Will Gold's Climb Up the Wall of Worry Come Crumpling Down?

By Peter Grandich
13 Mar 2006 at 01:08 PM EST

“Once a man worries, he clings to anything out of desperation; and once he clings he is bound to get exhausted or to exhaust whomever or whatever he is clinging to. A warrior-hunter, on the other hand, knows he will lure game into his traps over and over again, so he doesn’t worry.” ~ Carlos Castaneda, 20th century mystic and Toltec warrior

PERRINEVILLE, NJ (Grandich Publications) -- Ever since bottoming in 2001, gold has managed to climb the proverbial “wall of worry.” Along the way, there were several consolidation and corrective phases just like the one we’ve been experiencing lately. They’re never much fun but are a necessary evil en-route to new, all-time highs in gold, IMHO.

If you found yourself to be among the “nervous-nellies” of late, let me take you back through time via this chart and remind you what happen to previous worry-warts and especially those who said the end was near.

Gold rallied to the $375 area in early 2003. It then proceeded to decline all the way back to $325. I remember novice trend-watchers all noting how the uptrend was “broken.” Gold then climbed a wall of worry by busting through a double top around $375 and ran to about $425 in early 2004. It then tried more than once to get through that level only to fall below $400 and “all the way down” to $375. Once again, were told well now be little more than a snack for the gold bears.

Gold slowly creeps back to the $425 area and as 2004 winds down, it busted through to $450. However, that level is short-lived and we spend the first half of 2005 in a tight trading range of $425 to $450. (If I had a dollar for each “major top forming” comment or Larry Kudlow “gold is dead” comment.) Surprise, surprise, gold breaks above $450 in the second half of 2005 and rallies right up to multi-decade resistance of $500-$510. Once again, normal consolidation is seen by some as yet another top. The top soon becomes a bottom as gold begins 2006 in a full sprint to the $570 area.

On the way there, numerous former luke-warm and bearish forecasters begin to knock themselves over in a rush to issue new “bullish” forecasts. Suddenly, the wall all but disappears and the media is caught up in reporting the latest “multi-thousand dollar gold forecast.” Surprise, surprise, the gold price corrects from $570 twice, all the way down, down, down to the unbelievable low, low, low, low price of $540 (read my sarcasm…).

Come Friday afternoon, March 10th, I’ve spent the majority of the day hearing from mostly individual investors in semi or full-fledged hysteria that the gold run is over and they feel they’ve been left holding the bag. They were not alone. Here are just a few headlines regarding gold late Friday:

"Sell-off could mean end of bull run" - Financial Times

"Gold Watch: A bear camp lurking?" - Resource Investor

"Gold Moves further south" - The Economic Times

However, before you fall prey to “the party is over crowd,” please note that since 2001, the score is about Gold Bulls 10, Gold bears 0. But hey, who’s keeping score?

While I’m about to begin my 23rd year in the financial advisory world, I’ve learned a long time ago two key factors about my profession:

• You’re only as good as your last call.
• What have you done for me lately (which for some investors is just a matter of hours)?

With this in mind, and knowing there are far too many readers of mine going into trading this week on pins and needles, I will attempt to take a rationale look at where all the markets covered by “The Grandich Letter” may be heading.

Overall Assessment

Like many other things in life, is the cup half-full or half-empty? Larry Kudlow and the Talking Heads at Tout-TV (CNBC-TV- and I call it Tout-TV because I challenge anyone to show me anything close to equal representation of both bearish and bullish viewpoints from the so-called experts allowed on) see the cup half-full (and it seems to be a permanent position).

I believe Americans have been robbing Peter to pay Paul and Peter is tapped out. An all-out debt binge by government and its citizens has allowed many to live way beyond their real means. It’s not a question of if, but when it all comes home to roost. While this in itself is cause for alarm, the following factors combined have placed America on a slippery slope towards what is surely going to be its darkest times:

• The “Aging of America” (and the social, political, economical and religious ramifications of it) towers over the problems of terrorism and a budding energy crisis. Go and read former Federal Reserve Chairman Allen Greenspan's comments in his last six months or so on the job. I believe if you do and remove his name from the quotes and show it to members of the ““Don’t Worry, Be Happy”” crowd on Wall Street (Larry Kudlow is their five-star general), they would swear some gold bug said them.
• America, once a truly beloved group of people to most of the world, is quickly becoming the “black sheep” of the family. Canada, once the closest thing to being home, is no longer your long-lost brother. Not too long ago, the deepest that heated discussions with Canadians would go was about how American hockey teams were really made up of Canadians and therefore not “American” at all. Now, on the other hand, it’s best to wear an “I voted for Kerry button” while you walk the streets of Canada. It’s much easier to highlight our true allies on a world map now and takes less than half the time it did decades ago. Most Americans don’t realize what effect this is having on us in the global economy of the 21st century.
• Geopolitical problems around the world are bad enough, but in a few months, most Americans should come to realize that our national political process has not only nearly grinded to a halt, but an undeclared “war” has started between the Democrats and Republicans. It will make the Hatfields and the McCoys look like a love fest.

