From Things That Make You Go Hmmm, April 30
My name is Grant Williams and I’m a precious metals bug.
There. I’ve said it.
It feels good to get that off my chest.
Of course, those amongst you who have been riding alongside me these past few years probably already had a sneaking suspicion that was the case and, I imagine, several more of you are now tutting, rolling your eyes and muttering “I KNEW it. Where’s that ‘Unsubscribe’ button?” (bottom of the last page – no offence taken). Well today, we’re going to talk about precious metals again I’m afraid, but in a broader sense if that helps at all. For readers who are over the whole precious metals thing, there’s a nice cartoon on the last page and you’ll find several stories about alternate subjects scattered throughout pages 7 to 15). For those of you still reading at this point, join me inside the recesses of my mind. Please keep your hands and arms inside the carriage at all times.
Whenever I look at an idea as either a potential trade or a possible thematic shift, the very first question I ask myself is ‘does this idea make sense?’. Plain old common sense. Nothing to do with the numbers or the likely quantum of any associated move, but would the idea seem reasonable if presented to someone with either zero, or at best a very limited background in finance?
Whilst stories around individual stocks can fulfill this criterion reasonably regularly, they often operate in confined parameters (a particular geography or a particular market segment for example) and so an idea is easier to explain and simple to quantify. It is much harder to find bigger picture, macro ideas that make secular sense because, for the most part, these ideas– but it is these big picture shifts that contain the possibility to make real money.
To illustrate this point, one of my favourite charts of all time demonstrates how, by making a single trade in each decade, it was possible to take $35 in 1970 and turn it into $159,591 in 2008. Of course, had you then made a 5th decision and completed the circle by reinvesting that $159,591 back into precious metals - this time silver - in 2008 (and, to ensure nobody accuses me of picking the low price we’ll take the year high of $21, recorded the day Bear Stearns disappeared), you would, this week, have turned your $35 into a staggering $372,379.
Five simple, considered decisions over a forty year period for a gain of a little over 1,000,000%.
Easy..... Kind of.
The pressure to chase things, to follow momentum or to be ‘involved’ is a considerable influence on the decision-making process of most investors. It’s easy to get caught up in trying to pick interim ‘tops’ in a rising market with the intention of buying back on pullbacks to add a little vig to any gains being made. Get it right and you feel as though you’re a seer - possessed with vision many hope for but few achieve; get it wrong however and the consequences are potentially far, far worse. The chances are you’ll find yourself sitting on the sidelines watching your great idea make other people very rich because you just can’t pull the trigger to buy something 5% higher than you sold it - or 10%, or 20% - and for what? Because you tried to game a quick 5% extra by proving you could time the market?
I have lost count of how many calls I have had from friends of mine who have bought either gold or silver at some point in the bull run (sadly, most were late to the party because they just didn’t believe the story - but we’ll get to that later) and wanted to know whether it was time to take some profit. I’ve lost count of the number of calls, but the questions, in essence, were the same:
“Silver’s run really hard here. Should I sell some? What if it pulls back?”
“Gold’s over $1,500 now and I bought it at $1,200 - should I sell it and look to buy it back when it corrects. It’s gotta correct, right?”
My answer to both questions was the same. “What if it doesn’t?”
Yes, silver is extended. Yes, gold has performed incredibly well. But the point here is to understand WHY you bought them.
If you bought silver for a trade then go ahead and sell it - depending on your entry point it has been a hell of a trade. If you bought gold as a trade then the same thing applies. If it DOES pull back and you want to play again you can. If it doesn’t, then you still made some money. But if you bought either of the precious metals as an INVESTMENT, then you need to ask yourself a whole lot more questions before you call your broker, visit your bullion dealer or place an order to sell electronically.
