What recent market falls mean for gold

On Tuesday for the first time in modern history China became a world financial trendsetter. The Chinese stock markets declined (the Shanghai Composite Index fell 8.84% and the Shenzhen Composite Index fell 8.54%) and stock markets around the world fell like dominos.

That China is important to the world's economies and financial well-being should not have caught anyone by surprise. China has been credited, or accused, depending on your point of view, with the increase in commodity prices for several years now and the ascent of its vast population to middle class is supposedly going to convert hundreds of millions of investors all over the world into millionaires. So when China's stock markets fell, the world took notice.

China stock market falls

The reason for the markets' fall was China's government's announcement the previous day of a top-level task force to clamp down on illegal activities in the securities markets. Chinese investors have been flocking to stocks hoping to get rich, just as North American and European investors have been snapping up anything to do with China hoping not to get left behind. Chinese capitalism is today's Wild Wild West where just about anything can and will happen, where for every greedy investor there is an appropriately constructed plan to part him from his money and now the government wants to put an end to it.

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The Chinese banking system is rife with bad loans made to well-connected people who set up unprofitable businesses. Corporations borrowed money to build factories, offices and apartments, many of which are empty or operating at a loss. The boom in China's stock markets was, to some extent, also driven by debt, although I suspect it would be near impossible to figure out just how much of the speculation had been undertaken with borrowed money. When markets are debt-driven they are massively volatile both during the upswing, as an inordinate amount of money chases limited stocks, and during the down-cycle, as investors panic and fret about losing all they have and more, so it is not really surprising that China's stock markets took a plunge.

The only explanation for the contagion caused by China this week is that investors across the globe have entrusted their money to mutual fund and hedge fund managers that are gambling on the greater fool theory with their clients' capital. When the markets around the world fell in sympathy with China it illustrated loud and clear that many investors have no interest or faith in the companies they own; they are merely holding them in the hope of trading the stocks to another fool in the future.

According to the World Bank approximately one third of all of China's production is exported, and if you consider the flow through effect then perhaps more than half of China's economy is export dependent. As a bellwether, the USA being the world's largest economy and largest consumer is therefore far more indicative.

US economy in trouble

Unfortunately the United States is not in good shape. The latest from the Commerce Department is that durable goods orders fell 7.8% in January; the National Association of Realtors reported that January new home sales were down 4.3% from last year and the median sales price was down 3.1%; the Commerce Department revised gross domestic production for the last quarter of 2006 down to 2.2% from an earlier estimate of 3.5%; business spending fell 2.4% in the last quarter although consumers did their part by increasing their spending by 4.2% yet residential fixed investment fell 19.1%.

Consumer spending accounts for more than 75% of US economic activity and the US accounts for more than a third of all the economic activity in the world. The US consumer accounts for about 25% to 30% of global economic activity, meaning that if US consumer spending fell by only 5% there would be a 1.25% to 1.5% reduction in world-wide economic activity. There is no other single more important economic factor than the US consumer. Because the US consumer has been financing his spending with borrowed money generated mostly due to rising real estate values, we should look at the US real estate market for future guidance - not to the Chinese stock market.

Existing home sales fell 8.4% in 2006, the sharpest decline in home sales in 24 years. 30-year mortgage rates are still only at 6.14%, and so homes should be very affordable, but because of rising real estate values home buyers are battling to meet mortgage payments. Falling real estate prices have reduced some home values below their outstanding mortgages, making the homeowners prone to default on their mortgage payments. Nearly 6% of all sub-prime home loans were more than two months in arrears by the end of last year and first-year delinquency rates are up about 200% in little over two years.

Sub-prime mortgage meltdown

Approximately 16% of all mortgages issued last year were to sub-prime borrowers and with falling real estate prices the money available to these borrowers is drying up. That will reduce demand for homes.

There is an index (part of the ABX family of indices) that tracks how much it costs to insure BBB-minus rated bonds backed by mortgages to sub-prime borrowers. When the index falls it means such mortgages cost more to insure, which in turn is a proxy for the risk and value of these mortgages (as risk increases, insurance increases and value decreases). The index is down almost 30% since the beginning of the year. More than 20 sub-prime lenders have closed shop after having to repurchase bad loans they originated.