Gold

Back in 2001, gold found itself on life support systems near $250. Those left in the mining and exploration industry felt anything north of $300 would be Nirvana. Tell those folks back then that you foresaw the March 13, 2006 gold price of $540 and the ones who didn’t die from fainting and falling on their heads would have screamed, “Were going to be rich!” The long period of sub-economic prices led to a mass exodus of professionals, laborers and most importantly, lack of any significant exploration and discoveries. This would help lead to the resurrection of the gold price and the industry that surrounds it.

The first phase of the rally (2002-2004) was helped along by weakness in the U.S. dollar and the credence that the Euro was the new “King.” However, when the Emperor was shown not to have any clothes, gold began to climb against most major currencies, proving it was not a one-act wonder. This is phase two. When will we know for certain were in the final phase? When TOUT-TV moves the young lady from the NYMEX to the Comex on a daily basis and my neighbors stopped telling me about Google, Microsoft and Intel and instead ask me if I heard of this mining and/or exploration company.

Factors Influencing Gold

Supply versus Demand. As previously noted, the mining and exploration industry had several years of very limited exploration. You can count on your hands the current mega discoveries of 3, 5 or 10 million ounces that are available for production the next few years. Mine supply remains in a downtrend while demand continues to rise. In addition, the bad times have led to a real labor shortage in the mining industry. For every mining professional I met at the recent PDAC convention looking for interesting projects, another one was seeking to find a geologist, mining engineer, etc. Costs associated with building and running a mine also skyrocketed and has affected the supply side. None of these factors can change overnight so the supply side of the equation remains very favorable.

Physical Demand. While the jewelry industry accounts for over 75% of the annual gold usage, most individual investors pay the least amount of heed to it versus other factors. I caution them that this “physical demand” is the single most influential factor no matter what any gold bug tells them otherwise. There’s a well-documented seasonal cycle to physical demand. The period of September through January is usually stronger than from February through August. Keep this in the back of your mind. Much of the increased physical demand continues to come from Asia and especially China. While sharp rises in prices usually lead many in the jewelry industry to pull back from the table and await a price correction, the constant demand for jewelry wins out over time and I see no reason to think this time will be any different.

Investment Demand. While some jewelry is actually purchased for investment opportunities, most others buying gold are doing so not because it looks good on them but for a profit and/or to hedge other investments. Here we’ve seen demand steadily rise, especially after the introduction of gold ETFs (Exchange-Traded-Funds). Some hardened gold bugs argue that ETFs don’t offer real ownership of bullion but just a proxy. Whether that’s true or not, the fact is, the introduction of them has been the single largest positive impact to the supply vs. demand scenario. Not even the widest dreams foresaw the actual amount of buying. The question really is why?

When I started in the business 22 years ago, the saying “owning mining stocks is like owning gold” was common. Unfortunately, that proved to be more of a myth (October 20, 1987 is the ultimate proof). While bullion itself is the most direct way to own gold, silver, etc, most individuals and especially institutional investors, avoid it in lieu of buying, storing and maintaining ownership. However, when the ETFs were introduced and buying and selling was perceived as being as easy as buying common stock, a fire was lit. I know several institutional players who in the past either avoided bullion all together or bought major mining company stocks once in a blue moon, and are now placing significant funds into the ETFs. Say what you want about their true status of ownership but the fact is the gold ETFs have been a key factor in the gold secular bull market.

U.S. Dollar. As noted earlier, the first phase of the gold secular bull market was driven by the inverse relationship of gold vs. the U.S. dollar. About 85% of the time, gold moves in the opposite direction of the dollar. However, I believe gold has demonstrated how strong its internals actually are by rising throughout 2005 and into 2006 in the face of a rising dollar. Now of course, the correction in gold is being blamed in part on the expectation that U.S. interest rates will rise, which will cause the dollar to rise, and thus put pressure on gold.

