Gold Stocks, the Dollar and the Economy
by Kenneth J. Gerbino
Gold stocks have seen their lows. As all asset classes have been in a historic (time-wise) liquidation, gold has actually held up better than most other asset classes. But the gold mining stocks have been beaten up badly for various reasons that are now basically played out.

Concurrently, dollar strength has been based on two overriding circumstances and these are about finished as well. This means a very positive environment is about to affect the gold and silver mining stocks.

Reasons for Gold Stocks Being Liquidated:

  • Momentum players bailed out with zero understanding of company fundamentals such as reserve values and cash flow expectations.
  • The weak stock market affected the gold mining stocks.
  • Overleveraged hedge funds that had mining exposure had to sell everything in sight to meet margin requirements and redemption calls.
  • A major prime broker for hedge funds raised their in-house margin requirements on mining stocks from 50% to 100% “because they are so volatile”. This caused forced selling and further weakness.
  • Non gold bug investors coming to the party late came in at the highs and then bought into the “deflation” argument and started selling.
  • Many confused players in the gold community who have never understood Hayek, Mises or Menger bought into the deflation argument and created more selling.

Reasons for the Dollar Strength

  • Redemption notices to U.S. Hedge funds caused a huge flow into dollars. Hedge funds had sold dollars for years to buy foreign stocks. Making these purchases required selling dollars and buying the local currencies to buy stocks on these foreign stock exchanges. When these foreign markets blew up, hedge fund customers seeing horrible results wanted their money. Redemption requests followed. The funds had no choice but to sell the foreign stocks and with the proceeds buy U.S. dollars to redeem to their U.S. customers. This created a dollar demand that was significant but more importantly compressed into a short time frame.
  • Another reason overlooked by the press and the people on TV was that foreign banks and financial institutions were buying hundreds of billions of U.S. toxic mortgage and debt paper in various forms and had to hedge their investment by shorting the dollar for the last 2-3 years. If you were a Swiss or British or French institution and owned $100 million of real estate debt obligations packaged by Morgan or Goldman in U.S. dollars and are getting a 6% per year return, you needed to make sure that if the dollar kept going down you would not lose 6% or more because of the dollar depreciating. So you hedged the dollar risk because, after all, you have to eventually give back to your local investors Francs or Euros or Pounds. Since the debt obligations you owned collapsed and your $100 million asset is now, let’s say, worth only $50 million do you really need to have a hedge on for $100 million U.S. The answer is no. Hence you call your broker and tell him to buy back $50 million in U.S. dollar hedges. In other words you cover your hedge. You do not need it anymore. You go from short the dollar to a cover – you buy back the dollar hedge. This creates demand for dollars.
  • The third reason is that many central banks from smaller countries had many of their commercial banks hurting from the global fall out from the U.S. mortgage crisis and they needed to acquire U.S. dollars and spread them around to prop up their weak banking system. Their local currency had little prestige especially in a global meltdown and even though U.S. dollars were being created like monopoly money, they were still better than the local funny money that was now even more suspect. These central banks were borrowing or buying dollars.

These three reasons and the fact the dollar needed some sort of rest from the continuing multi-year down trend were why the dollar has been so strong while the Feds have been debasing it beyond belief in the last few months. As the dollar became in demand for the above reasons, gold which is denominated in dollars came down.

The reasons above have most likely played out. This means the dollar should resume it weakness because when the trillions of new dollars that are being created start circulating in the economy, inflation will return to the U.S. with a vengeance.

The U.S. Dilemma: Bullish for Gold

  • Fighting two wars
  • An energy policy that is poorly conceived and unworkable
  • Huge and unprecedented budget deficits baked into the cake
  • A credit crisis for institutions in full swing
  • A recession in the works that will create more financial stress
  • A medical and retirement commitment that will be overwhelming

The answer to all of the above is printing more money. It is as simple as that.

Taxes can be raised to 95% of income and it wouldn’t make a dent in the above.

If you own gold and silver and legitimate gold and silver mining companies, the above means you are in the right sector. You do not have to make things anymore complicated than that as your investment thesis.

Gold

The bailouts of Wall Street and Main Street will most likely continue to require massive amounts of new money and credit injected into the economy here and overseas. This is very inflationary and make no mistake about it – gold will respond globally to money and credit increases. The Feds have made it known loud and clear that they will do whatever it takes to bailout the financial system.

