Adrian Ash on Sep 06, 2010 03:02AM

Speculating in Gold

Since gold stopped being money, it's become 75% more valuable on average...

SO GOLD is now at "fair value" reckons Bill Bonner, long-time gold bug and my former boss/partner-in-crime at The Daily Reckoning's London HQ, writes Adrian Ash of BullionVault.

No, he won't sell yet...if ever...says Bill. But gold's huge under-pricing a decade ago has clearly passed by. Value-hungry investors got their "reversion to the mean", and in the form of 400% gains, too. What one ounce of gold bought 2,000 years ago ? a good suit of clothes, in Bill's oft-repeated example ? it now matches, if not exceeds in price, here in late 2010.

From here, that makes gold a "speculation".

Never mind that, around the birth of Christ, all clothes were hand-cut and sewn locally...rather than glued together by the world's cheapest labor, four or eight thousand miles away. A suitable outfit for visiting the coliseum or agora would have been made-to-measure, too...and today's finest tailors, at least in London or New York, will ask much more than the $1240 you'd raise by selling one ounce at current "Spot Gold" prices.

Never mind all that. Because Bill's point is well made, again...

Gold was a screaming buy at the start of last decade, sinking to its lowest price ? in real terms ? since the early '70s, as the chart above shows (courtesy of the World Gold Council, and taken from Roy Jastram's incomparable study, The Golden Constant).

But "Nobody cared! Nobody was interested," as a (very drunken) London dealer cried at me late last year. "I'd email out jokes, porn-site links, anything to get clients reading so I could repeat three simple words: 'Buy Gold now!'

"But they didn't care...I don't even know if they looked at the porn..."

Today, in contrast, you can't move for anxious investors and bullish hedge funds piling into gold. Or so the media coverage would make it seem. New gold dealers ? online and on Wall Street ? are meantime sprouting like fungus to catch the "retail dollar", and the story's grown so old, it's even spawned its own calendar for financial hacks (the summer lull, India's post-harvest festivals, quarterly data from the mining-backed World Gold Council, the Sept-end of each year of the Central Bank Gold Agreement). Wherever you look, the only debate that counts ? "It must be a bubble, so when will it burst?" ? rolls on for what is now more than two years.

As for the dumb lump of metal, yes ? it continues to pull in new money, nudging its purchasing power ever-closer to the big top of 1980. But look again at that chart above. For while Roy Jastram saw a "golden constant" in his two centuries of US data (and four centuries of British Gold Prices), the shorter-term volatility is striking. Not least since gold ceased being money 39 years ago, and became mere trinkets and collectibles instead.

"In terms of what gold will buy, it does not seem undervalued to us," Bill Bonner writes. "As near as we can tell, gold is now fairly priced.

"[So] the reward now is different. It is speculative...not inherent. We cannot expect to make money by waiting for the metal to revert to the mean. It's already at the mean."

But what is gold's mean purchasing power ? the "golden constant" of Jastram's peerless research? By our reckoning here at BullionVault today, it has risen sharply since the US abandoned its last pretence of a gold standard and floated the Dollar in August 1971. Compared with the first seven decades of the 20th century, in fact, gold's real purchasing power has stood more than 75% higher on average. Which seems odd. Because without being used as money ? its only utility beyond decoration ? gold became only more valuable. So while its purchasing power may have looked "constant" across long historical periods from Roy Jastram's vantage of 1977 (and again to die-hard gold bugs 20 years later), its utility had in fact changed.

Gold became more useful as a way of storing purchasing power, even though it was no longer money. Or rather, because it was no longer money, in an age where "Every morning, when you look in the mirror, I want you to think 'What am I going to do today to increase the money supply?'..." as John Ehrlichman, assistant to Richard Nixon, apparently told Fed governor Charles Pardee, sometime in the early 1970s. Post-war economic policy across the West was haunted by the shadow of the Great Depression, and thus flowed from the fear that, unless money was losing value, then spending and particularly investment growth would grind to a halt.

Without the spur of inflation, capital would choose to sit tight ? in purses, pockets and deposit accounts ? because its purchasing power today would be retained tomorrow. Savers could thus spend (or not) as they chose, rather than being forced to exchange or grow their money to realize or maintain its present value. Devaluing their money, in contrast, via persistent (and obvious) inflation would force savers into the stores and stock-broker's office. And thus today's targets for persistent (and obvious) inflation were born.

"[Harvard professor] Kenneth Rogoff is proposing that the United States use a burst of inflation to get out of its slump," writes Princeton professor Paul Krugman. "I agree...[but] if central banks can gain any leverage at all, it?s only by credibly committing to inflation over a fairly sustained period...[not Rogoff's] two or three years of slightly elevated inflation."

