J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 11
Monday, December 30, 2002

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The Bottom Line:

o During the secular bull market in the US and similar bull
markets in other developed nations over the past 10-20 years
(the major exception being Japan), equity bears, gold bugs
and commodity players were an endangered species; financial
assets were king.

o Bull markets of such historical proportions take decades to
work off the excesses that had been built in prices at the
peaks. While the US equity market has declined for three
consecutive years, the bear market is far from over.
Conversely, the price of gold has only recently risen through
a massive 22-year falling wedge pattern, the breakout point
being somewhere above $330 per ounce. From the onset of 2002,
fears about a falling US dollar became a reality, with the
greenback losing 13 percent year to date and sinking below a
prior low seen in June of this year.

o With growing signs of deflationary pressures even in China,
policy makers around the world are moving to anti-deflation,
as opposed to their traditional role as inflation fighters.
Recent speeches by central bank officials in the US, UK and
Japan raise the possibility of global reflation. Any
reflation, ostensibly in the name of global economic revival,
strongly implies a structural weakening of the US dollar,
which also happens to be the world's largest reserve currency.

o Thus the forces driving the price of gold are much more
complex than just the recent political tensions. In addition,
if it were merely a question of a falling US dollar versus
other currencies, investors could merely switch out of the
dollar and into the euro and the yen. But gold has been rising
solidly against all major currencies -- even those currencies
that historically show a positive correlation to the movement
of gold prices such as the Swiss franc and the Australian
dollar. The implication is that what is happening is more than
just a major turn in the US dollar; it is also about a
potential major turn in financial assets against physical
commodities in general and gold in particular.

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The Equity Bears and Gold Bugs May Be Moving in to Stay
During the secular bull market in the US and similar bull markets in
other developed nations (the major exception being Japan), bears and
gold bugs were an endangered species, as were value investors.
Following a monster rally that propelled the price of gold 8.5-fold in
a mere four years between 1976 and 1980, gold had been in a major
secular bear market, one that took the price of gold down some 70
percent over the next 20-plus years from a peak of $850 per ounce to
around $256.

Conversely, as the gold market was crashing, a major secular bull
market emerged in US equities from 1982. It was a bull market of
historical proportions, lasting for the next 18 years to early 2000
despite a short-lived but nasty correction on "Black Tuesday" in 1987
that many erroneously heralded as the end of the secular bull market.

It takes decades to work off the excesses of bull markets of such
historical proportions. Technically, the price of gold has only
recently risen after a massive 22-year falling wedge pattern, the
breakout point being somewhere above $330 per ounce. Conversely, the
Dow Jones industrial average is showing a massive head-and-shoulders
secular bear formation. While the market has declined for three
consecutive years, the bear market is far from over.

Don't Count on Rising Equity Markets in 2003
As the year 2002 draws to a close, the US equity market will have
logged its third straight year of losses, the first time this has
happened since 1941. Yet market pundits, in delving into the equity
market's prospects for 2003, are far from sure that next year will be
a slam-dunk in terms of market gains. The last time that the Dow Jones
and the S&P 500 recorded four-year declines was 1929-1932. Following
the peak in the Dow in early 2000, equity investors have waited in
vain for stock markets to come back. While more value-oriented
investors had been suggesting that the US (particularly Nasdaq and the
tech, media and telecom offerings, known as TMT stocks) was way
over-priced and due for a tumble long before the major secular peak
was confirmed, they were much less willing to suggest that once the US
market peaked and a bear market began, it would take all major equity
markets down with it. However, that is exactly what happened. Over the
past three years, the MSCI World index is down by 36 percent, and the
level of decline is essentially unchanged even if we factor out the
US. In addition, the FTSE Eurotop 100 has declined more than the S&P
500 over the past three years, despite suggestions by market
strategists early on in the post-TMT bear market that investors would
be better off over-weighting Europe and the euro versus the US and its

Strategists also suggested that Japan would fair better than the US
because the Nikkei 225, which had been in the throes of a bear market
since 1990, was supposed to have presented less downside risk than the
US market, ostensibly because it had fallen so much already in the
decade prior. However, the Nikkei 225 actually has fallen more than
the S&P 500 during the last three years, according to data compiled by
Trust Net that is current to December 19, 2002.

Even the Hedge Funds Aren't Immune
For most equity investors, 2002 is a year they cannot wait to be done
with. According to Lipper, a Reuters company, recent rallies have done
little to ameliorate the damage: Science and technology funds have
tanked 42.3 percent, telecommunications funds have fallen 40.2 percent
and health/biotechnology funds have lost 29.7 percent. All are on
track to exceed last year's record losses. Even the so-called
"defensive" utility funds have also been hammered 24.2 percent thanks
to Enron and other scandals. The utility-fund losses in 2002 are
headed for their second-worst year on record -- only the 29.9 percent
fall in 1973 was worse.

