The Outlook for 2011

January 3, 2011 – It is that time of the year again to record my expectations and outlook for the year ahead.  But before looking at 2011, as always I first re-visit what I was expecting for this past year in order to evaluate whether my forecasts were close to the mark.

My forecasts for 2010 were driven by my expectation that paper assets would continue the well-established trend that began with the outbreak of financial trouble in 2007.  It has been my ongoing expectation that paper assets in general and currencies in particular will become increasingly suspect, and therefore decline in value.  We remain in a financial and monetary bust, and I had already noted in my forecast for the year before that “the bust will not end in 2009”.  My point was that financial assets would continue to fall out of favor.  So I recommended to “avoid the dollar and other national currencies as well as the paper issued by governments.  Given the huge deficits they are incurring and their refusal to make the hard decision to cut spending, a sovereign debt default in 2010 has to be considered a realistic possibility.”

That macro call was pretty accurate given what happened to Greece and then Ireland.  Even though neither country actually defaulted because of the EU and ECB engineered bailouts that papered over these two countries’ horrific financial position, they in effect defaulted.  More importantly, this macro call set the theme for my basic recommendation for the year: “So the best strategy for 2010 is to continue accumulating the precious metals, and if you are so inclined to take the investment risk, the mining stocks as well.”  Let’s look now more closely at the specifics of this recommendation.

1) Gold began 2010 at $1,095.  The low for the year was $1,052.20 on February 5th, and based on the spot Comex closing price, the high of $1,421.10 was reached on December 31st.  I said: “Gold will reach $2000 per ounce ($64.30 per goldgram) some time during 2010.  Gold will not fall back below $1000.  In fact, it is likely that a floor has been put under the market around $1050, the price at which India made its recent gold purchase from the IMF, though I don’t expect gold to fall below $1080.  Like 2009, the low point for gold will probably occur early in this year’s first quarter.”

My forecast on the low was reasonably accurate, both in terms of timing (which was spot-on) and price.  We never got near to my $2,000 forecast high price, but I was accurate in the sense that gold would be in an uptrend for the year.  In the absence of a “huge short squeeze [that] could send gold to that price in a matter of weeks”, I said to expect “a continuous demand for physical metal will put gold in a steady climb throughout the year.”

It is worth noting my expectation that a driver moving gold higher would be “the growing demand for physical metal in preference to paper-gold.”  This demand preference for physical metal was indeed a major theme in 2010, as people everywhere became increasingly aware of the huge preponderance of paper promises to deliver gold compared to the stock of physical gold available for delivery.

2) It may seem somewhat hard to believe now, but silver began 2010 at $16.82.  Perhaps even harder to believe – given that silver is now over $30 – is its low price of $14.82, which like gold was also reached on February 5th.  In my forecast for this year I said: “Silver will eventually exceed its $50 per ounce all-time record achieved in January 1980.  Will it happen in 2010?  It is I think only a 20% probability, but that is high enough for me to mention it.  We need to start thinking about silver hurdling above $50.  If it doesn’t happen in 2010, this important event – which is unimaginable to many – will I expect happen in 2011.”

A $50 silver price isn’t so unimaginable any more, but as is obvious, I was making a 2-year forecast.  So we need to see what the silver price does in 2011 before judging that forecast’s accuracy.  Nevertheless, given the accuracy in calling for an uptrend as well as the general magnitude of the price forecast I was making, I think we can say my forecast was accurate enough.  The same can be said for the gold/silver ratio.

Here is what I said to expect: “The gold/silver ratio will drop to 45, and perhaps make a new multi-year low around 40.”  The ratio is presently at 46.0, its low for the year.  It began the year at 65.1, so it was an accurate call.

3) Just like my forecast for the price of gold, I was too optimistic about the potential for the mining stocks.  “The XAU Index in 2010 will break above its record high of 206.37.  Also, the mining stocks will outperform gold, so that the XAU Index returns to more reasonable levels of valuation above 6 goldgrams.  My upside target for the XAU Index for 2010 is 300…”

The XAU Index began the year at 168.25, and reached its low price of 146.42 on February 4th.  It did indeed make a new record high price, though it only managed to climb to 228.76, well below my 300 target.  But I did get it right though in that the XAU Index finally did better than gold itself.  The XAU rose 34.7% in 2010 compared to 29.8% for gold.

The above calls on balance were pretty good, even if I was overly optimistic about the upside targets I forecast for gold and the mining shares.  But did I miss anything in 2010 by a wide mark?

Well, some might argue that I was wrong with my forecast that the “US dollar is on the edge of hyperinflation.”  I did go on to more fully explain that comment by saying that “The Federal Reserve in the year ahead will therefore continue to purchase government debt and turn it into currency, which will eventually – and probably in 2010 – cause the US dollar to begin hyperinflating.”  So were my forecast and comments really off the mark?

