Further Thoughts on Gold at $300 Jude Wanniski February 12, 2002

Our assessment last week that with gold`s surge there would be less deflationary pressure and upward pressure on commodity prices was NOT consistent with our year-long projection of the DJIA skidding to 8500 by the end of March. The inconsistency has bothered me all weekend as it could not add up. Gold at $300 means some prices must continue to fall, because they have not completed a nominal adjustment to the deflation, but those equities tied to commodities would not have to decline. We may see a bottom at 9200-9400 with gold at the $300/oz. level, as these forces of deflation and contraction cancel each other out to some degree. Granted, a week ago we still wondered if we were seeing another short-lived gold spike, but it has been clear that the weakness of the economy has pushed government and household budgets into deficit and this means gold`s uptrend is real. At this level, it should have run its course for the time being, but there seems no serious reason for it to advance or decline. Assuming it remains at $300, we would expect to see a rise in commodity prices and the equity shares that depend upon them.

Just as the gold shares led the rise in bullion, the cyclicals seem to be rallying in anticipation of the higher commodity prices that underpin them. This can`t go very far, though, because the cyclicals have already priced in a recovery that remains burdened with a deflationary drag. There is no "inflection point" here, in other words. Bulls and bears seem to be locked into an equilibrium as close as the outcome of the presidential elections in 2000.

There of course has been no change in monetary policy behind the move to $300 gold, except perhaps for a sense that with the economy poised for a recovery, there is no chance of another cut in the funds rate and no reason for market actors to wait for lower prices. The gold surge is primarily the result of shifting demand for dollar liquidity, with the surplus not being drawn down by the Fed given its operating mechanism. We have said this is the "bad" way of ending the deflation, as opposed to straightaway devaluation of the dollar, but it still means there is less pressure for the DJIA to fall on that singular account. Unemployment should continue to rise, but nominal values of traded equities can hold in this environment - commodity sensitive equities rising, non-commodity sensitive equities still forced to decline.

I hope this brief clears up the contradiction of our report last Tuesday, which in itself was the outcome of a lengthy and excited debate within the Poly staff. The debate will continue because the dynamics ahead of us will be fluid as long as the dollar floats.