Gold Top 20 Reasons... part 2
11) Derivatives: A House of Cards
“In the present economic crisis, with currencies collapsing like dominoes, the huge market itself is in for a major crisis. This would add to the need for greater rates of monetary reflation.”
Pro: Many derivative models assume a normal distribution of price returns. Periods of unusual volatility can easily blow out the assumptions of derivative pricing models and pose greater profit and loss risk to financial institutions that manage derivative books. This in fact happened last fall when the yen had its explosive move on October 7, which was calculated to be a 5 standard deviation move by a currency risk manager at Tiger, who conceivably lost more money that day than anyone else in the entire world. Gold did rise on the heels of that event, but it was at the very tail end of last fall's panic.
Con: The problem with this argument is that it depends on where the derivative risk is. Regarding gold's behavior under deflation, my research says that for gold to rise under a deflation-induced derivative blowout, there must be a sufficient reduction in bank capital to require a large injection of capital by monetary authorities which must be judged a reckless inflationary overkill in monetary stimulus. Turning to last fall's problem, Tiger's losses in yen (which can be considered a derivative as much of their position was leveraged) were born by private investors and did not require a public bailout. Moreover, nearly all of Tiger's investors have made so much money over the years that a flat return for one year was considered a hiccup in the bigger picture: “shaken not stirred.” The final problem is with the derivative argument is that no one person can tell you how many of the derivatives are vanilla currency forwards versus the more toxic positions. So maybe the derivative problem is overstated.
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12) The Ballooning U.S. Trade Deficit.
Citing the Bank Credit Analyst, “The U.S. is already the world's largest debtor nation, and there will be a limit to the willingness of global investors to acquire dollar assets. Large external deficits are unsustainable on a long-term basis because they eventually lead to a self-feeding cycle of rising debt-servicing cost and a further deterioration in the current account, and thus, even more debt. The adjustment mechanism to the U.S. current account deficit ultimately will involve a decline in the dollar.”
Pro: As the collapse of Asian currencies in 1997 was triggered by capital outflows which had up to that time supported deteriorating current accounts, it's easy to apply the same model to the U.S. It's only a matter of time until capital flows dry up and the dollar collapses.
Con: Japan's large trade surplus with the U.S. generates billions of dollars which the Japanese must either invest in US$ based assets or swap for foreign currencies. As long as attractive investment opportunities remain in the US, then those dollars will end up in the land of the free and the brave and the US trade deficit will be funded for longer than anyone cares to image. Perhaps the best argument for a collapse in the dollar is a genuine Japanese economic recovery which will cause the Japanese to sell their dollars for yen and invest back home. [This is the point made by Chih Kwan Chen in his internet posted article: pages.prodigy.net ]
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13) Long Term Asian Gold Demand Growth
“When the current economic downturn reverses, Asia will reach even higher levels of sustained gold demand.”
Pro: Prior to 1997, strong economic growth from Asian and other emerging market regions powered the strong commodity boom from 1993 to 1997. Gold was a major beneficiary of this strong trend. Supporting this pro argument is that the Southeast Asian populace just lived through a very devastating economic collapse during which gold correctly functioned as a hedge against currency depreciation. People will be quick to save gold once their income stabilizes.
Con: But incomes haven't stabilized in many cases despite the illusion of prosperity garnered by the explosive advance in Asian emerging market equities in 1999. In the last part of 1998, Southeast Asian demand was running at about one-half of its pre-1997 levels. One also has to be concerned about potential currency devaluations in China and India, as each of these events could cause after-the-fact gold sales as people cash in their gold once its purpose as a currency hedge is achieved.
Please cast your votes.
14) Asia Central Bank Gold Buying
“The combined Asian nations have about $730 billion dollars in central bank reserves. Growth in Asian gold reserves has slowed during the explosive equity bull market of the 1990s. Currently, their largest foreign reserve position by far is U.S. Treasuries. In the same way that the European Central Bank will have a reasonable percentage of its reserves in gold, the Asian central banks should also move toward a reasonable and prudent percentage of gold in their reserves.”
Pro: In a speech delivered at the World Gold Council's annual Central Bank forum last summer, I discussed the behavior of gold under deflation and proposed an optimal central bank reserve policy under deflationary conditions. My conclusion was simple: if deflation spreads to the United States, the US dollar may become at risk. My recommendation is that central banks should consider gold as a part of reserves, principally as a hedge against an overweight dollar position. Any purchase of central bank gold is positive for gold whether the demand originates from Asia or other geographic regions.
Con: Despite the sound reasons behind the diversification benefits of gold in an overweight dollar reserve portfolio, there has been little movement among the Asian central banks to buy gold. Even last year's rumors of China's gold purchases were not confirmed by official statistics released during early 1999 which confirmed that not one ounce of gold was purchased by China during 1998. Also against this point is the modern portfolio approach increasingly taken by more central banks whose focus on total return hurts gold against other currency choices that can be invested in government paper with higher yields than can be obtained from gold lending.
