Some Recent Observations

September 25, 2000 – In recent weeks I have received a number of inquiries from readers on a variety of subjects. I also have some comments on a couple of market related matters. I thought the following to be particularly important, so I would like to share my observations and comments on these topics with all of you.

In Interim Letter #268-9, which included an essay by LarryParks, I explained why jewelry was a low-value use for Gold.When Gold is used as jewelry instead of money, to use Larry’s analogy,”It’s as if Perrier Water was diverted from its primary high-value/high-utility market as drinking water to a much lower-value/low-utility market, such as crop irrigation.” This conclusion has sparked some debate, which included a comment that ‘Jewelry fabrication demand is long-term bullish for the gold price’. This statement seems logical. After all, if demand rises, shouldn’t it be bullish for Gold? However, this statement about jewelry demand is in fact completely wrong.

Because jewelry is a low value-added use for Gold, jewelry demand CAN NEVER be bullish for Gold EVEN IN THE LONG RUN because increased jewelry demand always means that by consequence the price of Gold is low, and lower than it would be if the demand for Gold as money were higher. Thus, carrying this point to its logical extreme, the highest price for Gold can only be reached when there is no use for Gold as jewelry and no Gold used in jewelry. My conclusion is counter-intuitive, but there is some empirical evidence to support it.

In January 1980, the price of Gold and Silver soared as the monetary demand for both of these metals soared. You may recall how people back then stood in long lines on 47th Street in New York City to melt down their jewelry.

Had the monetary demand for Gold back then continued to grow, driving the price higher than $850, then even longer lines would have been forming to melt down jewelry. Those lines are the opposite of what is happening now because jewelry demand is strong, and the price of Gold is low. Thus, jewelry demand is never bullish for Gold even in the long-run because jewelry demand is strong/rising only when the price of Gold is low.

The Gold industry often uses the term”investment demand” to explain one use of Gold, instead of the more accurate”monetary demand”. Generally, anyone who uses the term ‘investment demand’ does not understand that Gold is money, and not an investment. Nor should the Gold industry want Gold to be considered as an investment because aside from this term completely misrepresenting Gold’s essential, fundamental nature, there is no way that Gold will ever stack up with other investments, like stocks, real estate, oil wells, etc. when measuring long-term rates of return.

What people call Gold’s rate of return is in reality the rate of the Dollar’s decline in purchasing power relative to Gold. Gold does not actually generate any rate of return in the true sense of that term, unless of course the Gold is loaned in order to generate a rate of interest. That interest compensates the holder of Gold for the risks of extending credit. So how should Gold be viewed in a portfolio?

Investment advisors usually speak of an investment portfolio being divided into stocks, bonds and cash. Where does Gold fit into that mix? It’s part of the cash component. Gold is liquidity (i.e., money), not an investment.

A number of readers asked me to comment on remarks made by Mr. John Mielke, a senior employee of the Commodity Futures Trading Commission. Mr. Mielke’s comments were originally reported in www.lemetropolecafe.com, but some of you also saw the report in Jay Taylor’s newsletter, Gold & Technology Stocks.

The gist of Mr. Mielke’s comments are that those who are short physical metal may in a market panic (or for some other reason the federal government deems important) be relieved of their obligation to deliver physical metal. In other words, if someone were to get in trouble by shorting metal, and the price began to soar, the shorts would be relieved of their obligation.

The fact that the federal government would break the contract between individuals that they freely entered into is a despicable statement about the mentality that pervades Washington, DC. But it should not be surprising. After all, for over hundreds of years governments all over the world have defaulted on their commitment to pay Gold. The US government defaulted in 1933 and again in 1971. Also, for just as long, governments have regularly let banks off-the-hook from their commitment to pay Gold. It’s a stacked deck in which the banks never lose.

Mr. Mielke’s comments should therefore be taken seriously, so protect yourself accordingly. Recognize the risk of owning someone’s promise to pay Gold. Own the physical metal, and not some bank’s or anyone else’s promise to pay physical metal. Take to heart my variation of the old saying, ‘an ounce in the hand is worth more than two in the bush.’

In August two university professors presented a paper to a Federal Reserve conference which concluded that the growing current account deficit poses a real problem for the Dollar, which could as a result lose 45% of its current exchange value. Shocking news, maybe too shocking for the Federal Reserve. So it was interesting to see how this news was reported on CNBC.

Viewers were told that the current account deficit is like someone with a heart problem. It could be years before you ever get a heart attack, so why worry? Yes, I am not joking, that was the gist of the CNBC coverage.

Back on July 17th in Letter No. 267 I said to expect one last drop in the XAU below its August 31st low of 48.89. This low in the XAU would set up another bullish non-confirmation with the Gold price. On September 20th, the XAU closed at 48.65, a new low, but only marginally, so this looks like a double bottom. So is the bullish non-confirmation is in place?

Yes, it is, but there is more needed to explain this point. In August the Philadelphia Stock Exchange, where the XAU is traded, changed the nature of the index. It added Phelps Dodge to the XAU and gave it a 14% weighting.

Phelps Dodge you ask? Good question because PD is a copper company, not a Gold or Silver mining company. So why did the Philadelphia Exchange screw up its index? As far as I have heard, no one has the answer to that question, but the point is that this change affects the non-confirmation noted above.

The price of copper has been relatively strong in recent weeks, and so has PD been strong on a relative basis compared to the Gold miners. Consequently, the September 20th low of 48.65 is much higher than it would have been had PD not been added to the index.

So my conclusion is that the non-confirmation has clearly been made. This non-confirmation is bullish for Gold. But the change in the XAU leaves me with a problem.

Does it make sense to follow an index for Gold and Silver mining companies that is 14% weighted by a copper company? No, probably not, so in the future I may be using a different index.