The Outlook for 2005

January 10, 2005 – From time to time over the past couple of years I have been comparing our present circumstances to those prevailing in the 1970’s. I made these comparisons in order to demonstrate that gold today has much the same potential to do what it did back then – namely, to achieve a dollar price a lot higher than most people expect. I even discussed this outlook in my interview in Barron’s in October 2003, part of which can be read by clicking here.

I would like to make another comparison to the 1970’s, because 2005 I think is likely to shape up a lot like 1973. That was one of those years that are not easy to forget.

The key points are that like today, gold began 1973 still early in its bull market, and finished that year with a 71.9% gain (no, that is not a misprint). Commodities and inflation were about the only things that went up that year. Crude oil for, example, climbed by 21.6%, which proved to be just a warm-up for itsspectacular 258.9% climb in 1974.

The stock market topped in January 1973, and the Dow Jones Industrial Average fell by 16.6% (which was then followed by a horrific 27.6% collapse in 1974).

The dollar didn’t do well in 1973 either. For example, it dropped 13.8% against the Swiss franc, 7.1% against the Japanese yen, and 18.4% against the Deutschemark.

I think the above examples illustrate what lies ahead in 2005. Don’t focus on the precise gains and losses recorded in 1973, but rather, the direction of each of the different markets. In other words, the likelihood is that 2005 will see the same gainers and losers as in 1973.

So the outlook for 2005 can be summed up with higher commodity prices and inflation, gold up and the Dow Jones Industrials putting in a top, probably in January – the same month as in 1973. The dollar will continue its major downtrend and be a lot lower against the euro and Swiss franc (and probably the Chinese yuan) by the end of the year. These results are likely to repeat because we have today the same monetary and economic problems that we faced in 1973.

Even a political comparison can be made between these two years. Bush, like Nixon before him, won re-election, beginning their second term in 2005 and 1973 respectively. Both have presided over unpopular foreign wars.

The ‘twin deficits’ existed back then just like today. The US government’s financial position was deteriorating because of a weak economy that did not live up to its full potential as well as the ongoing expense and the growing cost of the Viet Nam War. The United States’ trade imbalance put an ever-greater amount of dollars overseas.

Again, continuing the similarities from both time periods, the dollars going overseas from the trade imbalance today are not being used for capital investment in the US. They are being used to fund the federal government’s budget deficits, which are growing to astronomical proportions.

The Chinese (like the Japanese back in 1973, though the absolute amounts were smaller then) are sitting on $500 billion because they cannot easily get rid of these dollars, though they are trying hard to do so by purchasing Noranda and other companies, like their rumored plans to purchase Unocal. Expect more of the same by them, which is just one example that shows the US today just like 1973 is consuming infrastructure; the US is selling the family jewels in order to maintain an unsustainable level of consumption, which brings up the major difference between today and 1973.

In the 1970’s the Federal Reserve was willing to raise interest rates to at least give the impression that it would help preserve the purchasing power of the dollar. In contrast, the Fed today will do everything it can to avoid higher interest rates. The reason of course is the leveraged American economy and today’s debt mountain, which makes the accumulated debts in 1973 look like a molehill. There is so much debt – today the US is the world’s largest debtor compared to 1973 when it was the world’s largest creditor nation – any significant rise in interest rates (to say 8% on Fed funds) will surely sink the economy because of the debt burden (i.e., paying interest on the debt) and will also perhaps precipitate a serious banking crisis (e.g., from derivatives going wrong, or housing prices collapsing because of defaults on adjustable rate mortgages, etc).

Right now, real interest rates are negative (the Fed funds rate less the inflation rate is about -1%). Negative real interest rates debase and therefore destroy the purchasing power of currency, which explains in part why the dollar has been declining against the world’s other major currencies. The exchange markets are sensitive to perceived changes in the value of the dollar. In other words, the foreign exchange value of a currency declines first, and then the currency’s domestic exchange value declines (which is another way of saying that it will purchase less because of price inflation).

Given that the Fed cannot raise interest rates to defend the dollar, as higher rates would kill the economy and create banking problems with unpayable debts and defaulted derivatives, look for the dollar to head lower in due course. How much lower? Well, let’s get into some of my expectations for 2005.

Since peaking in 2001, the dollar has declined three years in a row, dropping 11.5% per annum on average. The US Dollar Index ended 2004 at 80.85. Another 11.5% decline in 2005 will put this index at 71.55. I think the Dollar Index will decline at least that much, and I don’t rule out a 20% decline, which would put the index at 64.68 by the end of 2005.

A lower dollar will obviously mean higher inflation and higher commodity prices. Crude oil, which gained 34.8% in 2004, will no doubt continue to climb. Some price over $60 is likely. Given that crude oil ended 2004 at $43.33, another 34.8% gain from that price would put crude oil at $58.40, but it has already been trading at that level recently. Given that the correction in crude oil is over, it’s more likely to expect a 34.8% rise from this $58 level reached a couple of months ago, which would mean that crude oil ends 2005 around $78 per barrel.

As spectacular as that would be, it looks to me like the really big gains in commodities in 2005 will be in grain prices, which remain cheap in nominal dollar terms, but are unbelievably cheap in inflation adjusted terms. A weak dollar will boost foreign demand for US agricultural products, again just as it did in 1973, which was a year of poor harvests and huge exports (back then the grain went to the Soviet Union; this year the big exports will go to China). So expect higher dollar prices for food as well as energy.

Higher inflation and a lower dollar mean a higher gold price, which closed 2004 at $437.50. We will climb above $500 in 2005, and I still expect to see gold over $500 early in this year, notwithstanding the bad start to the year that we saw last week. If gold were to match the 71.9% gain it achieved in 1973 – which is not an outlandish possibility in my view – then gold will end this year at $752.

Finally, what about the stock market? I expect the Dow Jones Industrials will have a tough time, at least in the first part of this year. If it matches its 1973 result, then the Dow Jones Industrials will end 2005 at 8993, a price last seen not too many months ago. But after a rough start, the stock market may hold up in the second half of the year. I expect that it will become more clear that the Chinese and other big holders of dollars will increasingly look to exit from the dollar by purchasing North American companies (think big commodity producers like Noranda and Unocal). Therefore, what’s good for Chinese dollar holders is also good for all dollar holders – dump the dollar and hold instead the shares of quality companies producing essential commodities. It is a stock market play that is already underway, but it is one that I expect will gain significant momentum by the end of 2005.

It looks like 2005 is shaping up to be a momentous year. It will be good for gold and commodities, bad for the dollar and at least in the first half of the year, bad for the stock market, even with negative real interest rates, which will remain negative in 2005 because the Fed will raise interest rates slowly.