Storm Watch Update from Jim Puplava
June 21, 2002
Changing Preferences:
The Velocity of Money & The Short Seller's Nightmare - Part 2
by James J. Puplava
Drastic Measures
In Argentina, the banks are closed and ordinary citizens have limited access to their funds. Their bank deposits -- or what remains of them -- are nearly worthless. For all practical purposes, the economy is degenerating into a barter system. Late last year Argentina defaulted on $95 billion in debt and devalued its currency. Now investors fear the currency disease may spread to other countries. In nearby Brazil, the currency of the country has fallen over 17 percent this year. International investors fear the socialist candidate for the presidency Luiz da Silva may follow through with promises to default on the country's debt. Brazil’s next government will face rising interest payments on its $345 billion in debt. The yield on short-term government paper has already risen to 18.9 percent. Soon, the government will need to tap into an IMF line of credit of $10-15 billion. 1
In Uruguay on Thursday, the government said it was abandoning trading bands for its currency and would allow the peso to trade freely. Uruguay’s Economic Minister, Alberto Bension, and Central Bank President, Cesar Rodriguez Battle, said they made the decision because of currency devaluations in nearby Argentina and Brazil. Mexico’s Finance Minister Francisco Gil Diaz said his nation might face the same cash shortfalls as Argentina. Diaz is calling for the government to reduce spending and raise taxes. The government has already begun to sell assets to raise money. Recently the government sold its 12 percent interest in Grupo Financiero, the nation’s largest bank for close to $1 billion. In the words of the Finance Minister, "At some point we won’t have anything left to sell, and that moment is very close.” 2
The battle of competitive currency devaluations continues as one country after another depreciates their currencies under competitive pressures. Each country is trying to gain an export advantage over its neighbor. The “beggar thy neighbor” policies of the present day hearken back to the trade wars of the 1930’s. These trade wars would eventually lead up to World War II. In the words of French political economist, Frédéric Bastiat (1801-1850), “When goods don’t cross borders, soldiers will.” 3
The Battle of Fiat Money
What we are presently witnessing is a worldwide recession that is being fought by governments through monetary policy. Each nation is trying to gain advantage over the other by depreciating their currency in order to edge out an advantage in the export of its goods. In the process, the value of money is being destroyed. The Austrian economist Murray Rothbard warned,
“With fiat based money established and gold outlawed, the way is clear for full-scale, government-run inflation… As always, government intervention to cure one problem raises a host of new, unexpected problems. In a world of fiat moneys, each country has its own money… Lack of monetary certainty disrupts trade further. The standard of living in each country thereby declines… Furthermore, government meddling with money has not only brought untold tyranny into the world; it has also brought chaos and not order. It has fragmented the peaceful, productive world market and shattered it into a thousand pieces, with trade and investment hobbled and hampered by myriad restrictions, controls, artificial rates, currency breakdowns, etc. It has helped bring about wars by transforming a world of peaceful intercourse into a jungle of warring currency blocks. In short, we find that coercion, in money as in other matters, brings, not order, but conflict and chaos.” 4
Look around you today. Is this not what we see occurring around the globe? Since the breakdown of the Bretton Woods system in 1971 and the end of the Smithsonian Agreement in 1973, the world has shifted to a system of fluctuating fiat currencies. This has led to a system of money moving freely around the globe into government and private assets such as securities that lack a secure backing and offer only tentative returns in exchange. The world’s entire financial system rests on the shaky platform of unlimited debt and the concomitant ability of central banks to supply a constant supply of money to the financial system in order to keep it liquid and functioning. In turn, this dependence has led to an extensive use of financial derivatives that are growing faster than the supply of money and debt as a means of hedging risk and enhancing speculation through the use of leverage.
Dual System
The use of derivatives has led to an increasing sophistication of risk plays by large institutions; while the average citizen is blind to the risk embedded in their investments. Instead of caution and a growing awareness of risk, the world marvels at the capital markets' revolution. What has evolved since the late 70’s is a dual system of money creation through the banking system and the securities markets. This has allowed governments to expand and increase the supply of money outside the channels of the banking system. Had this dual system of money not been created, governments would have had to resort to greater monetization of their debt through traditional banking channels. Had excess money been created through the traditional banking system, demand for goods and services would have increased relative to their supply -- resulting in higher rates of inflation.
