Gold's Uptrend Is Driven by Leverage

With gold now trading above $1,100/oz, many investors are starting to wonder if the fundamentals really support the yellow metal's seemingly unstoppable upward rise. But it's not just a weak dollar and inflation fears driving gold upward, says precious metals expert Adrian Ash; it also depends on "hot money" from leveraged players—who might very soon decide to move on.

Adrian Ash is the editor of Gold News and the head of research at BullionVault, the world's fastest-growing online gold service for private investors. Formerly head of editorial at Fleet Street Publications, Mr. Ash now regularly contributes to 321gold, GoldSeek and Whiskey and Gunpowder, and his views on precious metals have been sought by the Financial Times, the Economist, Bloomberg and others.

HAI Associate Editor Lara Crigger recently caught up with Mr. Ash to discuss the primary drivers behind today's gold markets, including the real reasons behind gold's rise, why gold is actually a terrible inflation hedge and whether we're nearing a gold bubble.

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): Gold has been on a real tear lately, and analysts often point to the falling dollar and inflation fears as the reasons behind its rise. But is that really all that's going on here?

Adrian Ash, head of research, BullionVault (Ash): I think there are several elements behind gold going so much higher. Firstly, the attitude toward the dollar is a really big part of that, because gold is priced in dollars. It's really quite mechanical to say dollar down, gold up.

But you'd have to look further, though. Gold has done nominally well against all major currencies. It's up three times over against the euro; it's done very strongly against the Japanese yen. Against a global basket of the major currencies of the world, it's made all-time highs. Currency appreciation is a main concern, driving a lot of money toward gold over the last decade.

But then there also was the government response to this crisis. People think of gold as being an inflation hedge, but you can't deny the studies that show that gold was actually a terrible inflation hedge for the best part of the 20^th century. It was a great inflation hedge during the 1970s, and during a genuine currency collapse, like Mexico in the ‘80s and ‘90s, or Southeast Asia in the late ‘90s or Weimar Germany. Then, certainly it was a fantastic store of wealth. When inflation reaches hyperinflation proportions, a lump of rare precious metal is a useful way of defending against that. But in everyday inflation, it was a terrible inflation hedge.

But gold has been a good defense against deflation. If you look at the last couple of years, we had deflation in asset prices. Again, gold has done very well in defending its value over those times, because people move to gold when businesses and banks are failing. They want that physical security that gold offers.

Crigger: So gold will do well regardless of whether we have runaway inflation or catastrophic deflation on the horizon.

Ash: It comes down to this: Gold tends to do well in times of financial stress. And inflation or deflation—they're two manifestations of the same thing, which is the destruction of wealth. High inflation destroys bond investors, cash savings. But then deflation does the same thing, but kills debtors indiscriminately, meaning cash holders and bond holders are destroyed. The net effect is the same: A loss of wealth. Gold's appeal steps forward there, as it's rare, physical, tangible property.

Crigger: Even though spot prices have shot up lately, investments in the gold ETFs have remained relatively flat lately. Why is that?

Ash: In the past three months, really since the end of summer, the move has been driven by leverage. If you look at the exchange-traded funds or businesses such as ours—yes, we're still doing very well, but we're not seeing the same kind of flood of new business that we saw months ago. That's not the game at the moment.

It's very much about institutional traders using the very cheap money they can now access: hedge funds, prop desks at the banks and so on. These guys are basically leveraged up on everything. That's why we see correlations getting very strong again between emerging markets, non-U.S. currencies, precious metals, and equities across the board. It's very much the reflation rally of 2003-2007 replayed. The broader markets have wanted to get back to that trend. So many financial players have been looking to get back to a world they understand—dollar down, everything else up—that's why I think you've seen such huge gains across the board between September and October.

It's not a different gold market in nature. Obviously, you've got to accept that a lot of hot money has come into gold, and it's coming in through the futures market, so the chances of a sharp correction are much greater than if you had a bulwark of cash buying the physical bullion.

Crigger: Given this influx of leveraged players in the market, how long do you think gold's upward trend will continue to last?

Ash: It depends on a couple of things. Firstly, what triggered the sell-off in gold futures last time, after the March 2008 high of $1,032/oz? The speculative position in gold futures was then very long, and wanted to get longer. But as the banking crisis kicked in, a lot of the prime brokers—the investment banks who'd enabled hedge funds and other large speculators to take huge positions had to shut them down, because credit was drying up. The cost of credit was going through the roof. So if you look at the destruction in long positions in mid-2008, any repeat of those circumstances, I think, would probably see prices come off quite hard.

Then again, that environment encouraged physical buying again by retail investors. I'm not saying there would necessarily be a replay of that if that were to happen. But certainly, the kind of environment that would force hedge funds out of long gold positions would likely encourage people to go buy physical.

On the other hand, if the hedge funds were to decide they'd had enough, and were ready to move on, that's a different story. Again, look at the reflation rally of 2003-2007. There was recycling: People would move on from one hot trend to another. Sometimes it was the euro, sometimes it was oil, or gold. But the three of them in general moved together. So if they were to decide to take a breather on gold for the moment, in the absence of any other kind of shock, you might well see a lack of the same kind of urgency we had in the middle of 2008, and gold would fall.

