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Drivers of Today’s Markets Fail to Reflect Underlying Fundamentals

Companies – not just people – are frequently victims of misplaced sentiment. If you believe that emotion doesn’t affect people’s investment judgment you’d better think again! Large corporations aren’t immune from making decisions based on sentiment either.

Most people in the minerals industry would run out of fingers counting the times mining companies have purchased assets at the top of the market, only to write the majority of them off over the next few years. Rio Tinto, Kinross and Barrick are three recent examples.

With gold failing to break above $1,400 recently on a sustainable basis, it’s understandable why the sentiment for the metal is so bad. But the overall disenchantment with mining equities is not entirely based on the price of the commodity they produce, whether it be precious or base metals. The billions in write-offs – and equally as painful the huge cost overruns associated with seemingly marginal new gold projects – has caused many investors to become skittish and search for better managed opportunities in other industry sectors. Frankly, it’s not hard to blame them.

There is some hope, however, that the minerals industry has finally come to its senses. Companies are beginning to manage production costs more effectively, putting off development of low grade projects that can only be made economic by developing them on a large scale basis. With that of course comes considerable CAPEX risk which is best illustrated by projects such as Barrick’s Pascua Lama on the Chile/Argentina border which the company is now proposing to develop on a staged basis. (Perhaps they’ve learned something from the old timers a century ago who developed some of the world’s largest gold mining camps using this strategy).

Some companies are even beginning to re-learn the fact that there’s simply no substitute for grade in this business and managing projects close to home is much easier (culturally for one) than doing it in foreign jurisdictions. While numerous factors enter into the economics of any mineral deposit, you want to be in the lower cost of production percentile to secure your future as a profitable producer. Companies that are carrying millions of ounces of gold resources at 1 g/t or less won’t see production any time soon in my opinion. And should that day come, you will see a mass of new gold production coming on stream which is almost certain to depress the price.

Unfortunately for mining companies, there’s little they can do about commodity prices because they are set (“fixed” some might argue) on world markets, a process that is often misaligned with their underlying economic fundamentals.

In late October the entire world watched the U.S. dollar catch a bid (at the expense of gold) despite the imminent threat of the United States failing to raise its debt ceiling which would have put the country into technical default – an unprecedented situation for the nation that prints the world’s so called “reserve currency.”

All of this was happening despite quasi threats from the biggest holders of U.S. treasuries, China and Japan. Is it any wonder that Chinese demand for gold is a record levels and may in fact exceed 1,000 tonnes this year? You have to think the Chinese know something all of us in the West simply don’t. (They certainly have thousands of years more history behind them than we do in this part of the world).

The day of reckoning for the broader market will come at some point although you’d never think so with all the cheerleading in major media outlets. As we’ve seen in recent years, the return swing on the proverbial market pendulum has become more and more extreme and the next one will be brutal when it arrives. Just imagine the Chinese liquidating some of their vast U.S. treasury holdings and replacing even a part of it with gold bullion after a run on the U.S. dollar.

Reading online business publications including Bloomberg and the UK’s Financial Times, you could easily get the impression that the market is the economy when in fact it’s so far removed from mainstream economic realities that it’s almost an abomination.

Whenever the gold price gets hit, you can almost guarantee it’s shortly after a negative piece in a major U.S business publication with quotes from the usual suspects at Goldman Sachs, Morgan Stanley and others.

These are the same people who upgrade and downgrade their gold forecasts almost monthly which no doubt helps support their algorithm-based trading systems along with short term technical traders whose idea of a long term investment is hours rather than weeks.

Just recently a major international news service was found negligent for providing sensitive market information to certain financial institutions before everyone else, allowing them to front run the markets. Deep down one suspects this is just the tip of the iceberg given the influence of various data points (U.S. unemployment rate, Consumer Sentiment Index etc) on the DOW and other major market indices.

Even worse perhaps is the recent LIBOR scandal, a series of fraudulent actions connected to the London Interbank Offered Rate. LIBOR is the average interest rate calculated through submissions of interest rates by major banks in London. The scandal arose when it was discovered that banks were falsely inflating or deflating their rates so as to profit from trades, or to give the impression that they were more creditworthy than they actually were. Libor underpins approximately $350 trillion in derivatives many of which trade on largely unregulated Over-the-counter markets.

In the meantime, the gap in employment rates between America‚Äôs highest and lowest-income families has stretched to its widest levels since officials began tracking the data a decade ago, according to an analysis of government data conducted for The Associated Press. Something’s got to give and when it does things could get ugly!

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