A rebuttal to "Gold & Gold Shares"

opinions issued this weekend, January 19th 2003, by my respected colleagues separately, and for various reasons reviewed, Andrew Smith and Robert Prechter

by James Sinclair, Jan 19/03

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Many economic commentators agree that we are at a major turning point. I agree with that. However, I argue that most analysis of where the economy is headed is wrong because of a fundamental misunderstanding about two crucial things: deflation and the dollar. This has implications not only on the US economy and whether we are headed for another Depression but also the price of gold and the direction of equities markets.

On Thursday January 16th the Bureau of Labor Statistics reported that the CPI (the consumer price index, the government's most widely used measure of inflation) declined 0.2%. The dollar fell on the day. This new number started a widespread discussion about deflation and its impact on the US economy. Many commentators leapt on this new data to cry that the major threat to the economy had just shifted from inflation to deflation. Some (notably adherents of Roberet Prechter) warned of a 1930s style collapse of the economy into Depression.

However, an article in the 1/17/03 Wall Street Journal moved beyond simply the headline number, and stressed an important and growing split between the two dominant sectors of the economy: goods and services. Prices for services rose 3.2% in December of 2002, from the previous year, pushed up primarily by rising medical care costs but also increased by tuition, homeowners' insurance, and rising charges for routine services.

But prices for manufacturing goods, excluding the volatile food and energy sectors, were down 1.5% in December 2002 from the previous year, compared to a year-over-year drop in November of 1.6%. It was the largest decline in such prices on record since 1958. Last year's drop included lower prices on everything from cars to computers to clothing for toddlers.

Will this send us into a 1930s type depression? I think not. Three important elements bear highlighting:

The divergent trend of prices for goods versus services has been in place for a considerable period of time. This event is not a new development.

The order of causal events is quite different from the 1930s. The financial policy makers are ready and willing to act to prevent another 1930s style collapse and can do so, with ramifications.

It is worth clearing up a few misconceptions. Deflation, to be the new kid on the block must be defined as the following: a contraction in the volume of available credit or money (the monetary aggregate, or M3) that causes a decline of general prices. That is the proper definition of what a deflationary depression is all about. So it is not just a decline in prices as is popularly understood. This helps to clarify the events that led to the Great Depression. In 1929, the stock market crash led to the rapid and broad-based collapse of financial institutions (particularly commercial banks), which in turn caused a sharp contraction of monetary aggregates. This series of events contracted the supply of money and credit resulting in the contraction of prices of goods and services.

Another often unnoticed aspect of the Depression is that the existence of the Gold Certificate Ratio. This gold cover clause limited the reaction of the authorities. This tied the use of monetary aggregates. The old style Gold Cover Clause mandated restrictive policy via increased interest rates rather than expansionary when the aggregate value exceeded the value of gold by 55%. Stated in other terms the value of the gold held represented by gold certificates held by the Federal Reserve had to equal 45% of the total value of the monetary aggregate. Simply stated the Central Bank in 1930 was required to contract rather than expand the monetary aggregate. In the 1930s this restriction was in place as the commercial banking system collapsed.

The spiral then in place tightened the noose of monetary policy just when it should have been totally accommodative. Today as Governor Bernanke states there is nothing to prevent the Federal Reserve from creating money at will. I will add yes, that is correct, with ramifications.

The major difference this time around is that the Federal Reserve is willing to sacrifice the dollar to save the economy. Credit has been expanded significantly (consider the real estate market and personal credit card debt) and interest rates are low. This leads financial policy makers to crank the presses and expand monetary aggregates (M3). Generally, central bankers want to crank the presses as much as a farmer wants to burn his barn full of this year's harvest. But that is what they (and Treasury officials) are going to do: they are going to burn the barn-they are going to let the dollar fall.

As evidence, consider two key recent speeches. On December 19th 2002 Federal Reserve Chairman Greenspan made a speech before the Economist Society in Washington to assure business that we will not see a repeat of the 1930 to 1934 "Deflationary Experience," which was a textbook event. Those conditions are simply not what is out there now. Chairman Greenspan and Federal Reserve Governor Bernanke assured the listeners that they had the tools to inflate the prices and if they had to, they would use those tools to reverse the move of the price of manufactured goods from the negative category. Monetary aggregates, or as Governor Bernanke put it, the "electronic money Printing Machine" has no restraints. Read it and see that what I am saying is absolutely correct.

