GOLD'S FUTURE? FOLLOW THE FUNDAMENTALS

By Mark Albarian, Executive Chairman

For example, during our current bull market, gold retreated from $725 per ounce in May 2006 to $560 per ounce in October that same year.

However, gold then resumed its upward trajectory, rising to $1,030 per ounce in March of this year. We saw similar shifts during the 1970's gold bull market before gold reached its then all-time high of $850 per ounce in 1980 (adjusted for inflation, gold would have to rise to over $2,000 per ounce in today's dollars to equal the 1980 high). No market moves in a single line. Nonetheless, between 2001 and 2007, gold has consistently gained each year. So far, 2008 has seen considerable movement and consolidation as investors attempt to digest the impact of the global credit and housing crises.

What does the future hold for gold? In my view, there are three factors which are bullish for the yellow metal.

INFLATION

The authors of a research study entitled Short-Run and Long-Run Determinants of the Price of Gold concluded, "long-run investment in gold appears to be a very effective long-run inflation hedge in the United States." Levin, Eric J and Wright, Robert E., Short-Run and Long-Run Determinants of the Price of Gold (World Gold Council Research Study No. 32 2006). The relationship between inflation and gold has been echoed by fund managers, analysts and financial advisors who often point to inflation as a significant driver for gold. Financial analysts and editors of the Aden Forecast, Pamela and Mary Ann Aden, probably summarized this relationship best when they wrote, "Gold loves inflation."

Between June 2007 and June 2008, the consumer price index, or CPI, in nearly every measured category was up considerably. For example, food was up 5.3%, transportation was up 12% and energy
was up 24.7%.

"Consumer prices advanced at a seasonally adjusted annualized rate (SAAR) of 7.9 percent in the second quarter after increasing at a 3.1 percent rate in the first three months of 2008. This brings the year-to-date annual rate to 5.5 percent and compares with an increase of 4.1 percent in all of 2007."

U.S. Bureau of Labor Statistics, Consumer Price Index: June 2008.

In ordinary times, the Federal Reserve would respond to inflationary concerns by raising interest rates and restricting the money supply. However, the economic crisis gripping the world may remove this traditional inflation fighter from the Fed's limited arsenal.

The U.S. economy is in peril with growing unemployment, a floundering factory sector and a housing market that remains in crisis. Economists polled in August by the Blue Chip Economy Indicators newsletter saw virtually no growth in the U.S. economy through the end of this year and very limited growth in 2009.

Although the Fed has suggested it may raise interest rates in the future to combat inflation, restricting credit may further weaken an already precarious economy.

Clearly Wall Street fears any rate increase. When the Fed chose to keep rates steady at its August meeting, the Dow rose more than 300 points in response.

An August survey of banks by the Federal Reserve found that a record percentage of banks were making it more difficult to borrow money.

"The survey shows little appetite at banks to lend for home mortgages, credit cards, home equity loans, commercial real estate loans, or commercial and industrial loans. No bank in the survey eased credit terms for any type of loan in the past three months, and only one bank said it anticipated easing standards for consumers in the next 12 months. Tighter credit could slow economic growth, especially consumer spending, economists say. Lack of credit could sink the commercial real estate market, and curb capital investments by businesses."

"Credit Squeeze Getting Worse," MarketWatch (8/11/08).

Given these circumstances, the Federal Reserve would be hard pressed to further tighten credit to combat inflation. To the contrary, recent history demonstrates the Fed's reaction to a slowing economy is to lower interest rates. If the Federal Reserve follows form in coming months, one would expect inflation to increase and, with it, the price of gold.

Oil

Gold prices traditionally follow oil prices. As oil prices increase, investors often turn to gold as a safe haven asset. (Goldline's Senior Vice-President, Robert Fazio, discussed the oil-gold ratio in the Summer edition of the American Advisor.)

Oil reached record highs in 2008, nearly doubling the 2007 average of $72 per barrel. Even with recent price drops, oil remains above $100 per barrel.

Some politicians and oil producers, anxious for a scapegoat, have argued that speculators were responsible for oil's recent record-breaking increases. However, the Commodity Futures Trading Commission (CFTC) stated that fundamental supply and demand issues were the "best explanation" for crude's ascent. These same supply and demand factors are likely to send oil prices to new highs in the future.

According to the International Energy Agency, world oil consumption is expected to rise by 50% from 2005-2030. Thus, global energy demand will grow despite the sustained high world oil prices that are projected to persist over the long term.

