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Three Myths Confusing Gold Mining Investors

Kenneth J. Gerbino
Kenneth J. Gerbino & Company
Investment Management
July 26, 2004

Information and ideas that are not true can still gain confidence among many professionals.  In the investment field, the more you grind down to truths the better off you are.

Below are some myths that are confusing and misleading gold investors and the so-called hard money camp. I might add the economists from Harvard to most of the big Wall Street firms are confused on some of these points also.  Before we start, some definitions regarding the money supply.  M1, this is the money supply number that consists of cash plus checking accounts and travelers checks. M2 equals M1 plus retail money market funds, savings and small time deposits. M3 equals M2 plus large time deposits, Eurodollars, and institutional money market funds.

Myth 1

A large portion of the M3 money supply is not money. The M3 money supply is not an accurate money supply number. It should never be included in any money supply discussions. Money is cash and spendable checking account balances. That's it.

Follow this very carefully. If the butcher takes $100,000 (cash or check) and deposits it in a large time deposit, his bank will report to the Fed $100,000 in a new large time deposit. This will be counted as part of M3. OK so far. Now if this bank lends the same $100,000 to the baker, and the baker decides to buy a Mercedes, then the Mercedes dealer now has the $100,000 and he goes to his bank across town and deposits this $100,000 in a large time deposit, that bank will also report to the Fed $100,000 of M3. The butcher owns a certificate saying he has $100Gs in his bank. The Mercedes dealer also has a certificate saying he has a $100Gs in his bank. The Fed will now count $200,000 in M3. But only $100,000 is really in circulation. The truth is that money circulates and is counted many times because it is not labeled correctly.

The real money supply in this example is the original $100,000 (cash or check). That's it. The second $100,000 that was counted should really be counted as a financial asset (since the Mercedes dealer bought a large time deposit certificate). It should not be counted as money.

A portion of M2 is actually double counted also.

So the question is how much have the powers that be increased the "real" money supply in the U.S. Real money being defined as cash or checking account money (the stuff that chases goods and services and creates inflation). The answer is not precise but the amount is most likely very large. M1, which is the real inflation creating money, I have always suspected is much higher than we are told. In fact it actually is, and I confirmed this recently (see below).

I have been using M2 as a gauge of money supply growth, but it also has its flaws. I believe the best guideline is using ratios from the mid 1950's to mid 1970's before money market accounts with check privileges came into vogue and distorted and confused the counting of  "money supply" numbers. Back then the average ratio between M1 and M2 was about 1 to 3.  M3 was usually only 10% higher than M2.  These ratios I believe can be used today to get a handle on money growth. Also the Monetary Control Act of 1980, which I lobbied against on many trips to Washington with Congressman Ron Paul, I believe created some backdoor mechanisms to the entire money creation process and this has added to the confusion.

Using the above ratios, the portion of M2 that is actually spendable cash or cash equivalent checking account money might be as high as $3.6 billion and this should actually be counted in M1. If this is true then the bottom line is that the real inflation inducing money supply (M1) in the last 10 years has increased by $2.2 trillion, not the $190 billion increase reported. I spent some time on the phone with a Federal Reserve Board official a few days ago to confirm my findings. What I discovered in the maze of documents that we both reviewed was that I was not too far off.  It appears that there is $1.971 trillion of money market mutual funds buried in M2 and these accounts have check writing privileges, so it is really "real" money. In other words M1 should actually be $3.3 trillion. It is being reported as $1.3 trillion (June 2004). This portion of M2 should be in M1, which is the basic money supply. These numbers imply that a severe and sustained inflation is more likely to occur than most people suspect and is very bullish for gold.

The confusion is that money (cash), credit money (checking account money (demand deposits) lent to you by a bank, under the fractional reserve system or created by the Fed by buying government securities) and financial assets are totally different animals.

This is why when the stock market (stocks are a financial asset, not money) loses $2 trillion because the tech stocks decline or we have a 1987 style crash, it really doesn't affect the price of carrots, pizza or movie tickets. You would think a $2-3 trillion financial hit would create a huge  "deflation", but it doesn't work like that. Stocks and bonds and buildings are assets that can be sold for cash, but are not cash.  Remember the cash you get from someone who buys your stocks or building means that person now doesn't have the money anymore to spend, since he has given it to you. The easy maxim is that financial assets and real assets are not inflationary, and that paper money increases floating around are what makes the prices of goods and services go up. To better understand all this I would suggest grinding through Ludwig Von Mises' Theory of Money and Credit one of the most insightful economic books ever written. Unfortunately it takes many years to honestly get through it. Some pages can take hours to really grasp what he is talking about. But the truth is all there.

Myth 2

A debt collapse is close at hand. and with it a massive deflation.  Someday this could actually happen, but to worry about this now is premature. Consider the following hypothetical scenario: There is a severe recession in the U.S. and there are massive bankruptcies and thousands of banks are about to go under. There is panic in the streets.