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15) A Massive, Unsustainable Short Position in Gold
“The consensus has been that these borrowings totaled something like 3,000 to 4,000 tonnes. In The 1998 Gold Book Annual, Frank Veneroso proves convincingly that the true total of gold loans at the end of 1997 was an astounding 8,000 tonnes. The big question is how would it be possible to repay this huge quantity of gold ($257 million ounces)? At some point the borrowers of this gold will face repayment, but 90% of the gold has been sold and consumed in jewelry manufacture. What happens when the currency crisis intensifies and central banks who have loaned most of this gold call these loans?”
Pro: Producer forward sales have been increasingly replaced by the purchase of put options as many producers don't feel comfortable hedging at such low gold prices. The problem with this strategy is that producers are so stingy in doling out the dollars for option premium that the put option's price is normally paid for by the sale of out-of-the money call options. Were a sharp rise in the gold price to occur, producers would have to buy large quantities of gold to cover their short gold call option positions. This situation could create an explosive gold rally of $50 to $100 dollars simply because of the delta hedging required to hedge the rising value of short call option positions.
Con: As long as the gold market stays in contango, it pays to be short. Earning that contango every day builds up a large reserve of accumulated profits which can withstand sustained gold rallies of 20 to 40 dollars without making longer term traders nervous. And for some smart producers like Barrick Resources who employ spot deferred contracts in their hedge books, were gold to rise suddenly, they can sell their current production at the current spot price and roll their existing forward sales out to future years, because of the dual nature of the spot-deferred contract's terms. Barrick has no reason to panic and buy gold to cover forward sale contracts were gold to rise suddenly.
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16) Shockingly Large Gold Trading Volume
“Worldwide trading volume in gold is vastly higher than most people realize. The average trading value of gold on the London bullion market averaged $12 billion per day in 1997 . . . Next time you see someone on CNBC talking about gold's minor role, remember that daily trading volume in gold is more than the total trading dollar volume in the major U.S. equity markets combined (NYSE, NASDAQ, and AMEX).”
Pro: In 1997, the London Bullion Market Association started the release of monthly trading volume in an effort to improve transparency in the gold market. Prior to 1997, the sole source of gold trading volume was futures volume data provided by the COMEX and Tocom exchanges. The first release of the LBMA's volume data met with some surprise and was higher than most participants expected. The figures do suggest that bullion trades in a quantity required to meet the liquidity requirements of many institutional investors, who have shied away from gold in the past due to gold's perception as a relative illiquid investment.
Con: It's common knowledge among bullion participants that trading volume in the upstairs spot market exceeds futures volume by several times. During 1994 and 1995 I conducted verbal surveys with the largest bullion dealers who indicated that upstairs liquidity exceeded the floor's liquidity by a factor of 3x to 5x for COMEX and 1x to 2x for Tocom. As a caveat, the dealers noted these liquidity factors were subject to substantial fluctuations on a day-to-day basis. I suspect these factors are lower in 1999. The primary problem with the LBMA numbers is that they include transfers of gold which may occur because of swap rollovers, collateral exchanges, and other activities which do not require a spot dealer to register a bid or offer. The LBMA numbers overstate gold's true liquidity and should be interpreted with caution.
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17) A Positive Real Rate of Return on Gold
Mr. Blanchard cites Frank Veneroso's book: The 1998 Gold Book Annual for the following fact: “between 1971 and 1996 the real price of gold in dollars increased three-fold. This constitutes a real return in excess of 5% per annum, which is higher than the real return on U.S. Treasury bills. Mr. Blanchard concludes: “Perhaps Frank's groundbreaking study will begin to convince the gold market that gold is a better investment over long periods of time than government T-bills.”
Pro: Certainly gold has outperformed T-bill returns during some historical periods. Central to the late 1970s gold bull market was the negative real rate of return experienced by T-bill holders whose nominal rate was more than wiped away by CPI increases. These types of inflationary macroeconomic episodes are generally favorable for gold or other physical commodities that can be hoarded as capital preservation tools.
Con: Veneroso's analysis is time dependent and many other time periods produce different results. Veneroso's results merely demonstrate that sometime in the past gold outperformed Treasury bills. Long periods of over/underperformance of asset classes is a common fact of modern investing. To imply that investors will suddenly buy gold because gold outperformed T-bills during a prior historical episode is a hollow argument if other more powerful reasons are not included in the proposition.
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18) Pervasive Bearish Sentiment
“The bearish sentiment in the gold market continues at an extreme. The more speculative gold shares of 1997 and 1998 experienced a Great Depression-style wipeout in value. Most exploration and speculative gold shares dropped 90% or more. Gold the metal compared to gold shares has held up very well, but continues to disappoint investors looking for even modestly higher prices.”
Pro: Playing the contrarian investor role is often an edge in investing and sentiment data can provide a quantitative measure of when to step in front of the crowd. Citing Market Vane's Bullish Consensus, gold analyst John Brimelow noted that gold's Bullish Consensus reading had sunk to a low of 16% during August 1988. “Two days at 15% marked the bottom this January [of 1998]. On March 5, 1985, a low of 16% also marked the end of the 1983-1985 bear market. Between 1985-1987, no other readings in the teens occurred. During the 1992-1993 base, the Bullish Consensus never fell below 31%. Readings this low have always been followed by violent rallies.” In fact a violent rally did occur between August 31 and October 8, 1998. The conclusion is it always pays to fade the crowd when sentiment is at an extreme. With current sentiment at historical lows, gold is a safe bet.
