Tuesday, 12 June 2012

After the Gold Rush.

June 2012 -- I first wrote on this subject back at the end of 2010. At the time I knew I was right, but often you can see the market through a telescope, and react too soon, and that was certainly my concern back then. Gold was overvalued but the famous axiom says that markets can stay irrational longer than you can remain solvent.

However I believe the turn is here and it is real. My new concern is based on this graph of weekly prices. Here are the 10 and 50-week EMA lines for GLD. For the first time in 11 years (not counting the sub-prime crises) there has been a serious crossing of the lines.

I have included a graph of Gold vs the stock market (gold is on the bottom) but you don’t need a graph to know the price is way too high already.

The gold market works much like any other, with supply and demand eventually equalizing, and runaway prices returning to long-term averages. Since 1980, the price of gold has averaged about $440 an ounce in U.S. dollars. But much like U.S. home prices over this decade, it can take some time for prices to return to normal.

Barclays Wealth in London predicts gold will fall to a fair value of $800 an ounce, as investors eventually dump it for riskier trades; Societe Generale, the French bank, in April 2009 predicted $800 gold. Analyst John Nadler of gold dealer Kitco predicts gold will fall to $900. Their reasoning is simple: investors are keeping prices high even as demand from non-investors is cratering. These men are economists, I am a speculator -- I know that things could be much worse than $800 an oz. $800 might be a fair number but we always overshoot fair numbers. Even the floor number of $500 an ounce (the cost of production) may be possible. After all Gold traded for years at its old production cost of $350 an oz.

Supply and demand dictates gold prices go up when demand for gold goes up, so someone is buying gold, but who is it? Could it be gold jewellery, which accounts for more than half of the world's gold market? Just the opposite, increased prices have curbed demand. Here is table of demand from the World Gold Council:

Demand of jewellery gold fell 6% in the first quarter of 2012 and is likely to continue to fall amid high prices that turn off shoppers. For example, in India, the largest gold buying country, high gold prices kept Indians from purchasing metal for the gold-buying festival of Akshaya Tritiya, which in turn drove down prices.

To find the answer of where the gold is going you must ask who is the world’s single largest buyer of gold? Are the Americans putting it in Ft. Knox? Is it China the new economic powerhouse? Perhaps tax evaders in Switzerland are putting it in vaults under the streets of Geneva?  No it is headed someplace new, it is an invention of Wall Street, an EFT (Exchange Traded Fund) better known by its ticker symbol, GLD. The GLD SPDR Gold Trust is an investment trust (started in 2004 -- note the change in the price of gold starting in 2005). Think of that, it only took 6 years to be the world’s biggest gold buyer! The Trust holds gold and issues SPDR Gold Shares in blocks of 100,000 Shares (Baskets) in exchange for deposits of gold and distributes gold in connection with redemptions of Baskets. The investment objective of the Trust is for the Shares to reflect the performance of the price of gold bullion. Originally, the details of buying, storing and insuring gold have made it difficult for most investors to enter the gold market on their own. SPDR Gold Trust solves this issue by creating securities that follow the gold market.

Even at its much lower Dec. 2007 levels, the GLD fund held more physical gold than China, the Netherlands, and the European Central Bank. It has more gold than Russia, the Bank of England, and Saudi Arabia. In fact, the difference between the gold reserves of the Bank of Japan and GLD in December was a measly 130 tons.

Let's do the math: GLD purchased 79 tons of gold between Dec. 2007 and July 2008. That corresponds to the total gold reserves of Australia or Kuwait. When gold approached the $1000 mark it retraced for a few months. Gold prices dropped briefly before they went on to gain it all back and more, however in the first two short months of the 2008 pullback the GLD fund liquidated 74.7 tons of gold... the equivalent of Egypt's total reserves.

