Thursday, May 3, 2012

Gold Revisited

Gold has broken to below its multi-year trend after hitting a peak around $1,800 in August of last year. Its a good time to re-evaluate gold investment and ask what, if anything, has changed.

I have noted on several occasions how both the gold and silver markets are manipulated but the Federal Reserve, and likely, by other Western central banks around the world. In those previous posts I pointed out that the Fed seeks to stimulate growth by promoting higher stock prices, low interest rates and relatively weak precious metals prices. As pointed out previously, this is because consumer confidence is linked to higher stock prices which has a "wealth effect", that is, we feel more confident in spending money when our 401k's are going up. Low interest rates make it easier to buy new cars and homes. A gradual (rather than quick) rise in precious metals does not raise the alarm of coming inflation.

Gold now seems to have broken its gradual rise that it has exhibited for about 12 years. Over that time gold gave its investors a huge gift of both low volatility and stock market beating returns. For those of us that held gold, you could not have asked for a better (and pardon the pun) "goldilocks" environment.

This period of easy returns is, at least for now, over. The Fed has realized that the cost of gold and silver rising has lead to alarm bells ringing for those of us who are rightly concerned with profligate spending and zero rate interest, easy money policies (ZIRP).

For those not familiar with commodities and futures markets, its worth taking a moment to explain the difference in commodity markets. After all, certainly you are wondering, "If central banks can manipulate commodity prices, why are food and gas going up? Why not manipulate those prices down too"? Its a fair question that deserves some explanation.

Commodity futures markets are made up both of speculators and end users who need those commodities as inputs for the products they make. Each future contract trades with an expiration date. At expiry, the final holder of the contract can settle in cash or take delivery of the commodity. With oil, wheat & rice, the commodity will likely be consumed by those producers who need the product as an inputs for their product. After all, refineries need the oil to make gasoline and companies such as General Mills, need wheat and rice to make breakfast cereal. Now contrast this with precious metals. Though some companies use gold, silver & palladium for electronic devices, most precious metals are kept in their pure form and held in vaults. These contracts are rarely held for "physical delivery" the way oil or wheat are. Thus, the global supply does not change in any significant amount with any month's futures contract expiration.

Because of this, banks have realized they can create "paper contracts" in large amounts without any great fear of having to stand for delivery. the ratio of "paper gold" to real gold is not known for sure but is estimated to be about 100 to 1. That is, there are contracts worth 100oz for every actual physical ounce of the actual precious metal. The banks only have to keep a small fraction of the physical metal to back the massive amounts of "paper gold" they have sold. If you think about it, its a fractional reserve system exactly like banks regularly do with money. When you deposit $100 with your bank, they must, by law, hold 10% in reserve. That means they can loan $1,000 for every $100 deposit they hold. Gold however is not regulated this way. Banks can write as many derivative contracts (their value is derived by the value of the metal) as they feel is prudent. This is exactly what they did with mortgages but instead of being leveraged 30:1 they are leveraged 100:1!!!!!

Bank Runs
In the 1930's many banks closed when there was a "run on the banks". That is, depositors demanded their money back but the banks had loaned all the money out and did not have the cash on hand to give back to their depositors. In a similar way, a gold run could happen as people and institutions realize that there is not enough gold to back all those derivative contracts they sold. This is why I advocate that investors hold physical gold rather than through an ETF which may or may not be backed by the real thing. Just imagine a game of musical chairs with 100 people. when the music stops, there is only one chair, one winner.

If the concept of holding physical gold became public wisdom the way internet stock investing was in the 1990's or buying real estate was in the 2000's then you would see the price of gold skyrocket as the banks had to deleverage their 100:1 positions.

To prevent this, the Fed is doing what it failed to do in the 1990's with stocks or with real estate in the 2000's, its smashing the price to prevent too much "irrational exuberance". This is what we saw one year ago when silver had accelerated from $11 per ounce to nearly $50 per ounce. Lately we've seen it happen again and again where huge volumes of contracts were dumped into the market in a way no sane seller would do, in order to take the price down. There is no rational reason any trader would dump such a huge volume of contracts unless the only objective was to take the price down.

This has been very effective over the last year. As I have stated in previous posts, it has also enabled China to buy huge amounts at a discount. I believe countries like China have placed a strong floor under the price, as they are buyers on every take down.

On Monday another take down was attempted.....but failed! Just how big was the trade? The Wall Street Journal reports:

The CME Group Inc.’s Comex division recorded an unusually large transaction of 7,500 gold futures during one minute of trading at 8:31 a.m. EDT. The sale took out blocks of bids as large as 84 contracts in one fell swoop and cut prices down to $1,648.80 a troy ounce. The overall transaction was worth more than $1.24 billion

Yup, one trade worth over a billion dollars. It also followed an additional pattern of "interventions" timed in thinly traded markets.

 At 750,000 troy ounces, such large trades are rarely conducted amid very thin trading volumes. Monday trading was expected to be quiet as market participants in China and Japan are out on holiday and many European traders are preparing for a holidays there.

This was the MO as the silver take down one year ago that occurred during thinly traded Asian trading hours on low volume. When large trades are made on low volume they have a disproportional impact on the price in the market. If you were a normal trader seeking the best price, this would be exactly the wrong time to place a trade so obviously the intent to take the price down is quite clear.

But on Monday, the reaction was not typical in gold. The price immediately bounced back!


 Trader Dan has more here

My suspicion is that the Fed is losing its ability to keep PM prices artificially low. They will not give up though. They implement their policies through primary dealers like JP Morgan who despite the Frank-Dodd bill, are still being allowed by the CFTC to hold larger than legal limits in metals contracts.

In the short term we are no longer benefiting from a gradual increase in the price of gold and silver as the Fed has been successful in depressing the prices. These actions have likely been taken to prepare the groundwork of more quantitative easing should we begin going back into a recession. Going forward they may be losing the ability to keep the price down or may allow the price to rise once a new round of quantitative easing begins.

Either way, the fundamentals for investing in gold and silver have become stronger in 2012 rather than weakening.

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