Long-Term Outlook for Gold

As we write this, the mood is somewhat sour in the gold market. Gold has failed to reach the highs of last May, never mind the 1980 record high. Recently, other investment classes which are normally countercyclical to gold such as equities and industrial metals have performed better than gold although the gold price remains in an up-trend against the U.S. dollar. In general, gold shares have underperformed gold itself for more than the last three years, with notable exceptions such as Seabridge.

What is the long term outlook for gold? In our view, answering this question requires that we understand the nature of the current environment. Virtually all asset classes are rising simultaneously throughout the world. This unprecedented, synchronized bull market in just about everything except the U.S. dollar and residential real estate is characterized by a total disregard for risk. Risk premiums, the additional return investors demand for taking additional risk, are at record lows. Emerging market equities and debt are outperforming more senior markets. The spread between junk debt and highly rated senior corporate issues has never been lower.

The explanation for the current environment, in our view, is that we are now in the midst of the first global speculative credit boom. The broadly defined money supply in most industrialized countries is growing at 10% to 15% annually, 20% and more in key Asian markets and 50% in Russia, This is not money supply in the traditional sense, not money saved or held within the banking system, but rather purchasing power created by credit markets from the leveraging of inflating assets. It’s a rising tide of liquidity which is not derived from operating cash flow and is not invested in the real economy but rather in financial instruments unconnected to productive, wealth-creating capital goods.

Consider M2 (a measure of cash and near cash resources) as a percentage of the total market value of equities. In the U.S., 20 years ago, M2 was more than 120% of total equity values. Now, the ratio is about 36%, a testament to the increase in credit financing of financial assets (see contraryinvestor.com, April 10, 2007).

Our economic system has become immensely dependent upon this liquidity low cost credit in abundance for asset purchases by investors and lifestyle enhancements by consumers. In the 1960s, a dollar of additional real debt (after applying the GDP deflator) generated $0.64 in real GDP in the U.S. economy. Now, a dollar of real debt buys only $0.15 of real growth. Why? Because debt is increasingly incurred for non productive consumer purchases and investments in real estate and financial assets. Corporations have discovered this, not only financial companies (where proprietary trading outperforms traditional business lines) but also operating companies which have acquired financial or investment subsidiaries. Economists are perplexed by the fact that corporate profits are at record percentages of GDP and continue to rise. The reason is that speculative profits are not capacity or supply constrained and accordingly account for a rapidly rising percentage of all profits.

The rising tide of liquidity explains the lower credit spreads and the yield curve inversion. There is unlimited purchasing power available to buy bonds and press down interest rates at the long end of the curve. Japan’s all but zero interest rate policy (now 0.5%) provides cheap funding for asset purchases as do Japan’s prolific savers who search abroad for higher yields. Meanwhile, the U.S. is running an $800 billion current account deficit dollars are created out of thin air and recycled into financial markets to fuel the credit boom.

In our lifetime, we have seen a growing and innovative financial system reshape our economy. We have gone from Commercial Capitalism, where entrepreneurs borrowed capital from commercial bankers to build businesses, to Money Manager Capitalism, where managers court investment funds and analysts to drive their stock prices, to Financial Arbitrage Capitalism, where Wall Street sponsored hedge funds and private equity pools multiply leverage to complete buy-outs at the top of the market, redirecting immense amounts of credit into non productive transactions. The equity bubble of 1999-2000 became the housing/mortgage bubble of 2005-2006 and has now morphed into the private equity bubble of 2006-2007. Each of these is itself just a manifestation of an underlying credit bubble (see Doug Noland, Credit Bubble Bulletin, April 13, 2007, prudentbear.com).

Every step of the way in this transformation of an operating economy to a financial economy, traditional standards of lending and investing have been progressively abandoned. What passed for investment analysis in the dotcom mania has been mirrored in the ridiculous laxity of “non-doc” Alt-A option arm mortgages and the six page bridge loan documents for LBOs totaling billions of dollars. Speculation rules the day and easy credit makes it possible.

What does all this mean for gold? In our view, as long as the credit bubble is expanding, gold will underperform most other asset classes. In fact, it is remarkable that gold has performed as well as it has over the past three years. Historically gold has done best in periods of contracting liquidity and slower growth, when investor confidence is weak and faith in financial markets and currencies is waning, when inflation expectations cause yield spreads to widen and economic weakness increases credit spreads, and when risk aversion outweighs the desire to speculate.

In our view, gold has performed as well as it has because it is under accumulation by smart, long-term money anticipating an end to the credit boom. The investing public at large is not yet involved in gold.

At Seabridge, we believe that the global liquidity boom will exhaust itself and a contraction will set in. Central Banks worldwide will try to forestall a slowdown by attempting to maintain system liquidity at any cost because they know that we are in the midst of a credit boom, not a real economic boom. Yield and credit spreads will widen as inflation expectations and perceived risk begin to mount. In these circumstances, gold will outperform all other asset classes and currencies including industrial commodities. With input costs such as oil and steel falling relative to the gold price, gold equities will outperform gold as operating margins improve. That is what we see ahead, but we cannot know when.

In the meantime, we have much to do at Seabridge as this report identifies. As long as the gold price remains in the current neighborhood, all of our major projects have the potential to be economic and enhancing them will enhance our share value. This year, we expect to add more resource ounces, improve the quality of those we already have, and further define the economics of our best projects.

We will also continue to avoid or minimize many of the risks inherent in the gold business. We will not involve ourselves in projects outside North America, a strategy now amply validated by the difficulties experienced by other companies operating in South America, Africa and Asia.

We will not issue shares to augment our cash position just because the money is available. Dilution is a critical risk for the shareholder of smaller gold companies searching for deposits or trying to put them into production. We guard against this risk by adhering strictly to our primary objective of increasing gold ownership per fully diluted share.

We will never attempt to build or operate a gold mine. The risks involved are immense, suitable only for large, well-diversified companies with strong balance sheets and deep technical teams. From permitting and environmental risks to financing, technical and market risks, the likelihood of failing to meet expectations is very high.

At Seabridge we are clear that our task is to provide you, our shareholder, with maximum exposure to gold and reduced exposure to the risks of the gold mining business. Compared to a gold ETF, we provide the leverage of finding or acquiring additional ounces and the leverage inherent in defining and improving the economic parameters of our projects. This approach has produced disproportionate gains for our shareholders to date. We remain confident that this record of success will continue.

I would like to express my personal thanks, and that of other directors, to Henry Fenig, who joined our board in 2002 as a representative of Albert Friedberg, our largest shareholder. Henry has decided to step down as a director in order to dedicate more of his time to his other obligations. We will miss his experience, his wisdom and his sense of humour at Board meetings but expect to have his continuing advice as a senior officer of the Friedberg Mercantile Group.