The Big Sell Off—18 Important Facts to Understand
Re: Gold Stocks and Bonds

by Kenneth J. Gerbino

 

 

Investing in mining companies of precious metals and base metals (copper, nickel, zinc, lead) and uranium

 

Let's get some facts straight before you make any decisions regarding your gold stock portfolio and your other assets. Most of these facts point toward higher gold and metal prices after the panic selling stops. Industrial stocks and bonds may have shown the first signs of a sustained decline or at least a major topping range.

 

1. There will be no recession or slow down in China which people feared would cut demand for gold and base metals as well as impact other economies. The facts behind this statement are: a) Money supply (M1) increases in China are 20.3% y/y (year over year) and have averaged an incredible 14% for the last five years. Recessions don't start with that kind of new money in the system; in fact this data spells boom times for years and inflation as well for China. Also retail sales in China y/y, has averaged 18% for the last four years which shows an internal economy is developing. China is most likely at least 2-3 years away from even a slowdown to 5% growth.
2. The Chinese authorities did the right thing in clamping down on illegal stock sales on the Shanghai and Shenzhen stock markets. Their other measures to curb speculation (margin and bank lending for stocks) caused a panic in these two overbought markets sporting an average p.e. ratio of 45 (these markets are mostly retail accounts and basically limited to Chinese nationals only). The result was a huge 8.8% sell off in one day. But the Hong Kong market had only a small reaction and was down only 1.75%. So the smart Chinese money in Hong Kong wasn't in any way panicking.
3. ZTE, China's largest phone equipment maker was up 3% during the panic. This is more anecdotal evidence of no recession anytime soon for China.
4. Gold in Hong Kong was almost flat in spite of the stock sell off on the mainland. Therefore the more sophisticated Chinese investors weren't buying into the TV talking head syndrome that the strong economy in China is now over and that gold and base metal demand would decrease.
5. In New York gold was only off $2.50 despite the Dow plunging at the close of the commodity trading session. In the NY after market which is illiquid and easily influenced by a panic, gold was hit hard and then the Gold ETF followed suit and sold off as well.
6. Bonds in the U.S. rallied as a safe haven. But will foreigners buy US bonds if the dollar continues to go down – which it did – which makes the gold rout in the aftermarket that much more suspect and temporary. My guess is that gold needed a breather since it has had a recent sustained rally.
7. The Fed is now faced with a housing slowdown and a possible further market crash from a nervous and obvious vulnerable stock market. They would be way out of character to raise rates any time soon, especially with the latest report on mortgage defaults at four year highs.
8. The Fed not raising rates means more weakness in the U.S. dollar and that is bullish for gold.
9. India is the largest gold consuming nation. What's happening there? 2006 M1 money supply is up 20% and has averaged 17% per year for the last 3 years! GDP is expected to grow 9.2% in 2007. These are powerful stats that should mean continued support for gold prices.
10. How long will it be before China lifts exchange controls and allows all those remimbis they have been creating to be sold for some other currency to facilitate investing overseas? This will allow the government policy of a weaker currency to be aided by the people themselves and allow their mercantilist economy to continue. A good Libertarian definition for Mercantilism is where a government is on the side of the factory owners and big business and pursues a policy that benefits the business class at the expense of the average person. A strong currency allows Joe six pack to buy cheaper goods from overseas whereas a weak currency makes everything more expensive for him but allows the business owners to export more. Mercantilism squeezes the little guy and helps government cronies. It's a bad deal and 180 degrees from a free market.
11. Margin calls are a real possibility in the next 24-48 hours. So one should just be patient with buying until the dust settles.
12. The sell off in the mining shares took place when almost every mining analyst, mining money manager, and gold fund manager who are anywhere on the global radar screen were all attending the BMO Gold Mining Conference in Tampa. These smart money players were all away from their screens and definitely out of the loop as their sector took it on the chin. Most likely by Thursday, when these heavyweights are back at their desks, they will have a shopping list of mining stocks they love but were waiting for a sell off to buy.
13. Nikko Cordial is the 3rd largest brokerage house in Japan. They are being nailed for cooking the books and their stock is plummeting. This should be another reason why some Japanese household money will find its way into gold.
14. My experience dealing with and knowing many hedge fund managers is that they have little knowledge or even know what Austrian school economics is all about and certainly have little knowledge of the hard money- paper money controversy. Ayn Rand, Nobel Laureate F.A. Hayek, Murray Rothbard and Harry Schultz could be Academy Award nominees for all they know. Hedge fund participation in the gold market and gold shares is growing not because of a deep seated reasoning on economic issues but only because it is a hot sector. The volatility in the gold shares will be above average in the coming years because of them. They will be the gold bugs worst nightmare and best friend – depending on the trend. This is why being on margin will be a bad idea.
15. Derivatives: With a global market panic starting in a low interest rate and, so far, low inflation environment, one has to wonder about the real reason for this sell-off. Easy money almost everywhere leads to leverage and speculation. No where is this more prevalent than in the global derivative market. It is not out of the question that third party defaults and risk aversion designed instruments that collapse and go sour may someday overwhelm the financial markets. Latest figures from the Bank of International Settlements: $8.3 trillion of real money is controlling $313 trillion in derivatives. That's 38 to 1 leverage. These figures are just for the over - the - counter derivatives and do not include the global exchange traded derivatives in currencies, stocks and commodities which are another $75 trillion. Any accidents here should make gold a very desired asset class.
16. Every once in awhile technical trading and computer trading take over almost completely when a human panic evolves in markets. This is what happened on Tuesday's crash. Fundamentals were ignored. The Shanghai and Shenzhen markets were selling at 45 price earnings ratios. Many of the mining stocks that we own in our fund are selling at only 2-3 times expected cash flow when they go into production. These developmental mining companies with documented reserves and real value in the ground sold off even though they are obviously not at speculative levels. I am sure there are similar stories for other mining portfolios. This across the board sell off is a sign that hot money is being chased out of the mining stocks and the shares will be going into stronger hands.
17. If the mainland Chinese are bidding stocks to 45 times earnings, it is an indication of how high they will eventually bid up gold mining companies in New York and Toronto when exchange controls are lifted. As Doug Casey likes to say; "it will be like Hoover Dam going through a garden hose."
18. The U.S. money supply is up 5.5% for the last twelve months and 16.7% for the last three years. Raw goods and Intermediate goods are now climbing at above 7% and this will soon impact consumer prices. With inflation in the pipeline, will foreigners want to buy US bonds which will be heading down? This will also hurt any dollar support in the future from this source and therefore be supportive of gold.

 

Conclusion

 

Excessive speculation in China by retail customers and a market correction have little to do with the Chinese economy's forward progress. The plans to build 120 airports a year for the next 10 years and tens of thousands of other projects will not be affected because some gamblers and speculators overdid it.

 

Gold and gold mining shares, despite a short term disappointment will surely recover as the investing world has been given a wake up call on the frailty of paper assets owned by global investors. Base metal stocks will also recover as the China and India growth story has many years to go.

 

For other commentaries on gold, mining stocks and the economy visit our company's website.

 

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Kenneth J. Gerbino

 

 

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