Eric Sprott's Gold Analysis Deconstructed: What The Gold Bulls Still Don't Get

by: Convex Strategies

On April 3rd, with gold trading slightly below $1,560/oz, I wrote that the break of major support would send gold (NYSEARCA:GLD) tumbling to $1,350. The majority of responses to my article were rooted in anger, fear, and delusion.

Less than two weeks later, gold reached my target of $1,350. The steady, calm, downward trend in the commodity complex cascaded into a full-on monsoon as hot money raced for the exits. Silver (NYSEARCA:SLV) and the rest of the metals complex saw historic volatility as retail investors were stunned.

Today, even with gold having rebounded to $1,470, precious metals investors are probably pleased to see April coming to an end. However, I still recommend selling essentially everything related to gold and silver, assuming an investment timeframe longer than 2-3 months.

I believe investors are now in the "return to normal" phase of bubble psychology. April's unprecedented sell-off confirmed what I've believed since the beginning of 2012; the tide for gold has changed. The pressure to be long income-producing and/or risk assets is simply too great to be holding significant amounts of gold.

The big story last week from gold bulls was that gold has recovered a pretty solid portion of its tumble. Gold's 2011 peak of about $1,900 to the recent April low of $1,325 was a decline of 30%, so we've only retraced a sliver of this new bear market (yes, gold is in a bear market). That's not much to write home about, especially when we consider the frequency of mammoth dead-cat bounces in bubble markets that have peaked:

If you consider Nasdaq as an example, it was quite an easy trade from the long side for a long time. It went from 1,500 in late 1998 to over 5,000 in early 2000 with hardly any meaningful corrections. From the short side, it was a really tough trade. After breaking down in very whippy fashion to under 3,100 in June 2000, the market then rallied back to near 4,300 in the next two months. This was a 40 percent rebound in a market that was clearly dead. Postbubble dead cat bounces can be vicious.

Colm Shea - Schwager, Jack D. Hedge Fund Market Wizards (p. 37)

The above is a great example of the kind of market action that characterizes bubbles or simply overvalued, frenzied markets. It's also a useful comparison to what we've seen from gold in the past two years. Gold went up for 12 straight years, went down 30%, and is now undergoing a rip-your-face-off rebound. This retracement is completely natural (perhaps even expected), and does little if anything to strengthen the bull case.

Eric Sprott's Analysis

A few weeks ago, I came across a post on ZeroHedge written by Eric Sprott. The article was in response to Societe Generale's bearish piece on gold, "The End of the Gold Era." While reading it, I noted several issues with both the structure and logical quality of the arguments, and disagreed with the conclusions.

The article summed up the philosophy that most gold investors seem to espouse today, so I think it would be useful to break down the individual arguments.

"Gold is a currency, not a commodity" -- When an asset loses 13% in two weeks, with daily swings upwards of 7%, it's neither a legitimate nor a reliable currency. Sprott goes on to say that gold "doesn't really work as a commodity because it doesn't get consumed like one." While it's true that gold isn't consumed the same way that something like oil is, this doesn't convince me that gold is a currency. The definition of currency isn't static, and means different things to different people.

The painful reality (for gold bugs, that is) is that while gold had a history of backing money, it doesn't work in today's highly dynamic global economy. We need a flexible money supply to handle a rapidly evolving world.

This misunderstanding's foundation is the flawed concept that an increase in the money supply equals increased inflation. The correlation isn't even close to as strong as the proponents of a gold standard believe. The Fed controls the monetary base only; the financial system is free to control the remaining 90% of the money supply. The Fed can attempt to make expansionary activities more attractive, but they can't directly force them.

Sprott also remarks that the widespread view that gold is a commodity "plagues gold market analysis." This is a bold claim, and I'm not sure what the relevance is with regard to the price of gold. I suppose he's implying that if people approached gold as a currency, we'd be back on the gold standard, and the price of gold would be fixed at a price much higher than the one we have today. Otherwise, I don't see how gold's perceived status as either a currency or a commodity really affects its price - It's still a question of supply and demand.

"Expansion of the Fed Balance Sheet Leads To Higher Gold Prices" -- These two items are clearly correlated, but Sprott once again gets too bold when he says the relationship is "very simple and intuitive."

Just because they're correlated doesn't mean there's a direct causal relationship. It's plausible that expansionary central bank policy (incorrectly, for the reasons outlined above) stokes inflationary fears in the marketplace, thus catalyzing a flight to precious metals, which have worked as stores of value in most time periods. But that doesn't guarantee a continuation of this currently prevailing framework, and thus doesn't guarantee that further expansion in CB (central bank) balance sheets leads to higher gold prices.

We are already seeing a divergence as gold failed to break through $1,800 on its third attempt, and subsequently broke major trendline support in the face of open-ended balance sheet expansion.

Sprott notes that during the last three months, CB balance sheets have declined by over $400 billion, and then draws the conclusion that gold fell as a result of this contraction. With the BOJ now easing, Sprott says, there's essentially no way gold continues to fall, since the relationship between balance sheets and gold prices is so strong.

If the relationship is so strong, why has gold been going down since 2011, even as central bank balance sheets have risen by about $1 trillion? Sprott's analysis reeks of recency bias, and ignores a critical change in market behavior.

"Governments need to balance their budgets and return to sound money practices" -- Sprott then addresses the fiscal recklessness that has been such a hot-button issue for the past few years. The only way gold crashes, Sprott concludes, is if governments balance their budgets.

While US deficit spending may diminish in scale, it will remain well above $1 trillion per year after factoring in unfunded obligations. We don't know of any creditable forecaster who believes otherwise.

Well, the CBO is forecasting a 2013 deficit of $845 billion, and this doesn't even include the spending cuts put into law on March 1st. It's already May, so we'll know soon enough who is right. At full employment, the budget deficit would be a little over $400 billion. Not too bad.

Furthermore, the deficit doesn't have to be closed in order to have a sustainable budget. You can easily run a deficit that is 2-3% of GDP in normal times; as the economy grows, you can take on more debt.

Oh, and about those unfunded liabilities. When people cite the $90 trillion or so we have in these unfunded liabilities, they fail to match this figure to our assets, and neglect the fact that these aren't paid back all at once. Tell me what our cumulative GDP over the next 75 years will be and then compare that to the liabilities if you want to be fair.


Sprott's central theses are:

(1) Global central bank balance sheets and gold prices are positively correlated

(2) Reckless spending will propel gold prices higher

Sprott is ignoring the divergence between balance sheets and gold that clearly began in mid-2011, and is making the slippery slope argument that today's deficits will result in either large-scale monetization and/or economic calamity, thus supporting gold. In reality, it doesn't necessarily follow that the current (dwindling) US deficit results in subsequent monetization or economic peril.

Gold continues to have major downside. The technical picture has broken down significantly, and the pressure to obtain income-producing assets and/or economically sensitive equities continues to build. Funds that have been locked into the "fear trade" have underperformed in a big way over the last couple years, and they're now looking to reposition.

I still recommend longer-term shorts of the gold ETF, silver ETF, and the mining ETF (NYSEARCA:GDX).

Disclosure: I am short GLD and gold futures. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.