I was joking the other day about how I get an email from Macy’s every day alerting me that some special sale is ending tomorrow and I need to act now to save 15-25%. Actually, it wasn’t really a joke because I have gotten an email like that from Macy’s just about every day since Halloween. It’s just kind of funny.
I am now fully desensitized to any sale by Macy’s since I’m sure the next one will be right around the corner just as sure as Joseph A. Banks will be having a three-for-one special on men’s suits before I finish typing. It’s kind of like the boy who cried wolf.
I bring it up because several times in the past few years I have recommended buying gold and silver (since they were at $1155 and $18 respectively) and I hope readers don’t think I’m crying wolf when I say (once again) that this may be your last great chance to buy gold and silver before they take off and don’t look back. 2013 is shaping up to be the perfect storm for a rising gold price. Silver, which trades in lock step with gold but with more volatility, is poised to do even better in my opinion. For this article, I will focus on gold but in general these ideas hold for silver as well.
There are several fundamental factors which will help to drive gold higher. Many of them have been in place for several months while others have yet to really kick it. But before I get to the reasons gold will rise, I’d like to first address the reasons why gold has been in a range bound holding pattern even as the fundamentals for gold have been getting markedly better since August of 2011. And I’d particularly like to address the inexplicable beat down in gold (-7%) and silver (-15%) surrounding the Fed’s announcement of QE4eternity. The two main reasons gold hasn’t really done much in 2012 despite record money printing are investor psychology and active manipulation (and manipulation to affect investor psychology).
Why has gold stalled and what’s with the recent beat-down?
I had the privilege of seeing Rick Rule speak at the Hard Assets conference in San Francisco last month and he used a story to illustrate investor psychology. A man purchased $1000 of a speculative mining stock for $1.20 a share. That same day, his wife went shopping and picked up a few cans of tuna for $1.20 each. The next week the stock price had gone up 50% and was trading at $1.80 even though nothing had fundamentally changed with the company. The man was thrilled with his performance and what a good stock he picked so he bought another $1000 worth. In the mean time, his wife went back to the store and noticed that the tuna had risen to $1.80 a can. She was furious. Not only did she not buy any, but she complained to the manager. Apparently, many of the other shoppers felt the same way because the next week when she went back to the store, tuna was on sale for $1.00 to clear out the old inventory. She promptly bought three times her normal tuna purchase. Unfortunately for the husband, that same week his stock had taken a tumble and was now trading for $1.00. Not liking where this was headed, he sold all his shares. “The question,” asked Rule, “is who made the smarter decisions?”
The point of the story was that when it comes to investing, our natural instinct is to want to buy when things are going well and sell when an investment hasn’t been doing well. When our stocks are doing well we feel smarter; we get emboldened. Instead, assuming the fundamentals of the investment remain the same, we should treat investments like a can of tuna and stock up when it goes on sale and stay away when it’s overpriced.
In the case of gold for the past 16 months, the price has come off its highs and hasn’t really threatened to break through to new highs so much of the quick profit seeking hot money has gotten bored with gold. But if you look closely at the charts for gold and silver you will also notice several periods of sharp drops in the price in a very short period of time. These drops can be nerve racking and scare away weaker investors.
That brings us to active manipulation of the gold and silver markets. To understand the manipulation one must first understand three things about the gold market. First, the price is not set by physical gold trading hands; it is set by paper contract representations of gold that often trade at many multiples to the actual gold available for trading. Second, gold futures and options are traded on leverage, where a small amount of collateral can control a large position in paper gold, but small dips in the price can wipe out that collateral. Third, much of the short term trading is done with computer algorithms that try to ride the gold price up and protect the investor from downward trends through stop losses and other automated rules.
For several years, market followers such as GATA, Ted Butler and more recently, whistleblower Andrew Maguire among others have been presenting evidence to suggest that there is active manipulation of the metals markets. Much of the evidence is circumstantial and involves connecting some dots so it’s hard to definitively prove. However, as the evidence mounts, and the instances get more intense, it’s hard to deny that something is going on. In the most recent instance, as Chris Martenson notes:
…in the run up to the QE4 announcement and then in the days right after, some entity has been selling literally thousands and thousands of gold contracts into the thinly traded overnight markets so rapidly that we have to use millisecond charting to see it for what it is. Again, there is no other legitimate explanation for this activity of which I am aware, besides having an intent of pushing the price down.