After all, look at what is happening to the prices of goods and services.  As I see it, the dollar is indeed beginning to hyperinflate.  Let’s consider some basic facts here, starting with the most obvious one that the Federal Reserve is buying US government debt and turning it into currency exactly as I forecast.

The Federal Reserve calls it “quantitative easing” instead of what it really should be called, which is “money printing”.  It is not money printing in the sense that more paper-currency is being created.  Rather it is the creation of deposit-currency, i.e., money that circulates as currency through the banking system, which is being conjured up out of thin air.  Here are some basic facts to consider when determining whether or not hyperinflation is beginning:

1) Crude oil began the year at $79 per barrel; it is now over $90.
2) The CRB Continuing Commodity Index has risen from 484 to 624 presently, which is a record high that surpasses the so-called “commodity bubble” that occurred in the summer of 2008 before the Lehman Brothers collapse.
3) Most importantly, as the inflationary signs all around us have become increasingly apparent as 2010 wore on, the yield on the 10-year T-note over the past few months has climbed from 2.4% to nearly 3.5%, despite the QE2 announcement by the Federal Reserve saying that it would be buying $600 billion of US government debt.

So maybe the dollar really was “on the edge of hyperinflation” in 2010.  Maybe general perceptions about what is really happening to the dollar are moving more slowly than the reality of the dollar’s actual descent toward hyperinflation.

In summary, I think my forecasts for 2010 were on-the-mark.  They captured the major trend of the precious metals and the mining stocks.  They were accurate in warning about the risk of sovereign debts, while recommending staying away from the dollar and paper assets in general.  Importantly, I don’t expect these trends to change in 2011, except one point is noteworthy.  The speed at which these trends are moving will noticeably accelerate, particularly in the first half of the year.

Here is what I expect for the year ahead.  I would first like to describe the general scenario I expect to unfold in 2011.

The demand for physical metal will be the major driver of the gold and silver price, and the accumulation of the precious metals will become an increasingly important portfolio strategy.  This demand is a continuation of the trend already in place, but will heighten in the months ahead.

Growing nervousness about the worth of government paper in particular and more generally, about the reliability of financial promises, will lead to a stampede out of currency-based assets.  These include government paper, corporate paper and bank deposits.  This money will move into tangible assets – particularly the precious metals – and near-tangible assets, e.g., the stocks of mining companies and other commodity producers.  In this environment commodity prices will soar.

Crude oil will climb back to challenge its all-time high approaching $150 per barrel.  Copper is headed for $6 in 2011, and basically all commodity prices across the board will climb as the US dollar moves ever closer to the hyperinflationary abyss.  Record high soybean prices above $18 are likely before this year’s planting season begins.  New records in corn and other agricultural commodities can also be expected.

The US government is already insolvent, but carries on like a zombie.  Not for much longer though.  The direct federal debt (ignoring the tens of trillions of its contingent liabilities) is $14 trillion, an increase of nearly $5 trillion in three years.  A 1% rise in interest rates adds $140 billion to the federal government’s deficit.  That $140 billion is more than 5% of annual government revenue.

The unspoken reason for the Federal Reserve’s QE policy is that the US government cannot afford higher interest rates.  The financial consequences are straightforward.  Higher interest rates will increase the US government’s borrowing costs, thereby raising its annual deficit, causing it to borrow even more money and therefore pay even greater amounts to meet its annual interest costs, with the result being yet a bigger deficit.

Clearly, what I am describing is a financial death spiral that always leads to hyperinflation when the debtor is a profligate, out-of-control spender with the ability to create money out of thin air, which all governments now do.  Rather than cutting back spending to borrow at amounts the market is willing to lend to it, a government on a hyperinflationary path keeps spending and borrowing.  The central bank steps in and turns that government debt into currency, which explains exactly the essential nature of QE.

The important point I am making is that the US government is already far down the road that leads to hyperinflation.  This approaching hyperinflation will be the dominant theme for markets in 2011, and everyone has to adjust their portfolio strategy for this event.  In short, the US dollar will be destroyed by hyperinflation – an eventuality that will become increasingly obvious in 2011 – unless things change right away.  I see no inclination of any change coming, so I think it is possible that hyperinflation and a collapse of the dollar could occur by the end of 2011.

1) Gold will reach $2000 per ounce ($64.30 per goldgram) in the first half of 2011.  Look for gold to exceed $1,800 by the end of Q1.  The low for the year will be made in January, probably in the first week.  Thereafter, look for gold to continue the hyperbolic uptrend it is already tracking.

2) Silver will reach $50 per ounce, probably in Q1 2011.  It will then take a breather by moving sideways, trading in a range between $50-$38.  It will do so in order to consolidate its tremendous gains, which if my $50 target is reached will be a more than three-fold increase in price from the year’s low of $14.82 in 2010.

3) The gold/silver ratio will continue its downtrend.  It will break below 40 during Q1 as silver soars in a massive short squeeze.  The ratio is likely to reach 30 during 2011, and I do not expect it to climb back above 52.

