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Today's Market WrapUp  02.13.2003  Mon  Tue  Wed  Thu  Fri  Puplava Archive

Possible Cause or The Gold Trend is Your Friend
BY JAMES J. PUPLAVA, CFP

Gold as an investment class has finally gotten the attention of the investment world. Even TV anchors can no longer ignore it. With the exception of one week, the price of precious metals has been launched into space for nearly 10 consecutive weeks. Then, just as quickly, the price of gold shed almost $28 an ounce.

Many new gold investors, as well as some not so new, seem puzzled by gold’s sudden drop–especially now when the fundamentals for gold and silver have never been better. Gold and silver demand is outstripping supply. The upcoming war and possible terrorist attacks that are expected to follow have added political uncertainty to gold’s fundamental demand. On the financial front most importantly, we have a declining dollar. For the fourth consecutive year, our stock market is at a loss in the U.S. The economy seems to be drifting and along with it, corporate profits. On the monetary front, the money supply continues to expand at a high rate. Fed officials have made it well known that they will burn the currency if necessary to keep the markets liquid and America’s climbing debt pyramid from imploding.

All of these factors are favorable for gold and silver. So why the drop in metals since February 4? There are several factors behind gold’s decline of which anyone of them or a combination of any of the above can explain gold’s pullback. There are four principal explanations are as follows: 1.  Technical correction 2.  Short positions in bullion and equities 3.  Planned intervention 4.  Fundamental valuations Reason #1  Technical Correction Let's start with the first and obvious one which is the technical side of gold. After going up for nearly 10 consecutive weeks, gold was subject to the laws of gravity. What goes up does come down. Besides going straight up, the $400 level for gold is a key resistance area. For once it breaches this level, then it is high ho silver for the metals markets. Round, even and century-type numbers tend to be areas of resistance and support once they are broken. As the long-term chart of gold, courtesy of Topline Graphics indicates, gold doesn’t run into stiff resistance until you get to the $500 level. There is minor resistance at the $415-418 level as shown on this chart. However, once gold blasts through those levels, then it should be on its way to $500. When gold hits $500, it will be on everyone’s radar screen including John Q. At $500 an ounce for gold, even John Q will know that the investment markets have changed and there is a new bull in town. The financial elites on Wall Street would not like to see this to happen. Meanwhile, technically what goes up quickly, as shown in the channel trends in gold over the last two years, does come down and correct. The upward channel in gold has expanded as shown in the top green line trend. It is only natural that gold would pull back. At the moment, the market is telling us that this is a normal pullback. Possible retracement levels are shown on the bottom left. What simply needs to be understood is that after the price of anything has run up, it is normal for prices to pull back and consolidate before building strength for its next assault at higher prices. It is like a long distance runner who slows down his pace in order to conserve energy before climbing another hill. A reading of long-term, monthly, weekly, and daily charts all indicates the new bull market in gold remains intact. [See Kitco's Live Gold] Nothing goes straight up. It doesn’t matter whether it is stocks, bonds, currencies or commodity prices. Strong market moves are always subject to countervailing trends–both intermediate and minor. A fundamental rule of technical analysis is that a trend is assumed to remain in effect until that trend is reversed. Until some external force causes this trend to change, as long as primary trends as shown in trend lines on a chart aren’t violated, then the proper assumption is to assume that that trend remains in force. Today a primary bull market trend remains in force for gold. For stocks, it is just the opposite. Stocks are in a primary bear market and in my opinion, that primary bear market will soon turn into Ursa Major.

Reason #2  Major Short Positions
The second possible reason for gold’s pullback is that there are major short positions in both bullion and precious metals stocks. The big boys are short bullion and precious metals. The short sellers range from hedge funds to major Wall Street players. Nobody ever reveals their short positions. Those who have held short are known only by the firms they deal with. Many hedge funds have multiple accounts off shore and deal with different entities in placing their short positions. The positions are large, so one can safely assume that John Q and his neighbors, Larry Lawnmower or Herbie Homeowner, are putting on those short positions. Listed below are the COMEX short positions as of last week. The Commitment Of traders Report is released each Friday with positions reported as of Tuesday of the same week. The short and long positions by investment group are as follows:

Short and Long Positions in Gold & Silver

One obvious observation is the big boys, otherwise known as commercial hedgers, are short in a big way–both gold and silver. Another observation is that there is not enough bullion on the exchanges to handle long positions, especially if longs demanded delivery. This is especially true in silver where the short position is or at near-record levels. The little guy is getting squeezed not realizing that those who are squeezing them are the ones that are most vulnerable. If the small trader demanded settlement in bullion, it would be all over for the silver shorts and the same for gold. It may be one reason with gold’s recent run up that Exchange officials have increased margin requirements by 50%. This affects the small trader more than it affects the big boys. The big boys are better capitalized and have access to large lines of credit. The small trader is not in the same position. The hike in the margin requirements may be the first sign of a Vesuvian tremor that may be ready to erupt. The shorts are vulnerable if bullion prices erupt–or even worse–if the small trader finally wakes up to the fact that the emperor has no clothes.

