 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
E-Mail: kjgco@att.net
Website: www.kengerbino.com
321gold Inc
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