As he alludes to, no seller in their right mind, trying to get the best price for their gold would dump a huge amount of contracts all at once at thinly traded times when there are few buyers to absorb their gold. (And yes that includes the rumored forced liquidation in John Paulson’s hedge funds and gold investors looking to book some gains ahead of the fiscal cliff tax increases.) Yet this is exactly what has happened, repeatedly in the past few weeks both in late night trading and right before the COMEX open. But who would want to push the price down? There are three potential culprits.
The first potential culprit is the large commercial banks who hold large concentrated short positions in gold and silver futures. Their large positions allow them to game the system. The idea is that when the price rises to a certain point, they flood the market with short sales which smashes the price triggering stop losses which add to the selling triggering yet more stops. Then they cover their shorts at the lower price when many buyers have been scared out of the market and let the process recycle. Alternatively, or perhaps in addition, the sellers may have options that payout big during high volatility and so they are willing to sacrifice some of the futures positions for larger gains in options.
The second potential culprit may be the U.S. Government or Federal Reserve itself. The idea is that the Fed has a vested interest in keeping the gold price low (or at least appreciating at a controlled rate) because gold is the best barometer of how much value the dollar is losing. The dollar (actually all fiat currencies) and Treasury bonds are based on confidence which would be badly undermined if gold were to rise dramatically, say after a QE announcement that the FED will be printing $1 trillion per year from here to eternity. One way they could keep the price in check is by strategically leasing the government’s gold to bullion banks, thus adding to the supply of tradable gold which can then be rehypothicated and levered by the banks in the paper markets. A recently leaked document from the IMF showed that central banks, including the FED, put up quite a fight to be able to list their physical gold holdings and gold loans and swaps as one line item on their balance sheets since disclosing gold loans would be “highly market sensitive.”
A third potential culprit, which was recently posited by Lee Quaintance and Paul Brodsky, that I find intriguing is that China and other Eastern central banks have the greatest incentive to keep prices low so they can quickly acquire as much physical metal as possible. The whole article is here but here’s a snippet:
“We certainly agree that gold should fundamentally be priced much higher than where it is and that the way gold futures seem to be reliably stepped-on before Treasury auctions and Fed meetings is a bit snarky. But as for the progenitors of the crime? It might be better to look east.
“Conspiracy theorists should consider foreign dollar reserve holders that would like to take delivery of as much physical gold (and silver?) as possible in a very short time, and do so at cheap prices. It would be simple to do: Fund offshore hedge funds that continually short gold futures through U.S. bank accounts, thereby keeping the spot price and London fixings down. Physical gold could then be delivered to sovereign accounts directly from mines and through exports at the suppressed prices.”
Again, no real hard proof, but it’s hard to imagine that foreign central banks don’t see what the Fed is doing and want to diversify some of their trillions of dollars of foreign reserves. Another dot to connect in the China theory is a comment made recently by Steven Leeb who said that he was talking with a Chinese diplomat who let it slip that China was looking to acquire gold to back the Yuan (before backtracking and saying, “No it’s not to back the Yuan. It’s because of jewelry.”) Interesting.
In any case, whether it’s commercial banks gaming the futures markets, the Fed trying to perpetuate the dollar ruse, the Chinese central bank biding time while they acquire real, tangible assets, or some combination of the three, the important thing to realize is that manipulation can’t go on forever as eventually reality always catches up. That appears to be happening as the physical market is starting to diverge from the paper market as more and more investors want to hold their gold.
But even if there’s no manipulation and it’s simply John Paulson forced to sell his levered positions to cover fund redemptions, or sellers cashing in their gold to avoid higher taxes, or hot money just forgetting about gold because it hasn’t done much lately it doesn’t matter. Don’t look a gift horse in the mouth! The price of gold is way too low for the fundamental factors already baked in the cake. As Rick Rule would say, gold and silver are on sale.
But this sale won’t last for long. In part 2 of this post, I will outline the many new developments that are coalescing to create the perfect storm for gold (and silver).