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Wednesday, August 16, 2006

Back to Basics

By William Trent, CFA of Stock Market Beat

Our Watch List has twice the allocation to basic materials (6%) as the S&P 500 index. As we wanted the list to be well-diversified, this is the largest discrepancy we permitted when building the list. On an industry basis, we have a 3% weighting in metal mining, compared to just half a percent for the S&P.
Metals, both base and precious, continue to rise. Nickel is flirting with record highs. Meanwhile, the PPI data shows strong increases in steel and aluminum (thumbnail charts below.)

South Africa, the world’s biggest producer of precious metals and ferroalloys, said metals and minerals output fell 1.2 percent in June from a year earlier. Gold production dropped 9.5 percent.
The supply of gold from South African mines has become increasingly constrained, resulting in a significant drop in the country’s contribution to global mine supply from 28% in 1990 to 13% last year. The tightening supply of gold is causing some mainstream analysts to forecast a $1,200 per ounce price.

Others are predicting even greater increases in the gold price, as the tightening supply is being met by increased demand for gold reserves from emerging market central banks. As Doug Casey writes in What We Now Know:

In the International Speculator, we’ve often mentioned the inevitable move by central banks to diversify their reserves out of the U.S. dollar. We’ve noted that, apart from the current situation, there is no precedent for any non-redeemable paper currency being held as the primary reserve of the world’s central banks.

That diversification out of the dollar, with a lot going into gold, has begun. A regime change is afoot–though few have yet recognized it.

Recently, Russian President Vladimir Putin ordered the Russian central bank to raise the gold share of its foreign reserves from 5% to 10%. That’s no small matter, given that Russia’s reserves have surged to $247 billion–the world’s fourth largest.

Meanwhile, in China, Monetary Committee member Yu Yongding is not alone in calling for Beijing to diversify its $875 billion reserves into gold to protect against a tumbling dollar.

Given the trillions of U.S. dollars washing around the world’s monetary system, these are not inconsequential developments. Quite the contrary. They greatly favor gold and other tangibles.

It may seem that the recent rise in metals prices is due for a correction. However, the case for an overweight position (falling supply, rising demand) in materials producers still seems strong, in our view.

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