Adrian Ash on Feb 08, 2010 08:06AM

Gold's Mistaken Identity

Gold is now more closely correlated with US stocks than with either the Euro or silver...

OKAY, this is getting weird. Too weird, in fact.

And weirder still, no one else has yet noticed...

It might just be me...if not my nicotine D-T's.

But every time I look, there they are. Gold and the S&P500. Right at the same level. Minute by minute, session by session...ever nearer.

What in the Simon Cowell can this mean?

"It is easy to see why the Euro fell [this week] and one could then say that the Dollar is the obvious alternative," writes Phillip Coggan in his Buttonwood blog for The Economist.

"But what about gold? Hasn't that been rising on fears that spendthrift governments would debase their currencies? Yet when these fears started to look real [with the Eurozone crisis], gold fell 4% on Thursday..."

Well, yes and no. Gold always rises on fears of default or debasement. Because that's what it's for ? hiding out when everything else falls in value, not least money itself.

But as gold has tripled and more over the last decade or so, it has also been rising thanks to that very debasement itself. Or rather, it's risen on the leverage which debasement enabled. Any pause or reverse in that leverage thus means the gold price can slip, whether or not debasement unwinds.

To recap: Gold began rising last decade because a handful of people saw deep trouble ahead in the race to slash rates. Also known as debasement, that race ? led by the Fed, which then feared deflation in the face of untold corporate-debt burdens ? took the cost of money below the rate of inflation pretty much worldwide.

Thanks to those record-low rates, global stocks all found their floor by March 2003. Yet the Fed waited another two years before teasing rates higher...and by then, this historic flood of cheap money had found a new use in finance:

Paying for leveraged bets against the Dollar itself.

Hedge funds, prop' desks...even retail investors and the weekly financial press...everyone saw that the Dollar was falling, yet the Fed refused to step out and catch it. Because the falling Dollar was also funding go-go days for home-builders, plus 10% year-on-year gains in the Dow.

Gold, naturally, was a prime mover in this bear market for cash. But with everything rising, gold's singular value seemed to offer just one more "risk friendly" trade.

You selling Dollars or Yen...swapping them for Euros or crude...? Then get yourself long of gold futures! Because that stuff's the ultimate carry trade, mate ? a pure speculation on repaying your finance with devalued cash.

"Gold's sharp run is a case of mistaken identity," wrote Tocqueville Asset Management's John Hathaway in 2006. Barring what proved a blip in mid-summer that year, gold rose with everything else for 5 years ending in 2008. And it was never fuelled faster than when fresh "carry trade" dollars poured in thanks to the Bernanke Fed's record Dollar-rate cuts as the banking crisis broke...

See how the geared-gold position leapt ahead of the price in late 2007...? See how it sank when Lehmans went down?

That's what happens when prime brokers, i.e. investment banks, throw money at hedge funds, only to blow themselves up. But then note how gold found its floor sooner ? one-third off its top ? while the "net long" held by leveraged gold bulls shrank by more than one half.

Where did the Gold Price find this support? After all, at the margin, it's gold futures trading which sets the price of the stuff. A higher (or lower) bet on prices next month of course means a higher (or lower) gold price today.

But the global meltdown in stocks sparked by the meltdown in banking brought in a flood of unleveraged gold bugs, all demanding metal ? not paper ? and standing in line to buy coins and small bars at rapidly rising mark-ups. (A good number opted to buy the safest gold at the lowest costs by using BullionVault, too...)

Yes, Gold ETF demand also shot higher, reversing the 12% drop of July to Sept. 2008 before swelling by more than three-fifths. But that trust-fund exposure was also cash paid, in full. Because leverage was dead...and didn't revive until the tail-end of last year, when it drove the Gold Price once more, up to new record highs even as coin sales flagged and the ETFs shrank.

To repeat: There was no palpable crisis driving new money to gold as 2009 ended. Yet the price jumped above $1200 an ounce ? and hit new all-time records in Euros, Sterling and pretty much everything else ? even as Gold ETF demand barely touched its previous peak of six months before. That big move, very much like the spike of May 2006, came instead on leveraged bets, powered by the Fed's all-too cheap money, rather than because of it.