Bill Bonner's bang on the money, in short. Gold from here is a speculation, but a speculation only on academics getting their inside man (whether Mervyn King in London or Ben Bernanke in Washington) to apply their latest hare-brained scheme ? massive new money inflation.

What price gold's utility as a store of real value if...when...they succeed?

Buying Gold today ? now simple, secure and cost-effective at world No.1 private-store, BullionVault...

Bill Bonner on Sep 06, 2010 02:58AM

Print and Be Damned

A new name for an old weapon in the central banks' war on what their own policies create...

JAPAN WAS the world's most admired economy in the 1980s, writes Bill Bonner in his Daily Reckoning.

Then it was the world's most despised economy in the '90s. By 1995, economists pointed their fingers and laughed ? the world's most admired businessman had lost his left shoe. But now, of course, much of the world is barefoot.

The US inflation rate has been going down since the early '80s and was cut in half since last year. It now hovers barely above zero. Surely Japan ? where prices have been falling for two decades ? has something to tell us. As we pointed out last week, the Nipponese have been in decline for the last 20 years ? with lower stock prices, falling real estate prices, and a falling GDP. Even the population has been sliding for the last five years.

Last week the Japanese decided to throw some more grit on the slope. Japan's central bank governor, Masaaki Shirakawa, said he was boosting his "special loan facility" by ¥10 trillion, about $120 billion. And Mr. Naoto Kan, Japan's premier, said he would support the central bank, adding a "second pillar of stimulus' of some ¥920 billion.

Yes, the numbers always sound impressive in Yen. But they are unlikely to give the economy much traction.

Professors Ken Rogoff and Carmen Reinhart studied 15 economic crises over the last 75 years. What they found was what you'd expect:

Real recoveries in the post-Keynes era are rare.

Instead, in the 10 years following a crisis, economic growth rates are lower and unemployment is higher than in the years preceding the crisis. In two thirds of the episodes, jobless rates never recovered to pre-crisis levels, ever. And in 9 out of 10 of them, housing prices were still lower 10 years after the crisis ended.

"Our review of the historical record, therefore, strongly supports the view that large, destabilizing economic events produce big changes in the long-term indicators, well after the upheaval of the crisis...

"Up to now," the authors warn, "we have been traversing the tracks of prior crises. But if we continue as others have before, the need to de- leverage will dampen employment and growth for some time to come."

It was perhaps this scholarly warning that roused Japan's Shirakawa to action, with Ben Bernanke right behind. Neither wants to be known as the central banker who followed in the footsteps of losers. Urged on by sages and simpletons, they will print money.

"It falls to the Fed to fuel recovery," writes Clive Crook in The Financial Times. "Under the circumstances, better to print money and be damned."

At last week's conference in Jackson Hole, Wyoming, the Americans promised to print more money, if needed. Shirakawa rushed home early so he could turn on the presses right away.

We would have more faith in central bankers if they had not been responsible for causing the crisis in the first place. Shirakawa joined the Bank of Japan more than 30 years ago. Ben Bernanke, an expert on the Great Depression, joined the Fed in 2002; he was standing at Alan Greenspan's right side, with a pin in his hand, years before the bubble reached a crisis level.

"In a sense," said Professor John Taylor, also at Jackson Hole, "the Fed caused the bubble." That is, in the only sense that matters ? they kept the key lending rate too low for too long. Now they are about to make another monumental mistake. No, two of them.

The first is already in progress. By promising the world extremely low rates for an "extended period" of time, they have created the exact conditions they wanted to avoid. President of the St. Louis branch of the Federal Reserve, James Bullard, explained that the Fed had unwittingly put the economy into an "unintended steady state." The key rate cannot go any lower as prices sink; it is already at zero. It cannot go higher, either, not as long as inflation remains below the target. So, it does not move.

The private sector has come to expect no policy response, Bullard concludes, "so nothing changes with respect to nominal interest rates or inflation." As in Japan, the US economy remains in a coma.

The second major mistake is still ahead. Quantitative Easing is a new weapon. It is not meant to kill Dollar holders or bond buyers. It is intended merely to scare them with a little bit of inflation. But with the Fed's QE shotgun staring him in the face, an investor may doubt the Fed's promise to pull the trigger "just a little." He will drop the Dollar and US bonds and run. Inflation will soar.

Here at The Daily Reckoning, we have argued that it is coming...but not soon. Our opinion hasn't changed. We're just getting tired of waiting.

Buying Gold today? "If there's an easier way, I've yet to find it," says one BullionVault user...

