Suddenly, Everybody is an 'Expert'

As we have pointed out on previous occasions, there has been a 'full court press' in the financial media against gold. It is amazing that an alleged  'barbarous relic' of no particular importance (according to Fed chief Bernanke, the US treasury only hangs on to its gold due to a kind of misguided nostalgia, i.e., because it's a 'tradition') all of a sudden receives so much attention.

It is noteworthy in this context that it garnered far less attention while its price went up. Today we regularly hear people holding forth about gold we have never heard from before. They only popped up once it broke through technical support and suffered a mini crash. Evidently here was a nest of gold bears somewhere – and most of them appear woefully uninformed about the gold market. However, that hasn't kept the financial press from publishing their screeds. It should also be pointed out in this context that so far, the low established in the course of the mid April crash continues to hold. All the bearish forecasts published since then have yet to prove their worth.

As we have mentioned as well, it is certainly possible to construct a valid bearish argument for gold. It is possible with regard to every financial asset at any point in time to fashion both bullish and bearish arguments that have at least theoretical validity. One can then contrast the bullish and bearish arguments and try to figure out which of them are likely to gain the upper hand.

 

Even that exercise is fraught with many uncertainties, especially in the short to medium term (it is much easier to come to conclusions about longer term outcomes). This is because we cannot know in advance which issues market participants will focus on in the short term. For instance, stock markets have risen in bubble-like fashion to a level of overvaluation on a par with the valuations seen at previous historical peaks, in spite of a very weak economy and a notable decline in earnings growth rates. This mainly happened because investors chose to focus on the 'eternal' Bernanke put instead of on the rather bleak underlying reality.

 

Dubious Arguments

In any event, the point we want to make is that many of the arguments that have been forwarded in recent weeks by gold bears make no sense whatsoever. Let us look at a few recent examples that weren't produced by unknown scribblers, but by the gold analysts of major banking institutions. For instance, Barron's reports on a recent analysis by Commerzbank:

 

“The steady exit from gold exchange-traded funds is as good a barometer as any for today’s low investment appetite for the metal. But here’s another way of looking at the outflows: Versus the size of central-banks’ gold buying.

For some analysts, ETFs have grown so important that central banks’ activities are now something of an afterthought.

Commerzbank’s strategists lay out the numbers this morning. Central banks bought about 30 tons of gold during April. So far in May, investors have pulled out the equivalent of 117 tons from ETFs like SPDR Gold Trust(GLD) and iShares Gold Trust (IAU). They’ve yanked more than 290 since the start of the quarter, according to the same figures.

‘[T]he 30 tons or so of gold purchased by central banks in April – as we reported yesterday – thus appear to be but a drop in the ocean,” write the firm’s strategists in a morning note.”

 

(emphasis added)

What is missing here is a mention that the '290 tons yanked from ETFs' are a 'drop in the ocean' as well. As we have pointed out many times, the buying and selling by central banks and gold ETFs is essentially immaterial to gold's price. It is just as immaterial as variations in the mine supply are. It simply makes no sense at all to focus on these data when trying to analyze gold. The total supply of gold is an estimated 175,000 tons. On the LBMA alone, as much  gold is traded every three to four days as is supplied by mines in an entire year. Anyone who is looking at the paltry amounts ETF and central banks buy or  sell in a period of three months is trying to analyze gold as if it were an industrial commodity. However, gold is not an industrial commodity, it is first and foremost a monetary commodity.

Gold must therefore akin to a currency and must be analyzed in a similar manner. Since the biggest component of gold demand is the reservation demand of current gold holders, one can only indirectly arrive at conclusions as to whether gold is more likely to rise or fall in the medium term (that its price will rise in the long term in terms of fiat confetti is a given, since the supply of the latter is always expanded at a far greater rate).

The notion that ETF sales are relevant to the gold price was also repeated in a bearish analysis released by Credit Suisse on Wednesday. Credit Suisse has the distinction of having turned bearish on gold before its recent swoon, but nevertheless several of its arguments demand rebuttal. All the talk about '450 tons of gold being sold here and absorbed there' can be safely ignored of course, as can the notion that gold was in a 'bubble' (we have already explained why gold is far from 'bubble territory'). We will therefore only look at the more nuanced arguments.