Well GLD sure has a lot of gold, but do these gold ETFs really buy all that gold “one for one”? They are suppose to, but if they don’t the potential crash could be even worse because its one thing to rush to sell real gold -- but to try and sell paper that pretends to be gold is another matter. Rick Santelli is a pit trader from the CBOT commodities exchange and CNBC reporter who says there is not enough gold in these ETFs:

Warren Buffet’s has a ‘folksy’ comment he made in regards to speculators who take dangerous risks during economic bubbles. His point is that during the bubble it is hard to see these people as risk takers, until after the bubble pops. What he said was “You only know who is swimming naked when the tide goes out”. Certainly that comment is coming to mind right about now. In hindsight many institutions were swimming naked in the credit crisis and it appears many gold bugs are wearing less than they think in the present time.

Pierre Lassonde, former president of Newmont Mining and past chairman of the World Gold Council, made a couple of interesting disclosures about GLD's gold. First, most of it was then stored in HSBC's London vault, but HSBC was in the process of constructing a new vault just outside London expressly to accommodate GLD's expected growth. Second, he had actually visited the vault and saw the gold. However, the reason he said that is many people are wondering if GLD really has been buying all the physical gold it is suppose to. Well the answer is, no, not really. GLD is unable to buy real gold fast enough these days, and so it also is trading swaps on gold, it buys those in the form of warrants from the gold miners. In effect these are like guaranteed sales of gold into the future for mining companies, as fast as they can pull it out of the ground. In short the world is hording gold faster than it can be mined. That gold is already bought and paid for, but the store of wealth GLD is suppose to have, it does not really hold, it really does not yet have delivery of the gold they are suppose to have.

Gold Warrants are one thing -- at least eventually the miners must deliver real gold in exchange for them, but GLD is also allowed to lease gold from gold holders such as nations with gold reserves. Leasing gold means that in effect it is counted twice. If China leases gold to the GLD ETF they still hold it as part of their national reserves. GLD also counts the same gold as part of their holdings. What’s more if push come to shove and the world wants to pick up the physical gold -- is China likely to just hand it over, or even play fair and pay the unit holders for the gold? Nope China will not give up any gold on loan, they will just tear up the lease and stop returning phone calls. In fact, since it is ‘leased’, China has no obligation anyway. Short of declaring war (not a good idea), how do you make a major sovereign nation do anything?

GLD has never being willing to say how much gold is not real but in fact leased, however, one good clue comes from their sister fund that does the same thing with silver. For months this fund claims to be stockpiling more than the world’s production. Hmm how do they do that?

As long as we are pushing the limits of financial reality, try this one: GLD also has the right to “lease out” the gold it holds in the vaults. So central banks “lease out” the GLD gold and make their reserves look bigger. The fraud is made up of central bank gold reserves leasing the same small nucleus of gold over and over to each other.  In banking this is called leveraging up and there are laws to prevent over leveraging, most banks cannot leverage up over 18:1 but for a Gold ETF there is not a thing stopping it. In fact the prospectus specifically says they are doing it. Clearly someone is swimming naked, waiting for the tide to go out.

There's even more price pressure from the supply side. Unlike most commodities like Oil, Gold is relatively easy to find. We know the location of thousands of marginal mines that shut down when gold was at its low but could easily spring to life as demand ramps up. Those mines are opening up everyday and world gold production is skyrocketing. Higher gold prices mean miners work overtime. The supply of mine gold around the world jumped 7% last year to 2,572 tons-the second largest increase in history. Places like China and Russia will help boost the amount of gold from mining by 4% to 6% a year through 2014. Because it costs miners about $480 on average to extract an ounce of gold, they plough ahead when prices are high, eventually leading to an oversupply situation. Imagine a world full of miners working triple overtime – working in thousands of recently reopened -- mines dumping record gold inventories into the world

Gold at $1,600 also brings out the sellers and resellers. In 2012, scrap supply-all those gold pendants, necklaces and coins people have lying around-hit an all-time high of 1,800 tons. What of all those "we buy gold" signs, Internet advertisements and late night television commercials? Well, they're starting to work. That scrap supply is getting very high – in just one year (2008 vs 2009) scrap gold purchased jumped 27%. So long as prices remain above $1,000-$1,100 we will continue to see a river of secondary reclaimed gold actually starting to compete with mine production.