What next as Feb. 2010 unfolds? With next week bringing the Chinese New Year, might the "physical floor" rise up once more now that prices have sunk alongside gold's erstwhile bull-market chums? Please note that the weird daily lockstep with the S&P stock index runs deeper than mere nominal price. In fact, gold's daily changes this week ? on a rolling one-month basis ? have been more tightly correlated with stocks than with either the Euro or silver.

I'd guess that connection will break, one way or other. And it's hard to imagine a genuine Euro-currency crisis doing anything but sending new cash into gold.

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Doug Casey on Feb 08, 2010 04:45AM

Sour Vintage for Private Equity

The sorry outlook for last decade's credit-bubble leaders...

WHEN PRIVATE EQUITY financiers talk about "vintage", they aren't commenting on the Château Pétrus, write Alex Daley and Doug Hornig at Casey Research.

Each year's investments are referred to as vintages, with some being more highly drinkable than others. But now, some of the recent vintages look like they'll turn out to be little more than vinegar.

The world of private equity financing doesn't have high visibility, but it is big business behind the scenes. Unlike venture capital outfits ? which provide startup money to very early-stage companies ? those who play this game grab existing private companies, often through leveraged buyouts (LBOs).

Private equity investing has never been for the faint of heart. But investors continue to engage in it, because the payoff can be substantial. And for the first few years of the new millennium, it was a go-go place to be. With so much easy money sloshing around, the number of private equity deals exploded, totaling over half a trillion Dollars at the manic peak in '07.

Then came the crash...
           
It's important to remember that credit was not a single bubble. It was a bubble machine.

Credit created the housing bubble, which fueled the personal debt bubble (which in turn popped the housing bubble, but that's another story)...while the mortgage market gave birth to a whole new range of derivatives, things like collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and the rest of the acronyms we've all become familiar with, even if we don't quite understand what they do.

(Don't be embarrassed if you don't get all those acronyms. Neither did the financial geniuses who swapped them like baseball cards...)

Frantic trading in these newly printed scraps of paper created its own bubble, manufacturing an incredible amount of seeming liquidity in a very compressed time frame. We know the ultimate consequences to the balance sheets of our banks, and our government, by now. But there was more to it than that.

The capital these transactions threw off had to go somewhere, and suddenly well-capitalized investors were pouring their phantom profits into something perceived as more solid: private equity firms.

Hey presto ? yet another bubble!

In a mania, all investments are at the mercy of the greater fool. Meaning that if you can't find one, you're it. Doesn't matter if we're talking housing, stocks, commodities, or whole companies. The last man standing is left staring into an abyss in which there are no buyers.

With private equity deals, investors don't acquire companies because they want to own them. They buy in because they expect to sell to a higher bidder. Here are their three exit strategies:

1. wait until the company goes public, and clean up when you sell your stock into the liquid public markets;
2. arrange for a takeover by a corporate entity; or,
3. pawn it off on another private equity firm in a secondary transaction.

And this is what's happened in those areas over the past eight years:
                   
Compare the two graphs, and it's immediately apparent that private equity firms are sitting on a lot of property that'll be difficult to move.

They invested an unprecedented amount right at the same time as the bottom was falling out of an overheated exit market, returning back to normal levels of deal flow in just two short years.

Furthermore, while it looks like public stock offerings (IPOs) in general recovered a bit in 2009, they still totaled just 25 from the ranks of private-equity-backed companies. And even that number may be misleading. According to PitchBook, a respected industry analyst, "a number of these IPOs did not represent full exits but were used as a means of raising capital to pay down debt and provide investors with partial returns."

At the same time, much of the huge money stack they piled up through '07 is still there. It doesn't move because, in the current environment, there's no point in adding more companies when they can't profitably dispose of the pile they already have. And that's led to a boatload of uninvested capital ? a massive cash overhang estimated at some $400 billion.

What to make of it? First of all, you can save the pity you might slop onto these firms. They are, after all, making some kind of return on the money they hold. Beyond that, though, we're looking at the potential for some pretty vinegary vintages.