In times of market uncertainty and high volatility, investors often
turn to hedge funds for solace. There are reports that even major
college endowment funds in the US have become active hedge fund
investors as the US bear market in equities drags on. But of the
various hedge fund strategies tracked by CSFB/Tremont (to the end of
November 2002), only global macro and hedge funds with a dedicated
short bias have managed to buck the global bear market in equities in
a convincing way, managing year-to-date aggregate gains of 14 percent
and 13 percent, respectively. Conversely, the more popular long-short
strategy hedge funds have lost some 2 percent year to date. Such
higher risk returns compare to a 13.8 percent return, for example, on
the Merrill Lynch Global Bond Fund.

Gold Rally Not a Fluke
Meanwhile, gold funds have been recording record gains. The HSBC
Global Gold and the FT Gold Mines indexes are both up more than 50
percent year to date, while three-year gains are well over 40 percent.
Moreover, the range of $325 to $340 per ounce is considered the
current "breakout area" for the gold price. This was an important
range in 1991-93 and 1985-86. It also marked the peaks of the October
99 spike. On December 20, the spot price of gold traded between
$338 and $343 an ounce. After starting 2002 at $270 an ounce, gold's
price is up 27 percent year to date. Ostensibly, gold's rally is
linked to a host of events: a weak stock market, terrorism fears, a
looming supply shortage if central banks and commercial banks try to
recover the bullion they have lent to third parties, and gold
producer efforts to reduce their hedge books. Since the secular bull
market in global equities cracked early in 2000 with the Nasdaq crash,
global investors have warily been eyeing the US dollar as an
over-priced asset.

From the onset of 2002, their fears about a falling dollar became a
reality, with the greenback losing 13 percent year to date, and
sinking below a prior low seen in June of this year. The dollar is
down to three-year lows against the euro because the replacement of
treasury secretary Paul O'Neill has fostered concerns regarding the
sustainability of the US strong-dollar policy. Saber rattling with
Iraq and the consistent movement of troops into the region are also
weighing on the sentiment surrounding the dollar.

The Dollar: Victim of Global Reflation?
With growing signs of deflationary pressures even in China, policy
makers around the world are moving to anti-deflation stances, as
opposed to their traditional role as inflation fighters. Recent
speeches by central bank officials in the US, UK and Japan raise the
possibility of global reflation. At the US Federal Reserve, Ben
Bernanke was quoted as saying: "The US government has a printing press
that allows it to purchase as many dollars as it wishes at essentially
no cost." From Alan Greenspan: "There is virtually no meaningful limit
to what we could inject were that necessary." Any reflation,
ostensibly in the name of global economic revival, strongly implies a
structural weakening of the dollar, which also happens to be the
world's largest reserve currency.

The prime cause of the increasing unease and debate over the prospect
of "deflation" in the US is the growing worry about the inability to
service debt. You can see the worry in the Fed's insistence that
a deflationary collapse cannot happen. In other words, they are very
concerned about the implications of deflation and rightly so.
Greenspan, Bernanke, et al have let it be known that they can and will
create all the dollars "necessary" to forestall this development,
which means that, right now, the most vulnerable "asset" in the US is
the dollar itself. Efforts to reflate will push down the value of the
dollar, while at the same time pushing up the value of gold.

Investors around the world are becoming more sophisticated in
understanding the relationships among the equity markets, the
dollar, local currencies and gold. Since most US investors have the
vast majority of their funds in US equities, they also need to
understand these relationships. The most important driver of gold
prices in both the medium and long term is the trend in
the dollar relative to other major currencies. Since the severing
of the link between gold and the dollar in 1971, gold has moved
inversely with the relative value of the dollar.

However, just looking at the trend in the dollar-denominated price of
gold does not tell the whole story about the underlying trend in the
value of gold. Gold could simply be rising in dollar terms because the
dollar is falling against other currencies, not because gold itself is
rising. To see how gold is really performing, one has to view its
price movement against several currencies, not just the dollar. Gold
is in a solid upward trend against all major currencies -- even those
currencies that historically show a positive correlation to the
movement of gold prices, such as the Swiss franc and the Australian

The current gold rally is not simply an issue of dollar
depreciation. From the lows seen in early 2001, gold has had a
dramatic rally, surging some 34 percent. Given the surging price of
gold, the aggregate market capitalization of the word's gold and
silver equities is now worth some $70 billion, up by 75 percent over
the previous year's levels. Average market capitalization values in
2002 are worth just less than 6,000 tons, or over two times annual
production. But comparatively speaking, market capitalization of the
sector is tiny. For example, the market capitalization of Toyota
Motors in Japan alone is some $92.4 billion.

As gold is a political commodity, new production and industrial
consumption are relatively unimportant determinants of gold's price,
even though many pundits make much of them. Unlike any other metal,
most of the gold that has ever been mined is sitting in the vaults of
central banks and the safe deposit boxes of investors. In other words,
gold is accumulated, not consumed. Indeed, there are some 130,000 tons
of above-ground gold stocks, compared to approximately 2,500 tons per
annum in new mine supplies. In this regard, while the CRB index, oil
prices and other commodity prices have also been on the rise despite
weak global economic conditions, there is no direct causal
relationship between gold and other commodity prices.