Julian D.W. Phillips on Sep 06, 2010 02:55AM

What Beijing Just Said

Is the US really selling its Gold Bullion reserves...?

The CHINESE GOVERNMENT is truly inscrutable, writes Julian Phillips of the Gold Forecaster.

Beijing is very careful not to say any more than is necessary on any subject. It's also very careful to have people, supposedly close to government, make statements that may appear to be government policy, but which may simply help lay a smokescreen for the true picture. These spokespeople may otherwise be looking to provoke, to get a reaction, like tossing a stone into a bush to see what flies out.

So before we get to what may be a crucial quotation, we have to tell you this quote is not from a top official but from a central-bank researcher. Because of his closeness to the People's Bank of China, it may be assumed he is telling us facts that are common knowledge at the bank. On the other hand, the quote is so explosive, and not backed up by fact, that it runs counter to common sense and against the information we have.

It's natural to then say, "Maybe he knows something we don't know". So whether you accept this as fact, or not, is your decision...

"Sales by overseas central banks could see a sharp fall in Gold Prices," the Financial News reported Wednesday, citing Zou Pingzuo, a central bank researcher. He continued, "Investors should be careful about investing in gold. Gold Prices could fall sharply because of intensive gold sales by the United States and other overseas central banks."

Are the United States and other central banks selling gold? We are of the opinion that the World Gold Council is a competent body and that they do gather accurate information on 'official' gold sales worldwide. We also note that leasing is not selling, just as swapping is not actually selling. And the figures published by the WGC tell us that the gold selling has stopped and that central banks, including China, are buyers.

Yes, when gold is leased or swapped ? such as happened via the Bank for International Settlements earlier this year (see BIS Gold Swap) ? the gold leaves the owners control. But unless the overriding agreement is broken the gold should return to the owner's control. It's there that the main questions lie. And it's there that the statement may gain credibility.

Many people are convinced that leased gold or swapped gold is a cover for what in reality is a sale. As a result many believe that the central bank holdings of gold are far less than published. If such obligations do attach to the gold owned by a nation, then at best, it is 'at risk' and this should be clarified. The risk of the gold not being returned does attach to that gold, because it lies under the control of an entity or person outside that bank. That certainly weakens ownership control as we all know.

More pertinently, why isn't the Federal Reserve happy to prove its Gold Bullion holdings in an audit? Congressman Ron Paul has wanted an audit of the Fed for a long time for, as he said, "the audit should determine not only the simple presence of gold in the US government's vaults at Fort Knox, Kentucky, and elsewhere but also "whether any of it has been obligated."

Congressman Paul is fully aware of the Federal Reserve's involvement in gold swaps with foreign banks, an admission made by Fed governor Kevin M. Warsh a year ago in his battle with GATA's litigation against the Fed under the Freedom of Information Act. It was there that Governor Warsh insisted that the Fed's gold swap arrangements must remain secret. What was the Treasury's response to the Senator?

"Representatives from the Treasury Department and US Mint did not respond to requests for comment on Paul's proposal."

Shouldn't the Treasury, the Fed and public institutions in general be transparent? You would think so, but then the perceptions we have of government, the Fed and its Gold Bullion reserves, may be radically altered and confidence damaged.

After all, it was only after the Gold Standard was dropped that it was discovered that the UK could not cover all the banknotes they had issued based on the previous commodity-exchange rules for Gold Bullion.

What stands out starkly is that if the Federal Reserve does have the gold they say it has, then an audit will reveal this and ensure confidence is bolstered in the central bank's reserves at all levels of the monetary world. So why would a central bank not audit its holdings regularly to shore up any waning confidence? After all, as the nation's purse holder, they should assure the public that their reserves are what they say they are.

And what would happen to the Gold Price if central banks and the US were selling? The answer to this question is not what you ? or the Chinese central bank ? may initially think. Our conclusions are available to subscribers of www.GoldForecaster.com here...

Buying Gold for your personal reserves today? Start with a complimentary gram of Swiss-secured Gold Bullion at world No.1 private-store BullionVault now...

Hard Assets Investor on Sep 06, 2010 02:46AM

Trading That Gold/Silver Spread

Playing silver and Gold Futures against each other as the Gold/Silver Ratio nears "break out"...

In MY REFRIGERATOR, a jar of something called "sandwich spread" has been lurking for weeks, writes Brad Zigler at Hard Assets Investor.

I honestly don't know how it got there, but I suspect one of my Canadian friends...invited over for our backyard barbecues...brought his favorite along and then forgot to export it from our premises. I would have preferred him leaving some of his Molson behind. But that's the thing about this condiment, a combo of mayonnaise and pickled vegetables. You either love it or hate it. I know no one who's ambivalent about it.

