The Room 2/25/08
Dear Readers,

Much to talk about this week. Too much, I fear.

I shall, therefore, endeavor to be succinct, a trait, unfortunately, that I seemed to have misplaced in my formative years.

Even so, as I like to believe that humankind possesses an innate ability to better themselves, I shall buckle down post haste and give it the old school try.

Hey, How 'Bout That Gold?

While it's nice to see things going along so swimmingly for our favorite form of money, even I am a little breathless after gold's surge to yet another record this week. And its kissing cousin, silver, has been no slouch either.

But I am not surprised, given that the precious metals are doing what they are supposed to do. Namely, reacting to the rising tide of inflation now beginning to make itself known here in the U.S. and around the world. This past week, we learned that even the Comedic Politicized Inflation index (CPI) is beginning to slip the leash. As you can see in the chart below from Shadow Government Statistics (shadowstats.com), which tracks inflation the good old-fashioned way -- i.e., the way it was done before all the jiggering - the actual rate of inflation is in a steady upward trend. It is only going to get worse from here.

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[click to enlarge]

On that front, we have been surveying global inflation and finding that, with only few exceptions, the trend I brought to your attention last week holds true... the inflation the U.S. is experiencing is, indeed, worldwide.

That is not to say that there are no deflationary pressures, there clearly are. Much of which is related to the declining net worth of homeowners whose inflated real estate values are headed in the wrong direction.

The result, we believe, will be akin to one of those television commercials where you have, say, a truck carrying chocolates colliding with another carrying peanuts... followed by a smiling bystander, covered in the accidental mix, licking his lips and finding the formula entirely to his liking.

Except that the stagflationary sludge which is coming next - faltering economies concurrent with higher prices -- will be to almost nobody's liking. Unless, of course, you are smart enough to take the necessary precautions and position yourself to profit. That you are reading this is highly suggestive that you belong in that category.

Here Comes the Gold Stocks

While there are a number of reasonable explanations as to why gold stocks have been lagging, I have come to believe that the single most important reason has to do with the fact that the price of gold was still under $280 as recently as January 28, 2002.

Against that number was a cash cost of around $250 per ounce, which was about as low as it could go, on the average, indicating an industry doing everything it could just to survive. Put another way, as a result of the 20-year bear market up to that point, the industry had been beaten down about as far as possible. Therefore, as gold began its upward move, it did so against the backdrop of an industry in mothballs, running on a skeleton staff and highly optimized operations.

This is important on a number of fronts.

  1. Having been trained in the acid bath of razor-thin margins, gold company management teams were intensely skeptical about gold's rising price. They assumed it would be just another bear market trap, ready to punish unwary optimists who went out on a limb by spending money to ramp up production.

  2. I used the phrase above "highly optimized operations." By that I mean the mines were focusing only on the easy-to-mine, higher-grade material that would allow them to produce a return... maybe. It also meant they were extremely frugal, reluctant to buy new equipment, or hire the bare minimum of employees.

  3. Another survival technique was the selling of future production at a set price, a perfectly rational exercise in a bear market, because it at least assured a price that would cover the known costs.

When you add all that together, especially the inherent skepticism of management, it becomes easier to understand why it was that the industry was slow to act even as the gold price started moving up. In fact, it was only in February 2003, with gold trending over $350, that Barrick Gold Corp., the world's largest, began the expensive process of unwinding its hedges. And it wasn't until November of that year that the company announced it was foregoing forward sales altogether and would work to bring its hedge book back to zero.

At the point that the industry realized that the bull market in gold was for real, it started to scramble to play catch up. Which, in a choo-choo industry like mining, means hiring and training lots of people, buying and refurbishing the equipment needed to reestablish production on more marginal deposits, upgrading facilities, building expensive new mills, etc., etc. And, of course, dealing with the cost of unwinding hundreds of millions of forward hedge contracts.

The rebuilding of the gold mining industry, in short, really only began in earnest over the past few years. As would be expected, the costs associated with this rebuilding required big hits to the financial metrics that institutional investors look at before making an investment decision.

The metrics were not helped by the shift away from high-grade ore (the lower the grade, the more the material you have to process)or generally rising inflation and a falling dollar. The end result was that the cash cost of production rose by as much as twice what it had been during the mothball years, keeping the margins tight and the miners unattractive as investments.

