Dear Crowne Gold Clients;

1994 REVISITED

By Eric J. Fry
DailyReckoning.com
Thursday, March 24, 2005

http://www.dailyreckoning.com/RudeAwake/Articles/RA032405.html

Two days ago, your New York editor guessed that Villanova might win the NCAA championships and that gold might soon resume its rally. The good news is that Villanova still has a chance. ...

The bad news is that Alan Greenspan thrust a semantic stake through the heart of the gold market .. .or so it has seemed since last Tuesday.

The chairman's quarter-point rate hike -- and his accompanying verbiage -- stunned the gold market, while also rocking most other financial markets. But despite gold's near-death experience this week, we suspect it will rise again ... along with most other commodity markets.

The commodity bull market might be out of breath, but we doubt it will suffocate.

Last Tuesday, around 2:15 Eastern Time, the benign American financial environment suddenly assumed a very menacing demeanor. At that very moment, Chairman Greenspan hiked short-term interest rates one-
quarter point to 2.75 percent. Within minutes, investors rushed to sell stocks, bonds, oil, gold, and every other financial asset that wasn't bolted to the floor. By day's end, the Dow had dropped nearly 100 points, crude oil had slipped nearly two dollars from its high and gold had tumbled nearly 10 dollars.

The Fed's itty-bitty adjustment to its itty-bitty interest rate should not have produced such a mess. After all, nearly every economist and investor in the land had anticipated this exact move. Apparently, however, all these economists and investors were not
prepared to learn that the chairman considered inflation to be a problem.

"Though longer-term inflation expectations remain well contained," declared the Fed's statement accompanying its rate hike, "pressures on inflation have picked up in recent months and pricing power is more evident."

This simple phrase erased billions of dollars of paper wealth in the span of a couple hours.

It is true, of course, that rising rates are not usually a great thing for asset prices. But they are not always disastrous. To generalize, FALLING interests rates tend to encourage speculation in all manner of financial assets. Conversely, rising rates tend to reacquaint investors with the concept of risk-aversion. And a risk-
averse investor is usually a seller of speculative of financial assets like emerging market stocks and bonds, as well as U.S. junk bonds and small cap stocks. In short, the riskier the asset, the more
damaging the effects of rising rates...at least that's the conventional wisdom.

If this wisdom proves true during this particular interest rate cycle, the red-hot emerging market stocks and U.S. small caps depicted below might be due for a lengthy cooling-off period.

However, commodities and resource stocks are somewhat more difficult to handicap. That's because they are very schizophrenic creatures in a rising rate environment. They are speculative, to be sure. But they
are also inflation hedges, which tend to excel during cycles of rising interest rates.

Therefore, this week's steep selloff in nearly every financial asset -- including gold -- compels us to ask ourselves two questions: 1) Is this the beginning of a serious correction in financial asset prices?
2) Once this correction of uncertain duration runs its course, which financial assets are most likely to reassert themselves?

To preview our conclusion: Financial assets that melt slowly when exposed to extreme heat are likely to perform better than those that burst into flames.

As a guide to the future, let's examine a small slice of recent history: 1994.

The most recent example of a "shocking" rate hike by the Fed occurred 11 years ago, on February 4, 1994. On that fateful day, recalls Matein Khalid of the Khaleej Times, "Chairman Greenspan dropped a bombshell on Wall Street. The Fed raised overnight Funds Rate from 3
to 3.25 percent. To the world, this was no big deal, a routine monetary tightening response to a slight up tick in inflation and GDP growth. However, on Wall Street, it was pure panic, a Black Death in the capital markets. Within two months, an estimated $1.5 trillion
was wiped out in the bond markets. ... Orange County, the wealthiest in the United States, went bankrupt. David Askin, one of world's leading mortgage derivates managers, blew up his entire $600 million
hedge fund. Dozens of supposedly 'safe' U.S. Treasury and money market funds lost 10-30 percent of their capital whose beneficiaries were literally widows and orphans. Proctor and Gamble, which is supposed to make money selling Pampers, needed Pampers itself as its
structured Libor notes went ballistic."

Ninety days after Greenspan's February 1994 shocker, every major financial market had fallen, especially the bond market. 10-year bond yields soared from 5.87 to 7.11 percent. The commodity markets shared the bond market's pain, as the rising rate trend threatened to slow
the world economy and curtail demand for natural resources.

However, one year after Greenspan's infamous rate hike, the S&P 500 and the CRB Index had both recouped their losses. Crude oil was up 20 percent and copper -- the commodity with a PhD in economics -- had
gained 50 percent. In other words, Greenspan's "shocking" rate hike of February 1994 jolted the commodity markets but did not electrocute them.

We expect history to repeat itself. In other words, the commodity bull market is merely resting, not retiring.

In the "oil glut" days of 1994, the supply of oil swamped demand. What's more, China consumed less than half the oil per day that it does now ... and still crude oil jumped 20 percent in the face of rising interest rates. Oil possesses a much more bullish profile today than it did in 1994, and so do most other commodities. Whether
rates are falling or rising, supplies struggle to keep pace with demand.

"China's long-run rise is inevitable," observes Justice Little, co-editor of Outstanding Investments. "Long-term erosion of the dollar is equally sure. For both of these reasons, I agree with Jim Rogers' assertions that we are in the early stages of a commodity bull market
that could last another decade or more."

Even so, Justice admits, "China may have gotten ahead of itself and the dollar still has the ability to confound in the near term. ... We have to be prepared for potentially rough waters in the latter half
of 2005. ...China is a compelling long-run story, but in the short run, the dragon may be close to overheating. Shanghai, for example, is experiencing a real estate bubble every bit as over-the-top as southern California's, and the fidgety nature of 'hot money' being pumped into China's infrastructure development is making even the most aggressive money managers nervous.

"In addition, the Federal Reserve is finally admitting what everyone else saw a long time ag that inflation is taking hold and the interest rate hikes may need to accelerate. The Fed slamming on the brakes could temporarily put the brakes on U.S. consumption as well,
and an ensuing slump in demand could temporarily take the wind out of crude oil's sails."

"This is not an alarm signal as much as a watch signal," Justice warns. "Crude may yet break through $70 without a hitch. Given that possibility, however, it's crucial to recognize that we are entering a delicate stage of the game. Multiple trends that have been intact
for the past year, if not longer, are showing signs of fraying ... and clear potential for unraveling is at hand."

We acknowledge this potential. But we also acknowledge the potential for the Federal Reserve to fail in its efforts to quell inflation, and the potential for global demand trends to drive commodity prices much higher and the potential for investors to prefer holding gold to
dollars.

In short, we suspect the commodity bull market is more powerful than Alan Greenspan's lexicon.

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