economy in the world behind the U.S.. Japanese banks are hemorrhaging from bad loans and the government itself is mired in debt. The real worry for the rest of the world is what would happen if Japan needs to call in its loans and investments? With $3 trillion in overseas assets, that could be a big problem. Economists dismiss this issue because of the fact that much of Japan’s overseas assets lie in the form of hard assets like factories that can’t be repatriated back home. However, this doesn’t prevent the Japanese from cashing in more than trillion dollars in liquid assets. Today, Japan has $673 billion invested in Treasuries and bank loans in the U.S..

What would happen if there is a run on Japanese banks by depositors? Their government is going to start to fade out deposit insurance beginning in April of this year. Already Japanese investors are lining up to change their yen or dollars into gold. Could banks in Japan be hit with a bank run and pull out investment capital from overseas? They did so in 1997 when a mid-sized Japanese bank, Hokkaido Takushoku, collapsed, thereby forcing a withdrawal of capital out of Thailand, making Thailand’s own domestic problems even worse. Within three months of the bank's bankruptcy, Japanese banks withdrew $118 billion out of the global economy which mostly came from Asia. According to a recent story in Forbes, that withdrawal of funds was behind the bankruptcy of South Korea. What happens to Japan could impact the entire world’s financial system because they are the world’s banker. Their economy is much too large to be bailed out by the IMF. Nor could the Fed print enough money or inject enough liquidity into the world's financial system to bail out Japan. There simply aren’t enough trees to supply the paper that would be necessary to liquefy the Japanese economy.

Argentina's Economic Earthquake Sends Out Tremors Elsewhere in Latin America
There are other problems that have only begun to surface around the globe. The markets are aware of what is happening to Argentina, but now the fire has spread to Venezuela with major implications for the country’s oil production. There is a capital flight right now in Venezuela with the country’s currency, the Bolivar, falling 25% after the government scrapped a five-year old plan to control the currency. It is beginning to look like Mount Vesuvius is about to erupt. This is why central bankers and the markets are on edge.

2] The End of Gold Carry Trade and Unwinding Hedges

A second factor that bodes well for gold is the end of the gold carry trade and the unwinding of gold hedges. Gold has been running a supply deficit for over a decade now, yet the metal price continuously fell throughout the 90’s. This supply deficit has been made up by central bank official gold sales and by gold sales generated by miners and hedge funds that have borrowed gold from central banks and sold it. It is estimated that the amount of gold that has been sold short is between 10-15,000 tons of gold. This represents between 5-7 years worth of annual production. As the table below illustrates, the supply deficit has been made up by central bank sales, disinvestment and scrap sales of gold. In 2001, gold disinvestment came to a screeching halt. The important point here to consider is how will that gold be paid back? With the annual gold deficit ranging between 1,000 to 1,500 tons a year, how do you cover gold shorts of 10-15,000 tons? The answer to that question is, you can’t.

The reason that you can’t cover the short position is that mine production could not ramp up fast enough to supply it. After decades of declining prices for gold, many mines have been shut down, gone out of business, or have been merged or taken over by larger mining companies. Exploration and development has come to a near standstill as the industry has pursued consolidation. This consolidation has not added to capacity. When a major gold company takes over another gold company, no new reserves or production capacity is added to supply. Inherently, the industry has been in the process of contracting.

Another reason these gold shorts can’t be covered is that even if prices exploded and remained high for a considerable time, it takes time to bring a mine from exploration to development and then to production. It is a process that could take many years, especially with all of the environmental red tape. The only way for that deficit to be made up is for central bankers to sell off most of their remaining reserves. If that happens, we will be in a real crisis. Central banks could end up like the emperor who had no clothes.

The message in the markets over these last few months is that gold hedging is coming to a halt. The game has changed with Newmont winning its bid for Normandy. That was a key inflection point in the battle for higher gold prices. Newmont and its new management team from Franco Nevada don’t believe in hedging gold prices. Newmont now stands out as the largest gold producer in the world with the majority of its gold unhedged. Other large gold hedgers like Anglo Gold have gotten the message and have begun the process of unwinding their gold hedges. Anglo Gold has had a policy of hedging about 50% of its next five year production. It has now begun to deliver to its book to the tune of 3.4 million ounces last year.

As large mining companies begin to unwind their hedge book, more gold will be taken off the market which is bound to further aggravate the supply deficit. As the price of gold rises, more of those hedges will have to be unwound or else many of those companies could find themselves at a severe loss. Key support levels to watch out for are $320, $325, and $350. If gold rises to those levels, the price could begin to explode because of short covering. If gold begins to surpass those levels, many bullion banks could experience severe financial difficulties. This could spell trouble for the largest hedger of them all  -- Barrick -- which has hedged 23 million ounces of its production. Barrick has sold close to four years of its future production. The only way that this major short position could be covered would be for central banks to clean their closets of gold -- a frightening thought that could only send gold prices even higher.

3] Low Interest Rates

Source: CNN/Money
A third and related reason that gold prices are bound to rise is the record level of low interest rates. As interest rates have fallen, it has virtually put an end to the gold carry trade. The way the gold carry trade worked was for hedgers, miners and hedge funds to borrow gold from a bullion bank at a very low rate of interest. Most of the time that interest rate has ranged between 0.5 and 1.5%. When interest rates were much higher, the gold could be sold into the market and the cost of borrowing that gold would average around 1%. The money received from selling the gold could then be invested in higher paying securities like short-term U.S. Treasuries, paying a much higher interest rate. It was like getting a free lunch. You could borrow at 1% and invest the proceeds at 5 to 6% in risk-free short-term Treasuries. However, when the Fed began to cut interest rates and bring short-term rates to the lowest levels in forty years, that game was no longer profitable. Now the spread between the gold lease rate, the rate which central banks charge to borrow gold, and the short-term T-bill rate are close to being the same. Lower interest rates also reduce the contango on future contracts which further reduces the incentives for gold producers to hedge their production.