Crigger: Are we nearing bubble territory in gold?

Ash: Well, obviously any bubble requires cheap finance. So the accusation can certainly be made.

But I think where that is amiss is that there simply isn't the overwhelming move into gold by the broader public that you really associate with a bubble. If you look at gold in terms of how much money has actually gone into it, compared to how much money is still in other asset classes—consider that back in 1982 or in the depths of the Great Depression in the 1930s, gold accounted for huge amounts of investable wealth, probably about one-fifth at some estimates. But today, you're looking at—even at the most generous estimates—less than 5 percent of investable wealth worldwide.

So my point is that gold is still under-owned by individual investors, and it's certainly under-owned on an institutional basis.

Crigger: So clearly there's still room left for investors to jump in.

Ash: Well, I think it's obvious what my view is. But what gold has done over the past few years has surprised everybody. Looking forward, yes, I think people are right to say that gold's only going to go higher if there's further trouble ahead.

And I think it's pretty reasonable to say that there probably will be. We've got zero interest rates across the Western world. We've got billions in government debt having to be issued at those historic low rates. How do you get out of that? How does the Federal Reserve, or the European Central Banks of England begin to move away from these extraordinary accommodations? I really just don't know.

Comments

[Mad Hedge F...:]

bji Paul Tudor Jones nicely summed up the fundamental argument in favor of gold. The yellow metal is accumulated, and not consumed, and is the ultimate store of value. Gold does particularly well during times of excessive monetization, inflation, and instability of the banking system, as we are seeing now. Central banks, which have been consistent sellers for the last 20 years, are about to flip to net buyers. If non G7 central banks, like China, want to increase their gold holdings from the current 20% of reserves to the 35% weighting now owned by the G7, it will require 1.3 billion ounces of new purchases, or 20% of the total world supply. Certainly they are getting fed up with their ever depreciating dollar holdings. Witness last week’s Bank of India purchase of 200 metric tonnes. ETF’s now own $50 billion worth of the barbaric relic, about 3% of the world total, making them the sixth largest holder in the world, and retail demand for these gold proxies is expected to explode in coming years. Private investors, mutual funds, and pension funds are all underweight gold. This is all happening in the face of declining production from traditional gold suppliers like South Africa. It all adds up to a whole lot of new gold buyers and a shrinking body of sellers. Paul didn’t give any specific price targets other than “up.” Long time readers of this letter know I have been banging the table about gold all year. Time to salt away more American eagles for those college funds and grandkids.

Nov 16 11:53 AM

[Marco G.:]

Thanks great interview and insights.

My main take away is that Gold is continuing up: "Looking forward, yes, I think people are right to say that gold's only going to go higher if there's further trouble ahead.

And I think it's pretty reasonable to say that there probably will be."

Nov 16 12:12 PM

[Donald Ingram:]

Gold will be much, much higher in price.
Less than 5% of the worlds wealth invested in gold? Agree. This is a small market. If the general public starts a panic buying spree the price will rise in multiples of tens per day.
If you own gold ETFs then at the end of the day you still own just paper. Don't get caught in the stampede when all this paper calls for physical delivery and it's discovered that there's not enough to satisfy demand for delivery.
Same as all those leveraged buys out there when it's time to pay the piper at the call. Paper. Paper every where! And no physical gold to be had!

Nov 16 12:44 PM

[The Recusant:]

Historically, we have never had the same conditions as we have now. The price of gold is not governmentally controlled (officially at least) and the recession and financial crisis has hit most countries hard, devaluing most currencies and threatening wealth. This round of price increases in gold will establish a new precedent as the skittishness of funds, banks, and investors hold onto the yellow stuff for insurance. How long they hold onto it will show who can look beyond six weeks and anticipate the looming future inflation.

Nov 16 07:49 PM

[rockerchic:]

Donald,
It is my understanding that gold ETFs, such as GLD, are backed by real gold, not paper.

Nov 17 03:19 PM

[Luke Skywooker:]

$110,000,000,000: all the world's gold stocks/equities (Sept. 25, 2005, Denver Gold Conference) (probably double that now)
$118,000,000,000,000: World Global Capital Markets (Stocks, Bonds, &?) Feb 2005 McKinsey Global Inst.
Sorry my numbers are out of date, but the amount of gold and gold stocks was only 1/10th of 1% in 2005. I doubt that it is more than 1% now. Not 5%

Nov 17 05:39 PM

[Kyrlit:]

That´s a tough question. The gold ETF´s are not being audited in any way that would remove all doubts. They are certainly not buying at Comex. And even if they actually purchase bullion in the unofficial market, what keeps them from leasing what they physically have in their vault to speculators?
Or use it to speculate themselves? Just look at what Barrick is doing with their future gold production!
It is safe to say that there are so many loopholes that there is only one real safe way out: Buy bullion and store it yourself.

On Nov 17 03:19 PM rockerchic wrote:

> Donald,
> It is my understanding that gold ETFs, such as GLD, are backed by
> real gold, not paper.

Nov 18 06:31 AM