You’re likely to hear this a lot over the near term so let me put one extremely important piece of history front and center that should at least make you seriously question this lame excuse: Throughout the second half of the 1970s and into 1980-81, interest rates rose to over 20% while the dollar rose as well. Yet, gold managed to increase 400% during that period. Why? Because the world was on shaky ground at the time. People were becoming more and more concerned about a deteriorating geopolitical and economic environment worldwide. Sound familiar?

The U.S. dollar, along with the United States of America in general, are the Roman Empire of the 21st century (don’t ask me if George Bush is Caesar-but I think Cheney is a distant relative). My daughter came home recently and told me she plans to take Italian when she enters High School next year. I told her if she really wants to better herself and her future children, to see if the school teaches Chinese. She asked why? I told her if she doesn’t, she might be one of the Americans doing their laundry 20 years from now.

Despite what you’re certainly going to hear in the next weeks and months, the U.S. dollar is toast over the long-term. While the ““Don’t Worry, Be Happy”” crowd rules the airwaves on Tout-TV and elsewhere, rest assured that the beginning of the end has already taken place. I could write a thousand pages why and not cover it all, but let me briefly go over some key factors I believe support my belief:

The world is awash in dollars. Some think this very fact is actually a positive since those holding so much of them won’t want to see it come apart. But the evidence is very strong that this very event is already unfolding. Nowhere is it more crucial than China. More than 70% of their reserves are invested in U.S. dollar assets. This fact has clearly helped the U.S. sustain itself despite ever-increasing large budget and trade deficits. Several times now, different people and groups directly or indirectly associated with the Chinese government have indicated the government is going to begin diversifying itself more within its rapidly growing foreign exchange reserves. A few months ago, Chinas foreign exchange regulator made a brief statement on their website. It said one of its targets for 2006 was to improve the operation and management of foreign exchange and to expand the investment area of reserves. Stephen Green, economist for Standard Chartered in Shanghai said of this news, “…this statement was the first time the Chinese Regulator publicly indicated a shift away from dollar assets. It’s a subtle but clear signal that they are interested in moving away from the U.S. dollar into other currencies, and are interested in setting up some kind of strategic commodity fund, maybe just for oil, but maybe for other commodities.”

1. Iranian Oil Bourse - Energybulletin.net wrote a superb piece about the new Iranian Oil Bourse. While you will hear more and more about the nuclear threat, I believe the oil bourse will have a far bigger negative impact (but then again, a nuclear bomb has a pretty good wallop itself, no?)
   
   “The Iranian government has finally developed the ultimate ‘nuclear’ weapon that can swiftly destroy the financial system underpinning the American Empire. That weapon is the Iranian Oil Bourse slated to open in March 2006. It will be based on a euro-oil-trading mechanism that naturally implies payment for oil in euro. In economic terms, this represents a much greater threat to the hegemony of the dollar than Saddam's, because it will allow anyone willing either to buy or to sell oil for Euro to transact on the exchange, thus circumventing the U.S. dollar altogether. If so, then it is likely that almost everyone will eagerly adopt this euro oil system.
   
   “The Europeans will not have to buy and hold dollars in order to secure their payment for oil, but would instead pay with their own currencies. The adoption of the euro for oil transactions will provide the European currency with a reserve status that will benefit the European at the expense of the Americans.
   
   “The Chinese and the Japanese will be especially eager to adopt the new exchange, because it will allow them to drastically lower their enormous dollar reserves and diversify with euros, thus protecting themselves against the depreciation of the dollar. One portion of their dollars they will still want to hold on to; a second portion of their dollar holdings they may decide to dump outright; a third portion of their dollars they will decide to use up for future payments without replenishing those dollar holdings, but building up instead their euro reserves.
   
   “The Russians have inherent economic interest in adopting the euro the bulk of their trade is with European countries, with oil-exporting countries, with China, and with Japan. Adoption of the euro will immediately take care of the first two blocs, and will over time facilitate trade with China and Japan. Also, the Russians seemingly detest holding depreciating dollars, for they have recently found a new religion with gold. Russians have also revived their nationalism, and if embracing the euro will stab the Americans, they will gladly do it and smugly watch the Americans bleed.
   
   “The Arab oil-exporting countries will eagerly adopt the euro as a means of diversifying against rising mountains of depreciating dollars. Just like the Russians, their trade is mostly with European countries, and therefore will prefer the European currency both for its stability and for avoiding currency risk, not to mention their jihad against the Infidel Enemy.
   