Mortgage defaults are now the highest in five years and rising with many of the problems tracing back to adjustable rate mortgages - what a surprise! Mortgage lenders such as Bank of America and Citigroup are now trying to get borrowers with adjustable rate mortgage to switch to fixed rate mortgages. That's a smart move for both parties: the US budget deficit will eventually cause interest rates to rise to much higher levels. Some banks are now also allowing borrowers to sell their homes for less than the outstanding mortgage and then forgive the shortfall since it is often less costly and time consuming than foreclosing on the homes. The catch is that borrowers may find they have to pay income tax on the forgiven debt. Sales of homes for less than their outstanding mortgage debt increased by 25% during 2006 according to Bank of America.

Keep in mind that the increase in bad loans is broad based and is occurring during exceptionally strong economic conditions, at least if you believe the authorities and talking heads. US consumer confidence is still at a five year high indicating that the collapse of the US real estate market has not had a major effect on consumer spending yet. What is going to happen when consumer confidence finally does fade and economic growth does stall?

As more and more home owners get into financial trouble and more and more homes go on sale it puts downward pressure on house prices. Home prices fell in about half of all metropolitan areas during the fourth quarter of 2006. For the first time since the National Association of Realtors started recording home prices in 1979 home prices fell in the majority of the cities surveyed.

Home construction has fallen to its lowest level in ten years. Housing starts in January fell 14.3% and building permits fell 2.8%. Luxury home builder, Toll Brothers, reported a 67% decline in its last quarter's profit as it wrote down inventory. The company also lowered its earnings outlook for 2007 based on fewer orders and rising cancellations. The company's net orders are down 33% from a year earlier as it struggles with a 30% cancellation rate.

It's not just real estate loans that are going sour. Wells Fargo, the 4th largest bank in the US by market value, reported $726 million in net credit losses for the fourth quarter and most of these were concentrated in its auto-lending portfolio. Consumers are increasingly unable to pay for all those new cars they bought when the car companies were running specials to get rid of inventory. US Bancorp, the 6th largest bank, saw a 25% increase in charge-offs and predicted that writing off retail loans will continue to increase during 2007. These are by no means the only banks seeing an increase in loan defaults, merely an example of what is happening.

The problems don't end with autos and homes either - the economy is integrated. Home Depot expects earnings during 2007 to fall between 4% and 9% as it doesn't expect the residential and housing markets to improve during the year. Manufacturing output fell 0.7% in January with manufacturing capacity utilization at only 79.6%. Manufacturing of automobiles fell 6% in January and excluding autos, industrial production was still down 0.2% for the month.

Is this all not more worrisome than the pullback of an over-bought Chinese stock market?

What this means for gold

The dollar lost about 2.5% against the yen during the week. I wrote about the yen carry trade and how, when it unwinds, it will cause the dollar to fall. Last month Japan raised its overnight interest rate from 0.25% to 0.5% and this is potentially far more significant than what happened in China this week. Higher Japanese interest rates will cause the yen to appreciate on foreign exchange markets and will put pressure on the yen carry trade. On Tuesday of this week the dollar recorded its largest decline versus the yen in over a year as investors sold dollars to buy yen.

It is somewhat incorrect to say that the dollar is falling since it is actually the yen that is rising. The dollar has been reasonably steady against most major currencies this week but the yen rose against almost all of them. I suspect that over time the yen will rise against most currencies and the dollar will fall against most currencies because much of the yen carry trade involves being long dollars and the US still has an enormous trade deficit that has to be addressed.

From my perspective as an investor primarily interested in gold, the events of the week were very interesting because the gold price in US dollars fell even though the dollar was down sharply against the yen.

Unlike the investors who panicked and sold this week, I was happy to see falling gold stocks. Share certificates are certificates of fractional ownership in a business and I only buy stocks of companies that I really want to own, so I don't mind if the share prices fall because it means that I can increase my ownership at a lower cost than before the decline. When I look at my portfolio and see a stock that I would not like to see fall in price I sell it immediately, before it has a chance to decline.

With gold and gold shares falling I am quite content to wait and see what happens. Nobody can predict the future so to sit and debate whether this is going to be a big decline, a long decline, a short decline, a non-event, is pointless. The markets are so emotionally driven and far removed from any sense of value that there is no telling what will happen or how long it will take. Fortunately, if the carnage is short lived then stock prices will soon recover and everyone will be happy. If the declines continue then we will find much better buying opportunities going forward and I'll be very happy.

At some point I think the US dollar is going to come under serious pressure and when that happens the dollar and the gold price will decouple, with the gold price rising and the dollar falling. I am actually hoping that the gold price continues to fall in the interim as it only means there will be more money to be made in the longer term.

First published on Kitco.com (www.kitco.com)

By Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.