Gold: Home On The Range?
Source: Baseline
Chart: Recent massacre of gold by speculative selling
On Friday, March 12, 1999, hedging managers of gold producers received
phone calls from a leading bullion dealer asserting that the gold price
rally was over. At the time, the gold price had just barely broken above
its 200 day moving average, a key chart point. Further upside could have
damaged the equity and bond markets, as the Federal Reserve has stated
that it watches gold to predict future inflation. A strong showing by
gold would force the Fed to raise interest rates. Recall that this
turning point was accompanied by strident calls from world leaders to
sell IMF gold, a prospect already discounted by the market. Proposed
quantities are too small to make a real difference, but IMF sales became the rallying cry for the bears.
In one particular call, a gold producer was advised to put on new
forwards (sell short) to take advantage of the imminent decline. On the following Monday, the gold price did in fact break. Subsequently, the gold price fell to fresh lows for 1999, underscoring the clairvoyance of the bullion dealer's exhortation to sell. Similar calls to other gold producers and hedge funds were made at the same time.
Our friend responded to the bullion dealer by saying that he was more
inclined to buy in his book (cover shorts) in light of the significant
chart point and the fact that the most recent CFTC numbers indicated a
large speculative short position of approximately 200 tons. He was told that the 80-90 tons of speculative shorts had already covered the night before. Incredulous, he asked how such a large short position could have been covered with so little disturbance of the gold price. He was told that there was "liquidity from everywhere" and "heavy producer selling."
No trader in his right mind would buy gold in the face of this
information. For years, bullion dealers have terrorized the gold
producers to such an extent that their market calls become
self-fulfilling. We have already described how bullion dealers spread
rumors to generate business. (see our recent commentary: Bullion
Dealers: Spin Meisters Of The Gold Market) We estimate that bullion
dealer compensation in the form of spreads and interest are as much as
$10 to $20million per year from some of the larger producers. Gold
producers have been lining the pockets of bullion dealers, in the name
of enhancing their corporate cash flow. In the process, they have
alienated investors who would buy gold shares for the upside in the
commodity, not sophisticated financial engineering.
Gold shares, as measured by the Philadelphia Gold Index (XAU), are
trading at the lowest levels in twenty years. This low ebb reflects
investor despair that gold has become a perpetual range trade, with no
real upside. Hedging by major producers has in large part created this
impression by helping to cap rallies. Relying on the Pavlovian response of gold producers to bullion dealer bell ringing, hedge funds have been able to profit consistently on the short side for the past three years.
What would happen if the gold mining community, when gold next
approaches the top of its range, were to take a public stance against
hedging in that instance? Such a statement could well be the catalyst
for an upside breakout that would create more value for shareholders in one month than the cumulative effects of financial engineering of the last five years.
Despite bullion dealer claims to the contrary, this most recent rally
was capped by speculative short selling. Bullion dealers borrowed gold
knowing that there would be a barrage of statements by public figures
calling for IMF gold sales. Central bank eagerness to lend gold to
bullion dealers, at miniscule interest rates, created the cheap supply
to cap the rally. For the sake of generating returns of less than 2% per annum on a small portion of their gold reserves, central banks have achieved a substantial devaluation of one their most important reserve assets. Congratulations are in order to the new, enlightened breed of central bankers for this stunning accomplishment. It is worth asking whether the voters of the various nations whose central bankers are engaged in lending, call writing, and other activities that diminish the value of this important reserve asset are aware that this is going on, and if so, whether they would endorse these goings on.
The rally was capped by speculative selling made possible by central
bank lending. Producer selling was only a minor factor and there was no central bank seller. In fact, speculative short covering (at a healthy loss) by commodity traders was overwhelmed by dealer short selling. Gold is locked in a trading range dictated by the overpopulated bullion dealing community which has now succeeded in shafting all of its constituencies, commodity traders, gold producers, and central banks.
This can only go on for so long. Fundamentals are lining up on the
bullish side. It is only a matter of time before the bullion dealers
themselves realize that their self-interest lies in taking the long side of the equation.
Gold fundamentals at this juncture are simple to summarize. The price
has been beaten down to such a low level that most producers are not
reporting profits. Pressure has come from a combination of producer
selling, central bank selling and speculative selling, often in
connection with a carry trade that shorts gold to buy financial assets.
There is today a massive short interest that, in all likelihood, defies accurate calculation. The highest estimates could easily be too low.
Looking ahead, central bank selling will decline sharply. The already
wide deficit of supply relative to demand is growing based on the
recovery of Asia. Gold producers have only limited capacity to expand
forward positions. Therefore, only speculative short selling is
available to hold down the gold price. For the gold market to go lower,
it must get even shorter. How foolish it would be for the gold mining
community to continue to aid and abet the collusive behavior of
speculators and bullion dealers that has all but destroyed their equity evaluations. How contrary to their respective national interests are the new age central bank management practices designed to gain a little income for the price of undermining the value of a key reserve asset.
Gold is a financial asset. The position of the financial markets is
precarious. New highs in the averages mask the underlying deterioration.
Almost two thirds of all stocks are already in well-defined downtrends. Valuations of the leading market issues are indefensible by any rational standard. At the same time, long-term interest rates are creeping higher. A rise in short term interest rates would lead to a severe market break. A breakout in the gold price is as good as an interest rate increase. With the recovery in Asia beginning to gather steam, the downtrend in commodity prices is coming to an end. Even traders at bullion dealers will soon recognize that gold's trading range is a distinctly uncomfortable place.
John Hathaway
April 1999
Mr. Hathaway is a Senior Portfolio Manager at Tocqueville Asset
Management L.P. and portfolio manager of The Tocqueville Gold Fund.
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