Generally, the wait time for a vintage to mature ? i.e., for the investment to show a profit ? is about five years. So the more than $1 trillion thrown into private equity firms between 2005 and 2007 will be expected to yield fine wines from now through 2012. Which or may not hold good. But for comparison, we can also look at private equity's sister market, venture capital.

In a recent analysis of venture capital funds, investment advisor Cambridge Associates reported that returns were off steeply from their heyday in the early '00s, falling from 36% to 14% following a similar flood of increased inflows during the early part of last decade. A similar decline in returns from private equity investments ? with lower risk and lower expectations than venture capital ? could take them down into the single digits, if not close to or below zero. You might as well be in Treasury notes.

The takeaway? Private equity fuels the IPO market, as well as the growth pipeline for big companies that can't grow organically. But private equity firms are now sitting on the financial equivalent of a bunch of drunken Vegas marriages, having pledged "till death do us part" at the top of the frothy debt market.

All those unwanted spouses in the portfolio mean lower gains. Now add in the excess capital, much of which may end up being recalled by investors tired of waiting for it to be invested, and the big firms ? which grew cocky playing with billions in this once-lucrative market ? are likely in for some lean years.

What does all this mean to you as an investor? Well, you need to be wary of IPOs; many of the dogs will be trotted out for public flotations, with tails wagging and mouths closed to hide the rotting teeth. Also headed your way are diminished returns for the banks and insurance companies that back the private equity guys. And if stock-market prices remain at recent highs, there will probably be a shakeout in the industry, as increasing numbers of companies look to global public markets to raise money, instead of turning to private equity

Indeed, that trend is already apparent with the incredible number of secondary offerings over the past few months (in just two days this past September, nine were filed or priced on US markets), and the thawing global IPO market.

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The Gold Report on Feb 08, 2010 04:41AM

21st Century Alchemy

Turning paper into Gold Bullion at the emerging-world's central banks...

CENTRAL BANKS are becoming modern-day alchemists, says Christopher K. Potter, principal of Canadian-focused hedge fund Northern Border Capital Management Inc., which he founded in 2002.

India's big gold purchase late last year was a game-changer, Potter here tells the Gold Report, and more and more central banks will follow suit ? he believes ? successfully managing to turn the paper money their countries accumulate into Gold Bullion...

The Gold Report: Just after the Reserve Bank of India (RBI) bought 200 tonnes of gold last November, you wrote an article entitled Game Changer, highlighting previous transactions such as China's Central Bank 99-tonne purchase gold in '02 and Argentina's 55 tonnes in '09. Since no other central bank has stepped forward in the months since India's announcement, was that really a game changer?

Chris Potter: I think so. For as long as I can remember, gold bears have warned that central bank gold is a massive source of supply that is capable of overwhelming any conceivable demand scenario. They said that this would make it very difficult for the Gold Price to rise significantly. It's been an easy argument to make because one fifth of all the gold ever mined is sitting in central banks' vaults.

But what we've seen over the last nine years is that argument being steadily dismantled, piece by piece. Year after year, signatories to the Washington Agreement have sold less than their quota of gold. We've also seen various central banks add and talk about adding to their gold reserves. Then when the world became aware that the International Monetary Fund ? which I think is the third largest holder of gold ? was a potential seller of 400 tons, there was all kinds of speculation that this would have a very detrimental effect on the Gold Price.

Well guess what, the opposite happened when the Reserve Bank of India announced that it not only bought 50% of what was for sale but bought it at market prices! All of a sudden people realized that central banks might be net buyers rather than net sellers of gold. This was a big development. We still haven't heard about who is going to buy the other 200 tonnes but the market no longer seems concerned that a buyer will be found. You mentioned that no other central bank has bought gold since the Reserve Bank of India announcement ? well, we don't know that that is the case. If you were a central bank interested in increasing your gold reserves, you would not likely telegraph to the market that you were doing that until you were finished buying.

TGR: Is the IMF actively trying to sell the other 200 tons?

Chris Potter: They reported that they planned to sell 400 tonnes so I see no reason to believe that they have changed their minds about the remaining 200 tons. It had been rumored that the central bank of China was going to buy the whole piece and that is why the Indian announcement was such a surprise. Perhaps China buys what's left.

