The Expect Short-Lived, Perfect Storm

The drop in gold prices and gold equities over the past month has been precipitous. From its recent high above US$960, the gold price has fallen by about 15% at the time of this report.

This is the fourth significant correction since May of 2006. Two of these three previous corrections went significantly further (26% and 20%) than the current one has to date. Being a gold investor in a gold bull market is not a comfortable experience.

As we see it, three factors have combined to create a perfect storm for gold, a storm which should be relatively short lived, in our opinion.

First, the U.S. dollar has rebounded from an oversold position largely due to shifts in central bank policy statements. The European Central Bank had been consistently hawkish on inflation and had threatened to raise interest rates. The ECB recently shifted its emphasis to a concern about economic growth and signaled that its next move in interest rates would likely be down, contrary to market expectations. Meanwhile, the rhetoric from the U.S. Federal Reserve shifted at the same time to tough talk on inflation which convinced the market that its next move would be to increase rates. In themselves, these statements might have been expected to weaken gold which has tended to trade in parallel with the euro. However, a great many hedge funds were long commodities, positions which they have apparently financed by shorting the U.S. dollar. This is the so-called “inflation trade” which was quickly unwound as the dollar began to strengthen against the euro. Gold was dumped as part of the commodity complex.

Oil was a second factor contributing to the decline in gold. Oil was the center piece of the inflation trade. In the first half of this year, it went almost parabolic to the upside. Commodity funds and speculators leveraged their positions, making the market vulnerable. Regulators and politicians then stepped in to increase uncertainty by proposing rule changes and legislation to limit speculation in oil and also food. Oil broke down, again pressuring investors in commodities to sell their positions including gold.

A third factor driving down the gold price was the perceived rescue of the U.S. financial sector by the U.S. Federal Reserve. Gold and gold equities are anti-financial investments; they perform best when the financials are weak. Gold hit its all-time high in mid-March of this year when Bear, Stearns was declared insolvent. Recently, the market has concluded that with the rescue of Fannie Mae and Freddie Mac, two massive U.S. financial institutions, and the announced “sale” by Merrill Lynch of mortgage-backed securities, the worst has been seen. Furthermore, the market has become convinced that the Federal Reserve will do whatever is necessary to preserve the financial system. Hedge funds have therefore rushed to invest in the financials while selling commodities and the financial stocks have been extraordinarily strong in the past several weeks.

Our thoughts? Gold is not a commodity, it is a currency, the only one whose supply can’t be inflated by central banks. Gold will decouple from oil and industrial metals when the instability of the world’s financial institutions becomes evident once again. In our view, this development will not take very long.

We believe that U.S. dollar strength against commodities is ephemeral. Given the state of the U.S. economy and financial system, we think an increase in rates by the Federal Reserve is most unlikely and that the market will soon come to see this. Money supply is growing at a furious rate in major economies such as China, Russia, Brazil and the Gulf states and central bank reserves are increasing at a staggering rate of about US$200 billion per month. The U.S. dollar has been helped by war in Georgia and U.S. investors and U.S. investors aggressively pulling money out of developing country stock markets which have sagged badly in recent months. The U.S. dollar positives will prove short-lived, in our opinion, while exploding U.S. federal and state government deficits will prove to be long-lasting dollar negatives.

There is no bottom in sight for the housing markets of the United States, Great Britain and large parts of Europe to name just three. Delinquencies and foreclosures continue to rise. Sales volumes continue to shrink and the backlog of unsold properties is now at record levels. To date, banks have written down their losses in the sub-prime market to the level which equates to the current state of the housing market. As the housing market continues to soften, further write-downs will be required and the evidence suggests that higher-quality mortgages are now defaulting at a quickening pace as well. A new study indicates that fully one-third of U.S. residences now have mortgages exceeding their property values.

Particularly in the U.S., the banking sector has developed and marketed financial innovations which, in our opinion, will now prove to be its undoing. A recent example is the so-called Auction Rate Securities market which consisted of US$350 billion of securitized loans on which the interest rate was set periodically by auction. Clients of Citigroup have recently obtained a US$7.5 billion settlement forcing the bank to repurchase these securities which regulators characterized as fraudulent. Morgan Stanley has announced a similar repurchase for US$4.5 billion. Other securitizations involving mortgage-backed securities such as Collateralized Debt Obligations are likely to be litigated with a view to forcing the banks to repurchase hundreds of billions of dollars of these now worthless securities. Investigations of bank lending and securitization practices are mounting. Meanwhile, as the economy softens, consumer credit defaults of all types are on the rise while declining corporate profits are likely to expose banks to a growing default rate for these assets as well.

What is needed for the next move up in gold, and what we expect, is growing concern over the financial sector and the fear of deflation. Gold began its bull market in 2002 as the U.S. Federal Reserve and other central banks took unprecedented action to prevent a possible deflation, which then appeared to be imminent in response to the recession which was occurring at that time. There is nothing like the fear of deflation to ensure currency inflation and devaluation. Gold investors should watch the financials and look for increasing deflation rhetoric. We believe these will be the leading indicators for the next move up in gold.

Concerning the Seabridge share price, it is clear that we have suffered from a growing short position in our stock. As of July 28, 2008, the short position reported by the American Stock Exchange stood at about 3.9 million shares. It is our sense that we began to attract a growing short interest after the abrupt termination of construction at the Galore Creek project which is also located in northwestern British Columbia and has some similarities to our KSM project. The assumption seems to be that logistics and capital requirements for KSM are likely to make the project uneconomic. We completely disagree with this assessment. We are confident that the Preliminary Assessment for KSM which is now in progress will demonstrate the potential for a robust, large-scale mining operation at current metal prices. If we are right, the short position in our shares will prove to be a significant asset to patient Seabridge shareholders.

Report to Shareholders (excerpt)

August 13, 2008