Central Banks and Gold

Commercial banks do not trust each others paper. That is why the credit and commercial paper market is currently effectively frozen. This is a crucial concept for gold. Commercial bankers and central bankers have the same ethos, many times come from the same schools, study the same bad economic text books, know and adhere to the same misguided economic concepts. They think alike.

The current global “credit freeze” is because of mistrust by bankers of other banks solvency. If commercial bankers globally don’t trust each others paper then central bankers are also not going to trust each others paper (currency and notes of the host government) either. Therefore, I believe some central banks will be buyers of gold because even with the dollar still believed to be better than their host currency, these bankers know the dollar is going to be debased dramatically in the future and gold cannot be debased.

With this mindset, some portion of the 200 or so central bankers in the world will most likely quietly (under the table) buy gold. They will never bad mouth paper money because they are perversely addicted to paper money but they will buy gold. Some may buy gold to protect their countries banking system from the politicians who run their own countries.

It won’t take much buying from just a few of these central banks to create a much higher gold price. Just like countries buying jets and bombs and guns to protect their borders, central bankers will buy gold to protect their financial system, since the paper money hoax on this planet is just about over.

Current Reasons for Gold and the Shares to become stronger

  • As discussed above, the forces that were bullish for the dollar have abated. Gold bullion and coins are in short supply as reported by coin shops and dealers in many countries.

  • The China and India story is an old one on Wall Street for many investment themes. But with inflation now increasing and horrific money increases in these two countries, gold buying will go from just a normal saving concept by hundreds of millions of people to a rush for protection from a major inflation cycle just getting started in these countries. I expect 10% plus inflation rates to ensue in both these countries in the near future since both countries have doubled their money supplies in just the last five years! With the global financial system in fear and these two countries stock markets worse off than the U.S. markets, I expect even more money creation to take place and this will increase more gold buying.

  • Tens of trillions of dollars of investment funds in the United States and Europe are managed by conservative, traditional, and establishment type money managers. Many have never understood gold. Most are in shock and now are questioning the “system” and the establishment conventional wisdom since many of the best and most respected Wall Street firms are bankrupt, insolvent and disgraced. These conventional managers and asset allocators do not have to be gold bugs to know that trillions of dollars of new money in the U.S. monetary system has got to be inflationary. Just a small per cent of these managers taking just small positions in gold and the gold stocks will have a new and powerful effect on gold and the better gold mining companies.

  • My Swiss financial friends tell me that most Swiss money managers they talk to, say they are reallocating a portion of portfolios to gold.

  • At lunch last week, a top analyst for one of the largest Canadian investment banks told me that most of their 400 hedge fund clients in the U.S. have between 50-70% cash as they are expecting high redemption rates. These funds will soon be looking at the extreme low valuations for the mining stocks and they most likely will have some cash to start buying.

The Stock Market

A bad stock market in a low inflation (official rate) and low interest rate environment is not going to help gold or the gold stocks. A bad stock market affects all stocks including gold stocks except when inflation is roaring ahead.

If stocks are going down because inflation is moving interest rates higher, then gold stocks will decouple and move higher because of inflation while the stock market moves lower due to higher interest rates.

The stock market may be ready for a consolidation. 8000 on the Dow is a pretty solid decline from 14,000. The market and the economy may get a reprieve here because of the following:

The government is flooding the country with money and credit and bailout funds and this liquidity despite all the hype and doom and gloom will eventually find its way into economic activity and the stock market.

  • British Petroleum and G.E. are now so low they have a 6.5% yield. This type of value is very appealing to institutions and conservative investors globally. There are other companies like this on Wall Street as well.

  • The largest pool of investment funds are in Balanced Accounts managed by thousands of investment management companies. The allocations for these funds are usually 50% stocks and 50% bonds. When stock values get low enough these allocations change by a 1-5% shift into stocks from bonds. There are tens of trillions of dollars in these types of accounts worldwide. Even a shift of 1% from bonds to stocks can create a major rally in stocks. This is where the money comes from at stock market bottoms when everyone thinks there is no more buying power left.

  • The stock market is still suspect for the long term, but when so much money is created and thrown into the world economy, the result is currency depreciation and future inflation but the short term effect usually can help oversold stock markets.

I will address the “Deflationistas” in my next week’s article. Be sure to look for it.

The greatest mistake one can make is to think a deflation is coming because houses and stock prices have collapsed. We are entering one of the greatest inflationary periods in our history.

Kenneth J. Gerbino




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