The reasons for buying precious metals are myriad, and their intrinsic worth will continue to be debated - probably for centuries - but, like it or not, based upon 5,000 years of history, gold IS money. Silver IS money. You can argue it. You can flat out denounce it, but there will always be somebody happy to take your gold and silver off you at whatever market price you may deem ridiculous. You can’t win. Nobody can unilaterally declare the idea of gold and silver as stores of value err..... well, valueless.
Last year Mark Dice went to the beach in California and tried to sell a one-ounce solid gold Canadian Maple Leaf coin (worth, at the time, $1,100) to passers-by for $50 cash.
This was one of my favourite exchanges:
Dice: “Wanna buy it?”
Dude: “No thank you”
Dice: “Twenty bucks?”
Dude: “Not for me.”
Dice: “It’s Canadian.”
Dude: “Oh, definitely not”
But the best part of the video is when Dice tries to sell the coin to a passer-by who has a live parrot casually sitting on his shoulder. When you see a man in the street wearing a tropical bird as a fashion accessory look at someone trying to sell him a 1-oz gold coin worth $1,100 as though HE’S crazy - you’ve pretty much hit rock bottom. (If you want to watch the video, it’s HERE but PLEASE... no emails about Dice’s views on anything else - to me it’s just an interesting video)
But enough about parrots and passers-by - they are mere distractions from the point I am trying to make here.
In a big picture sense, as you can clearly see from the chart, left, owning precious metals (in this case gold) has been the right trade for the last ten years - it has been one of those once-in-a-decade decisions that, if you had made and stuck with, would have made you real returns. However, the volatility that has been evident during periods of those ten years is such that many people were, to use Richard Russell’s analogy, ‘shaken from the bull’. Many people saw 10% corrections or even the big shakeout after 2008 and, with very few believing gold was anything but the next bubble, they dumped their holdings - convinced either a ‘major correction’ was under way or just around the corner or that the bull run in gold had ended and the bubble had burst. Many were selling with a view to buying back and many were selling fearing a return to $300 gold was not only possible, but probable. The ‘big trade’ was all-but forgotten in the panic of deleveraging.
Many who sold have yet to buy their gold back and have missed out as gold has more than doubled from its late-2008 lows.
In Bud Conrad’s chart, he shows how a switch from one asset class to another once every ten years would have been all that was required and it just so happened that, at each crucial juncture, another asset presented itself as the next ‘big trade’. The danger is that, in following Bud’s example to the letter, especially now precious metals have run for ten years, it would be easy to switch out of them and into the next ‘big trade’. But what is the next big trade?
It could be a short trade in US Treasuries, as many believe (certainly when something is at zero and can’t, in absolute terms at least, go below that level - in this case the discount rate - it is a pretty safe assumption which way it will ultimately be headed). It could be a long position in crude oil or a basket of commodities if you believe in all or part of the ‘Peak Everything’ theory laid out beautifully in the great Jeremy Grantham’s latest letter - which you will find HERE. (As an aside, if you HAVEN’T read it yet - I recommend you take the time to do so as it is a truly marvellous piece of work - even by Jeremy’s lofty standards - and one you will doubtless want to read again at some point.)
But here’s the thing. What if the big trade is buying precious metals - again?
At no point does Bud Conrad say you can’t have your money in the same asset class for consecutive decades - in fact, Bud doesn’t lay out the rules at all because there aren’t any. It’s about finding the ‘big trade’, making sure the logic of it is sound to you and then sitting with it until it has either run its course, or you feel that a better opportunity for long-term gain has presented itself.
Has the precious metals trade run its course? Well, I guess it’s possible - but let’s look at the factors that are affecting the price of what, for the specific purposes of this part of our program, we will refer to as ‘monetary metals’.
Until 1971, gold backed every dollar in circulation. Period.
Behind every $35 in paper money, in a vault in the United States, sat an ounce of gold. Quiet, immutable, stoic. The gold couldn’t be printed at will or created out of thin air. The idea of dropping gold from helicopters would have seemed downright dangerous or overtly stupid. Of course, as it turns out, dropping paper money from helicopters has proven equally dangerous - particularly to the value of the dollar itself which broke through 73 this week and has now lost roughly 90% of its purchasing power since the decision was taken by Nixon to shut the gold window.