We've heard that the Chinese Central Bank has been a consistent buyer of gold over the last several years, but we haven't heard anything officially. I suspect that they do not want to signal that they have a lot of gold to buy, because that would just drive the price up. If they are negotiating with the IMF for the remaining 200 tonnes, we won't hear about it until the deal is done.

TGR: Could China just be buying it in such small increments that it might take them a year to buy it but they wouldn't have to report it?

Chris Potter: I'm pretty sure that the US Federal Reserve is required to report purchases and sales of gold and other assets. I'm not familiar with the reporting requirements in other countries, but I would take any lack of disclosure about Chinese purchases of gold with a large grain of salt. In other words, just because they have not announced that they have been Buying Gold does not mean that they have not been.

TGR: Jon Nadler, Kitco's senior investment products analyst, suggests that central banks' acquiring gold is no more than re-balancing their portfolios. It's part of a natural course of events since their portfolios are growing, and in that case, it shouldn't affect the price of gold one way or another. What do you think of that view?

Chris Potter: By purchasing 200 tonnes of gold, the Reserve Bank of India increased its gold holdings by 50% ? I would hardly call that rebalancing. But what is even more important than the amount of gold that central banks are buying is the realization that they are buying and not selling. This is a brand new idea and completely alters market perception about supply and demand. This kind of change in perception can have a very meaningful impact on price. So no, I do not agree with Jon Nadler's suggestion.

TGR: So how do you look at it?

Chris Potter: If I were running a central bank and I had the ability to create money at virtually no cost and I could then exchange that costless money for one of the earth's scarcest resources, why wouldn't I do that all day long? Why not exchange something that costs me nothing for something that is incredibly rare and incredibly valuable?

TGR: It's not a central bank's role to print money for the purpose of Buying Gold, though. Creating more money creates other negative trends in the economy.

Chris Potter: Sure, it's inflationary. But take the example of India buying 200 tonnes of gold. That's a very large amount of gold, but relative to the amount of money that they are creating for other purposes, it has a very minor inflationary effect.

TGR: I've always had the impression that central banks were held to a higher standard to do what's best for the economy.

Chris Potter: Well, maybe what they're doing is best for their economies. If you're a central bank and you're observing that around the world vast amounts, unprecedented amounts, of new money is being created, you have to realize that somewhere down the road every one of those currencies is going to take a big hit. So, how do you distinguish you currency and your economy from your neighbors'?

Well, one thing you can do is Buy Gold. So maybe the Reserve Bank of India is being proactive about their economy. They are saying, "Look, we can Buy Gold now for $1000 an ounce and five years from now, when we are all swimming in newly printed money, gold might be $5000 an ounce. We can increase our wealth without inflating our currency to the same extent as other nations." Essentially they are hedging against a decline in their currency and that is good for their economy.

TGR: A lot of financial advisors tell investors they should have assets that include 10% to 15% precious metals as "insurance." Are the central banks looking at this as an insurance policy, too, or in some other way?

Chris Potter: I suppose you could call it an insurance policy and that is the way a lot of people think about gold. But that is not the way I think about it. I view gold simply as a currency whose supply and demand characteristics are vastly superior to other currencies. Perhaps that is a more accurate explanation for why central banks are exchanging their paper for gold.

TGR: Gold's been trading around $1100 for the past few weeks. There seems to be some resistance at that level. Some gold bugs say gold will be at $2000 before the end of the year. Where do you project as a trend for the physical Gold Price through 2010?

Chris Potter: I have a much stronger view of where the Gold Price will be in two or three years than I do over the next few months. It's had a good run so I am not surprised that it is taking a breather here. If I had to guess I'd say we'll see new highs before the end of the year. I just think that the path of least resistance is up because the amount of debt that continues to mount around the world is staggering ? a lot of that has to be monetized.

Everyone talks about deleveraging but the US ran a budget deficit of $1.4 trillion or $1.5 trillion last year, and it looks like we're going to do something similar this year. I think I just read we're trying to increase the debt ceiling here by $1.5 trillion Dollars to $14 trillion. These numbers would have been unheard of a couple of years ago. I think back to a speech that Bernanke gave in January of 2007, in which he worried that the US budget deficit would approach 9% of GDP by the year 2030.

