-->Simple Supply And Demand

The Daily Reckoning

London, England

Monday, 7 April 2003

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*** When Baghdad falls? Prosperity and a bull market?

*** More joblessness...fewer profits...gold falls...but
gold stocks go up!

*** Reconciliation...and more!

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What will happen when Baghdad falls?

Milton Friedman says that the economy will take off. The
Nobel Prize winner believes the end of the war will bring
prosperity. How he can know these things is a mystery to
us...but who are we to argue with him?

On the other hand, what does he really know? The last time
Baghdad fell to an invading army was in the 13th century,
when the grandson of Genghis Khan brought a regime change
to the desert capital.

That is the problem, dear reader; things like this don't
happen every day...so it's impossible to know what comes
next. When was the last time stocks fell three years in a
row? When was the last time manufacturing payrolls dropped
for 32 months without a break? When was the last time
business profits, as a percentage of GDP, declined for 4
decades?

When was the last time the Fed cut rates 12 times
consecutively...without producing a serious recovery?

When was the last time the world's second - and perhaps
third - largest economies were in deflation? And when did
the U.S. last run a $500 billion budget deficit...and
another $500 billion trade deficit? And when was the last
time the U.S. consumer was so completely tapped out by debt
- with debt at 200% of GDP - that he could no longer carry
the world economy forward?

We have never been here before, dear reader. Where we will
be tomorrow is anyone's guess. Friedman's guess is as good
as any. But probably no better.

Over to Eric Fry with the latest market news:

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Eric Fry, reporting from the Big Apple:

- One step forward for the coalition forces, two steps
backward for the US economy. The only aspect of the
American economy that is advancing as swiftly as the
coalition forces toward Baghdad is the tally of unemployed
workers. The Labor Department's monthly jobs report last
Friday showed a loss of 108,000 jobs. And the weekly tally
of initial jobless claims soared to 445,000 last week - the
eighth straight week above 400,000.

- But the stock market cannot be bothered with such
minutia; it marches to a different drummer. Battlefield
headlines set the cadence for the stock market, not the
economy. The Dow Jones Industrials gained 132 points to
8277, while the Nasdaq climbed 1% to 1383. As stocks gained
ground, the safe-haven assets retreated: gold and Treasury
bonds both yielded ground last week, with gold falling
$6.40 to $326 an ounce.

- How long, we wonder, can the lumpeninvestoriat turn a
blind eye to the struggling U.S. economy?"The current
earnings-warning season has been quite negative," Barron's
observes,"with nearly three downside revisions for every
company raising its profit forecast. First-quarter earnings
for S&P 500 companies are expected to rise 8.7% over a year
earlier. But strip out energy companies that feasted on
high oil and gas prices, and the increase for everyone else
is put at only 4%. The consensus projected growth for all
of 2003 has fallen below 12% from 14% at the turn of the
year, and most of that is expected to come with a quick
ramp in profitability in the second half."

- The stock market would appear to be 'pricing in'
something better than 4% earnings growth. At current
levels, there is little room for disappointment."The fact
is," Barron's continues,"the current valuation of tech
stocks can't easily accommodate erosion in this year's
profit picture. Pip Coburn, tech strategist at UBS Warburg,
notes that the tech sector now trades at 29 times expected
2003 operating earnings, compared to an average forward
valuation of 26 in the pre-bubble period of 1992-96. And
the current multiple is based on earnings that are expected
to soar by 34% this year."

- Ominously, the meager earnings 'growth' that is managing
to appear results from cost-cutting, rather than from
revenue growth. In other words, mounting job losses are a
direct consequence of corporate America's efforts to
'grow'."Since the start of 2001, when the economy slipped
into recession, U.S. employers have cut more than two
million jobs" Dow Jones news reports. Since July 2002,
monthly job losses in the manufacturing industry have
averaged 50,000.

- All else being equal, an investor would prefer to see a
company prosper because business is booming, not because
pink slips are swirling around company cubicles like crows
around Tippi Hedren. Though the stock market is holding up
for now, the economy looks more like a Hitchcock film every
day...

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Bill Bonner, back in London...

*** Gold dropped last week - as low as $325. But gold
stocks seemed to want to go up. Gold's day will come, of
course...but it may not be today or tomorrow.

*** A brief reflection, of no importance, on Sunday's
religious service in our local church: as long-time readers
may know, your editor attends the French Catholic mass
regularly, despite the fact that he is neither French nor
Catholic. He gets along well enough, but occasionally is
confronted by something puzzling.

First, the Sunday service was not held on Sunday, but on
Saturday night. It was called a Mass of Reconciliation, or
alternatively, a Penintential Mass. At one point in the
service, all of a sudden, the priest placed a big-print
version of the bible on a little table in front of the
altar and then moved to the side of the church. All was
quiet. No one moved.

Then, just as suddenly, Col. Aubray, a big man with direct,
military bearing, crossed the church, heading in the
priest's direction, as if he was going to negotiate a
surrender. Your editor knew that the colonel had exchanged
harsh words with the priest on the previous weekend. On the
cleric's side, the charge had been that the congregation
was much too traditionalist...and unwilling to accept
change, the main one being the lack of priestly attention.
There simply aren't enough ordained clergymen in the area
to keep the churches open and to attend to the needs of the
quick and the dead. On the colonel's side was outrage, for
Père Marchand had not even bothered to come to administer
last rites and extreme unction...for which there had been
more need than the usual this past winter. In the months of
January and February, 13 people from the commune had been
interred, only one with benefit of clergy.

"I can't drive down here from Poitiers every day," the
priest had explained.