 

“The rationale behind the February call was Credit Suisse’s sense that the most fear-inducing chapter of the post-2008 crash environment began to draw to a close after the European Central Bank’s July 2012 decision to finally commit to being the lender of last resort to help the eurozone weather its debt crisis. The cornerstone for a slow recovery was finally in place, which undercut gold’s fear-based allure.”

 

To this we would note that it is true that a 'fear premium' that was embedded in gold's price has been taken away after the market's worst fears regarding the probability of euro area sovereign defaults receded. To think that the central bank somehow put in place the 'cornerstone for a slow recovery' is however erroneous. Central economic planning hasn't suddenly begun to 'work' as if by magic. Moreover, it is far from certain that the debt crisis is over. Let us not forget, the 'Draghi OMT put' has yet to be put to the test.

 

“Behind the latest call, published last week, is that the other major motivation for buying gold since the crisis—namely to hedge against inflation in the face of rapid expansion of central bank balance sheets, simply hasn’t been necessary. In fact, it’s been difficult to create any inflation at all, and a significant increase in the velocity of all the money sloshing around in the economy has not yet come to pass.

“Financial markets have decided that the remaining risks can be navigated in relative safety and so a growing number of investors think the opportunity cost of gold is too high a price to pay,” the report said.”

 

(emphasis added)

The opportunity cost of holding gold remains actually a strongly bullish factor, as real interest rates (nominal rates minus inflation expectations) remain deeply negative. So this is a spurious argument. As to the idea that the 'need to hedge against inflation' as somehow disappeared, this is preposterous. The need has rarely been greater. The Fed has inflated the true US money supply by 80% since 2008 and continues to inflate it at a brisk rate. The fact that officially reported 'CPI' hasn't increased much is not relevant in this context. For one thing, CPI has been tame throughout gold's bull market to date. It seems highly likely that it will eventually rise strongly, but the time lag involved can be very large – very often many years, even decades can pass before a vast increase in the money supply brings about a notable rise in final goods prices.

With regards to 'velocity', this is simply an erroneous concept. It is far more accurate to speak about the demand for money. 'Velocity' is nothing but a fudge factor that is used in the tautological 'equation of exchange' of the Fisherian quantity theory of money. When this so-called 'velocity' is deemed to be low, what is really happening is that the demand to hold cash balances is high. However, a high demand for holding cash balances is not a bearish factor for the gold price, but a bullish one. This is so because gold is a substitute for cash holdings. Anyone holding gold is essentially holding cash in form of another currency. In short, what CS believes to be a bearish argument is really a bullish one.

The remainder of CS's argument concerns itself with deliberations about ETF selling, which as we have pointed out above is simply nonsensical from the outset.

If this is all the bears can come up with, you should buy gold with both hands. As far as we are concerned, a bearish argument that may have some validity is that the rate of growth of the US budget deficit is declining. However, as we have previously discussed, the current budget deficit estimates may prove to be overoptimistic, as there was a large one-off effect occasioned by people rushing to take capital gains and corporations distributing dividends prior to the tax hikes instituted earlier this year. Moreover, the budget is highly sensitive to 'bubble revenue'. If the stock market bubble should falter, a large source of revenue (capital gains tax) will disappear.

Another bearish argument that deserves consideration is the fact that gold has stopped reacting positively to what should, on the surface at least, be bullish news. However, this can probably be explained by the fact that the perceptions regarding declining risk of sovereign defaults in the euro area have removed some of the 'risk premium' that was previously embedded in gold's price. Now that this premium is gone, the market is once again free to take other factors into account.

 

Conclusion:

The gold bears should really think of a few better reasons if they want to make a bearish case for gold that stands up to scrutiny.

Several of the most important drivers of the gold price remain very bullish, among them negative real interest rates, a brisk expansion of the money supply and the piling up of ever greater risks in the debt and other 'risk asset' markets.

To be sure, there are a few bearish arguments that deserve consideration, but in our opinion they hold less water than the bullish arguments at this stage. This is further buttressed by recent developments on the technical front, which are discussed in Part Two of our gold update.