TGR: Oh, we're way beyond that already, and 2030 is still 20 years away!

Chris Potter: Absolutely. Last year at $1.5 trillion, our budget deficit was more than 10% of GDP. Bernanke's great fear about what the budget deficit might do occurred 20 years early and it happened not because of our unfunded Social Security and Medicare liabilities that he worried about but because of the global financial meltdown. When we layer on the unfunded liability issues we have a really gigantic problem that will be extremely difficult to grow our way out of, despite what Washington tells us. That is why I say that the path of least resistance ? the solution to this ? is to inflate these liabilities away.

That requires printing money. It requires a lot of new Dollars, a lot of new Renminbi, a lot of new Yen, a lot of new Euros, a lot of new Roubles. I think you're going to see all of those currencies depreciate against other assets, and probably most against gold. I imagine that will continue this year, but anyone who has been involved in the gold market over the last seven to nine years knows to expect some scary rides up and down.

TGR: You've laid out a compelling argument about all governments increasing their money supplies and we'll have inflation worldwide. How much higher do you think gold can go?

Chris Potter: It's always difficult to put a number on it, but the inflation-adjusted Gold Price, depending on your assumptions and in which year you start, is somewhere between $2200 and $3100 per ounce. I've run a number of different models to see where the Gold Price could go and have come up with anything from $1500 to $3500 an ounce. In the end it's anyone's guess as to what the ultimate high will be, but as I said, the path of least resistance seems to be up.

TGR: If you follow the gold patterns, the summer months have historically been relatively low, with prices picking up again for the holiday seasons, particularly in India. Given that more gold is being bought as an investment or as insurance now, do you see that seasonality coming into play over the next two to three years?

Chris Potter: As you point out, more often than not we've seen a rise in the Gold Price in October and November, which coincides with the Indian wedding season. I have no particular expertise here, but I'll guess that that seasonal pattern will continue. Ultimately though it is not a primary driver of the Gold Price If you look at a nine-year price chart, those seasonal moves are just blips.

TGR: Should investors be looking at physical gold, the majors, the juniors? How should they play what you see as upward trends in Gold Prices over the next several years?

Chris Potter: My strategy is to own both physical gold and mining stocks. I focus on the smaller capitalization gold companies, the exploration companies, the early-stage producers just because if you get those right, they have a lot more leverage to a rising price for the metal.

The problem with owning only Gold Mining equities, and no bullion, is that in a market sell-off, they can go down with everything else. I know people who were managing gold funds who had a very difficult time in 2008 despite the fact that the Gold Price was up. As we saw, gold mining companies were decimated. Many of those equities were down by 50% to 90% in 2008, and the Gold Price was actually up.

TGR: So is the combination of physical and equities a kind of a hedge against each other?

Chris Potter: I wouldn't characterize it as a hedge. I would just say that it gives you a greater chance of participating in a rising gold market under various market scenarios.

TGR: As I understand it, you consider the Canadian market somewhat less efficient than the US market, thus making it easier to uncover attractively valued companies. What do you think accounts for the discrepancy, and is it specific to small caps or also true of large caps?

Chris Potter: It's really true of both large caps and small but it's not a permanent discrepancy. It's more of a lag. What I mean is that US investors take a lot longer to recognize and buy high quality Canadian companies than US listed ones. I used to be concerned that this lag would somehow be arbitraged away, but I've been doing this now for 12 or 13 years, and it has not.

There are a lot of reasons behind that. For one thing, there seems to be an apathy or ignorance on the part of US investors about almost everything Canadian. There's also a perception that the Canadian securities laws are lax, that its investment community is run by mining promoters, and that US investors won't get a fair shake up there. While there are certainly landmines to look out for when investing in Canada, they are no more dangerous than those in the US

To characterize the entire Canadian investment scene as corrupt because of the Vancouver mining community and the Bre-X Scandal in the late '90s ignores the fact that the US has had plenty of its own investment scandals such as Enron and a banking system that perpetrated the greatest financial fraud in history this past decade.

But I can't tell you all of the reasons for the valuation lag that I continue to see between US and Canadian companies.

TGR: Thanks so much for your time, Chris. This has been great.

