The Precious Metals in 2009

December 22, 2008 – This letter is the last one for this year, so it’s time to look ahead to 2009.  It’s shaping up to be an ugly year for financial institutions and the economy, but a good one I expect for the precious metals.  But before I look ahead, I would first like to look back at my forecasts for this year and evaluate their accuracy and usefulness.

For perspective, one year ago gold was $793.30 per ounce ($25.51 per goldgram), and silver was $13.826, equaling a gold/silver ratio of 57.4.  The XAU Index was 165.80.  As of today, gold has risen to $836.40 ($26.89/gg), while silver has dropped to $10.819, resulting in a gold/silver ratio of 77.3.  The XAU Index is 112.75.

Here is what I forecast for gold in 2008: “Gold will finally break into 4-digits, which will be an event that gains worldwide attention.  I think the high in 2008 will be $1,500, and the low will be $780.  Gold will probably end the year at $1200-$1300, generating at least a 50% gain in 2008

We’ll see in nine days how gold ends the year, but that forecast isn’t bad.  It looks like 2008 will be another up-year for gold.  Gold did achieve 4-digits, but didn’t stay there for long.  Consequently, the 4-digit gold price did not have the opportunity to gain the worldwide attention I expected.

More important though are the reasons why I forecast gold to climb in 2008.  Here’s what I said, all of which remains relevant, timely and descriptive of what we can expect in the coming year, so it is therefore worth repeating.

“The same monetary problems driving gold higher for the past six years continue, including: (1) the dollar will continue to decline, threatening its 6-decade global monetary stranglehold as the world’s reserve currency, (2) inflation will worsen as the price of commodities as well as other goods and services rises, (3) the federal government budget deficit will grow, further debasing the dollar, and (4) global trade imbalances will continue to create huge pools of hot-money looking for a safe home, much of which will end up in gold.

Add to the above monetary problems a new worry – counter-party risk.  This risk was highlighted by the bank-run at Northern Rock, and the depositor withdrawals presently underway in some institutional money-market funds in the US.  Funds and more financial institutions will collapse in 2008, further highlighting this growing counter-party risk.  Gold will benefit from this turmoil because it is the only money without counterparty risk – its value is not based on the promise of some financial institution.  Gold is a tangible asset, not an IOU of some financial institution.  This attribute of gold will become more widely recognized in 2008, significantly increasing worldwide demand for gold and causing its price to rise to my forecast high of $1,500, probably as the result of a collapse in the dollar or the collapse of some fund or major financial institution.”

My forecast for silver, unfortunately, was way off the mark.  I expected that “Silver will clear $30 in 2008, as the ratio falls below 40.  A $1200 gold price and 40-to-1 ratio puts the price of silver at $30.”  While I went on to say that “Silver is the best play for 2008“, I did provide some sensible warnings.  The first was that “silver is never a smooth ride.”  I also said: “It comes with a lot of risk.”  Then perhaps the best warning of all, given that silver is notoriously difficult to forecast, was my advice to “keep in mind how far off the mark I was about silver this year“.  That admonition is now true for two years in a row.

Lastly, my forecast for the XAU Index was off the mark.  I expected the XAU “will nearly double, closing over 300 at some point during the year.”  It did break above 200, but then tanked.

So in summary, my forecast for gold was okay, and I was right about the major themes of more financial problems.  I also correctly forecast the collapse of “funds and more financial institutions“.  But clearly, my outlook for silver and the XAU Index were poor.  What did I miss?

Without any doubt it was the de-leveraging, and particularly, the massive asset liquidation by hedge funds and other leveraged investors.  So even though I was right about the monetary turmoil and the collapse of funds and major financial institutions, I did not foresee the rush to repay debt.  In short, the monetary turmoil turned into a global credit crunch.  But in fairness, I did pick up on this theme early in 2008.