By contrast, the base metals companies bottomed much earlier, in late 1998 and the first quarter of 1999, thanks to increasing demand out of China and elsewhere. As a result, they were well on the road to recovery when the big price increases for base metals began in 2004, positioning them to make free cash flow hand over fist. Thus, while the gold miners have been largely shunned in recent years, the base metals sector has been enjoying salad days, reflected in multi-billion mergers and acquisitions and, of course, sharply higher share prices.

Here at Casey Research, we are of the firm opinion that now that the worst financial aspects of restarting their industry are behind them, the big gold companies are poised to take off. Proof of this point should come in rapidly improving margins which, lo and behold, we have begun to see in the quarterly reports now being released. Just this week we have learned that Goldcorp's profits almost quadrupled last quarter, Barrick's net profit rose by 28% last year and is expected to build rapidly from here and Kinross has just posted a record quarter, with profits up almost three-fold over the same quarter a year before.

The exception to the pack was an announcement that Newmont lost $933 million in the last quarter. But even there we find confirmation, because the loss was mainly associated with a one-time write-down of costs associated with acquiring new reserves and closing down an unprofitable merchant banking operation. In sum, Newmont took the write down because they could afford to, and because the high price of gold would help mute any investor disappointment. In essence, they have effectively cleaned up the books in order to join the profit party.

We will not long be alone in noting the pending improvements to the bottom line of the big gold companies... the investment herd is coming and, we expect, coming soon.

Now, I am going to dig down one more layer to make a couple of points you may consider blatantly commercial. Be that as it may, I'm not going to shy away from making these points simply because Casey Research will benefit if you take the action I'm going to recommend.

The first point I want to make is that if you don't already have a subscription to BIG GOLD, now is the time to take one. Our number-one pick, Kinross Gold, has already bucked the trend by moving up over 68% in the last 9 months, but the show is just beginning. The underperforming big gold companies and the new producers we are following, are going to catch up in a big way and soon. If you haven't yet subscribed, do yourself a favor and do so today. You can subscribe today for just $79 a year, and your subscription comes with a 3-month, 100% money-back guarantee, so you have less than zero to lose.

Click here to learn more about BIG GOLD and to subscribe.

The second point I need to make has to do with the junior exploration companies.

History has proven that, other than discovery stories, the big gold stocks need to get in gear before the investor sentiment reaches the critical mass needed to spill over into the junior sector. History also shows that, as profitable as the big gold companies are in a bull market, the returns offered by the juniors can blow those away. Exponentially. This upside, of course, comes with a greater degree of risk.

As the existing subscribers to the International Speculator will attest, these stocks can move down just as fast as they can move up... but if you have the tolerance for volatility and invest only with money you can afford to take a 50% (or more) haircut on, then you absolutely have to take a subscription today, while the bargains are still available. Again, we offer a discounted new subscriber rate and a 3-month guarantee... meaning you lose nothing by giving it a try.

Click here to learn more and to sign up for a subscription to the International Speculator now.

If you have the means, you really should have both.

While that may be the most blatant pitch I have ever made in this missive, I hope you can appreciate that I believe every word.

In fact, I have never been more bullish on the gold stocks in my life. That doesn't mean I'm right, but you can rest assured that I am completely, entirely sincere. We have a great team here, all of whom work very, very hard to get things right. Which, generally speaking, we do. Right now, the single best recommendation I can give you is to get very serious about your gold stock portfolio. Know why you own each stock you do, and don't bet the family farm, but be bold and the payoff should be truly extraordinary.

I don't think we are going to have long to wait for the show to really get on the road.

Spy vs. I

An outraged instant message from Fitzroy MacLean of Without Borders, our international investment and lifestyle letter, popped up on my screen earlier this week. Now, given that Fitzroy used to earn his porridge by engaging in covert and overt operations where a failure in risk management could lead to a bullet in the head (he is former CIA and an Army Ranger), he is not easily flapped, so his strident message caught my attention.

He was writing me from Germany where the news had just broken that German intelligence officers had paid on the order of US$5.9 million to a Liechtenstein bank employee to steal a disk containing the names of all the German account holders of the bank (and, I suspect, everyone else... giving the German government a very nice trading card). The purpose, of course, was to crack down on anyone who had been trying to avoid taxes by stashing funds in that tax haven.

Now, unlike Fitz who was appalled that the country's intelligence services were being put to work spying for the tax department, some of you may think that it is good and proper that the tax cheats are being rounded up and hauled off to the cells. If so, then you'll have much to cheer you in the months and years just ahead.

The fact is that governments in all their many permutations are themselves starting to feel the pinch from their overspending and overcommitting to spend more. The pinch will turn to a vice grip as the flaws of the fiat monetary systems they uniformly deploy begin to collapse as they futilely try to keep the *** from bursting.