Yet investors continue to pile in to gold as a hedge against a “race to the bottom” for the worlds currencies, each trying to out do the other in devaluing the currency. But in 2011 things began to change and the world returned not to Gold but the US dollar as a safe haven.  

If the US $ looks a lot like a an upside down graph of the price of gold there is a good reason -- gold is priced in US dollars and moves 60% correlated to the value of the US dollar. A strengthening dollar equals a falling price of gold – and the opposite is true too.

Certainly there are lots and lots of arguments why gold will keep climbing, and this may not be the bottom yet. The US is printing money and creating inflation, US manufacturing went offshore to China, US unemployment is too high, US home prices are very low. Yup, I hear that. But the other side of the story is also compelling. How many speculators are piling into gold in pure trust that it is going to go to $3,000 an ounce?

How many people believe in things like this man who says $15,000 an once:

or Peter Schift predicting gold prices at $10,000 an ounce:

How many speculators have bought that gold on margin? Will that hold up if the economy does recover fully? The reality is today US firms are posting record profits, and are flush with cash. How long before that triggers M and A, IPOs and hiring? How long before US stock rise to compelling levels and investors want back into equities.

There is a basic reason why Gold did so well from 2008 to 2011, and it all kicked off with an email. On January 30, 2007, Jamie Mai wrote an email to his partners Charlie Ledley and Ben Hockett. "If a broad range of CDO spreads starts to widen," he said, "it means that a material global financial clusterfuck is likely occurring." This was the "subprime crisis" they had been waiting for. On January 31, 2007, a broad range of CDO spreads started to widen, dramatically. In other words, the banks had realized that for years they were selling cheep insurance against mortgage default and now they could smell trouble coming. The long-feared meltdown was upon us all -- not that most of us knew it, at the time -- and a very small number of investors were about to get paid out on the trade of their lifetimes.

Of course with this kind of foresight there comes great rewards. But they had also told many others on Wall Street about this and John Paulson had been listening, he to had been shorting the housing market by snapping up credit default swaps against the US mortgage industry. However Paulson was a whale running a huge fund. On Wall Street his bet was very very large and when he realized that the other side of his bet was held by Lehman brothers, Goldman Sachs and AIG and that these firm could never pay him. Within inches of victory on the edge of the housing collapse he realized he was “too smart by half”. Further it became obvious the US financial system could never hold together if he even got a good part of his massive bet paid out. But there was a saving grace, these same firms he bet against want desperately to hedge. They too want CDOs of there own to cover the risk of their bad bets, and as the crises unfolded there was Paulson and the rest ready to sell potential useless CDO right back to the stupid banks that never should have issued them in the first place. But still there was a nagging concern that the USA might not survive this, Paulson astutely placed his money not in to US funds or in US banks, he bought Gold lots of it. Two home runs in a row.

That was 2008, four years have past and disaster was avoided. The astute Dennis Gartman had been counselling long gold for some time, and so had George Soros. But the tide is changing. Paulson & Co, cut its stake in the SPDR Gold Trust for the second straight quarter.

Paulson held 17.3 million shares in the exchange-traded fund backed by bullion as of Dec. 31, 15 percent less than the 20.3 million on Sept. 30, Securities and Exchange Commission filings showed. His holdings fell 45 percent from end-June, the first reduction in more than two years. He is still the biggest stakeholder.

Dennis Gartman, investor and publisher of The Gartman Letter, says gold is just another "entity of trade" that rises and falls. "Save havens do not fall 7% in two weeks as gold in dollar terms has done. Save havens do not fall 3.6% in two weeks as gold in EUR terms has done. Safe havens are safe. Safe havens are stable; gold is not safe and certainly it is not stable and to think otherwise is to learn a very serious lesson in the course of the past two weeks."