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Julian D.W. Phillips on Feb 08, 2010 04:39AM

Gold Price Plunges

What will longer-term investors make of the current sharp fall in Gold Prices...?

The GOLD MARKET has fallen dramatically in the last few days, writes Julian Phillips of the Gold Forecaster.

Where will the Gold Price go now? Investors will soon have a large amount of chart-based technical commentary to hand, and the bulk of this will point downwards. Is that enough to make the market follow the technical analysts' predictions?

Technical analysis is a vital part of Gold Investment information, especially amongst institutional traders. The US gold market, whether it be Comex Gold Futures or gold exchange-traded funds, have dominated the short-term trends of the Gold Price itself over the bull market to date ? and these markets place an overriding emphasis on the technical picture.

Major buyers follow these short-term forecasts, carefully picking to time their own actions in the light of the short-term picture. They can dominate the short-term Gold Price through their actions.

But we need to stand back to see clearly the shape of the gold market. An analogy we have often used is that the gold market is similar to the sea shore. Because you have the moment-to-moment wave action. On a daily basis, you also have two tides indicating longer term averages that influence short-term prices. Then you have the currents that completely dominate the sea. But short term, it is the noisy reactive movements of the waves that attract the most attention. While they can become frothy in reaction to the wind and extend their moves in and out every seven or so waves they are subject to the tides and currents. Tides are simply more forceful expressions of waves but currents always dictate sea moves.

The parallel in the gold market? Traders are the short-term players chasing quick profits, with larger, weightier players again chasing the bigger, slightly longer-term profits. The very biggest players, however, don't play for profits in the gold market, but invest to retain value over the longer term.

For most of man's history, gold has served as a reliable measure of value as true money. The currency experiment of the last 40 years has been a departure from that, but in the last 10 years we have seen the return of respect for gold amongst the biggest investors in the gold market. We believe that this respect will continue to grow, and that such investors will quietly and unobtrusively dominate the Gold Price going forward. A big dip serves them well.

So what do the three sides of the gold market tell us now?

1. The technical picture points down but into a large barrier of support. The short-term traders point to the strong Dollar rally, if not a turn in the fortunes of the Dollar and take the Gold Price down as far as their short-term wave actions allow.
2. The bigger longer-term speculators (represented by the tide) feel the same at the moment, either closing long positions or actually selling gold short.
3. Large gold investors worldwide, but particularly in the US, are presently sitting on the sidelines, with a tendency to sell small amounts into the market. Their present anemia from the deep currents of the gold market is encouraging shorter-term speculators to sell, and so a picture is presented that the market is worthy of a fall.

How far still remains to be seen. But this makes the Gold Price look weak and dangerous. And in the short-term the speculators may still have their way.

What of the big long-term investors from all over the world...the sea currents? What do they feel about the Gold Price and how will they act in this market?

To see this one has to realize that the bulk of the world's gold is not dealt inside the USA, but outside it. The US has to go there to get the bulk of its physical gold too. The loud and noisy short-term US markets such as Comex are heard all over the world, but have little real power.

For instance, if President Obama gets his way and prevents US banks from proprietary dealing (using their own money to trade markets), then their presence on New York's Comex Gold Futures exchange will have to diminish. What is that presence now? They hold an overwhelming number of "short positions" on Comex that they will have to close. Comex has always had an extremely low number of physical deliveries taking place, for each contract represents a future delivery time and so is matched against the opposite number of opposing trades disappearing before delivery must take place.

So buying and selling simply takes net profits or losses, but usually doesn't pay more than a 10% margin or so for the privilege. Yes, Comex should hold sufficient gold to deliver the net amount of selling over buying and vice versa, but this is a relatively small amount.

For a major bank such as J.P.Morgan to be made to deliver on its "short" contracts, this would mean that they would have to go out and Buy Gold first, so they could deliver it to the market. COMEX does not hold that amount of gold in stock. The fact that President Obama has put this on the table must have J.P.Morgan trying to cover itself and want to unload into the market. If long-term speculators take long positions in the hope that the huge short covering will take place and hold the Gold Price up, then the amount of short covering deals will far outweigh the de-hedging we've seen over the last few years. Is there enough gold out there for them to do that?