So it goes with another type of spread: that which pits one futures contract against another. Spreads can precisely provide the nuanced approach desired by some traders, while boring the hell out of others. A lot of misconceptions abound about spreads, largely because they're unique to futures. There are no direct analogs in securities (we're talking stocks vs. futures here, not options).

Take the Gold/Silver Ratio for instance. Breakouts in the ratio of Gold Prices to Silver Prices are a favorite of spread traders. So why not look at the trade through their eyes?

First, a spread consists of two or more related futures positions. Note the word "related" here. In order for a spread to be recognized for margin purposes ? more on that in a moment ? there has to be an economic connection between its constituents. Plainly, gold and silver are fellow-traveling precious metals, but formal recognition of the spread by the exchange clearinghouse is required to derive the spread's benefits. What benefits? Well, in most cases, reduced margin requirements.

Let's look at how this facilitates a Gold/Silver Ratio trade...

Comex Gold Futures are traded in 100-ounce contracts, which require a minimum performance bond (or margin deposit) of $5,739 each. Comex silver's $6,750 margin requirement is based upon a 5,000-ounce contract. And if you think the gold/silver ratio will move in the white metal's favor (meaning it will fall, as gold becomes less costly in terms of silver ounces), then you might be inclined to Buy Silver.

Purchasing silver outright, however, means you're only going to make money if the price advances above your buy point. Using the futures market instead, in contrast, you can sell gold against a silver purchase, betting instead on an improvement in silver's buying power, whether it derives from a rise in silver's price or a decline in gold's. A spread, therefore, gives you greater flexibility.

You won't be required to meet the outright margin requirements for each of the spread's legs, but you do have to meet the clearinghouse spread rules. Spread treatment for a gold/silver trade is based upon a 2-to-3 ratio. This means that for every two gold contracts bought or sold, you must take an opposite position in three silver contracts.

Thus, the spread bet would be made by purchasing three silver futures while selling short two Gold Futures contracts. The clearinghouse grants a 50% margin credit for the spread, which would bring the minimum margin deposit to $15,864 for all five contracts:

( ($6,750 x 3) + ($5,739 x 2) ) x 0.50 = $15,864

Now, suppose we use the December contracts for our ratio trade. As of Sept. 1, Gold Futures settled at $1,248.10/oz and silver at $19.38/oz, yielding a ratio of 64.4-to-1. Banking upon an increase in silver's purchasing power means you're looking for the ratio to decline (in other words, the number of silver ounces bought by one gold ounce diminishes).

Suppose we set up our trade and watch as the gold/silver multiple declines to 60x. The ratio could decline as metal prices advance, or as they decline, giving you a profitable return just as long as your short position in gold paid you more (or cost you less) than your long position in silver cost (or earned).

Of course, there's no guarantee of a decline in the gold/silver ratio. A widening of the ratio could subject you to open-ended losses, whether prices advance or decline. So what are the odds? Well, we've seen the gold/silver ratio move into an increasingly tight range over the past year. This pattern is a typical setup for a breakout move. So the question spread traders now ponder is the probable direction of the breakout ? to a higher or lower multiple?

 

We can apply a little probability theory here to better visualize the odds:

• Over the past year, the average for the ratio was 64.5x;
• Volatility has been clocked at 21.4%, which means in effect there are two chances out of three that, in a year's time, the ratio will end up in a range plus or minus 21.4% from its average;
• That makes for a one standard deviation range bounded by a 50.7x multiple on the downside and by 78.3x up top.

So if volatility remains constant, the odds of a breakout through a standard deviation are, logically, small:

If volatility remains constant at 24.1%, your odds look like this...

Ratio moves...	30 days	60 days	90 days
Above 78.3x	0.2%	2.3%	6.5%
Below 50.4x	0.0%	0.5%	2.1%
Exceeds either	0.2%	2.8%	8.6%

However, the essence of a breakout is increased volatility. If there's a short-term spike, say to the 35% level, the odds look quite different:

Ratio moves...	30 days	60 days	90 days
Above 78.3x	4.0%	14.5%	24.5%
Below 50.4x	1.1%	7.1%	14.2%
Exceeds either	5.1%	21.6%	38.6%

You don't need to move the ratio needle very far to make a handsome profit on a gold/silver spread. We saw the gains and losses attained from a narrowing of the ratio to 60x as well as those garnered from a widening to 68x. What are the odds of either level being attained at a 21.4% volatility?