For example, here is what I wrote on March 17, 2008 in Letter No. 421.  “We are in one of those recurring periods when the solvency of banks is doubted, like the late 1980s when the S&L crisis was brewing.  Or perhaps it is more like 1974 when the failure of Herstatt Bank in West Germany set off banking crises throughout the world, culminating with the collapse of Franklin National Bank in New York City.  The problem is leverage.  Too much debt has been extended on too little capital, so even a small decline in the value of a bank’s assets can significantly erode its capital and make it insolvent.”

Importantly, the global credit crunch will not disappear anytime soon.  Most banks and many companies and consumers have become over-leveraged.  It will take time to bring their balance sheets back into a sound position, so the impact of the credit crunch will remain throughout 2009. 

Consequently, the credit crunch and insolvent financial institutions will remain the major theme and driving force in the year ahead.  Economic conditions will continue to deteriorate around the globe, but the race to zero interest rates by central banks will not solve the problem.  The issue remains one of solvency, not liquidity. 

Banks always predictably lend too much, creating the boom. The bust then inevitably follows after it becomes clear that the boom was built upon easy credit that fostered bad decisions.  We have moved from a period of over-spending and over-borrowing to one in which the bad loans and bad decisions from the boom years come home to roost, creating the bust. 

In other words, we have had the boom, and we are now in the bust.  The bust will eventually end when the bad loans now plaguing banks and other financial institutions have been repaid or reneged.  But the bust will not end in 2009.  Consequently, the outlook for gold remains positive.  Here are my 2009 targets.

1) Gold will climb into 4-digits in the first quarter and this time will remain in 4-digits for the rest of the year.  The potential high is $1800 per ounce ($57.87 per goldgram).  I expect the low to be $850, which will be reached early in the first quarter.

In short, 2009 is shaping up to be the key “break-out year” for gold.  It will become a “break-out year” because the average investor will start becoming aware of gold and begin buying.  Despite its remarkable performance throughout this decade, few people own physical gold.  That will begin to change in 2009 as the financial disruptions will worsen and people seek a safe haven for their money.

2) Will silver finally outperform gold in 2009?  Having been burned two years in a row, I am asking this forecast as a question rather than offering it as a statement.  The underlying fundamentals for silver continue to improve, and we saw a spark of silver’s potential early this past year when it climbed above $20.  I expect silver will again break above $20 this year, and I repeat my $30 forecast from last year. 

Silver is dirt cheap.  It’s only a matter of time before it climbs above $30, but if you choose to buy silver, be prepared for the volatility, which is reflected in the gold/silver ratio. 

I think the ratio will not break above over-head resistance in the low 80s.  The downside potential for the ratio is 45 or so, which is the bottom of its multi-year trading range.  If I am right that gold reaches $1800 sometime during the course of 2009, and if the low in the gold/silver ratio is 45 at that same moment in time, then mathematically, silver would be $40.  If the ratio only moves to 60, then silver will be $30.

In any case, I expect the gold/silver ratio to fall in 2009.  Thus, regardless the prices they eventually achieve, I expect that silver will outperform gold in 2009.

3) The XAU Index will bounce back strongly in 2009, beginning in the year’s first quarter.  Widening profit margins due to lower energy and other input costs will bring investors back into the gold mining sector.  The mining stocks are unbelievably cheap.  It is reasonable to expect them to return to more normal levels of valuation, which would imply that the price of the XAU Index in terms of gold would be 6 goldgrams and perhaps as much as 8 goldgrams (see the page-5 chart). 

Therefore, if gold does indeed reach $57.87/gg (which is $1800/oz), then 6gg to buy the XAU would mean this mining index would be 347.  The XAU Index would be 463 if it cost 8 goldgrams and if the price of gold actually rises to $57.87/gg.  These numbers seem outrageous, but they are not unreasonable when viewed within their historic context.  The big question of course is whether gold will reach my upside target.

In an environment in which people are increasingly fearful about the downturn in the economy, the safety of banks, and the outlook for the dollar, anything is possible for gold.  And if 2009 turns out to be the year when the biggest bubble of them all pops (i.e., the dollar becomes suspect), the sky is the limit for gold.