A Melman Minute — January 18, 2008

As long term readers know, I am a fan - almost a fanatic one - of the late William S. Gilbert of “Gilbert and Sullivan” fame. Not only was he a superbly talented wordsmith, but he also exhibited a high level of understanding of the human experience which he could capsulize in just a few well-chosen words. One of my favorite Gilbert quotes is this:

“Things are seldom what they seem,

Skim milk masquerades as cream.”

That saying seems applicable to interpretation of economic concepts as it is amazing how readily many observer ‘buy into’ market concepts that turn out to be either patently false or at least are effective only under certain circumstances.

Two of the most common myths are:

* - Low interest rates bring about rising securities markets, and

* - High interest rates are bad for gold because the ‘holding cost’ for gold, which bears no interest in its metallic form, becomes a disadvantage.

While both sound reasonable, market performance indicates that both are frequently untrue, and, in fact, the direct opposite has actually been the case in real life. Examples abound, but two clearly illustrate the point.

Beginning in early fall, the Federal Reserve Board started an aggressive campaign to once again lower interest rates as they dropped the Fed Funds Rate down from 5.25% in successive moved on September 18 to 4.75%; October 31 to 4.50% and December 11 to 4.25%. In addition, Fed Chairman Bernanke gave strong indications in early January that further cuts were in the offing. So, did the market rejoice in such ‘positive’ news? Not at all. When the Fed began its rate cutting in mid-September, the Dow stood near 14,000. As of this morning, it is perilously close to breaking under 12,000! How could this be?

The answer may lie in the direction of asking why interest rates fall. If rates are low because of a confident and strong economy where credit risk remains low, such as existed in American from the late 1940s until the early 1960s, declining rates can surely be regarded as positive. However, if rates are being driven down in a seemingly desperate attempt to salvage a collapsing economy - which is what we have seen since mid-September - such moves become a virtual admission that the health of the economy is weak and uncertain, and markets truly hate such a background, as has been amply demonstrated by one look at the Dow Jones Industrial Average over the past few months.

The discussion regarding the second concept, that of gold being an unattractive investment if interest rates rise, also yields to a similar analysis. Again, the relevant question is why interest rates are rising. If rates are rising because of growing economic and social uncertainties combined with rising inflation which increasingly threatened the purchasing power of unbacked currencies, that type of background, in point of fact, is actually positive for gold. On the other hand, if interest rates are rising specifically7 because of a determined effort by monetary authorities to rein in future inflation, that background can be decidedly negative.

As inflation and interest rates rose during the period 1977 to late 1979, gold soared in its greatest percentage rally to date. However, when then Fed Chairman Paul Volker drove rates to horrendous peaks in early 1980 and again in summer 1981, gold was past its peak and entering a period of disfavor which lasted almost two decades.

The “why” can clearly be much more important than the “what.” In the present period, declining interest rates can be interpreted as reflecting a negative economic background, not positive, and we see markets falling. If negative economic performance continues and if inflation begins to rise, then investors will likely require ever-higher interest rate returns to compensate for additional perceived risk - and that should be an excellent background for higher gold prices.

In our opinion, that is the world we expect over the next several years.

Please accept our apologies for being a bit late with this morning’s MM, but we wanted to see the reaction to the overnight bullish talk about how the markets would rally on new plans for stimulation of the economy to be announced. Well, the Dow did indeed open up by 180 points, but it quickly reversed direction and fell to minus 100+ points before returning to close to unchanged after about three hours of trading. Gold has rallied back to near US$880 spot and the base metals are putting in strong performances as hope for economic stimulation has provided a more positive background for copper, lead, zinc, nickel, etc. Crude oil is up slightly to near US$91 per barrel.

DISCLAIMER

The information presented above is based on data which we believe to be from reliable sources, but the accuracy of which cannot be guaranteed. Any opinions or predictions contained herein are those of the editor and are likewise offered also for information purposes only.

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