Ratio moves...	30 days	60 days	90 days
Above 68x	36.0%	51.8%	60.1%
Below 60x	26.4%	42.6%	51.5%
Exceeds either	61.9%	88.1%	96.6%

Viewed from a volatility perspective, the odds favor a move upward in the gold/silver ratio, meaning gold's purchasing power is more likely to increase rather than wane. Traders heeding the odds would then Buy Gold futures against the short sale of silver contracts.

There's something else these probability tables tell us. A hike in the gold/silver ratio would indicate the metals' fear premium is strengthening ? a likely consequence of continuing dismay over economic prospects. Downticks in the ratio would indicate more enthusiasm for silver and its industrial applications in an improving economy.

Forewarned is forearmed, I always say. But all this has made me hungry for a sandwich...and a Molson.

Want Physical Gold or Silver today, not derivatives with leverage and counterparty risk? For the maximum security at the lowest costs, go to the award-winning world No.1 BullionVault now...

Dan Denning on Sep 06, 2010 02:44AM

Worth Watching Out For

Shame about Europe's government debt bill. No government is proving great for Aussie investors...

The AUSSIE STOCK MARKET is up 2.8% since the Federal election on August 2nd, if you use the ASX/200 as your proxy, writes Dan Denning in his Daily Reckoning Australia.

This whole "not having a government thing" is working out well for investors, in short. It turns on the uncertainty of having no-one in charge is better than the certainty of having someone in charge. Maybe that will all change this week, though.

To begin with, Friday's jobs data from the US gave the market a positive lead. We're not sure this matters one little bit. True, the private sector in the US added 67,000 new jobs. But that doesn't have a lot to do with Macquarie Group's earnings, does it? Those figures were a bit of a revelation in themselves, as the banking group told the ASX that it expects first half profit to be 25% down on previous expectations.

Macquarie's new number for the half-year set to end September 30th ? $360 million ? is not small. But it's smaller than expected. Why? Well the obvious answer is that in a deleveraging world with more risk and uncertainty, it's hard to be a profitable investment bank and securities dealer. Mind you, Macquarie is still profitable. But corporations seem less eager to take on debt, so they don't need Macquarie to arrange the offerings. And individual investors are scaling back the volume and frequency of their share trading.

Early Monday, Mac Group's little peek behind the scenes led to an 8% fall in its shares earlier this morning. That took the steam out of a strong start. And for what it's worth, we're wondering when affairs in Europe and America are going to begin weighing on the Australian mind again.

For example, the Financial Times is reporting that Eurozone governments will try to raise about double the amount of cash in September that they did in August. Last month, Eurozone borrowing was only about ?43 billion. This month, about ?83 billion in new bonds on offer to anyone who will take them.

How will you know if the Eurozone debt problems are hotting up again? Watch the spread between Germany bonds and Irish, Spanish, and Portuguese bonds. In Ireland, the spread between Irish and German bonds of similar durations reached its highest level ever at 356 basis points. There is also a 24-hour strike in France to watch out for.

The French are always good for an entertaining strike. It can be mildly inconvenient if you have to take a taxi, a bus, a train, or have garbage that needs collecting. But it is a French tradition of standing in solidarity with your fellow workers, even if you don't collect garbage, drive a taxi, drive a bus, or engineer a train.

Is it serious, though? Well, it will start to be more serious when people in France, and the UK, and Italy, and Greece, and America realize that austerity measures and reduced government spending and higher taxes all add up to one simple fact: a lower standard of living. When you have to pay lots of big bills out of current and future cash flow, there's less money to save and spend.

This is why we reckon the next stage of the Sovereign Debt Crisis (originally the Global Financial Crisis) will be political and sociological as much as it is economic. But then, economics is really the study of choices people make with money. So all economics is political. It's just going to get political in an angry way in the coming months.

To the extent that angry people are nervous investors, this is probably a good world for traders and a horrible world for pensioners.

For traders in Australia, there is the added element of the new quarterly pricing system for iron ore and coking coal. There's a nifty little article on the back page of today's Financial Review about the subject. The article points out that the increased variability in underlying prices for steel-making materials introduces a new level of variability to the quarterly earnings of iron ore and coal producers.

Does it change the way you value them? We'll ask the stock Doc when he gets back from London on Wednesday. But our view is that the variability in underlying steel-making materials prices is essentially a derivative of fixed asset investment in China (residential and commercial real estate investment in China). If THAT turns out to be a bubble (like we think it is) the volatility in iron ore and coal prices is just a prelude to a 2008-like reversion to the mean.

Buying Silver or Gold Bullion today? Make it simple, secure and cost-effective at BullionVault...