In the United Kingdom, for example, the government has made the decision to nationalize the failed Northern Rock bank at a cost of almost US$7,000 per citizen. And in Germany, you have a bailout now approaching US$2 billion underway for the 1KB bank.

But this is only so much kinder-play when compared to the U.S., where the banks have been lining up around the block to take advantage of the Fed's Term Auction Facility (TAF). Which is to say, the banks are handing the Fed a bunch of toxic waste as collateral and receiving, in return, tens of billions of freshly minted dollars at a very agreeable interest rate.

And even that doesn't begin to measure up against the $170 billion of handouts contained in the stimulus package.

Which pales in comparison to the larger 2008 budget deficit, now estimated to be over $400 billion.

But all of that is only a splash on the rim of the bucket against the tens of trillions of bills now coming due for the benefits due the retiring baby boomers, a number sure to go higher when President Obama rolls up his well-pressed sleeves to implement universal healthcare... and... and...

The pressure is beginning to be felt all the way down the chain. In California, Governor Schwarzenegger attracted a lot of unhappy attention by suggesting the state start letting criminals out of jail, cutting welfare and closing down public parks and other facilities because that once golden state could no longer afford the bills. Here in Vermont, the governor has proposed selling the state's lottery to raise some pocket cash.

Make no mistake, we are still in the early, more friendly phase of this process. Once the state really starts to come under pressure, it will do whatever it takes to keep afloat.

A relevant comparison, sadly, comes from ancient Rome. During his unhappy term in office, Roman Emperor Caligula first spent the treasury dry, then, after it was depleted, turned to doing whatever it took to keep the state afloat. Which, at that time, involved - among other activities - accusing the wealthier citizens with treason followed by a speedy trial ("Hail Gaius! You're guilty, off to the lions with you. Have a nice day!") and the confiscation of all their property. As things slipped further down the slope, he passed into law incentives whereby friends, relatives and fellow countrymen of said property owners could rat them out, for which they would receive a cut of everything confiscated. And, one would imagine, as a bonus get a front-row box seat to watch the lions eat.

Expect to see more and more of the sort of covert activity engaged in by the Germans spread around the globe. We are at the beginning of the trend, not the end.

Watch yourself.

And Now for Something Entirely Different

As you know, at this point we are avoiding traditional equities (except to short some), and have no interest in fixed income. But we are birds of a different color than most investors, being determined contrarians with a solid speculative bent.

For those of you who skew a bit more toward the traditional, you might appreciate reading some of the material put out by Fidelity Independent Advisors. Olivier Garret, our CEO, and I met Fidelity's Don Dion at a conference last year and were impressed. While I personally wouldn't rush into some of the sectors they follow, you might be more inclined in that direction. If so, check out their free Hotline e-letter by clicking here...

Energy Chart of the Week

By Chris Gilpin
Contributing Editor, Casey Energy Speculator

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[click to enlarge]

For the past three years, there's been an unusual divergence between the prices of oil and natural gas. Historically, the price per unit of energy between the two fuels is roughly equal. It might swing apart during cold winters when natural gas prices sometimes spike, or during times when political tensions in the Middle East put a "terror premium" on crude prices, but all things considered, they usually fall back into alignment.

That's because several large industries, and some power plants, have the capacity to switch back and forth between the two fuels. With crude costing twice as much per million British thermal units (MMBtu) as natural gas, you can rest assured that no one is burning petroleum products to power their operations or feed the electricity grid, not if they can possibly help it.

This widening price gap poses a pressing question: is oil overvalued, or natural gas undervalued? Both, is the most likely answer.

What's most fascinating is that this graph also clearly shows that the price of energy per unit - no matter what the fuel source - is rising sharply, proof that the global energy boom is in full swing.

(Ed. Note: If you are looking to get in on the energy boom, that is a sector we follow. You can learn more about the Casey Energy Speculator by clicking here.)

The Mailbag

I had any number of interesting reader emails this week. Here are excerpts from a few I thought you'd find of interest...

"You recommend highly speculative stocks. Given the respect you carry in the industry and the size of your readership, I am concerned about the timing of when you believe it is time to get out of the precious metals. I wouldn't think your exit would have much of an effect on gold or silver, per se, but I would like your honest and transparent belief over how much your "sell signal" will affect those small and highly speculative precious metal mining companies. I think it will be substantial, and frankly, I believe this precious metals bull market may last a lot longer than you seem to think from your writings. I don't want to be caught holding the bag, waiting for a small company to come back from carnage that could ensue when you guys recommend getting out.