Because gold is a political commodity, it is in the true meaning of
the phrase, "price governed." That means actions by the world's
central governments are a major source of market uncertainty. The Gold
Antitrust Action Committee, a controversial group that contends
central banks and commercial banks for years have suppressed gold
prices, says this dollar-gold indicator (measured by the gold spot
price divided by the Fed's major currency dollar index) has in recent
history rarely gone above 3.25. This ratio of late has been above 3.25
for the last week or so. Thus if the "gold cartel" truly wanted to
suppress the price of gold, they probably could. Given the recent
surge in gold prices, the market is certainly susceptible to
short-term profit-taking.

But the world's central banks have learned long ago that they cannot
fight a major market move forever. Gold bugs have been focusing on the
apparently huge short-spread gold derivative positions on the books of
major gold bullion banks, which lease gold bullion from the central
banks. One major gold bullion bank in particular is reported to have
the equivalent of some 900 million ounces worth of positions, or more
than the entire amount of gold held by the world's central banks.
According to the scenario, risk-control programs would dictate that
these short-spread positions be backed by long gold positions at a
ratio of 1:0.6 when the price of gold breaches $330 per ounce and
essentially at a 1:1 ratio when the price of gold hits $354 an ounce.
Any attempt to reduce these positions over the short term would, of
course, cause the price of gold to skyrocket. At least one major gold
producer and a bullion bank have been taken to court on such
allegations. Blanchard & Co., a dealer in rare coins and precious
metals, has sued Barrick Gold and JP Morgan Chase & Co., accusing them
of making $2 billion profit by manipulating the price of gold. The
suit seeks a court order to end trading agreements between Barrick, JP
Morgan Chase and other unnamed bullion banks.

In addition, the five prerequisites for a sustainable gold rally
o A US current account in a deficit position that is growing.
o A sustained depreciation in the dollar.
o A long-term bottom in general commodity prices.
o Waning trust in paper assets, ostensibly because of a
sustained bear market.
o Decelerating capital appreciation momentum in the bond market.

The more entrenched these trends become, the more difficult it will be
for the "gold cartel" to artificially suppress gold prices. Moreover,
a "blow-up" of a gold bullion dealer's position could seriously
threaten their derivatives on all underlying assets, which run as high
as $72 trillion.

The Link between Gold and the Nikkei 225
The Nikkei 225 has on occasion tracked well with gold prices, but this
is merely because both react positively to a weaker dollar. Until
1990, the Nikkei 225 (in dollars and yen) was leaving the price of
gold in the dust but has since completely erased the gains it made
versus the price of gold since 1985, while gold is only now moving
above where it was in January 1985. As Japan is in much more dire need
of a major reflation than is the US, the reflation argument for a
weaker currency (and therefore better relative performance of gold and
gold shares) is arguably stronger for the Japanese yen than for the US

On the other hand, the yen has so far been supported against the
dollar and major trading currencies by: a) continued growth in net
foreign assets that have made Japan the world's largest creditor; b)
the fact that Japan's balance of payments surpluses are now largely
driven by income from foreign investments; and c) a surplus in the
social security system that significantly mitigates the much-
publicized gross government debt and festering nonperforming loans in
the banking sector, helping to create the apparent paradox of a strong
currency amidst serious fiscal and financial-sector problems.

For the first half of fiscal 2002, income from overseas investments
accounted for 59 percent of the current balance of payments surplus,
and the trade/income surplus of 10.1 trillion yen was largely being
recycled into direct and portfolio investments of 8.6 trillion yen.
Japan's international investment position as of the end of 2001 was
179.3 trillion yen, up 34.7 percent from the previous year and a
record high. Some 40.4 percent of the reported increase was
attributable to outward investments being funded by the current
account surplus, while 60.2 percent was due to the yen's depreciation.
In addition, liabilities decreased 23.1 trillion yen simply because
the value of equities held by foreigners depreciated as a result of
falling Japanese stock prices. Moreover, a weaker yen also made the
foreign direct investment and portfolio investments in foreign
currencies appear larger when quoted in yen.

While Japan's international investment position continues to increase,
the country is recycling the bulk of this back overseas, and the weak
yen makes the increase in the surplus look much larger than it
actually is. Thus, the major factor driving the price of gold -- a
secular breakdown in the value of the dollar -- does not necessarily
make gold and gold shares less attractive to Japanese investors.
Indeed, gold and gold shares are cropping up in the discussions of
strategists and economists of major investment banks and asset
managers. A veteran fund manager at one of Japan's larger asset
management companies says, "The Japanese economy is facing
extraordinary circumstances, and it would therefore be prudent to
allocate a certain portion of assets to physical assets such as gold."

If it were merely a question of a falling dollar, investing in the
euro or the yen would suffice, but the fact that gold is appreciating
against all major currencies including the gold-backed Swiss franc

a) Deteriorating trust in paper assets, ostensibly because of the
sustained bear market in equities and the structural debt overhang;

b) A long-term bottom in general commodity prices.

Under such circumstances, Japanese equities and, indeed, all financial
assets are in the same boat as US equities and the dollar. They're all
facing a new era where equity bears, gold bugs and commodity players
have their day in court, following a 20-year hiatus.

-- Darrel Whitten

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