Cognizant of the dangers of rising inflation, governments increasingly turned to central bankers for advice. In order to avoid a repeat of the inflationary 70’s, a revolution in the capital markets was invented to take its place. In Debt & Delusion Peter Warburton writes about this evolution in thinking. “Stung by a second serious inflation within seven years of the first, governments turned to their central banks for advice. The thrust of this advice was given in three parts: to raise short-term interest rates in order to restrain bank borrowing by individuals and businesses, to cut government borrowing and to finance the budget deficits by selling debt instruments (mainly bonds) to domestic and overseas investors.” 5
The credit system that has evolved has moved further away from the traditional banking system and towards the global financial system that we now have today. In this process, to quote Warburton again, ”…central banks seem not to have appreciated how the cultural shift from the money markets to the bond and equity markets would undermine their (central banks) own authority. Gone are the days when central banks could announce a new interest rate and validate it indefinitely through their operations in the money markets. Nowadays, the most important source of information about future interest rates is to be found in government bond markets, not in the minds of central bank policy committees. 6
Addicted to Credit
The expansion of credit and money has led to one crisis after another as individuals and institutions take on greater risk knowing that central bankers will bail them out if they fail. The moral hazard has become fully embedded in the financial system. This has led to growing anarchy in the financial system as we witness one financial crisis after another from Orange County to Mexico, Asia, LTCM, Argentina, and now Brazil. One by one, each crisis follows the one that preceded it in more rapid succession. This is what we are now seeing unfold in the present. The global financial system based on fiat currencies and unlimited debt creation is breaking down. To paraphrase the thesis of Warburton’s Debt & Delusion, the world has become addicted to credit and no longer cares about its consequences.
Global Stock Markets Hemorrhaging
Source: Sharefin
This breakdown is most visible in the collapse of financial markets around the globe and the rapid succession of devaluations worldwide. As shown in these graphs above from the U.S.' S&P 500, Japan's Nikkei, England's FTSE, France's CAC40 to Brazil's Bovespa, stock markets around the globe are hemorrhaging. In addition to financial markets, paper money is depreciating globally. Some are falling slowly; while others are collapsing. What we are seeing take place is the central banker's worst nightmare. Individuals and institutions are starting to rid themselves of paper. This explains the growing rise in the demand for gold and its price around the globe. Like the 1970’s money is starting to go back into “things” or real assets. In Japan, investors are beginning to exit the banks and buy gold. Gold buying is up over 100 percent from the year before. This phenomenon is starting to occur globally as one currency after another and one stock market after another falter and collapse. As the next series of graphs below illustrate, the price of gold in local currencies is rising around the globe as well.
"Things" Replacing "Paper"
Source: Sharefin
Gold's Ascendancy
As local currencies depreciate, the price of gold in that currency rises in direct proportion to the fall in the value of that currency. In effect, gold is once again taking on its historical mantle as real money. Investors worldwide are increasingly returning to gold as a means of safety from the growing perils that surround them. Faced with wars, sagging economies, falling stock markets and growing deficits, governments and central banks have resorted to rapid money creation in one form or another. That is the message of gold markets. Gold’s rise is a barometer of the financial system and the shape of things to come. It is flashing a warning that goes on unheeded by most holders of paper money.
What Would You Do?
Imagine you are a citizen of Brazil. You’ve seen the value of your currency decline 17 percent this year. The prices of goods are rising everywhere, but your leaders cannot explain why. Your country's stock market, the Bovespa, has declined by close to 20 percent this year. In dollar terms, it is down over 33 percent. You’ve watched with horror at the events that have taken place in neighboring Argentina. You want to protect your family and provide for your loved ones. You have little faith in the promises made by your countries leaders. They promise cures with no pain or they simply blame others. What is your most likely course of action? Do you trust your country's leaders? Is it time to think every man for himself? Many citizens are starting to wise up, flee the system and hedge their portfolios with gold. The smart money has already moved out of paper assets.
