October 2008

Over the past few months, we have witnessed massive liquidation of all asset classes as de-leveraging by huge hedge funds and institutions took place amidst a credit crisis. The increase and speed of the markets’ volatility would indicate a more technical trading environment with fundamentals being pushed aside by fear. Typically during times of economic and monetary uncertainty, a flight to precious metals occurs. This time around, gold-related assets were also sold into the fray, as liquidity became the rule of the day. Cash and U.S. government-guaranteed securities became the assets of choice. This is not to say that there is a newfound belief in monetary discipline within the U.S.; nor is it that the prospects for our fiat currency have improved any … to the contrary. It has become rapidly understood that the U.S. itself is too big (and too indebted) to fail without bringing down the economies of our trading partners. Decoupling between emerging and developed economies will only take place after a sufficient number of participants have achieved “middle-class status” and thereby become more self-sustaining. At this time, emerging economies are too dependent on U.S. consumption and exports for their growth. This is changing, but it will take time. As we have pointed out in previous letters, an artificial demand for dollars around the globe exists because of its world reserve currency status. Expect this too to change in the years ahead once the current financial crisis runs its course, and developing economies become less dependent on U.S. consumption.

Common stock prices have largely been adjusting to a weakening earnings picture as the U.S. grapples with recession and the fears of a souring jobs market. We suspect that consumers will begin in earnest to “tighten their belts” and reluctantly accept the reality of recession as credit availability is reined in. The stock market is generally a front-runner to economic activity and we have witnessed a “crash”. In our opinion, many stocks are selling at very attractive levels to their fundamentals but continue to decline due to the fear and uncertainty as to how long and deep the recession will be.

We generally agree with market commentary that many stocks are oversold at this time. But, we also believe that moving cash back into this market should be done sparingly. The months ahead hold additional uncertainties for the market: a new administration; year-end tax selling; possible changes to the capital gains tax; a worsening jobs picture; rising delinquencies in credit-card debt; an over-stocked housing market with falling prices and rising foreclosures; and so on…

We believe that interest rates at this time are artificially low across the yield curve as the rush to relative safety in U.S. dollars and Treasuries continue. Investors should prepare for the inevitable surge in the cost of selling debt obligations in the future. Foreigners will most likely demand much higher interest rates in order to hold an ever-increasing supply of dollars and any dollar-denominated debt from a government whose balance sheet has replaced good debt with bad.

As for gold, demand for physical bullion is the strongest that we have seen in decades in spite of the dollar price decline. We believe that the basic reasons for the softness in the gold price during these turbulent times are: 1) massive sales of commodity funds (gold derivatives) by institutions, hedge funds, pension funds and the like, and 2) sale of bullion to meet margin calls (forced sales) in a time of “sell not what you want, but what you can.” We believe that much of this de-leveraging has taken place over the past few months, however it could continue into some of the fourth quarter. Once completed, we expect the dollar gold price to resume its upward secular move as the dollar reverts back to its long-term downward trend and continued debasement. The long-term prospects for gold remain extremely attractive, and we would not be surprised to see the dollar gold price above its previous high sooner rather than later.