Where we are GOING and why?
InsideGold
Team
Intro
InsideGold is writing this edition of the newsletter to let our readers
know what we think of the current state of the gold market and where
we believe it is going.
The Gold Price, The Market and Where is it Headed
General
First a little perspective is in order. Gold bottomed out in late
1999 at around $250. It spiked to $325 in October of 1999 then gradually
fell back to $255 in Feb of 2001. Since then, the price has been rising
fairly steadily, reached a peak of roughly $425 in January of 2004
and is currently hovering around $400. The price was most recently
at $400 in 1996 before it started its five year decline.
We cite this history to show that $400 gold in the overall scheme
of things is a very good price. Gold producers, or those still around,
are covering costs and making healthy profits. Explorers are out in
the field working hard for the substantial rewards making a significant
discovery can bring. The majors are anxious to replace their dwindling
reserves and everyone is only too happy to oblige. The newspapers and
day traders are worried about each tick of the spot price, but on the
whole, all is well.
The price has come a long way and we believe it has a long way to
go.
Looking
Forward – US Economy
To
look forward, we have to look at what moves the price of gold. We
agree with the
majority of the many experts out there saying pretty
much the same thing – the most important lever impacting the gold price
at the moment is the US Dollar. This may change, but it is where the
debate and attention is centered for now. In turn, the factors impacting
the dollar are; deficits, inflation, deflation, money supply, and geopolitical
power shifts. Together these elements all affect the “economy”. So
let’s look at the US economy.
In spite of the liquidity-driven recovery currently underway, we feel
the US economy is in trouble. The unprecedented levels of debt held
by individuals and corporations as well as the country/government is
unsustainable. There are a few ways to correct this problem and all
benefit gold. The least painful and most probable path forward for
the US and the world is that the US will inflate their way out of debt.
As the US money supply increases, each dollar loses value and the US
can repay its debt at a lower real cost. At the same time, interest
rates are being held at extremely low levels for two reasons; to avoid
deflation and to lower the value of dollar in relation to other currencies,
thereby stimulating exports. As exports increase, the budget deficit
lessens and the economy is put on a more solid footing. At some dollar
level as well, foreign capital will begin to flow into the US thereby
further positively addressing the budget deficit.
Interest
rates are also low in order to avoid a Japanese style deflationary
problem
at all costs. The US population is in such debt that should
deflation begin, it would start a vicious cycle of consumers postponing
purchases, thereby decreasing demand, lowering production, cutting
jobs which further decreases demand, further delaying purchases, etc,
etc. It is very hard to stop, and if two of the world’s largest economies
are in that state, the entire world economy would likely follow.
The
problem is that several countries are trying to avoid deflation at
the same
time. To do so, they are attempting to allow their currencies
to devalue simultaneously and stimulate exports. This begins a cycle
of competitive devaluations. China is doing this now by leaving its
currency pegged to the dollar. As the dollar devalues, so does China’s
currency, making its exports even more competitive. So although China’s
holdings of US Treasuries are losing value, its economy is roaring
ahead and the Chinese people become more prosperous. And as China continues
to purchase US Treasuries thereby financing the US deficit, its political
power grows.
The
dilemma facing US policy makers is this. They want a low dollar for
the domestic
economy, but need to keep the dollar attractive to
foreign investors. The dollar cannot fall too far too fast or foreign
holders of US hard and financial assets will lose confidence in the
currency and choose another currency to hold, like the Euro. This is
the worst possible scenario since it may cause a rapid decrease in
the dollar’s value with accompanying stresses and painful adjustments
forced onto the economy in a compressed time frame.
It
follows that should the dollar falls too far and/or foreign investors
begin
to look elsewhere and interest rates may rise in order to make
holding dollars more attractive. As a result, the recovery may be choked
off and growth may slow. The result of this occurring is a further
weakness in the dollar. On the other hand, if rates remain low, the
dollar is less attractive to foreigners and the probability they will
go elsewhere is increased. Further, lower rates for a longer period
encourage inflation and speculative bubbles due to easy credit and
the fact that there is very little return (even negative) when one
leaves money in the bank. The bottom line of all this is that policy
makers are walking a tightrope, we believe that either way they decide
to go the direction for the dollar is down, perhaps not at the pace
we’ve grown accustomed to, but down.
We
believe that when authorities say that the deficit will be addressed
by market
forces or the deficit is not an insurmountable problem, they
mean “let the dollar fall and let some inflation into the system and
we’ll be paying back the deficit with less real dollars”.
Recent
events as we go to print we believe confirm the above. The latest
employment
report from the US showed far fewer jobs being created
than expected, calling the strength of the recovery into question.
And the G7’s statement which cautioned that excess volatility and disorderly
currency market movements are undesirable for economic growth have
condoned the US weak dollar policy and is simply an acknowledgement
that the dollar will continue to fall, but it should not do so too
suddenly.
Looking
Forward – The Power Shift
The financial power in the world is shifting to the east. Asia is
financing the US deficit to a large degree. As discussed above, we
believe this, all things being equal, will allow the Asian nations
to play a much stronger role in world politics than in the past.
The enormity of these countries, their populations and the inevitable
move to establishing consumer societies will create attendant economic
power which will assert itself. The change is happening now. Skilled
workers who, with some training and investment, are as productive as
North Americans at significantly less cost is a huge competitive advantage.
Economic activity will continue to shift to these areas as it has been
for the last several years.