Now go overseas and look at the large players. Russia bought 24 tonnes of gold in December as part of a persistent buying program which we believe China is doing surreptitiously too. That's apart from individuals from Mumbai to Shanghai, in large numbers, Buying Gold as part of their long-term savings plan. The demand for physical gold is ignoring potential interest rate rises in the US; they simply Buy Gold as financial security. And this deep current of money knows nothing of technical price action, except to look for a floor to reassure them that when they buy, the price won't fall again.

Most of all, this long-term Asian gold investing does not buy for a future profit. The cultural difference between Western and Eastern investors is enormous and telling!

Just think of it ? half the world is getting richer by the day and steadily buys gold. They ignore the day-to-day wave action and look at the tides, to get the right entry points. Like a current they are unstoppable. This type of demand, like a sea current, gives solid support to the Gold Price and ensures that the upward trend stays in place. It doesn't chase prices and doesn't take profits, except rarely. It absorbs supplies.

What is the future of the importance of the US futures and options markets to the Gold Price? It has to wane in the face of the current of new investment money and investment of new wealth gained from the Western developed world. Gone already are the days when it could take the Gold Price from $300 to $390 then back to $326 at their whim. Now they too, have to read the market with a vision wider than the Technical picture.

Is the gold market solid in the face of these realities? Yes, indeed, telling us that any heavy fall in the Gold Price will invite long-term investors of all shades into the gold market. Lighter falls will invite those already waiting to enter the market. The distance the Gold Price has come is relevant to a profit seeker, not one buying to hold as financial security.

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Hard Assets Investor on Feb 08, 2010 04:35AM

Don't Sell Gold ? Short It!

Zero rates aren't low enough, and health-care is driving Gold Prices. Apparently...

IT'S A HARD TIME to be a gold bug, says Lara Crigger at Hard Assets Investor.

Dropping to $1045 last week, the Gold Price is currently trading way off its lofty highs of December 2009. And it could have even further to fall, says Brian Nick, investment strategist with Barclays Wealth, a leading global wealth management firm with more than $220 billion in assets worldwide.

In its latest investment call, Barclays Wealth took a decidedly bearish view on gold, advising investors not only to sell the metal, but to sell it short ? profiting from further falls in price ? because gold was "significantly overvalued relative to fundamentals."

HardAssetsInvestor.com (HAI): In a recent investment call, you advised investors to short gold. Why?

Brian Nick, investment strategist, Barclays Wealth: Now is a good time to short gold, but probably a better time to short gold would have been back in November, when it was $200 per ounce higher.

We think that the run-up in gold was overstated, and we don't think the reasons for it were sound. We think that a lot of the fear driving people to invest in gold has to do with the devaluation of the US Dollar, interest rates in the US staying too low for too long, worries about inflation and the US debt, and so on. With all that tied together, people flocked to gold as a store of value. But when you look at the fundamentals, this doesn't seem like an environment where gold should do well.

Crigger: How so?

Brian Nick: If you look at inflation, you see inflation's actually quite low; core inflation is actually decreasing. So we don't have an inflation problem here. Plus, we have 10% unemployment and a large output gap still in the economy. So those three things taken together would dictate that the Federal Reserve should be cutting rates to well below zero, probably something like minus 4 or minus 5 percent, which obviously they can't do.

So the fact that they're at zero, as contradictory as this may sound, that's actually a relatively restrictive stance at the moment. That's one of the reasons why they took extra measures: because they knew that they had a lower bound of zero, and they needed to do other things to increase the money supply, to get economic activity moving again.

Crigger: That's contrary to a lot of what you hear, with people saying these extra low interest rates are very bad for the economy, even a setup for future inflation. So are we facing inflation in the future?

Brian Nick: No, we don't think we are. Look at virtually any other market where you'd see signs that people were worried about inflation, and they don't exist anywhere except the gold market. Look at TIPS for example [Treasury Inflation-Protected Securities], which should tend to outperform by quite a bit when people are worried about inflation, as breakevens between them and Treasuries rise. But you aren't really seeing that. Today you're seeing a sharp contraction in breakevens. They've been pretty stable for the past three or four months, and they're really only at average levels historically. So there's no inflation premium in that market.