Bottom line: How big of an effect do you think your sell signal will have on those stocks?

An excellent question and a welcome sign of a heads-up investor paying close attention to their personal knitting.

The answer, generally speaking, is that we expect the serious Mania phase in the gold stocks to last at least a year. At some point in the run up, likely six months or so into it, we are going to come to the conclusion that the Mania is headed toward its apex and recommend our subscribers begin looking to lock in profits by selling into volume.

Remember, this is pure conjecture, because it is impossible to say with any certainty what market conditions will be like at the time that we begin to feel the Mania is reaching full stride.

However, as the subscriber just quoted so aptly points out, inherent in the discussion above is the fact that, yes, we are likely to put out the sell signal well before the bull market run is over. That should, we would hope, allow for an orderly exit, over a leisurely period of time. Will our recommendation to take profits at that point cause the stocks we follow to take a big hit?

Impossible to say - as much will depend on whether you, the subscribers, decide to rush to the exits, and what the level of the volume is coming into the stocks at that time. I don't think there is much chance of a mass exodus, however, because it is human nature to hang on longer than is prudent. With markets being in full bloom at that point, the odds are that most of you will want to hang around in the hopes of yet another double.

The best way, as always, of viewing our services are as a source of unbiased, deeply considered research on investments to potentially include in your portfolio. But how you manage your portfolio has to remain an entirely personal activity. When you get a 3- or 4-to-1 shot, we would suggest you do yourself a huge favor and, no matter how exciting the party, don't wait for us to tell you to scrape your original investment and a handsome profit off the table.

This is, of course, a topic we will continue to address over time. For now, however, we are still very much in the portfolio-building phase.

Hi David,

I wanted to share a story with you that I found quite shocking and relevant to many of the topics surrounding the current financial predicament this country now finds itself in.

Since I travel just about every week all over the country, visiting and working with our various customers, I try to get a gauge on how the current financial situation is affecting average working Americans. As part of the general IT strategy work we do, we typically do a great deal of process re-engineering work as well. As I have been recently working with a client in a very rural area, we have focused a lot of our efforts trying to eliminate many HR-related inefficiencies in their organization.

As a result of some of the preliminary workshops we ran the first week, I was shocked to find out that at the current client, their 401(k) plan has witnessed a dramatic drop in the number of participants in the plan over the past 3 years, from a high around 59% participation back in 1998. At present they have about 28% of their employees who opt in to the plan. However, only 23% of the employees contribute the full 100% tax-deductible contribution which the company matches at an average rate. On top of this, their HR department has recently added money management classes due to the number of their employees that now find themselves in an ever-increasing pile of credit card-related debt and in a few cases, bankruptcies.

This is just one example of the plight of Americans and the current negative savings rate which we are witnessing now. Given that this is the second-largest employer here in the area, in my mind this is probably a fairly good representation of the overall community at large. Oddly enough, the local Super Wal-Mart was jam packed with local shoppers purchasing everything from flat screen TVs, to groceries and iPods.

So as much as I would like to think that most of these folks who choose not to participate in their companies' 401(k) plan was out of sheer financial hardship and necessity, I am driven to conclude that there are a lot of people out there who simply do not know how to manage their money properly and just make stupid decisions? It would be interesting to see what these averages look like on a national basis?

Just thought I would share that with you.

Human psychology is very complex. You would think, given that their employers were willing to match funds, and that the money saved has tax advantages, people would happily contribute to their 401(k) plans. It is, however, a well-documented fact that people make financial decisions that don't make any sense.

I also believe that decades of intonations by politicians that the citizenry will be looked after has, in my opinion, led people to an unrealistic view of their future, and a naïve belief in the ability of the government's safety net to hold up when they are ready to plop into it. In fact, I think the biggest problem this country will ever face will be the problem of the indigent elderly... 20 or 30 years down the road.

Regardless, there is a new book out on behavioral economics - i.e., what people actually do with their money, rather than what the economists think they should do. It's entitled Predictably Irrational by MIT professor Dan Ariel. While I haven't yet read it, I heard Ariel interviewed yesterday and found his experiments about how people make financial decisions very interesting. He used as an example the decision making that goes into deciding how much to pay for a piece of chocolate. You put the chocolate in your mouth and it melts, creating an enjoyable taste sensation. But what process determines how much you are willing to pay for that sensation? I plan on reading the book.