Instead of being played like a fiddle, the small trader may one day eventually wake up and realize how vulnerable the shorts are and start demanding delivery. If that ever happened, I believe they would close down the exchanges and go to a cash market. There simply isn’t the physical inventory to handle investment demand or cover short positions if physical delivery is demanded. Most transactions are settled in paper or cash. Therefore, paper has been able to control the physical markets rather than the other way around through leverage. That day may be coming to an end soon as all three of my storm fronts increase in intensity in the currency markets, financial markets and in the economy.

Reason #3 Intervention
The third reason why gold may have pulled back as quickly as it did is that there appears to be intervention of one sort of or another in the currency market, stock market and in the metals markets. A good example is in the graphs of all three major averages today. Notice the flagpole rallies that took place around 2:30 and 3:30 PM today on all three exchanges. They couldn’t quite pull it off, but they managed to turn around triple-digit losses in the Dow to only an 8-point loss. The explanation as to why the stock market turned around in such a sharp and abrupt manner is that investors did some last minute bargain shopping. Do they really think investors have been dumped down so much to find this credible? Whoever this big player is, they telegraph their moves openly. This is the opposite approach of an investor who wants to buy stealthily at lower prices.

I would suggest that the reader peruse Fed position paper No. 641, July 1999, and the speeches of Greenspan and Bernanke given last November. I don’t pretend to have contacts at the Fed, privileged information or access to government officials running the Exchange Stabilization Fund. The Fund’s name speaks for itself. Nevertheless, nothing is acting normal these days in the currency markets, the bond markets or the stock market, and at times in the precious metals markets. The Bernanke speech references actions taken in the past to fix interest rates through intervention. It also makes mention of doing that again. It should come as no surprise given these statements and the financial community's support behind it that this may indeed be taking place now. These thoughts are just personal conjecture, but are based on observation and studying statements made by key Fed officials. Intervention never works when a government tries to alter the direction of the markets. In the end, the markets will have their way. This has been proven time and time again throughout history. It is a lesson that every government has to learn. There are consequences when a government  borrows, spends and lives beyond its means. The markets in the end are the final arbiter and restorer of equilibrium. However, governments over time never accept this fact, so they are doomed to repeat and relearn the lessons of history.

Reason #4 Fundamental Valuations

A final reason behind part of the decline in precious metals equities has more to do with valuation concerns. Unlike most common stocks that are valued on the basis of P/E multiples, dividend yields and book value, mining companies are valued differently. A mining company is the ultimate option on the price of gold or silver. That is because the earnings of a mining company are leveraged to the price of the bullion. Since most of the cost of mining gold and silver is fixed, a movement up or down in the price of the metals impacts the bottom line directly. If a mining company can mine gold at $250 an ounce and gold is selling at $300 an ounce, it earns a $50 profit. If the price of gold were to rise as it has from $300 to $357.60, that extra $57.60 is pure profit. The rise in gold goes directly to their bottom line.

It is important to keep this in mind when you see the price rise for bullion. The rise in price also makes the reserves (gold or silver in the ground) that the company owns worth more. Think of a mining company as a warehouse full of gold or silver. That warehouse represents the company’s inventory of product it has to sell. If the price rises, it doesn’t cost the company any more money. That price rise is pure profit. So when prices rise, the entire value of inventory in the company warehouse is worth more money. A rise in price thus affects profits and the value of the company’s inventory of assets known as reserves. That is one reason why precious metals stocks usually move up more than the price rise in the bullion.

Therefore when evaluating precious metals stocks, key yardsticks of value are the amount of reserves of gold or silver the company owns. Based on those reserves, two additional valuations can be made based on those reserves. They are market cap per ounce of reserves and market cap per ounce of production. You can compute these values by finding the company’s market cap, which is the current stock price, multiplied by the total shares outstanding. To this figure, you must add the amount of debt and preferred stock issued minus the miner's net current assets (effectively its cash holdings). This gives you the total capital employed in the business. The denominator part of the equation is the company’s proven and probable ounces of reserves. Dividing the adjusted market cap of a company by total proven and probable (P+P) reserves gives you a yardstick measurement for comparison with other companies. It essentially tells you what you are paying for ounces of bullion buried in the ground.

Mkt Cap/Oz P+P =(Price x  # shares issued) + (Debt + Pfd – Net Current)
Amount of Proven & Probable Reserves

The next yardstick is what you are paying for each ounce of gold or silver produced. The formula for this calculation is the same adjusted market cap used up above. However, this time you want the annual production of gold or silver taken from the latest financial statement. You can use last year's production or this year's forecast. It is similar to using trailing earnings or projected earnings for a company. The formula is as follows:

Mkt Cap/oz prod= (Price X # shares issued) + Debt + Pfd –Net Current)
Total production last year or production forecast this year

Various analysts use different methods with the standard based on this year's production forecasts. However, by using these yardsticks, an investor can usually find out if the company stock price has gotten way ahead of itself in relation to price per reserves and production. It becomes a metric of measurement of value. Technicians may pay little heed to this approach and simply follow chart and momentum. However, sometimes when stock prices aren’t reacting to bullion in the way that is expected, this is one area that might give you a clue and forewarning that share price has gotten ahead of itself.