Precious Metals: Scarcity & Short Supply
The problem with gold and silver is that they are both scarce and in short supply. Supply has been unable to keep up with demand. Both precious metals have been running supply deficits for over a decade. The fact that the financial markets have not noticed this is an anomaly in itself. Central bank sales, gold leasing, producer hedging, and dishoarding by investors have made up that supply deficit. In the case of silver, the once abundant supply of silver has been whittled down to no more than two or three year’s worth of supply in silver. That figure isn’t accurate when you consider Warren Buffett is unlikely to part with his silver holdings -- roughly 32% of the known available supply of silver bullion. In today’s $40 plus trillion dollar financial markets, the annual production and the supply of gold and silver are pocket change. Annual silver production is no more than $2.3 billion. Annual gold production isn’t much more than $24 billion and the value of the world’s gold and silver equities is no more than $50-60 billion. When added together, both the annual value of gold and silver production and the value of the entire world’s mining stocks don’t come close to approaching the value of Coca Cola.
Even though gold and silver have been running supply deficits, their value has not been allowed to rise. Government intervention through bullion sales or leasing, the gold and silver carry trade, and the huge short position in gold and silver derivatives have kept the price down and have interfered in the normal market process. Under a free market system, the price of gold and silver would have risen in response to supply deficits. Instead, the price has actually fallen even as deficits have widened. Similar to the London Gold Pool of the late 1960’s its price has been suppressed. Eventually the London Gold Pool collapsed and the price of gold was liberated. Like a coiled up spring, it rose like a Phoenix from the ashes until it reached its pinnacle at over $800 an ounce in 1980. Where it will peak this time around is anyone’s guess. It would be safe to say given the amount of paper currency in circulation, gold’s price is more than likely to exceed 2-3 times its previous record. That is just a guess. It’s actual price rise could go even higher depending on the degree of currency debasement or the amount of fear that builds in the markets. All markets, whether paper or tangible, tend towards extremes driven by either fear or greed. In the case of human emotion, fear has proven to be the more powerful of the two.
Four Arguments for Higher Prices
The upside potential this time around, I believe, is much greater. There are several reasons, fundamentally and technically, why I believe gold and silver prices are headed much higher. There are others, more knowledgeable than I, who have written extensively about the numerous reasons why precious metals are headed higher -- much higher at that. However, I believe that they can be boiled down to four key arguments for higher prices: supply deficits, a record short position in gold and silver, currency debasement and what I call, "Brave Hearts and Strong Hands." War, government budget and trade deficits, faltering financial markets, distrust of the financial system, and a declining U.S. dollar are background noise and will only accelerate its rise.
#1 Supply Deficit
What needs to be understood is that gold and silver have been running supply deficits for more than a decade. Those deficits are based on industrial demand only. Monetary demand for metals hasn’t even entered into the picture. Moreover, there are no large new mines that are coming on stream over these next five years that could ameliorate the current supply deficit and even much less able to handle any increase that would result from a monetary demand for precious metals. It takes time to find new sources of supply and bring them into production. That time period is estimated to run between 5-6 years. Even if that time span could be shortened, there are no known large gold and silver minefields waiting to be explored. A multi-decade long bear market in the price of gold and silver has decimated the industry. Mines have been closed, production curtailed and exploration budgets slashed. The industry has consolidated through mergers or acquisitions or in many cases bankruptcies. New supplies just aren’t there to handle industrial demand much less monetary demand. The only solution is the liberation of gold and silver through higher prices. Only when that happens will the supply and demand imbalance be corrected. This means much higher prices are ahead of us.
Financial alchemy can’t fill the gap between supply and demand even though governments think they can achieve it. Paper cannot be turned into gold and silver. It has been one of the supreme lessons of history that has to be relearned in almost every generation by almost every government. In the words of Murray Rothbard written nearly half a century ago, “Of all the economic problems, money is possibly the most tangled, and perhaps where we need perspective. Money, moreover, is the economic area most encrusted and entangled with centuries of government meddling. Many people — many economists — usually devoted to the free markets stop short at money. Money they insist is different; it must be supplied by government and regulated by government. They never think of state control of money as interference in the free market; a free market in money is unthinkable to them. Governments must mint coins, issue paper, define 'legal tender', create central banks, pump money in and out, 'stabilize the price level,' etc.” 7
It is this sad lesson in history that must be relearned again. George Santayana said it well --
“Those who cannot remember the past are condemned to repeat it.”
#2 Short on Position
There are many other reasons why the price of gold and silver are heading higher. The most explosive one short-term is the huge short position in gold and silver, which has the potential to bring the financial system to its knees. In their article A Top in Gold at $330, authors James Sinclair and Harry Schultz describe the current short position in gold as “The Mother of all short positions in history”. According to their figures taken from the IMF and the BIS, that short position is estimated to be $280 billion. The reason we may call this "The Mother of all short positions” is that annual gold production is estimated to be around $24 billion in contrast to a short position of $280 billion. At some point, this short position will either be forced to be covered or those who have shorted gold will go under, thereby causing a financial crisis that will send metals prices north of the moon.