("Why not bury them all at one time," was Jules' helpful
suggestion.)

So, when Col. Aubray crossed the aisle to approach Père
Marchand, your editor half expected the two men to come to
blows. Instead, what ensued was a whispered conversation,
followed by the sound of creaking bones, as many other
churchgoers rose to approach the Book and then the Priest.
Each walked up, read a little passage, meditated for a
moment...and then moved on to make a brief confession to
Père Marchand. Parishioners seemed to want to stand long
enough before the Book to show that they were humble enough
to recognize their faults...but not so long as to cause
their fellow Catholics to begin to wonder.

The Daily Reckoning PRESENTS: Gold, down 16% from its $390
peak of last February, seems to have lost its sparkle
lately."From far away, it looks like the ultimate store of
value is on the ropes," comments James Boric."But," he
adds,"if you move in to take a closer look, you might be
surprised by what you see..."


SIMPLE SUPPLY AND DEMAND
By James Boric

In college, I wasn't sure what I wanted to do when I grew
up. I started out double majoring in political science and
history. I thought I might want to be a lawyer. Then, in my
sophomore year, I decided I wanted to teach. So I added
secondary education as a third major.

My parents were supportive of anything I wanted to do. They
only gave me two stipulations. I had to graduate in four
years. And I had to be 100% self-sufficient as soon as I
walked off Indiana University's beautiful Bloomington
campus.

Needless to say, I had a few sleepless nights. I wondered
what I would end up doing...and could I make it in this
dog-eat-dog world? Then I discovered my first economics
class. Something clicked. All the charts, formulas and
theories made sense. It was as if the proverbial light bulb
went off over my head. This was my calling.

Economics is logical. When supply exceeds demand, prices
fall...and vice versa. When demand is greater than supply,
prices rise. It's such a basic idea. Yet how many times do
we apply that logic to the investments we make?

Probably not as much as we should. But if you have read The
Daily Reckoning for the past three years, you know that
demand for gold has far exceeded supply. As a result, gold
prices rose steadily in 2002, and gold stocks dominated the
market. It made perfect economic sense. But 2003 has been a
different story...or so it looks on the surface. The yellow
metal has fallen from a high of $382 on Feb. 5 to its
current price of about $320. Both the XAU and HUI indexes
are off 19% and 20% respectively.

From far away, it looks like the ultimate store of value is
on the ropes. But if you move in to take a closer look, you
might be surprised by what you see.

The world consumes about 120 million ounces of gold each
year - most of it for jewelry. But gold mines only produce
80 million ounces a year - leaving a real deficit of 40
million ounces - or 50% of its production. Demand still far
exceeds supply. So why are spot prices and stocks falling?

Nothing ever rises straight up for an extended period of
time. In any major bull run, there are bound to be some
correction periods. Take, for example, the most explosive
gold rally in the past 100 years - the 1970s bull run.
After coming off a double bottom in 1970, gold rose from
$35 an ounce to $65 in the summer of 1972. Then the yellow
metal consolidated for about six months, trading between
$50 and $60 an ounce.

Investors who sold during the initial downswing (thinking
the run-up was over) missed the next explosive rise. By
January 1975, gold sold for about $180 an ounce. And as we
all know, it didn't stop there. Gold prices soon soared all
the way above the $800 mark.

All during the 1970s, demand for gold remained high - as
evident by the 9.9 million ounces of gold coins sold in
1979. (This was a record at the time.) Still, gold prices
and gold stocks didn't rise straight up; people took
profits from time to time. And that's what is happening
today.

Demand for gold exceeds supply by 50%. And as long as that
remains true, this bull run is not over. If I am right, you
can be assured of two things. One, this current correction
in spot gold prices and in gold stocks is just that - a
correction and not a downturn. And two, the best way to
profit is to buy when everyone else is selling - that would
be now.

So...what stocks should you look to own? You may scuffle,
but your best bet for high returns will be to invest in the
smaller gold producers - the juniors. Consider why...

Just to break even in terms of production, gold miners
worldwide must find 80 million new ounces each year. Most
of that gold is mined by the major companies. Or so most
people think. But even the largest mines eventually get old
and become depleted. So how do the world's largest
companies keep meeting that 80 million mark?

Not by finding new gold on their property. Nope, they
acquire smaller, hungrier gold companies with fresher
mines. Take Newmont Mining for example. Newmont is the
world's largest gold producer. Last year, it was able to
replace 9 million ounces of depleted gold. President Pierre
Lassonde said no other company has ever accomplished such a
feat. How did it do it? It acquired two smaller gold
companies - Franco-Nevada and Normandy Mining. This is key.

Major gold miners are running out of ways to replace lost
gold. So, they are forced to look to smaller companies to
pick up the slack. And that is one reason to own juniors
now - in anticipation of more acquisitions and greater
consolidation. When a smaller company is bought out by a
larger one, shareholders usually benefit with a premium
stock price. In the months leading up to the Franco-Nevada
acquisition, its share price rose nearly 40%.

I expect to see more consolidation in the gold mining
industry - especially as demand for gold continues to
exceed supply. Large companies will keep looking to buy
smaller companies to match last year's production levels
and take advantage of high spot gold prices above $300 an
ounce.

And if all of my theories are correct, there couldn't be a
better time to capitalize on the junior gold miners than
now. Many stocks are down 50% or more from their highs in
the past year. Overall demand for the yellow metal remains
high. And the herd has been on a selling spree for two
months now.

If you are a contrarian with a tolerance for risk, this is
your cue to buy.


Best regards,


James Boric
for the Daily Reckoning