4) This year will be a great one for the mining stocks, which have been out of favor all decade long.  The bear market in mining stocks began with the collapse in Bre-X back in 1997, and it ended with the collapse of Lehman Brothers, when the juniors were totally decimated and even the best mining stocks were selling at unbelievable values.  Consequently, I expect the XAU Index will exceed 300, and I expect most of that gain to occur in the first half of 2011.

5) I expect another “Lehman Brothers” event in the first half of 2011.  It might be a bank, but it could just as easily be a government.  However, if another Lehman-like event occurs, the response by gold and the mining stocks will be completely different than 2008; this time they will rise, not fall.  The event this time will be a ‘failure’, not a ‘collapse’ like Lehman.  The Lehman collapse resulted in a rush by countless overleveraged debtors to get liquid.  The failure I expect in 2011 will have a different result.  There will be a rush to safety, meaning the avoidance of counterparty risk.  The best way to avoid counterparty risk is to own gold and silver.  The second best way is to own the shares of top quality commodity producers.

Note that the above forecasts focus on the first half of 2011.  I have done that purposefully because the second half can go either of two very different ways.

To explain, the serial bailouts of banks and countries over the past couple of years will I expect come to a head within the next few months, i.e., in the first half of 2011.  Governments and central banks will hit a wall when the market for government paper collapses.  Look for more failed auctions like the ones we saw last year in the UK and China as well as with the ECB.

The trigger point for this collapse will probably occur when Spain, Belgium and/or Italy all come to the EU and ECB at more or less the same time for a bailout.  In other words, the ongoing serial bailouts of adding more debt cannot go on forever, just like the unlimited borrowing by the US government cannot go on forever.  This financial recklessness will end in the first half of 2011.  The question is what comes next.

Unfortunately, that part cannot be forecast.  It is unpredictable because the outcome depends upon something that goes beyond numbers derived from balance sheets or supply/demand statistics.  It depends on what the politicians do.  Will they go the right way or the wrong way?

The right way would be to reverse the bad policies they have been pursuing.  Any society built around a free market and protected by a rule of law that secures the right to private property needs sound money.  It can’t survive on fiat currency.  It doesn’t need bailouts that add yet more financial obligations on an already overburdened middle class.

The wrong way would be more of the same, particularly more government debt and monetization of that debt by central banks.  When faced in the first half of 2011 with a financial and monetary blow-up that will make the Lehman Brothers collapse look like a cakewalk, policymakers might finally see the light and be motivated to change.  We can always hope.  Or they could make matters even worse by imposing capital controls and Draconian measures like higher taxes, closing markets, forcing pension funds to buy worthless debt and probably dozens of other terrible things that governments may call remedies but really are desperate acts that damage our capitalist society.

Personally, I am not optimistic that governments will do the right thing.  The reason is captured in a quote in The Telegraph by Germany’s chancellor, Angela Merkel.  I am not picking on her, but am highlighting her quote because I think it accurately captures what all politicians are thinking today.  Commenting that the eurozone was “facing an exceptionally serious situation”, she went on to say “the primacy of politics over markets must be enforced.”

Ponder that comment for a moment.  That is very scary talk.  She is in effect saying that markets be damned because politics are more important, even though it is the free market and not government that creates the wealth that raises mankind’s standard of living.

It is this kind of talk that leads to government actions that damage the market process, and when that happens, the economy is destroyed and society as a whole then suffers.  If you doubt this outcome, I recommend reading Fiat Money Inflation in France by Andrew Dickson White, a classic and one of my favorite books.  Written a century ago, White examines the impact on France from the monetary collapse during and after the French Revolution.

So my recommendation for 2011 is the same as it was for this past year, and in fact is the same as it has been all decade.  Continue accumulating the precious metals, and if you are so inclined to take the investment risk, the mining stocks as well.  Focus on owning tangible assets that make sense – gold, silver, useful commodities and the shares of well-run companies that produce these things.  Avoid the dollar and other currencies.  Avoid all government paper, and if you own a corporate bond, make sure it is convertible into equity.

Become self-reliant, and most importantly, do not rely on any government.  Learn from those who were not prepared for Katrina.  Even though they lived in a hurricane zone, they thought they could rely on the government to help them, but everyone who ended up in the Superdome looking for help suffered as a result.  A financial Katrina is coming, and I think it will hit in the first half of 2011.  It will be an unprecedented crisis because the US government is tapped out and the serial bailouts of governments and banks worldwide are coming to a head.

As a result, government policies that have led to monetary debasement for decades are going to accelerate in 2011.  Be ready for it.  If governments continue to follow the wrong policies and make the wrong decisions when confronting some critical moments in the months immediately ahead, then the sky is the limit for gold and silver as national currencies hyperinflate and approach a total collapse.  Consequently, everyone needs physical gold and physical silver now more than ever.