Overnight Report 25 May, 2005 Goldfinger Tim Drayson ABN AMRO Equities UK Limited 27 May, 2005 Last week I suggested an overweight cash position. Both bonds and equities have since rallied. Rule one: do not listen to economists for short-term trading tips. With this risk warning, I am now going to discuss gold and particularly gold mining equities leveraged to the gold price. Gold is a lousy investment, but a good insurance policy which you hope you don't need. It pays no income or dividends and over the last 25 years it has failed to keep pace with inflation. (Though it has over a longer time period). Under normal circumstances I would stay well clear. But as we set out in 'warning flares' on 2 May, today's environment is more like the 1970s. Once freed from the shackles of a fixed price, gold rose from $35 in 1970 to over $800 in early 1980, as investors shunned equities and paper assets in favour of a store of value. Currently, gold has lost its investment status. It behaves like a commodity. But unlike other metals, mine supply is contracting and demand is fairly non-cyclical. Its price is set globally, but quoted in dollars. So movements in the trade-weighted dollar index tend to be reflected in the gold price (R2 = 0.93 since 1 Jan 2002). Gold is a hedge against inflation, as a weaker dollar tends to signal higher global inflation as the rest of the world is forced to reflate. Conversely, the recent flattening of the US yield curve is a deflationary signal and negative for gold. In dollar terms the gold price has risen 50% since 1 Jan 2002, but for European investors the return has been a mere 6%. So buying physical gold has been fairly pointless unless you are a US citizen or your currency is linked to the dollar. But if you bought gold mining equities leveraged to the gold price, then it has been possible to make a good return. The types of companies one could look for are those with unhedged future gold sales and with their cost base in US dollars or similarly weak currencies. The case for medium term dollar weakness is overwhelming. A benign rebalancing of the US current account deficit will require a further substantial fall in the dollar. This should be supportive for the gold price and gold equities. But I think we are heading for a disruptive adjustment and serious dollar weakness with the Fed printing money to prevent an asset price collapse. In this environment gold could perform spectacularly. Since my job is closely linked with the stock market performance, I have already taken out my insurance against armageddon! Going for gold click on images to see the charts - - - > The 1970s are best forgotten, but the bull market in gold was memorable. It culminated with the spectacular quadrupling of gold prices in the year to January 1980. Since then it has been downhill most of the way. The bear market ended during 2001 and gold prices have recovered to over $400 an ounce today. Yet this is still only around half the record high. In real terms (deflating using US CPI) the performance has been dismal. Gold has failed to be a good store of value. Though over longer time periods it has kept pace with inflation. But 25 years of macroeconomic stability are now under threat and gold could benefit. The weakness of the dollar has driven the rally in gold prices since the start of 2002. The gold bugs hope that gold will eventually decouple from the dollar. This would make holding physical gold rewarding. But for this to happen I think it would require a financial crisis. Something I certainly don't rule out. But the investment case for gold stocks does not require a financial meltdown. The dollar is likely to decline over the medium term as this is a vital part of the adjustment of the US currentaccount deficit. Without a change in exchange rates and in the absence of a serious US slowdown, the currentaccount deficit and external debt are both on an unsustainable path. But in the short term, our equity strategists warn of potential dollar strength if the carry trade continues to unwind and short dollar positions are covered. So further turbulence for leveraged funds could put more downward pressure on gold stocks. The XAU index (a market cap weighted index of nine gold and silver mining companies) has under performed the gold price in the last few weeks. Previously, the XAU index has always reverted to the gold price. But the general commodity price boom has pushed up wages in the mining sector and the rising cost of oil has also undermined profitability. My final chart shows that over the last 10 years, US gold and silver equities have generally been negatively correlated with US equities. It is only since 2003 that both indices have risen together. When dollar weakness causes the long end of the US yield curve to rise, it is likely the negative correlation will resume again. Tim Drayson ABN AMRO Equities UK Limited +44 20 7678 7339 email: tim.drayson@uk.abnamro.com website: www.abnamroresearch.com DISCLAIMER APPENDIX © Copyright 2005 ABN AMRO Bank N.V. and affiliated companies ("ABN AMRO"). All rights reserved. This material was prepared by the ABN AMRO affiliate named on the cover or inside cover page. It is provided for informational purposes only and does not constitute an offer to sell or a solicitation to buy any security or other financial instrument. While based on information believed to be reliable, no guarantee is given that it is accurate or complete. While we endeavour to update on a reasonable basis the information and opinions contained herein, there may be regulatory, compliance or other reasons that prevent us from doing so. 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