Source: Sharefin
A more accurate analysis of this short position can be summed up by simply saying, it can not be covered. The shorts would never even stand a chance of covering. Not unless every central bank in the world dishoarded its stockpile of gold or if every woman, man, and child turned over their gold jewelry in an effort to aid the short sellers. History and facts indicate that another epic crisis is ahead of us.
The same short position in gold is replicated in silver. In the case of silver, it is even more dramatic. There are no large central bank stockpiles of silver. According to the most recent CPM Group Silver Survey, there are only around 403 million ounces of refined silver left in the world outside of silver coin. Most of this silver has already been spoken for. The most reasonable guess is that there isn’t much more than 12-18 months worth of silver left to cover supply deficits. This is yet one more crisis waiting to erupt.
#3 Currency Debasement
Another fundamental argument for higher prices for gold and silver is the present state of the world’s monetary system. Most of the major currencies in the world have been depreciating. With economies now in recession, war on the horizon and most government budgets out of balance, currency debasement will be the result. From Roman emperors and kings of The Middle Ages to the Prime Ministers and Presidents of our present age, rulers have always haughtily claimed the profits of debasement as “seigniorage.” 8
The most likely outcome of this debasement is summed up in Rothbard’s book on What Has Government Done to our Money?. In it he concluded, ”As we face the future, the prognosis for the dollar and for the international monetary system is grim indeed. Until and unless we return to the classical gold standard at a realistic gold price, the international money system is fated to shift back and forth between fixed and fluctuating exchange rates with each system posing unsolved problems, working badly, and finally disintegrating… The prospect for the future is accelerating and runaway inflation at home, accompanied by monetary breakdown and economic warfare abroad. This prognosis can only be changed by a drastic alteration of the American and world monetary system: by the return to a free market commodity money such as gold, and by removing government totally from the money scene.” 9
#4 Brave Hearts and Strong Hands
The final reason for higher prices is that gold and silver investors are a different breed of investor. They are intelligent, long-term investors -- macro thinkers with a firm understanding of history and the role of gold and silver. Many have ridden out the bleak years of the bear market holding on to their physical bullion and equity shares. They are not about to relinquish those shares or physical metal when the prospects for vindication and redemption are at hand. To many who hold precious metals either in bullion or in equity form, gold and silver represents freedom. Gold and silver are the only form of money that isn’t someone else’s liability. No government stands behind the precious metals. They need no guarantees. They stand on their own. To their owners, precious metals represent the only real form of money in the world. In other words, brave hearts and strong hands control the metals markets.
I believe the four factors listed above are the main fundamental ingredients that will propel prices higher in the new bull market in gold and silver. Wars, rumors of war, falling financial markets and financial scandals are factors that will aid its ascent. They provide background noise to the main factors of supply and demand imbalances, a huge record short position, currency debasement, and investor strength.
How to Participate in the New Bull Market
When it comes to investing in these scarce resources, the gate is narrow and the selections are few. Investors can participate in this new bull market in three ways. They can buy gold and silver bullion, invest in gold or silver equities, or invest in paper gold and silver known as derivatives. In my opinion, the third option is not viable because of its limitation and shortcomings. The coming short squeeze may make those returns on paper uncollectible. Those entities who have sold metals short will not be able to deliver in the future once the short squeeze begins. All future settlements may have to be made in depreciating paper. Therefore, if investing in bullion, investors would be better off making investments in physical bullion and taking delivery or securing it in safe storage. Given the huge short positions, warehouse receipts may not be honored at a time of crisis. So if investing in physical gold and/or silver, always insist on taking delivery. You then have a safe storage for your investment. Given what we now know about supplies, deficits and inventories, the time to buy physical is on a short fuse.
A second way to participate in the metals markets is to own shares in gold and silver producers. When investing in equities, it is imperative to avoid the shares of heavily hedged mining companies. These companies have sold their gold and silver short at lower prices. Therefore, they will not participate in the rise in metals to the same extent as unhedged companies. In fact, many companies may go under because of their hedged positions. They will not be able to deliver into their hedge book and the value of their hedges may go negative, as is the case with Barrick Gold and many others who have hedged their production. This is reflected in the difference in the performance of the XAU and the HUI indices. As of today, the HUI Index of unhedged gold and silver mining companies is up 109.67% year to date; whereas in comparison, the XAU Index is up only 43.6%. This narrows the choice to very few unhedged companies. As I mentioned earlier, the choices are few and the selection is narrow.