Bernanke is correct. There are no restraints now to the expansion of aggregates. There is however one thing that will reflect it. That is the value of the US dollar. Chairman Greenspan in his December 19th 2002 told us that there is a rescue mechanism for the US dollar when it needs to be utilized. That device is GOLD. Here and now, I want to go on record telling you that Gold is coming back into the US Dollar within five years. Its form of remonetization will be a modernized and revitalized Gold Cover Clause not tied to interest rates, as it was as in 1929 - 1930 as the Federal Reserve Gold Certificate Ratio, but tied to the ability to expand M3 directly.

In 1930, it was the contraction, not the expansion of monetary aggregates that was the mechanism that reduced the prices on services as well as goods. That is a huge difference from today. That difference will create significant different market implications not understood so far as I see by the commentaries of my respected colleagues, Mr. Smith and Mr. Prechter. The 1930 experience is not out there now and probably will not be out there at all! Economically, what exists now that will impact markets is a unique event of significant differences not generally understood by the analytical group. The new gold community is literally terrified due to lack of understanding and their respect for these two respected honorable gentlemen who are bearish based I believe on incorrect interpretation of the economic/market causal factors now and in the 1930. The gold share community therefore is motivated to sell, at the market, whenever they see their own shadows. The definition of their own shadow is their worst fear or classic deflation that simply does not and will not exist this time around.

What is the future of the price of gold?

The answer hinges on the dollar. If the dollar declines, gold will rise. The inverse is also true but I believe that there is no case now for dollar strength other than short-term rallies from oversold conditions natural to all markets.

As we know the value of a real estate investment is determined by location, location, and location. The US dollar, the US dollar and the US dollar will now determine gold's value as indicated by the USDX (The US Dollar Index). As the USDX declines, gold will rise.

This editorial, IMO, offers significant recorded historical fundamental evidence with clear definition of the condition, deflation, to respectfully rebut those who claim (such as my honorable and respected colleagues Robert Prechter and the Elliot Wave technical analysts and Andrew Smith in his $310 to $385 prognosis) that we are headed into a Deflationary Depression and taking the price of gold down. Gold in fact recently touched $360, a significant level. Gold has gained its price level not because of any public participation. Buying gold shares does nothing for gold bullion price.

Buying gold coins does nothing for gold bullion's price. Trading in paper gold futures does nothing for gold bullion's price. Trading in gold options does nothing for gold's price. Instead, those who are responsible for the recent, and probably future, of the price of gold price are the Asian and Islamic buyers. Their trading desk managers understand technical analysis so it is no surprise that these technical levels are being hit, reacted from and proceed to the next, one after another.

Thus the dichotomy between the strong gold price and the recently weaker gold shares can thus be easily explained: because almost the entirety of the public participation is focused on gold shares and the professional (Asian and Islamic) buyers are focused in cash gold bullion itself. Gold shares are likely to rally as individual investors see the fundamental support built in to the price rise cash bullion. It is not as if one cannot feed into the other but, in my opinion, the following is certain:

* Gold will not go significantly lower for any significant amount of time from here!

* Gold will trade over $400 in 2003

* The US Dollar is your measure of what gold will do now and into the foreseeable future until we maximize this entire major bull market!

Certainly, it is correct to sell 1/3 of your gold share position using strict Technical Analysis for price objectives. My position speaking to the entire gold community and not to a private clientele is that those two points now will be the broader $373 and the final point of the first wave of a 5 wave bull market in gold which will be over $400. In no way have I have moved away from the sell 1/3 program but only adjusted to what I feel the community can handle efficiently. What others do with a private clientele is of course personally communicated, more active and preemptive.

The most popular interpretation of the Elliott Wave is, IMO, wrong both on its Elliott Wave count as well as the interpolation to the economic phenomena as a duplication of the 1930 events. It is wrong, IMO, in its prediction of the gold price and economic performance.

In conclusion:

* Financial policy makers have a different attitude (aggressive) and tools (namely cranking M3) than they did in the 1930s to fight this present unique type of price decline in the price of manufactured goods which is not a classic deflation

* These new tools spell fundamental support for a major bull market in Gold.

* The bull market in gold is just beginning.

* The US dollar is the one major leader that will determine the direction of gold.

* Therefore the recent opinions offered by respected, well intentioned and well known advisor concerning the advent of a new depression may well misguide the gold investor into a liquidation at an inappropriate time and price.

James Sinclair, Chairman & CEO Tan Range Exploration

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