If the tide goes out even a little, how much gold will GLD dump on the markets? Fund managers already got burned in 2007 for having long equity positions. Would not those same funds now be nervous about a super gold bubble? If gold drops 20% will mutual funds, and national banks along with ordinary people run for the exits?  Before the GLD most of the world’s gold was managed by countries and used as a hedge. Managers of these hedges can ride out panics and simply co-ordinate with other nations and agree not to sell. But that is over, they are no longer in control, and no one has asked what effect that might have on price stability. Don’t forget GLD is not a Mutual fund -- it is an ETF. It is not “managed” it simply buys and sells physical gold as needed, it is not allowed to “think”. There is no manager who says “Let’s hold out for better prices”, if the GLD units are traded in by the clients the ETF has only a few days to liquidate the underlying physical gold or their gold warrants. In a panic, what price will that gold get when it hits the markets? Worse what if after the physical gold is sold and more people want out of GLD, all that is left in the funds is worthless lease documents?

EFTs like the GLD do not move like a stock, they are very liquid. They keep the price they have by using arbitrage, there is always a computer market maker buyer of GLD units just pennies away from the current price, so that means in a panic, the ETF can not “bar the gates” or even drop in price, they must trade, and the cash flows right now.

Unlike a stock, all the holders of the ETF could get out in moments and the computers would sell to them at the price of gold as quoted, but then the GLD ETF would need to actually start selling physical gold a few days later. The price difference could be huge. The people that run the ETF say that gold can not move too far in a day, but there could be a run on gold this time of size and scale like never seen before.

Here where the panic will come from, when you sell your GLD ETF units you get market price that second. This is only possible because they hedge your sale with comex gold futures -- until they can sell the physical gold later. BUT in a panic, futures can go "limit down" in other words stop trading -- but the GLD ETF can't stop trading, they must sell your ETF for market price, (if the futures are limit down that means there is no hedge, or in wall street parlance, selling nakid) the day that happens GLD will need to sell real bars of Gold in a huge hurry, but they have WAY too much Gold, no one can buy that much. They have 2,000 metric tons of Gold. The US reserves in Ft. Knox are only twice that big, and it took 100 years to build that up.  No one has ever in history sold 100 tons of gold in a week, let alone 20 times that.  There just is no place to sell that much gold in 10 years, let alone a few days. Game over another crash much worse than in housing. 

It’s a perfect storm: As gold is pilling up in vaults in London and people are not consuming gold for jewellery, Mines are producing more gold than ever in human history, mines are even selling “to be found gold”, more gold than it is even possible to pull from the ground. Compound this further as some of the gold of these funds is double counted “leased gold”. Mean while as America recovers, equity risk is gaining momentum, the US dollar is strengthening. In a panic, Wall Street can’t stop the sale of the ETF units and the price will not adjust fast enough. Don’t forget the price of any stock or commodity goes down far faster than it goes up. Gold’s first panic “flash crash” could be in 2013.  

What I am not saying:
  • I am not saying the price of gold will drop in half today, but it could be as soon as now. In the past wild run ups have always gone on longer than I thought possible but this run does look out of steam.
  • I am not saying that gold might not drop a bit and run up some more, there are always some “head fakes” and bottom timing is not easy – catching a falling knife.

What I am saying:
  • There is far too much gold being mined and sold for the world’s needs and the price is clearly being manipulated by speculation. Speculation after a bubble always ends badly. Ask anyone who bought Internet stocks in 1999 or “nifty fifty” stocks in the 1960’s or tulips during the Holland tulip bubble.
  • Look at the graph of the rapid rise of gold prices. It is straight up since 2005. The crash down will be harder and faster than the rise up was. Most of the past 5 years of rapidly rising gold prices will be unwound in less than 8 months -- when the panic hits.
To everything there is a season, and
a time to every purpose under heaven:

A time to be born, and
a time to die;
a time to plant, and
a time to pluck up
that which is planted;

A time to kill, and
a time to heal;
a time to break down, and
a time to build up;

A time to get, and
a time to lose;
a time to keep, and
a time to cast away;

From The Bible
Attributed to King Solomon

  •  I think even if you went short gold today, that any near term future rise up, if any, will be less than the fall to come, so it might be time to look at heading against gold already. At least be like me and have your “finger on the sell short button”.

More to read:

No comments:

Post a Comment