Investing Caffeine

Gold Market Lunacy Kicking Into Gear

So wait a second, let me get this right. A company pays billions of dollars to buy insurance, and then decides to sell $3.5 billion in dilutive ownership rights (current stockholders losing more than 10% of their ownership) so that they can pay somebody else another $5.6 billion to take that same insurance they previously loved away. In my book, I call that lunacy. This madness is exactly what Barrick Gold (ABX) just decided to do. The world’s largest gold miner issued approximately 95 million common shares at $37 per share to remove gold price hedges (used to lock in gold prices at a certain level), so if gold prices spike Barrick will now be able to participate fully without the drag of the hedges.

Effectively, management has decided to turn the mining company into a Vegas casino, where shareholders can now freely speculate in the price of gold without the volatility reducing hedges in place. Does this outlandish behavior signal a top in gold prices (now hovering around $1,000 per ounce)? I’m not stupid enough to call the end of frothing, speculative behavior – just witness Alan Greenspan’s “irrational exuberance” speech in 1996 when the NASDAQ traded at 1,300 (then went on to peak above 5,000). But what I am bold enough to do is call a spade a spade and to point out how ridiculous this reverse hedging activity is.

Other signs of speculation beyond the 4x price increase over the last 8 years or so, is the fact that gold prices have risen in the face of incredibly weak gold jewelry demand, -22% year-over-year globally in Q2 according to the Gold Demand Trends. This leaves the remaining demand coming largely from speculators and global central banks. If you need more evidence for the gold speculation, just turn on your local AM radio station and listen for the endless number of get-rich-quick on gold advertisements – some stations need to fill the gaping hole once held by those advertisers hawking mortgages.

From a gold investors’ perspective, I would say I fall more into Warren Buffett camp of thinking. Unlike other commodities (some of which I believe will be driven upwards by my emerging market demand and other forces) , gold is something dug up from the dirt in South Africa, melted, transported to another hole, buried in the ground (central bank), and then storage costs are incurred to guard the shiny metal. Sure, jewelry and small commercial applications are drivers for real demand, but the majority of demand is derived from intangible desires. Other commodities, for example oil, copper, uranium, and natural gas offer a lot more utility.

So what’s next when it comes to the price of gold? Peter Schiff an uber-gold bull broker at Euro Pacific Capital believes Armageddon is coming for the U.S. economy and hyper-inflation will drive gold upwards to the $4,000 per ounce price range (See How Peter Schiff’s Other Forecasts Have Performed). Another possibility to consider is a complete collapse in gold prices (and surge in the dollar) like we saw in the early 1980s after Paul Volcker raised interest rates and gold prices did not appreciate for a 25 year period. Hmmm, I wonder what direction interest rates are going next with the Federal Funds rate currently at effectively 0%? Could we see a repeat of the early ‘80s? Seems like a possibility to me. Certainly if you fall into the civil unrest, soup kitchen, and bread line camp, like Schiff and other U.S. bears, then piling into the diluted Barrick Gold shares may not be a bad strategy.

Inflation

Given the massive stimulus, debt loads, money supply growth and legislative agendas currently in place, inflation is a major medium and long-term concern. My remedy is government guaranteed Treasury Inflated Protection Securities (TIPS) that not only compensates investors with interest payments (unlike gold), but will also see principal values increase in tandem with principal if inflation indeed rears its ugly head. For those conspiracy theorists that believe the Consumer Price Index (CPI) is rigged, there are alternative international flavors of TIPs that reset according to other inflation benchmarks. As a kicker, some of these particular securities offer a hedge against a sliding U.S. dollar, which may or may not continue.

So as I lie in my recliner with my popcorn and TIPs, I’ll watch Barrick and other speculators continue the gold buying frenzy, wondering when and how ugly the gold finale will be?

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management and client accounts do not have direct long or short positions in ABX or gold related securities or BRKA/B at the time the article was published. Sidoxia Capital Management and its clients do have long exposure to TIP shares. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

September 14, 2009 at 4:00 am 1 comment