4] Credibility Crisis in Corporate America

Finally, there is a fourth reason for a probable rally in gold. It is the growing credibility crisis in our financial system. Whether it is Enron, Global Crossing, Tyco, or a host of other companies, investors are losing confidence. As I have highlighted in Breakdown: Greed, Complexity, Conflicts of Interest and the Moral Hazard,  “…investors can’t trust the directors, executives, accountants or analysts to come up with good numbers." This is rapidly eroding investor confidence and faith in the system. Just last evening it was disclosed that Nvidia Corp., one of the best performing stocks in the S&P 500 last year, is having trouble with its numbers. The SEC and the U.S. Attorney’s office are now investigating its accounting. Oddly enough, Nvidia has just replaced the shares of the bankrupt Enron in the S&P 500. The SEC is looking at insider trading and booking product costs from one quarter into future quarters. Recently, we learned that Krispy Kreme, which has used synthetic leases to keep debt off its balance sheet, has been forced to restate their financial statements. When investors can no longer trust management, the accountants, the analysts, or their broker, the system begins to break down. People begin to distrust the system and when that happens, they begin to look for alternatives. This is dramatically visible in Japan right now. When confidence is lost in paper, it cannot be quickly regained.

Other Issues Still Fan The Flame of a Gold Rally

Watch The Money
For years now, the Fed has been flooding the financial system with money. Since last year the money supply, reflected by M-3, has grown by over $1 trillion. Throughout the Nineties and up until recently, whenever a crisis arose, the Fed was able to put the fire out by injecting money into the financial system. (See SWUpdate 2/8/02) It was the Fed’s good fortune that the outlet for most of that money was the financial system, and in particular, the U.S. stock market. Whenever a crisis arose -- whether it was the Mexican Peso crisis in 1994, the Asian Hurricane in 1997, the Russian debt default and the LTCM derivative crisis in 1998, or Y2K in 1999 -- the injection of money usually went into the financial markets creating an artificial boom. Now that money is no longer going into financial assets. Last year the money flowing into stock mutual funds dropped off by $309 billion or 90%. Yesterday it was reported that Charles Schwab took in only $3.6 billion in new client assets in January, the lowest level of new money growth in nine months. Schwab’s commission and trading business were also down last year and in January of this year.

Argentines are stripping off their jewelry and trading it in at the local pawn shop to get extra cash. If they are out of jewelry, then they sell their violins, cameras and furniture. The government’s currency devaluation has cut their peso in half. Most people’s life savings have been locked up at the bank. Without access to their savings and depreciation of their currency, monthly wages no longer cover the bills. So the average citizen, from the poor to the middle class (what’s left of it) have resorted to selling what items of value they have. Everything is for sale, except the shirt off their backs.

Watch Japan
In Japan, with the government about to put an end to savings deposit guarantees, the average citizen is standing in line to buy gold. Japanese are prodigious savers. The average Japanese has over $100,000 in savings in the bank. Today their savings is earning next to nothing in interest. It is why, with the value of their currency dropping and deposit guarantees soon to end, the Japanese saver is fleeing out of cash and into gold. Gold holds its value when a currency depreciates unlike any other paper or financial asset. Japan now accounts for 20% of the world’s investment in gold. The danger for the rest of the world is that is the world’s largest saving class is heading for the bank to withdraw a rapidly depreciating savings account and exchange the cash for gold bars. This is creating fears that, like Argentina, there could be a run on the banks which could lead to a banking collapse when deposit guarantees begin to lapse in March. The Japanese consumer watches CNN and can see what is happening to the citizens in Argentina. There is no confidence in government in Japan. As one administration follows another, nothing has been done to solve the problem over the last 12 years. As the graph of the Nikkei and the Dow indicates, their financial system has fallen on hard times.

Plain and simple, Japan is important to America because the U.S. owes Japan a lot of money. They are our largest creditor. They own $333 billion worth of U.S. Treasuries, have $340 billion in loans to the U.S., and have additional billions invested in our stock market. America has never been more dependent on any one country to finance our growing trade and current account deficits. America’s prosperity is built upon a debt pyramid much of which is financed from overseas.

"There is a time for everything,
And a season for every activity under heaven
A time to plant and a time to uproot...
... A time for war and a time for peace."
Ecclesiastes 3:1-3,8b

We have experienced one of the greatest bull markets in history. For close to two decades the price of stocks went up year after year. Now we are about to experience our third year of decline. As the series of charts below indicate, the Dow has risen every year but the last two. During these last two decades, the prices of gold and silver have declined and have remained dormant. There is another chart from the final installment in my Storm Series that should be studied carefully. It shows that bear markets can last a long time. It took 25 years for the Dow to regain its lost ground from the Great Depression. It would take 16 years to regain and surpass the peak the Dow reached in the late 60’s. Bear markets are a fact of life in the financial markets -- as are bull markets. A final graph which comes courtesy of Sharefin at Sharelynx.net, shows the relationship of the Dow to the price of one ounce of gold. I leave the reader to ponder the last two charts and figure out which trend is about to reverse.

The charts below are from The Perfect Financial Storm, Part 10 Riders on The Storm. The article was written August 16, 2001. At the time, the Dow was midway between the two support levels: 10,500 and 10,000. Where do you feel the trend is going? ~ JP

Please refer to today's Market WrapUp for Jim's stock market summary.

© 2002 James J. Puplava
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