 

Addendum: Gold in 2013 versus Gold In 1976

Ironically, the Commerzbank analysis included a comparison of the 1976 correction pattern with the 2013 correction pattern which according to the analysts should best be ignored. We will reproduce it anyway:

 


 

gold-76 versus 2013
Gold's 1976 correction pattern compared to the 2013 pattern. As Barron's notes: “The firm isn’t reading much into it and makes a point of calling it “not something to trade on.”  To this we say: we shall see. Via Commerzbank – click to enlarge.

 


 

 

 

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2 Responses to “Gold Update, Part One – A Plague of Experts”

  • ManAboutDallas:

    @RedQueenRace, who wrote
    “In theory gold could flow out of a fund simply by the investor redeeming his/her shares and taking possession of the physical gold and thus have nothing to do with selling. ”

    I guess you’ve never heard of a certain individual named “George Soros”. Mr. Soros is reported to have done just this recently. He is, of course, Soros, and perhaps that takes him out of the realm of mere mortals who have to be content with simply “buying and selling ” the shares of GLD, itself.

  • RedQueenRace:

    You’re correct to look askance at metal flows into an out of the ETFs for perhaps more reasons than you realize.

    Investors do not pull metals out of ETFs. All they do is buy and sell ETF shares in the market.

    In theory gold could flow out of a fund simply by the investor redeeming his/her shares and taking possession of the physical gold and thus have nothing to do with selling. In practice this does not happen because

    1) One must be an AP (Authorized Participant, e.g., market maker) to do so.

    2) The minimum redemption “basket” is so large virtually no individual investor could swing it. For GLD my understanding is the minimum “basket” is 100,000 shares and at today’s closing indicative value of $136.69 this would represent a dollar amount of $13,669,000.

    There are also redemption fees (GLD’s is $2000 or no more than 0.1% of the redemption) but coming up with $13+ million in shares to redeem would be the tough hurdle to leap.

    The following is my understanding of how this works, based on the ETF creation/redemption mechanism.

    Holdings are increased and decreased via arbitraging actions taken by the APs when the ETF share price gets too far out of line with intrinsic value. For example, using GLD:

    If the share price is sold down sufficiently below intrinsic value the AP buys the shares and shorts the physical. To close it delivers the shares to the ETF, receives the corresponding ounces of gold and delivers the gold to close the short physical position. ETF number of shares and holdings both decrease in proper proportion.

    If the share price is bid up sufficiently over the intrinsic value of the fund’s holdings the AP shorts the shares and buys the physical. To close the trade they deliver the gold to the ETF, who simply creates the appropriate number of shares which the AP then delivers to close the short. Holdings and number of shares outstanding both increase in the proper ratio.

    These actions keep the physical/share ratio at the desired level. For GLD each share should represent 1/10 of an ounce, though this ratio drifts lower over time due to fund expenses. It also provides arbitrage profit opportunities for the AP.

    It should be obvious that there is no specific level of physical holding the fund must have at any particular price. It simply must have the appropriate ratio between the outstanding share count vs. the underlying holdings. They could have 400,000 shares at a gold price of $1500 or they could have 400,000,000. All that matters is that it is backed by 1/10 (adjusted for expenses) ounce per share.
    As can be seen above, the ETF does not actively buy/sell gold for its holdings. It merely exchanges shares for gold and vice versa, though presumably it sells some gold periodically to cover its expenses (and reducing the gold/share ratio).

    If any investor who held GLD shares could redeem them at any time and in any quantity it would be possible to completely deplete GLD’s holdings without an ounce of gold being sold. It is set up however, to ensure the shares trade in the secondary market.

    The “ETF gold is being raided”, “investors yanked”, “ETFs dumped”, etc, arguments are wrong and based on an incorrect understanding of how the underlying assets move in and out of the funds. Gold could have declined to $1320 or whatever the low was in a more orderly fashion and without the loss of a single ounce of gold from the ETF. In fact, it would have even been possible for holdings to increase. Since the April low another 130+ tons have been “dumped” by GLD and yet the gold price is back above $1400.

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