HUI (Amex Gold Bugs Index) Market Cap 6/21/02
AEM Agnico Eagle 1.08 Billion
CDE Coeur D'Alene 103.9 Million
FCX_pc Freeport-McMoran PR C 103.1 Million
HL Hecla Mining Co. 352.2 Million
ASA ASA, Ltd. 342.7 Million
GLG Glamis Gold 801.1 Million
NEM Newmont Mining 9.90 Billion
FCX Freeport-McMoran GD 2.78 Billion
Source: Yahoo! Finance
FYI: the market cap for Coca Cola is $139.1 Billion
An example of how thin this market is can be seen by the current capitalization of the HUI. Very few companies have market caps over a billion. The goliaths of the gold industry such as Newmont, Barrick, Anglo American, and AngloGold have market caps under $10 billion. Most gold and silver mining companies have market caps under $1 billion. Most of the industry is made up of juniors. In effect, these juniors are really in the micro-cap class. They are thinly traded with a small float of shares available for the investment public. That is why many of these high-grade juniors have seen their share prices rise between 100-600 percent this year. The reason that they have risen so dramatically is threefold. The first is that there are very few shares available. Scarcity means higher price when demand rises. The second is that juniors are the main future supply of gold and silver reserves. The majors will have to replace their reserves or go out of existence. Since it takes 5 to 6 years to find gold and silver and bring it into production, it is much easier to buy shares of a junior.
Those who now want into this market will have to make their purchases in a period of scarcity. The supply of above-ground silver is vanishing. Gold is scarce outside the vaults of central banks. Even then, central banks have sold or lent out a major portion of their holdings. The gold that has been sold is either in the form of coin or worn as jewelry around the world. To the women of the world, their gold is just as precious. They would have very little sympathy for the plight of the short seller. That is why in the end, the laws of supply and demand will eventually win out.
Sleepless Nights Ahead For Some
Markets always win despite the best efforts of government to thwart them. This has been an irrefutable lesson of history, which tragically must be repeated. It is a lesson that has been forgotten by today’s short sellers. Each day as they turn on their computer screens, read or watch the news, they are reminded of their predicament. There are tensions in the Middle East. There are wars in Asia. Terrorism threatens to bring the world closer to World War. In the financial markets, the value of paper is steadily eroding as confidence slowly evaporates. Investor preference is changing as well. It is moving ever so slowly away from paper and back to things -- especially gold and silver. This inevitable crisis is what keeps governments and short sellers awake at night. It has become their nightmare.
Those who own precious metals are aware of its 5,000-year track record. They own it because of strong convictions held through a very long and protracted bear market. Gold and silver investors represent a different class of investors. They think long-term, just like the durability of the metals they own. Those shares of precious metals stocks or the bullion will not be relinquished. Any pullback will only be used to buy from those who are foolish enough to sell at today’s multi-decade lows. This is something to ponder if you are short, thinking of selling, or just now thinking of buying. For those who own bullion or shares in gold and silver equities, patience and persistence are about to be rewarded. For those who have sold short, a nightmare is slowly unfolding. ~ JP
© 2002 James J. Puplava
ENDNOTES
1 Rebella, Jorge, "Uruguay Currency Plunges After Peso Allowed to Trade," Bloomberg.com, June 20, 2002.
2 Ibid. See also:
Fear Mounts in Uruguay of Argentina-Style Crisis, Reuters 6/21/02
Mexico Could be Next Argentina, Reuters 6/20/02
Germany's BEAL is Latest Bank to Leave Argentina, Reuters, 6/21/02
3 Bastiat, Frédéric, The Law
4 Rothbard, Murray, What Has Government Done to our Money?, Pondview Books, p. 85-89
5 Warburton, Peter, Debt & Delusion, Trafalgar Square, 1999, p. 15.
6 Ibid., p. 16.
7 Rothbard, Murray, What Has Government Done to our Money?, Pondview Books, p. 12
8 Ibid., p. 63.
9 Ibid., p. 111.
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