If you look at the US Treasury market, the 10-year rate is now at 3.6%, which is extraordinarily low. If there were really concerns about inflation on the horizon, we think the bond market would be reacting. But as it stands, it seems only gold is really pricing in a severe inflation scenario.

Frankly, if you were worried about inflation, there are cheaper ways to express that view, whether by buying TIPS or shorting a Treasury. It's cheaper than entering the gold market right now.

Crigger: On average, Gold Prices have gone up for the past nine years. Will this trend continue in 2010?

Brian Nick: We certainly don't see gold going up in 2010, just because of the significant overvalue relative to where it should be and where its historical average is. One of the reasons gold tends to go up has to do with the credibility of monetary policy, and the credibility of the Federal Reserve. For a lot of the past 10 years, as you hear a lot of critics saying these days, the Fed kept interest rates fairly low, probably lower than they absolutely needed to, especially in 2003-2004. That's credited with a lot of the bubble in asset prices that we saw pop in 2008.

So we would expect gold to do well if the Fed were being overly accommodating, which, probably for most of the past decade, we think it was. But right now, we don't think it is. So we would have expected to see a sharp reversal in the Gold Price back down somewhere below its long-term average, between $700 and $800 an ounce. But instead we saw the opposite: We saw gold continue to appreciate. And we think that is the result of a misunderstanding or misinterpretation of signals we're seeing from the Federal Reserve, signals we're seeing from economic data. It's due for a correction.

Crigger: Is gold's long-term average of $700-800 an ounce a fair value for the metal?

Brian Nick: Yes. In fact, if the Fed is a little more restrictive than normal ? which we think it is ? it should actually be a little below that number. But as we see interest rates start to normalize, and the economy start to improve, I think that's going to work itself out. So a return to an equilibrium price somewhere in that range is what we expect. We don't necessarily have a target date or time horizon, but we think gold will trend lower overall.

Crigger: How does investment demand from Gold ETFs make a difference in gold's demand picture?

Brian Nick: The gold market has really changed, as far as the makeup in where demand is coming from. One of the reasons why I think you've seen such a sharp, dramatic run-up is that it's become a lot easier for the mom-and-pop investors to invest in gold. There are exchange-traded funds now, like GLD, that you can buy through your online brokerage account, which hold gold directly in the fund, and you don't have to find a way to store the physical. So it's a lot easier to buy and sell, and it's a much more liquid market than it was.

As a result of that, and as a result of the recession we just came out of, Gold Investment demand has really swamped demand coming from end-users of gold, whether they're jewelry makers or industrial users. We've really seen investment demand take over the market.

That worries us, because as quickly as that demand ramped up, it could also unwind. And so you have the potential for so much gold coming on to the market, as people are selling out of their positions, but there's very little demand to soak up the supply. So we think, if the correction starts to happen, it could happen very quickly, because there's close to a decade worth of industrial demand already sitting out there in the gold market. There's no way end-users of gold can absorb all the supply out there without taking much lower prices for it.

Crigger: So bottom line, we're not going to be seeing $2000 an ounce Gold Prices anytime soon...?

Brian Nick: No, but obviously, it's a very volatile market. Over a long-term picture, being two-three years at least, we think it will trend lower, but there's always the potential to spike. There's a lot of policy risk out there. A lot of the trepidation around gold, I think, surrounds some of the policies that the Obama administration has tried to push through. I think it's caused a lot of fear about the long-term sustainability of the national debt, and the short-term fiscal deficit.

For example, when the Massachusetts Senate election happened and the Democrats went from 60 to 59 in the Senate, the day after that was a very bad day for gold, because it dimmed the prospects for serious, comprehensive health care reform. Rightly or wrongly, I think that was one of the major drivers of gold. There were a lot of individual investors who were worried.

Crigger: But you don't really think about the health care debate as driving Gold Prices...

Brian Nick: No, but I think it's part of the larger picture of people just being uncertain about whether the US will spend itself into a death spiral. I think that was one piece of the puzzle. I don't think health care was necessarily the largest piece ? obviously we have some structural problems too. But in the long run, I think there was just a heightened sense of fear that drove a lot of people to gold, part of which was the prospect of having to deal with larger government.

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