A unique site. When you click on the website link below, a world map comes up showing what strange & dangerous things are happening right now in every country in the entire world & is updated every few minutes. You can move the map around, zero in on any area & actually upload the story of what is going on. This "map" updates every 300 seconds... constantly 24/7.

http://www.globalincidentmap.com/home.php

Click on any icon on the map for text update information. It's not just about terrorism - it's about everything happening every minute some place in the world of terrorism threats, explosions, airline incidents, etc.

Pretty cool, if accurate. For instance, you would have thought we would have heard something in the main street media (or "lame street media," as some like to call it) about the Indians being arrested while smuggling uranium. I just googled it, and sure enough, there it is. In fact, if media reports are right, this is the second such incident in India in recent years. As if Pakistan doesn't have enough trouble...

MISCELLANY

Think Your Laptop is Small? In a recent edition of these ramblings, I shared my general optimism about the future of humanity, thanks to steady technological progress. That is, of course, a theme often referenced by Doug Casey, the chairman of this organization and my favorite partner of all times. Doug is looking forward, especially, to the era of nanotech, when all things will be possible. While waiting, we can entertain ourselves with a steady stream of cool new stuff. Here is a link to one of the coolest I have seen of late...

Speaking of Laptops... if you are traveling internationally, you may want to give consideration to the idea that the local border clerks - you know, the ones with the warm smiles and hand guns - may take an unhealthy interest in your laptop and decide they should have a poke around, or just confiscate it outright. Some words to the wise here...

The Stella Awards for 2007 are out (www.stellaawards.com). These are the prizes awarded for the most frivolous lawsuits, named after the woman who sued after burning herself on a cup of MacDonald's coffee. Here's the 2007 winner...

Roy L. Pearson Jr. The 57-year-old Administrative Law Judge from Washington DC claims that a dry cleaner lost a pair of his pants, so he sued the mom-and-pop business for $65,462,500. That's right: more than $65 million for one pair of pants. Representing himself, Judge Pearson cried in court over the loss of his pants, whining that there certainly isn't a more compelling case in the District archives. But the Superior Court judge wasn't moved: he called the case "vexatious litigation," scolded Judge Pearson for his "bad faith," and awarded damages to the dry cleaners. But Pearson didn't take no for an answer: he's appealing the decision. And he has plenty of time on his hands, since he was dismissed from his job. Last we heard, Pearson's appeal is still pending.

This is not a new story, but it is instructive, nonetheless... I knew a judge once who was crazy as a rabid rabbit. Eventually, he too was dismissed after getting caught climbing into the window of his ex-wife's house, gun in hand.

About that Ethanol Stuff. We have made derisive noises about the etha-not boondoggle that is costing you a lot of tax dollars and helping to drive up the global cost of food (33% of all the corn grown in the U.S. is expected to be used for the stuff over the next decade). Well, recent news has it that the demand for ethanol not only pushed up the price of food by 4.9% last year, but that it will double the level of greenhouse gases produced over the next 30 years. Okay, now let's see how long it takes before the politicians pass a law which, in principle, explains, "Oh, about that ethanol stuff... well, hmm, never mind." I'm betting it will take a decade, at least.

Protectionism Watch. The last thing the world needs right now is a trade war. But, as I have commented on previously, it may soon get one. The latest sign comes from the Australian government, which is looking to pass legislation that requires that sovereign wealth funds are "independent from the relevant foreign governments." I wonder what part of the term "sovereign" our friends down under don't understand? Meanwhile, Beijing is none too happy following a decision by a U.S. government panel to disallow a Chinese state company, in conjunction with Bain Capital Partners, to buy 3Com Corp. This sort of thing is happening fairly frequently now, and the pace should only accelerate as people get more nationalistic, urged along by politicians looking to assign blame for economic woes anywhere but where it actually belongs.

That's It For This Week!

There is much, much more one could comment on... the failure of auction debt markets (yesterday 395 out of 641 auctions failed. To get a sense of what that means, consider that since the auction debt market was established in 1984, there had been a total of just 44 failures); the shooting down of errant satellites; the burning of embassies; the invasion of our friends the Kurds by our friends the Turks... but there is only so much time in the day, and other responsibilities call.

A quick check of the screens show that gold is holding strong at $944, oil is $96 and the U.S. stock market is, again, down almost 100 points. Business as usual, I'd say.

Until next week, thank you for reading!

sig

David Galland
Managing Director
Casey Research, LLC





Posted 02-25-2008 2:20 PM by David Galland