There are other yardsticks that I could cover, but that will be left for another time. There are major improvements in the works that will be added to our precious metals resource page in the months ahead.

The point that needs to be understood is that even mining companies have valuation metrics that every investor needs to understand–regardless of which camp you belong to in the investment arena. There are times such as this that many of the top performers have gotten ahead of themselves and it may be one reason they are breaking down. There are several attractive bargains at the moment where the market cap per ounce of reserves is way below the price of gold; while some of the top performing gold stocks over the last six months are now selling at levels that don’t make business sense. Valuations will always come into play at some point or another and the investor should become knowledgeable of these factors.

In summary there are many reasons why the price of gold has pulled back temporarily in my opinion. It may be one of those above or a combination. The reader can draw his own opinions, but I think all have played a role. Intervention may have taken place to cap the price, short selling is certainly a factor, and technical barriers and a strong run up that lasted ten weeks has been another.

Today's Market
Now to today’s stock market and its miracle recovery from the abyss. The markets fell for the seventh day out of eight with investors ignoring favorable reports by government on the economy. Retail sales last month rose if you exclude autos. There are always excludables in government reports these days and Wall Street earnings forecasts. Auto sales weren’t what they should have been, which means the buying binge by debt-happy consumers may be coming to an end. The unemployment claims were less than expected. The markets ignored this piece of good news and instead focused on the coming war with Iraq. The Secretary Colin Powell and U.K. Prime Minister Tony Blair have disclosed evidence of Iraqi missiles that exceed the permitted range under U.N. resolutions. It now appears that war is imminent.

The markets traded down on these fears with the Dow losing well over 100 points. Lo and behold, there occurred another miracle recovery in the final 90 minutes of trading with two separate buying charges into the markets as shown in the graphs under intervention up above. The major averages squeaked by with only minor losses. The Dow and the S&P 500 are down over 7% for the year and the NASDAQ has lost over 4%. Dell reported better-than-expected earnings after the market closed. However, the company CFO said “We don’t expect near-term improvement in the industry.” PC shipments outside of Dell grew at only a 1% annual rate in the fourth quarter. In other earnings news, Office Depot cut its 2003 profit forecast, CenterPoint energy lost $.03 instead of making money, and McKesson Corp, the third largest U.S. drug wholesaler, is being investigated by federal prosecutors for its sales and marketing practices.

Volume hit 1.46 billion on the Big Board, the most this month and nearly 10 percent above the three month average. Volume on the NASDAQ was 1.33 billion shares. Market breath was negative by 19-13 on the NYSE and the NASDAQ. The VIX ended the session at 38.45 and the VXN popped up to 50.97.

Ten Sigma Warning
One of the key assumptions to my next Storm Watch Update on unexpected events is an attack on the world’s oil infrastructure. Like my Perfect Financial Storm installments Rogue Wave/Rogue Trader 1 and 2,  the unexpected will come from the same likely corridors of an asymmetric attack and a possible derivative implosion. I gave a detailed seminar on this subject recently that will be incorporated into Ten Sigma, which will be written in two installments because of the scope of the subject matter. I’ve written on this issue in the past in several of my past Market Wrap Ups of which two have been archived from last November [11-19-2002 and 11-20-2002].

One of my key predictions is that the terrorists are going to go after the oil infrastructure in the world. This includes refineries, oil transportation choke points and pipelines. Today ABC News broke a story of a foiled Al-Qaeda plot designed to cripple the Saudi Monarchy and the US economy by attacking the largest refinery oil refinery in the world Ras Tanura in Saudi Arabia. [See al Qaeda's Oil Plot] Since there is a possibility that many of the ten sigma events may happen before I have the chance to write about them, please read my past Wrap Ups links above, and listen to my interview with Neil Adams and my radio broadcast “Terrorism & Oil “ from last November. This will give you an advance look at what I will detail in Ten Sigma.

Have to go. Today is turning out to be an all-nighter, so I must end and be brief or this will never get out on the web!

Overseas Markets
European stocks slid as the Bank of England said the risk of war in Iraq will stunt economic growth in the region's second-largest economy. British Airways Plc declined after the U.K. government ordered the army to guard London's Heathrow airport against terrorist attacks. The Dow Jones Stoxx 50 Index slipped for a fourth day in five, shedding 2.1 percent to 2177.13. The Stoxx 600 Index dropped 1.8 percent. Both have lost more than 8 percent in 2003 amid concern a U.S.-led attack on Iraq would hurt consumer spending and crimp company profits.

Japanese stocks rallied as the Nikkei 225 Stock Average posted its biggest gain in seven weeks. Honda Motor Co. and other exporters rose as a drop in the yen in the past two days raised optimism for higher overseas sales. The Nikkei rose 2.1 percent to 8664.17. The average recorded its biggest gain since Dec. 26. The Topix index added 1.7 percent to 857.23, with automakers and computer-related stocks accounting for a quarter of its gain.

Copyright © 2003 Jim Puplava
February 13, 2003

Charts courtesy of www.stockcharts.com, www.bloomberg.com and www.toplinecharts.com

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