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Economics: Gold: The Shine is Back!
New York: September 22, 2004
By John R. Stephenson

Lately, gold has been on a tear. The former currency and precious metal has zoomed in the past few weeks and now trades at $447.10/ounce. In May of this year, gold was trading for just under $380/ounce (representing a 17.6% price increase in the past six months). The reason? The poor performance of the U.S. dollar.

No other factor is as significant for strong gold prices as the devaluation of the U.S. dollar. On a trade weighted basis, the U.S. dollar has dropped some 4.8% since May and 3% since the end of June. But just why is the dollar under pressure? Because of the massive IOU's that the U.S. government has racked up in both the government deficit and the current account deficit (exports minus imports) that at its present level of 6% of GDP is unprecedented. The problem? As a nation, we are spending more than we are making, with foreigners bridging the gap and extending us the credit to keep on spending. Not only are we spending like fools, but our savings rate has plummeted to 0.2% of disposable income - down from 7.7% in 1992. As Morgan Stanley's chief economist Stephen Roach writes: "The day will come when foreign investors simply say 'no' to this arrangement - refusing to fund America's consumption binge without getting a meaningful concession on the terms of the financing. That's when the dollar collapses, U.S. interest rates soar, and the stock market plunges."

In a recent visit to Frankfurt Germany, Alan Greenspan, chairman of the Federal Reserve, commented to a banking conference that: "the United States should cut its record budget gap and narrow its current account deficit to avoid the need to offer higher rates (interest) of return to retain foreign investment and painful economic consequences." His comments, when broadcast, caused U.S. markets to take a nose-dive last Friday. He went on to say "an eventual desire by foreign investors to cut the risk of holding too many dollars may lead them away from U.S. assets or lead them to seek higher rates of return." If interest rates rise to encourage foreign investors to buy U.S. government debt, this will send the stock market for a tumble and house prices in reverse. So there it is. The dollar is under pressure because currency traders and investors are worried that the size of our debts is simply too great. The beneficiary of that dollar weakness? Gold, which is regarded as a safe haven during times of economic uncertainty.

With oil prices still high and the Index of Leading Economic indicators falling for five straight months, it seems unlikely that we will be able to grow our way out of this problem. Although the treasury secretary, John Snow, has said that the administration is in favor of a strong dollar, the administration has done little, if anything, to support the dollar. No doubt, a weak dollar can work to stimulate the economy in the short-run by making exports cheaper and imports more expensive. Although the value of the currency may bounce around over the intervening months, it seems a safe bet that the trend is toward a lower not higher dollar in the years to come.

This is good for gold whose fortunes are closely tied to a falling dollar (correlation of 0.90). With a faltering economy and a weak currency, people tend to lose faith in paper assets and move into real tangible assets such as gold. Investing in gold companies has been tricky because, for most investors, there are all kinds of operational risks such as cost overruns, strikes and political instability to try and figure into the analysis. Buying the metal itself poses problems for investors because you have to store and insure it. Another option open to investors is to buy gold futures contracts (traded on a futures exchange but for future delivery) but that exposes investors to enormous volatility. Luckily, there now exists a way to successfully purchase an interest in gold without the hassles of storage, the operational risk issues inherent in buying gold stocks and the volatility associated with the purchase of gold futures. Last week, a major problem for investors was solved with the introduction of a new exchange traded fund, the StreetTracks Gold Trust (symbol GLD) which allows equity investors to directly track gold bullion. The benefit of an exchange traded fund, such as the new GLD contract, is that it can be bought and sold just like a stock and yet it gives investors direct exposure to the value of the metal, without the need to figure out which companies are best positioned to profit from a rising gold price.

But what are some of the other ways that investors can profit from a falling U.S. dollar? For starters, industries with a large international presence (technology, pharmaceuticals and consumer staples) and commodities (price-setting capacity resides outside of the U.S.) are likely to outperform with a weaker dollar. Basically, the effect of a lower dollar can take the form of a potential benefit to exporters and a potential risk to companies who profit from an increase in capital flows. Sectors such as financials, which are dependent on capital flows, or sectors that are dependent on the domestic market such as healthcare services and consumer cyclicals are sectors investors should avoid. A recent study by Sandford C. Bernstein and Co. found that, in general, a weaker U.S. currency would favor large capitalization companies (over small capitalization companies) who have a large international presence.

For our money, we think that investors should hold at least some exposure to gold and think that the new exchange traded fund (GLD) would be one smart way to obtain exposure to the price of gold without the risks inherent in the more traditional approaches. A well-balanced and diversified stock portfolio with exposure to the energy and commodity sectors more generally should also be a benefit to investors. As well, exposure to the international marketplace, most notably China, which has many more decades of strong economic growth in store should keep investors smiling in the years ahead.

Figure 1. Industries with Above Average Foreign Sales Exposure

Source: Company Data and Sandford C. Bernstein Research

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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