Con: As a technician, I have learned to appreciate the concept of signal failure. Simply put, when a market doesn't do what is should according to a powerful technical setup, it usually does the exact opposite. This in fact is the problem with low sentiment readings as a gauge of any future gold rally's magnitude. If from 1985 to 1987 the price of gold nearly doubled to $502 after a Market Vane reading of 16% in 1985, then surely we must be disappointed by gold's 1998 respective rallies of just $36 and $30 following sub 20 Market Vane readings at the onset of each rally. Further, the speed at which sentiment turns bullish after sentiment lows is alarming. According to Peter Palmedo, of Sun Valley Gold Company, following extremely low sentiment numbers at the April 5, 1999 gold low – this time using MBH Commodities Daily Sentiment Index, sentiment had swung nearly 60 points on a 100 point scale with only a $10 dollar movement in the gold price. If this is what little is required to swing sentiment from bearish to bullish, then traders shouldn't become agitated about a $200 gold move in today's environment whenever Market Vane falls below 20.
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19) U.S. Dollar Imperialism
In this point, Mr. Blanchard captures anti-American and anti-IMF sentiment emanating from countries like Malaysia whose leaders rather outspokenly last year blasted both (1) the freedom of international capital flows which were an important precipitator of the Asian crisis and (2) the harsh macroeconomic prescriptions of the IMF. “The end result of Western meddling in the Asian economies will very likely be a new, pan-Asian currency bloc. This is not a far-fetched idea; Asian politicians and finance officials have already hinted at such a monetary union. If it is enacted, you can rest assured that the U.S. dollar and the euro will play a relatively small part in the foreign reserve component of this union, and gold may hold a relatively important role.”
Pro: The pro gold argument concludes that since the experiment of dollar-linked currencies failed, Asian economies will create their own monetary union whose new currency would presumably be backed primarily with yen and gold. As was prognosticated last year, prior to the Euro's advent, this new currency would compete against the dollar, reducing its importance as a reserve currency, and gold's importance as an indirect result.
Con: Asian monetary union was a pipe dream made during the heat of last year's turmoil by disenfranchised parties. At best, this proposal merely vented anger about the financial devastation and at worst was a trial balloon designed to poison the political climate during IMF debt negotiations. In addition, as much as Southeast Asian economies may have resented the US and IMF for meddling in its economic policies, it hardly pays to pick a fight with the US who is a principal buyer of Southeast Asian exports.
Please cast your votes.
20) A Coiled Spring
“Much higher than normal official gold sales helped create an anti-gold bias among investors. In addition, a large increase in producer forward selling encouraged huge new levels of speculator short selling. The basic supply/demand situation for gold has been bullish for a long time and is getting even more bullish. After all, gold production is roughly 2,000 tonnes per year and consumption – or demand – is over 3,000 tonnes.”
The substantial gap between annual mine production and total fabrication demand has existed since the early 1990s. Were gold any other commodity, the supply/demand imbalance would have produced sharply higher prices. However, gold's high above-ground stocks – relative to what is produced annually – means that activities of investors and central banks are far more important in setting gold prices than traditional supply and demand figures for other commodities such as foodstuffs produced primarily for consumption. Several years ago, Martin Grant of SBC Warburg Australia calculated that less than 1/3rd of the variation in annual gold prices could be attributed to mine supply and jewelry demand; the balance belonged to investor and central bank activity.
Pro: The bullish view is that net central bank sales and investor dishoarding are temporary factors which are actually required to fill the ongoing mine supply/jewelry demand deficit for the market to clear. Any temporary cessation of these sales will release the coiled spring and gold will explode higher. In fact, gold's most recent bull market peak in early 1996 was marked by this exact sequence of events. Because of a large rise in gold lease rates, gold's forward curve actually fell from contango to backwardation in the last months of 1995, decreasing the incentive of producers to sell gold forward as the forward price of gold fell. This episode of reduced producer sales allowed a substantial gold rally in the space of about 10 weeks.
Con: The negative view is simply that there are so many sellers of aboveground gold stocks that these sales have been transformed from a temporary to a permanent factor in the gold market. And over time the problem only magnifies itself as nearly all fabrication demand can return to the market in the future through sales of scrap jewelry and gold bar sales. Finally, on the producer side, at the rate production costs have been falling, forward sales at today's spot prices – which even 2 years ago would have been unthinkable - do make sense for some companies.
Please cast your votes.
Conclusion
Having reached the end of 20 reasons to buy/not buy gold, if you are confused you are not alone. All attempts at predicting the gold price through fundamentally derived models have failed because gold's fundamentals are highly complex and change very rapidly. I hope my presentation has caused each of you to consider gold in ways other than simply an inflation hedge, a libertarian vote against government, or a Y2K financial planning tool. Gold's complexity is high and therefore deservedly retains its mystique among many of the worlds investors. Thank you for your attention.
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