   “Only the British will find themselves between a rock and a hard place. They have had a strategic partnership with the U.S. forever, but have also had their natural pull from Europe. So far, they have had many reasons to stick with the winner. However, when they see their century-old partner falling, will they firmly stand behind him or will they deliver the coup de grace? Still, we should not forget that currently the two leading oil exchanges are the New York’s NYMEX and the London’s International Petroleum Exchange (IPE), even though both of them are effectively owned by the Americans. It seems more likely that the British will have to go down with the sinking ship, for otherwise they will be shooting themselves in the foot by hurting their own London IPE interests. It is here noteworthy that for all the rhetoric about the reasons for the surviving British Pound, the British most likely did not adopt the euro namely because the Americans must have pressured them not to: otherwise the London IPE would have had to switch to euros, thus mortally wounding the dollar and their strategic partner.
   
   “At any rate, no matter what the British decide, should the Iranian Oil Bourse accelerate, the interests that matter those of Europeans, Chinese, Japanese, Russians, and Arabs will eagerly adopt the euro, thus sealing the fate of the dollar. Americans cannot allow this to happen, and if necessary, will use a vast array of strategies to halt or hobble the operations exchange.”
2. Japanese Carry-Trade - After going from being an economic powerhouse in the 1970s and 80s, Japan was in a depression-like state for several years. This caused interest rates to go to zero (hard to comprehend but actually was briefly below zero!) However, thanks to money becoming so cheap to borrow for so long in Japan, the ultimate carry trade was created. Investors were borrowing in yen and investing in higher yielding markets like the Australian dollar, Brazilian real and U.S. treasuries. This should all but now come to an end with the Bank of Japan (BOJ) announcing an end to their dramatic easing stance. So why is this important? For starters, many experts have suggested this super-easy monetary stance has greatly aided the sales of U.S. treasuries and helped prevent our deficits from severely impacting us. The yen vs. U.S. dollar has been a one-way street. Now with two-way traffic returning, the U.S. dollar has to lose some benefit that existed while the carry-trade blossom.
3. Euro - I don’t know whose reign as heavyweight champion was shorter, Leon Spinks or the euro? Billed as the economic powerhouse to challenge the USA in the 21st century, the “Single European Act of 1986” that paved the way to the EU, is still weighted down by political and cultural differences among its members, along with selective acts of protectionism by individual members. Never-the-less, lending to euro zone consumers and to businesses is growing at the fastest rate since the start of the decade. This has played a role in the European Central Bank (ECB) raising interest rates recently. Mr. Jean-Claude Trichet, president of the ECB strongly hinted of more raises to come.
   
   Up until now, the Euro has primarily acted as the “un-dollar,” rising when the dollar fell out of favor and falling when the greenback was back in demand. While I don’t expect it to become the “one and only” sought after currency, it’s important to comprehend that the euro and yen have to be more competition now than they were just a few weeks ago. I remind you again that you need to question those who are saying the U.S. dollar is going much higher simply because our interest rates are heading higher.

Debt and Deficits. ROB-TV recently had a gold debate (it was more like a discussion. Put Brian Acker or Larry Kudlow on versus Bill Murphy and turn the air-conditioning up full-blast because it would be heated). One of the guests, Mr. Dennis Gartman, made several comments I would take issue with but none more than his belief that budget and trade deficits never impacted interest rates in the past and this time they won’t either. I believe Mr. Gartman, who may not be a full-time member of the “Don’t Worry, Be Happy” crowd but clearly would rather reside there than in the gold bug camp, is missing one critical fact: we were not the world’s largest debtor nation during those past periods.

The U.S. trade deficit hit another record in January amid increasing political jitters in Congress over rising imports from China and Americas increasing reliance on foreign capital.

America has been robbing Peter to pay Paul and Peter is tapped out. Our savings rate for 2005 was negative 0.5%, the lowest since the Great Depression. I laughed aloud but cried internally watching Kudlow and the Talking Heads on TOUT-TV drool while speaking about the employment report and especially wages increasing.

Because Mr. Kudlow and most of the gang of merry men are in the 10%-20% highest earners in America, they are clearly unaware (or don’t care) that 80%-plus of all Americans have seen no real economic benefit from the “goldilocks” economy. They don’t grasp the fact that the ratio of debt to assets (this ratio measures the amount of debt Americans have, relative to the market value of all their assets) hit an all-time record high. Nor do they seem to care much about the fact that the debt service ratio- the percentage of after-tax household income that goes to cover required principal and interest on debt- hit a record 13.75% in the third quarter of 2005.