Never were the words of Nixon’s Treasury Secretary, John Connally, more apropos than today:
“...[the dollar] is our currency, but your problem”
Since that day, with the restraint of a gold-backed dollar removed, the amount of dollars in cirulation has steadily increased until, as the waves of 2008 crashed upon the world’s shores, it absolutely exploded. The graph below shows the adjusted monetary base, with the near-vertical updrafts representing QE1 and QE2.
My friends Paul Brodsky and Lee Quaintance of QBAMCO recently published parts II & III of their paper entitled ‘Apropos of Everything’ and I would recommend everyone who reads this to email Paul and ask him to send you a copy of all three parts as, together, they comprise one of the single best reads I have seen in years. In fact, if you only have time in your busy day to either finish reading this or dig into Paul and Lee’s exceptional writing then let me help you out: STOP READING THIS AND EMAIL PAUL. NOW.
In ‘Apropos of Everything’, Paul and Lee revisit their ‘Shadow Gold Price’ which is a measure of what returning to a gold-backed dollar would mean to the price of gold:
In a report distributed to our investors in December 2008 we divided Federal Reserve Bank Liabilities by US official gold holdings and dubbed it “The Shadow Gold Price”. A few months later we began using the more conservative denominator, the Monetary Base, in our calculation. As it turned out, dividing the US Monetary Base by US official gold holdings happened to be the very formula used in the Bretton Woods system to establish the global fixed monetary exchange rate. Our logic was confirmed by long convention...
The “Flat” column in the table above shows our current SGP, which implies the substantial devaluation of purchasing power of the US dollar that has already occurred. Are we nuts? Are we asserting gold should be valued at $10,000/ounce when it is trading around $1,500/ounce in London and New York?
The SGP’s purpose is to provide a sense of magnitude as to how much the US dollar has already been devalued and how much further it may be devalued. (Obviously there can be no guarantees about future pricing.) We believe the Shadow Gold Price provides the intellectual framework for the magnitude of necessary future global currency devaluation. We feel most comfortable with this metric for two practical reasons: 1) there is recent precedent for its use and 2) it actually produces a lower figure than othervaluation metrics that include systemic credit in their calculations...
To put this table in perspective, the Fed already increased the US Monetary Base over 200% since 2008, from about $850 billion ($3,251 implied SGP) to an estimated $2.6 trillion (following the completion of QE2). It is important to note that the Monetary Base only constitutes systemic bank reserves held at the Fed and currency in circulation. It does not include upwards of $70 trillion in US dollar-denominated claims, a significant portion of which conceivably must be ultimately be repaid in money from the Monetary Base that does not yet exist.
And there, in a nutshell, is the ‘big trade’ in gold.
How do the world’s central banks find a way out of the dire straits in which they find themselves? Faltering economic growth (look at this week’s US GDP number), insolvent banking systems in multiple insolvent sovereign countries (you know who you are), plummeting consumer confidence (Japan and Germany the latest examples of this phenomenon), crippling debt levels at both the national and individual levels (higher US deficit ceiling anybody?), spiralling inflation (no matter WHAT ‘core’ numbers may tell you) and their favourite (and some would say ‘only’) tool to fight it, namely interest rates at or close enough to zero to make them almost ineffective.
Fear of all these issues amongst investors has driven them to what they consider ‘safe’ money. Money that can’t be manufactured at will (though it CAN be confiscated - but more of that another day) and that will protect their purchasing power.
Yes, there is definitely some speculative froth in the monetary metal prices (nowhere more obvious than silver at the moment) but, structurally, there are more reasons why monetary metals could well be the next, next ‘big trade’ and that resides in the difference between the futures price and that of the metals themselves.