The Fed would PR everyone into a one-time increase in the money supply to add liquidity to the system and ease the crunch, turmoil and panic. Let's say they propose a 16% increase in money and credit. Certainly a very large number that would raise a lot of eyebrows but that is what would be necessary according to them to handle all the problems. If they base this 16% increase on the M2 money supply that means the Fed could create one trillion dollars!  I am sure you will agree that $1 trillion would handle an awful lot of debt defaults and banking problems.

Of course this would be inflationary and they would most likely come up with some clever yet reasonably sounding explanation like "this may raise consumer prices but the extra $1 trillion will help productivity, create new jobs and help in capital investments which we feel may actually counteract many price increases etc. etc."

The thing to realize from the above is that this is exactly what they will do. The Fed will create liquidity (cash, credit. whatever it takes) until the cows come home. In order to bail out the establishment institutions, debtors, banks and their savers and everyone who votes. This is inflationary and of course debases the currency and is bad news. It will make gold and silver and the mining stocks go up. Someday, when they print too much money and no one wants it, a total collapse could occur but this may be a long time from now. They will not let the system collapse. At some point in the future they may not be able to do anything, but I think we are many trillions of paper dollars away from that point. Von Mises talks about the end of paper money as the point when everyone knows everything they buy will be selling at a higher price very soon (within days or weeks), therefore everyone spends the cash as soon as possible to beat the price increases. This is when a hyperinflation becomes a runaway inflation and paper money is exposed on the grandest of scales as a fraudulent economic concept.

A deflationary collapse could occur sooner, but it would have to be on the order of many trillions of dollars of defaults and bankruptcies all at once - an economic accident of huge proportions. Therefore I wouldn't bet on a deflationary nightmare just yet, but I still would not take any chances and recommend owning some gold as well as precious metal mining stocks just in case.  As long as they can print money and get away with it, a massive or even small deflation will not take place.

To a gold investor the argument is non-consequential because in an inflation gold is your best bet as it retains its purchasing power. In a massive deflation gold is also your best bet as it is the only money still standing. Either way you are protected.

Myth 3

The gold price is somehow related to the price of oil. Not true. Oil and mushrooms, shoelaces, wheat and beef all have their own demand/ supply dynamics. Gold does too. But gold is also money and until that idea changes, pegging gold to the production of anything (except paper money) can lead to a false conclusion.

Yes, if oil is going up because of "inflation" and corn flakes and everything else are going up.. most likely gold will go up for the same reasons. the depreciation of the money supply. But you could very easily see $25 oil and $50 corn flakes someday because of price mechanisms that are based on supply and demand and that are manifesting themselves independently of currency depreciation and have nothing to do with gold.

There are over 1000 commodities. I am sure we could all produce a few graphs that trend to gold and then we also could go off into the world of false correlations. As a commodity, oil does deserve to be included in any inflation discussion, but if oil goes down to $25 a barrel but 200 other commodities go up in price I wouldn't bet on gold going down because it was linked to oil - and the opposite is true as well.

I hope the above explanations help you.

In the final analysis I think gold mining shares should be on the top of anyone's investment list. I expect the summer to be more or less quite for the mining shares. Canadians who dominate the global mining professional circles usually freeze so much during the winter they take plenty of time off in the summer when the sun is out. The brokerage and investment industry does the same. Europeans, traditional gold investors are also gone for the summer. The summer is usually a good time to accumulate shares on sell-offs.

A recent extensive survey of Global Fund Managers by Merrill Lynch had 10% reporting that they thought inflation would be "a lot higher" in one year. There are tens of thousands of fund managers globally. If 10% of this group decides to start buying gold mining stocks, as a hedge against this expected "lot higher" inflation rate then a very strong demand will develop in this sector. This is what I expect.  Since the inflation cycle is just starting, I am sure the number of managers that start seeing the trend will swell in the months and years to come. This will be a lot of buying power coming into the gold mining shares.

Our portfolios are currently overweighed towards mining companies with large billion dollar developmental projects. These are companies that have very large and very well defined deposits of mostly gold and silver, some with copper, zinc and lead as well. This group looks better valued at this time than the large producers. Both categories are a good idea, but right now I would add weight towards the developmental sector on sell-offs.

The game that has now presented itself to the powers that be is a tough one. How can they continue to print money when inflation has clearly reappeared yet how can they not print money when it is necessary to keep interest rates low to bail out the huge debt burdens that are everywhere. It appears their only solution is gradual rate hikes and plenty of new money at the same time. It means more inflation and more money creation. Long term bullish for gold mining shares.

Good Luck...

I am giving a talk at UBS PaineWebber in Beverly Hills on August 3rd. at 1:30 p.m. on Gold Mining Stocks. RSVP to Jason at 310-281-3860 if you are interested.

For other articles on gold and the economy please visit our website.

Kenneth J. Gerbino
July 26, 2004

Kenneth J. Gerbino & Company
Investment Management
9595 Wilshire Boulevard, Suite 303
Beverly Hills, California 90212
Telephone (310) 550-6304
Fax (310) 550-0814

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