The most recent Federal Reserves quarterly flow of funds report showed the real explosion of debt. For the first time ever, net savings in the economy fell below 1% of gross domestic product. But Kudlow and his pied pipers remain aloof to what is happening to Middle America.

Inflation. From the lows in 2001 of $250 all the way up to most recently, the “Don’t Worry, Be Happy” crowd “panned” gold because they said you buy it only when inflation is rising and it wasn’t according to U.S. government statistics. Call me a kook, but the inflation the government says exists, and the price increases I see in my daily life, doesn’t seem to be remotely close. In his last meeting as Fed Chairman, minutes of the session showed Allen Greenspan said more rate increases may be needed because inflation has been “somewhat higher than acceptable.” Hopefully by the time the real inflation rate is realized by the typical Joe, the “Don’t Worry, Be Happy” crowd will be suggesting gold as an inflation hedge. Remember, you’re going to need to sell your $1,000 gold to someone. Who better to give it to? LOL!!!

Geopolitical Concerns. There may be no I in team but the letter I helps spell trouble for the U.S.- Iraq and Iran. Hard to imagine but Iraq may just have been the “opening act.” While I truly prayed the people of Iraq could be free to live from under Saddam the tyrant, what’s unfolding there now may end up making him the lesser of two evils (hard to have imagined). More and more Americans are feeling it wasn’t worth the loss of life and financial costs and that should only increase. Then there’s Iraq’s neighbor, Iran. You know the drill by now- nuclear weapons, oil, a man leading the country who says the Holocaust never took place and Israel should be “moved” a few thousands miles. Iran is going to be more and more in the news as the U.N. (you know, that place that loves America) is about to take up the issue of nuclear weapons.

It may be a good or bad thing, but a senior Israel Defense Ministry official told The Jerusalem Post on Friday that the U.S. has until now not done enough to prevent Iran from obtaining nuclear weapons. “America needs to get its act together,” the official said. This official said only tough economic sanctions and things like not refining Iranian oil will cause the Iranian people to rise up and make a “change” in government leaders. He said it was “pointless” to expect talks to stop Iran from enriching uranium. He claimed they’re just trying to get more time and will continue lying and deceiving the international community while simultaneously trying to obtain nuclear power. Israel’s Defense Minister Shaul Mofaz told reporters in Germany last Wednesday that Israel had all it needed to defend itself against Iran.

Asked by reporters if Israel had a military plan handy in a desk drawer to strike Iran, Nofaz said: “Israel has many drawers containing everything it needs to defend its citizens.” Israel, Mofaz told senior German officials, would not stand by idly while its very existence was at risk. “We do not plan to turn a blind eye to these threats and we will do everything possible to make sure they don’t materialize.”

The Middle East may be grabbing many of the geopolitical headlines at the moment, but I believe by this fall most Americans will have seen the 21st century version of the Hatfields vs. the McCoys here in the U.S. between the Democrats and Republicans. The word dirty will be a weak adjective in describing what the race for Congress will be like. And it will be just the warm-up for the next Presidential race, which if you can get long odds on, take two woman presidential candidates Ms. Clinton vs. Ms. Rice. Washington insiders can attest to the virtual halt in progress in Congress and the Senate on numerous fronts, but especially the one area Greenspan and the President made a big case of in 2005- entitlements.

Gold’s Technical Picture

There’s no denying it, gold now has some important resistance around $570. Even more crucial at the moment is its sitting just above some key support in the $535 area and below its 50-Day M.A. It not only needs to hold $535, but really needs to reverse up and back above $550 ASAP or is in danger of having to test more important support down in the $500-$510 area.

This will definitely cause some readers to gasp, but gold can decline all the way back to its 200-day M.A. at $480, while not violating its long-term uptrend - but it will likely cause a big bump up on calls to suicide hotlines. The fundamentals look far better at the moment so a break down technically should not be cause for changes in long-term strategies.

And Finally on Gold - What Are the Potential Negatives for Gold?

• Physical and investment demand decline sharply even if prices decline.
• A marked increased in Central Bank Selling (I believe they would’ve done so already if they could, especially at the $500 level).
• The ending of the carry-trade greatly lessens purchases of gold (I think it will for commodities in general but gold is the only monetary play among commodities).
• The U.S. dollar rises above 95 basis the U.S. Dollar Index.
• The manipulation argument was all hogwash (yeah and the NY Jets and Vancouver Canucks win the Super Bowl and Stanley Cup, respectively).

© Grandich Publications, LLC 2006

Peter Grandich is Editor of “The Grandich Letter,” published by Grandich Publications, LLC, which provides research, analysis, and investor relation services.