The
US itself has made a huge shift in its economy – from manufacturing
to service and now to finance. There are relatively fewer jobs in the
financial industry compared to the manufacturing industry and financial
jobs are more highly skilled. As the economy moves this way, the infrastructure
for manufacturing deteriorates, and to re-establish the ability to
compete effectively with lower cost structured countries is extremely
difficult and expensive. We expect the reallocation of resources to
take approximately ten years.
Supply and Demand Fundamentals
So
the dollar is headed lower. What about the supply/demand fundamentals
of gold
itself. The latest statistics to Q3/03 provided by the World
Gold Council have supply roughly in line with demand. We will assume
that supply will stay roughly constant, which is not unreasonable given
it takes several years to bring mines on stream, Central Banks are
discussing the renewal of the Washington Accord (an agreement between
Central Banks of the world to restrict their sales of gold into the
market), producer hedging seems to have become a thing of the past
and the gold carry trade is dead with interest rates this low..
However,
there are several trends and developments that may significantly
increase
the demand for gold. The first is Chinese consumption. The
Chinese government has recently loosened the restrictions on individuals
to own gold. Prior to this, they loosened restrictions on who could
participate in the “wholesale” market. Second, new financial instruments
that trade publicly now give investors the ability to effectively hold
a share of physical gold and thus be exposed to the price of the metal
without actually buying gold coins or bars to put in safekeeping. As
the public gains awareness of these vehicles, their demand should increase,
and with it, demand for gold. Gold has also been recognized as having
a negative correlation with the major stock market indexes, which translates
into a valuable asset to own for portfolio managers – it allows them
to structure a portfolio with greater return for a given level of risk.
Third, we expect the public to look to gold as a store of value, as
it historically has been. Terrorism and the lack of confidence in fiat
currencies are a few of the reasons we expect the demand for gold for
this reason to increase. And fourth, one other comment to mention is
that the Japanese finance minister has mentioned that his country may
consider holding gold as a reserve asset in the future. Assuming other
central banks may be thinking the sake way, this may reduce central
bank selling and could actually result in central bank buying.
Therefore, although supply may remain fairly constant, we expect demand
could rise substantially.
Reasons to Look at Gold Stocks, and Specifically
Exploration Stocks
Why
We like to investigate exploration stocks in particular because they
give the best leverage to not only the price of gold, but also the
discovery of gold. There is no denying these are the riskiest of the
gold stocks to own, but the market is the most inefficient in this
area and the rewards of picking the right stock at the right time are
correspondingly huge.
How - People
Therefore,
we at InsideGold believe the best way to look at the gold market
is to review a series of gold exploration stocks with the best
chance for success for the least amount of risk. To reduce risk, we
consider the people first. Do they have a track record in the business?
What are their qualifications? What sort of team have they been able
to assemble? This is the primary concern. As the saying goes, nothing
succeeds like success. A manager who has a prior success is more likely
to attract the kind of support from the investing public and the team
around them. Investors are more willing to be patient and wait the
extra amount of time required to accomplish corporate goals. Working
in a part of the world for an extended length of time is also a major
benefit to a company. Familiarity with local customs, people and players
builds support locally as well as opens up doors to interesting projects
which could come to the company in time. There are several additional
considerations, but these are a few we believe to be important.
How - Projects
Second
are the projects. Do they stand up to reasoned questioning on a geological
basis? What kind of area are they in? How sensitive to the gold price
is the project (is it deep away from infrastructure
or shallow)? Are there other deposits nearby based on the same geological
model? Can the company easily explore here? Of course there are the
political and environmental questions. Since we are looking at exploration
companies and very rarely will they or we follow through to development
of the mine, these concerns are not nearly so great as they would be
if we were considering producers. We also look at the fallback plan.
If this project does not pan out, for whatever reason, what is the
downside? What is Plan B for the company?
How - Potential
And
then there is potential. We want to understand what can potentially
happen if
all goes well with the company’s plans. Is there potential
for 100,000 ounces or 1,000,000? Could the project be sold to a major
or is it likely to sit on the shelf?
Also of importance are questions regarding financial matters; what
is the cash position of the company, what is the burn rate, the capital
structure, accounting status and disclosure record. How is the company
handling the new corporate governance provisions? Are they leading
or lagging? Do they have reputable partners in their joint ventured
properties? How is the company valued in relation with its peers? How
liquid is the stock?
Conclusion
We believe the US economy will not fare well over the next several
years taking the value of the US dollar down with it. The supply of
gold will likely remain steady in the foreseeable future while there
are several trends underway that could significantly increase the demand
for the metal. We expect the price of gold to increase substantially
in the next five to ten years.
To capitalize on this trend, investors should consider owning well-chosen
gold exploration securities. The leverage to the price of gold is tremendous,
the rewards for holding a stock which makes a significant discovery
are huge and if an investor does their homework, they can greatly reduce
the risk of what is inherently a speculative investment.
We also want to point out that the companies which we review are screened
on the above criteria; people, projects and potential. Our goal again
is to look for companies which have large upside potential, but also
feature minimal downsides. By nature we feel the timeline involved
with properly executing a corporate strategy is between six and eighteen
months.
Disclaimer
At this point we will point out that we do not make investment recommendations
and only want to point out interesting situations that a reader may
want to further investigate. Please speak to a registered financial
advisor prior to making any investment. Gold exploration stocks are
considered speculative investments. InsideGold will be profiling and
reviewing several gold exploration companies in the next several weeks
which we encourage you to look into on your own and discuss with a
registered financial advisor if you are seriously considering investing.
Sincerely,
The InsideGold Team
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