Historically, the monetary metals futures contracts were used primarily by gold producers to hedge their exposure to fluctuations in the gold price and/or to lock in prices against their forward production. Simple. There have been all sorts of conspiracy theories about central banks leasing their gold holdings in order to keep the price of gold down, thus validating their fiat currencies, and of bullion banks manipulating the futures prices to make profits from the technical funds, but, again, we will leave those aside today.
In August 1999, John Hathaway of Tocqueville Gold Fund wrote an essay called The Golden Pyramid (I have linked to it in a previous edition of Things That Make You Go Hmmm..... but in case you didn’t see it, or didn’t have the time to read it, I would urge you, if you have any interest in the monetary metals, to do so. You will find it here)
In his essay, John lays out quite clearly how what he calls the ‘Golden Pyramid’ works:
The old currency gold/pyramid has been replaced by a little understood labyrinth of paper claims against gold. Responsible senior officials of mining companies, central banks, and bullion banks cannot begin to understand the internal mechanics in order to make appropriate judgements of risk. There are few published figures, no reserve requirements, no supervision or regulation, and no accountability. It is the private domain of bullion dealers, central banks, and mining companies. The credit worthiness of the old currency/gold pyramid was quantifiable. The credit worthiness of the new pyramid can only be an educated guess. Our guess is that it is bankrupt.
The gold derivatives pyramid is a vigorous free market creature. It cannot be put down with a simple declaration that the paper is no longer redeemable in gold, as governments did with currency. It is a short selling scheme that has become a trap from which few short sellers will escape. Paper claims in the form of derivatives far exceed the underlying physical metal on which they are based. The trust, which balances this new pyramid, is based on false assumptions and lack of information. Paper gold claims have proliferated at a pace rivaling any government printing press. A surfeit of paper gold has driven down the price of the physical on which it is based.
The structure can survive as long as bullion dealers, the mining community and the financial media subscribe to the bearish case. But the position of short sellers is precarious. This is true whether gold stays at current levels, or drops below $200/oz. The point is, they will be unable to realize their paper profits, and stand to lose money on their positions in the aggregate. The compound miscalculations on which the gold market is based rank with the blowup of the yen carry trade in 1998. The yen carry disaster illustrates how over-investment and near unanimity of market opinion can lead to a vicious squeeze. Compared to the yen, gold’s liquidity is microscopic. The coming squeeze will lead to a several hundred dollar rally and a permanent change in attitudes towards gold.
Read that last sentence again.
The coming squeeze will lead to a several hundred dollar rally and a permanent change in attitudes towards gold.
Many casual readers of John’s work would have found that statement difficult to accept in 1999. They would have, in fact, dismissed his words simply because the outcome he was proposing - a rise in price of several hundred dollars - would have seemed extremely unlikely with Gold trading around $300. And yet, the beauty of reading this essay now, 12 years later, is that you can clearly see a simple idea that, with the benefit of hindsight, makes complete sense.
The trick comes in trying to find these simple, clear ideas WITHOUT the benefit of hindsight.
So, to recap:
Sovereign governments are awash with debt; several are on the verge of inevitable default (you STILL know who you are), Central Banks around the world have printed trillions of units of their respective paper currencies in the past three years in an attempt to stimulate their moribund economies (which are either slowing in the case of the US and the UK, or are tipping back into recession like Japan), politicians are starting to finally understand that Austerity ISN’T Calvin Klein’s new cologne and are about to find out just how hard it will be to apply in the real sense, consumers are pulling in their heads and are more concerned about the future than at any point since the depths of the crisis in 2008, the housing market in the United States - Ground Zero for the debt-driven disasters that tipped the world on its head - has turned down once more and is about to make new lows just as a slew of Option ARM resets are due, inflation is starting to bite in a real way, not only in Asia, but in the West as well and all the REAL money that has ever been mined could STILL only fill a cube 67 feet in each direction (thanks for that, Warren).