The third world is quickly becoming the largest consumers of petroleum. Given China's oil growth rate of 6% to 7% per year, it is estimated China will use 20 million barrels a day by 2020 -- about the same as what the U.S. uses today. By 2030, China would be up to 40 million barrels per day -- twice what America uses now. India, the second most populous country in the world, is expected to have the second highest growth in oil consumption, increasing at an annual rate of 5.5%.

While demand grows, production has fallen behind. The CFTC stated: "World oil consumption growth has simply outpaced non-OPEC production growth every year since 2003." Unfortunately, "since 2003, OPEC oil production has grown by only 2.4 million barrels per day while the ‘call on OPEC' (defined as the difference between world consumption and non-OPEC production) increased by 4.4 million barrels per day. As a result, the world oil market balance has tightened significantly."

Perhaps even more concerning, there is a growing dependence upon Middle East oil to fuel the world's oil needs, according to a report by the Institute for the Analysis of Global Security. That same report quoted the Chief Economist of the International Energy Agency who said, "We are ending up with 95 percent of the world relying for its well being on decisions made by five or six countries in the Middle East."

There seems little doubt that OPEC and these Middle East countries are committed both to high oil prices and to promote their own agendas and influence in the world. Further, geopolitical tensions and strife in the Middle East can easily propel oil prices higher.

For those who speak of a commodities bubble, which includes both oil and gold, consider what Jim Rogers, co-founder of the wildly successful Quantum Fund,told the Wall Street Journal.

"‘I've been hearing the commodities bubble is dead for seven years,' he says. ‘Maybe it will end, but I don't think it will be for another several years,' he says. The market is simply consolidating, he says. He points out that investors wrote off gold because it reversed a climb upward in the 1970s for two years. But then it went on to much greater heights."

"Oil Goes to the Bears," WSJ, (8/12/08).

U.S. Dollar

As the dollar weakens, dollar priced assets such as gold become more attractive investments to holders of stronger foreign currencies. Further, those people and institutions holding dollars seek to diversify themselves out of their dollar based assets, often turning to gold for its value as an inflation hedge.

Thus, gold generally benefits from a weaker U.S. dollar.

Americans have watched the dollar fall over the past few years as more and more dollars are printed and our government incurs more and more debt. Since its inception in 1973, the U.S. Dollar Index, which measures the dollar against a basket of foreign currencies, has dropped from 100 to around 79 points.

Over the past seven years, federal spending has grown at a 6.2 percent nominal annual rate while receipts grew at only 3.5 percent. The 2008 budget deficit is expected to be $410 billion-a $600 billion swing from our budget surplus eight years ago. The administration forecasts the 2009 budget deficit to reach a record $482 billion. This number assumes no government bailouts, stimulus packages or other significant spending plans required by national or world events.

Our greatest spending and most significant threat to the dollar, however, lies with what is referred to as "unfunded liabilities"; those future liabilities for Social Security, Medicare and Medicaid for which we have no offsetting asset or revenue.

Estimates of these unfunded liabilities place the number at $99.2 trillion. This is equal to $330,000 for every person in America, or $1.3 million for a family of four. To fund these programs through taxes, the federal government would be required to increase taxes by 68 percent. Alternatively, the government could cut discretionary spending (things like defense, national security, education, etc.) by 97 percent.

The Government Account Office wrote in The Nation's Long-Term Fiscal Outlook (April 2008 Update):

"...the long-term fiscal outlook is unsustainable... Despite some improvement in the long-term outlook for federal health and retirement spending, the federal government still faces large and growing structural deficits driven primarily by rising health care costs and known demographic trends."

Our appetite for debt is funded in large part by foreign governments and investors. China alone has approximately $1.7 trillion in foreign reserves, the majority of which are dollar based assets. Saudi Arabia is reported to hold $800 billion in U.S. dollars. Should these countries choose to diversify out of dollars either for economic or political reasons), the dollar will lose key support.

In some respects, a weaker dollar actually benefits the U.S. economy. Exports have increased and the trade deficit reduced as U.S. goods are cheaper for foreign consumers. Thus, our gross domestic product (GDP) is currently bolstered by the weaker dollar. Therefore, the government may be motivated to keep the dollar weak to foster foreign sales, especially given the weakness in our economy.

The former president of the National Bureau of Economic Research told Bloomberg radio, "‘Market pressures over time are going to put downward pressure on the dollar... A more competitive dollar has been the driving force in keeping gross domestic product expanding.'" Harvard's Feldstein Says U.S. Dollar Has Further to Decline, Bloomberg.com (8/11/08).

These same pressures, along with rampant government spending, are, in my opinion, likely to keep the U.S. dollar weak for the foreseeable future. As a consequence, investors will turn to gold to diversify their portfolios.