The past few weeks and months have witnessed an impressive rally in the price of precious metals. When any commodity has such an impressive run as silver and gold have, it would be natural to question how far it has left to go. While many market pundits have turned bearish on gold's prospects, we remain steadfast in our belief that precious metals are in a secular bull market, and have quite a ways left to go.
As usual, we'll start with technical considerations and move into fundamentals.
Is This What a Bubble Looks Like?
There has been much talk recently about precious metals being in a "bubble." To be honest, we attribute much of this discussion to the fact that there were two bubbles in the past 10 years, and it is now the craze to try to call the next one. However, such terms should not be taken lightly, and we hope to dispel the myth that gold is currently in a bubble.
The following chart compares one of the most widely accepted bubbles, the tech bubble of 2000, to gold's current trajectory. The Nasdaq is shown in blue and gold is shown in yellow. The chart is normalized for percentage.
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As can be seen, over a 10 year period, the Nasdaq was far more ridiculous than anything gold has done over the last 10 years. The primary characteristic of the Nasdaq bubble, and all bubbles for that matter, is the parabolic, increasing trajectory of the security's price during the final days of absurdity, followed by an epic collapse. Gold has exhibited anything but such a quickening of pace. It has risen steadily for the past 10 years, and even though it has risen 432% during that time span, it has yet to experience the amazing rapid rise that is a precursor to an eventual fall.
But hasn't gold risen too fast, and isn't it at an all-time high, so it must be due for a catastrophic fall? This type of logic never ceases to amaze me. Even though investors have been burned by many high-flying securities in the past, it is extremely important to know that just because a security has reached an all-time high does not mean it is overvalued. In fact, it is a sign that the security is moving in the right direction.
To illustrate the point, the below chart shows gold vs. Microsoft (MSFT) stock from 1985-1995, a period no one could claim is a "bubble." Just below is another chart to show where this fits in the historical context of Microsoft as a whole.
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During 1985-1995, Microsoft stock rose 4400%. Now, if we had told you that any stock rose by that much in a 10 year period, you would be inclined to be skeptical. But look at what Microsoft has done in the next 16 years.
Microsoft withstood the entire tech bubble, albeit losing quite a bit from its peak, but is still up almost another 500% since rising 4400% in that 10 year period. If an investor had used the logic of "selling into an all-time high" with MSFT, he would have been infuriated with himself. So why should investors sell gold just because it has reached its all-time high?
Of course, none of these arguments take into account gold's "value." We use value in quotation marks because gold is a unique commodity in that it is a monetary substitute and has no real industrial uses to speak of. Let's now delve into the fundamentals of gold to see if the current rise is justified.
Money-Printing: The U.S. Pastime
While it cannot be refuted that inflation as reflected in the CPI numbers has not yet occurred, let's take a look at the size of the Fed balance sheet in relation to the price of gold. The Fed is shown in red and gold is shown in yellow, and the chart is normalized for percentage.
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As can be seen, the price of gold has tracked the size of the Fed's balance sheet with uncanny accuracy. This is a very important fundamental comparison, as gold is alternative currency. Since gold cannot be printed or conjured out of thin air as the U.S. dollar and other fiat currencies can, people buy gold when they lose confidence in the ability of currencies to hold their purchasing power. When the Fed increases the size of their balance sheet exponentially, it rightly causes investors to worry more about the solvency of the Fed. To understand this concept, we have to go back to the depths of the financial crisis.
When the Fed took the extraordinary steps of purchasing toxic mortgage-backed securities from banks in exchange for cash in order to bolster banks' balance sheets, this bad debt did not just disappear. Rather, the effect of these transactions was to take dubious debts off the balance sheet of suspect and teetering borrowers, the banks, and place them on an un-bankruptable entity, the Fed. Since the Fed can just print dollars, the banks were instantly propped up by this action, and as a result, the economy returned to growth extremely quickly, sparking the 100% rally in the S&P 500.
Usually, undertaking such a ridiculous act of money printing is hugely inflationary and initiates a deathly hyperinflation spiral in a country (similar to the Weimar Republic, Zimbabwe, etc.). However, this is where the U.S. separates itself from other failed experiments in easy monetary policy. Because the U.S. consumer is responsible for most of the world's consumption and thus fuels the export industries in countries such as Japan and China, foreign countries have no choice but to continue to buy U.S. debt and prop up the U.S., even if they hate U.S. fiscal and monetary policy. For this reason, we have not seen much of a meaningful rise in U.S. government bond yields even though U.S. debt has exploded exponentially.
However, this should not be taken to mean that the U.S. will avoid inflation, as inflation in this country is inevitable. However, unlike Zimbabwe, inflation in this country will occur gradually, and as part of the economic cycle. The reason for this lies in the same Fed actions during the financial crisis.
All the new money created during the financial crisis went to banks' balance sheets instead of into general circulation. Because banks have been extremely reluctant to lend, this money has not found its way to consumers. This is a concept known as the velocity of money, or how fast money moves through the financial system. While the amount of money in the system has been increased drastically, the speed at which that money is moving remains slow. As the recovery gains steam and banks and other companies gain confidence in its sustainability, the velocity of money will increase, and with it inflation.
As inflation peaks, the rallies in gold and silver will reach a fever pitch, likely going parabolic and achieving heights not possible to currently predict. At that point, gold will turn into a sell and this incredible bull market will be over. But to sell gold now would be to implicitly acknowledge that inflation has reached a peak when it is only currently running at 2.1%.
Another argument we hear frequently is that the coming inflation has already been reflected in the gold and silver market and that when it happens it will be a sell the news event. We do not believe this is the case, because other, more capitalized assets have not reflected any inflation whatsoever.
Consider U.S. government bonds, with the 10 year yielding 3.46% and the 30 year yielding 4.51%. An investor willing to accept 4.51% per year for the next 30 years does not sound like one who is particularly worried about inflation. This is very important, because the market for government bonds is infinitely larger than the ones for silver and gold, or even all commodities combined. As these investors start to realize that they need to diversify into precious metals to hedge against inflation (institutional investors currently hold a 1% allocation to gold and zero to silver), the market for precious metals will take off.
Loss of Confidence in Currencies and Central Banks
Recent events have highlighted the reasons why investors should be extremely wary of central bank activity as well as competitive currency debasement. After the earthquake in Japan, the G7 countries intervened in the currency markets by selling yen and buying euros dollars, and pounds, an event we forecast. However, such events are net-bullish for precious metals, as investors' fears that currencies are not being respected are confirmed.
Furthermore, the desired effect of the yen selling is also indicative of why precious metals remain in a bull market. The Japanese desperately needed a weaker yen in order to ensure their manufacturing/export sector remained competitive. Normally this would not be a problem, except that every country in the world is trying to do the same.
From China artificially keeping its currency weak, to Brazil imposing capital inflow quotas to stem its currency's strength, to the ECB buying bonds of over indebted nations, every country in the world is attempting to debase its own currency in order to make exports look attractive and stimulate the economy. In today's day and age, a rising currency is seen as a problem and a falling currency considered a boon.
The obvious question when viewing this unprecedented monetary policy is: is this sustainable? The answer is no, and the gold market is confirming that answer. As long as currencies continue to be manipulated, and competitive currency debasement remains the norm, silver and gold will be a buy.
Last Week's CFTC Report
Yet another argument we hear frequently is that the price of gold is being driven up by speculators, and as soon as they change their minds, the price of gold will collapse. The following chart shows the price of gold in yellow and the Managed Money net long position in white.
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As can be seen, the Managed Money net long position has actually fallen quite a bit recently even though the price of gold remains at an all-time high. This is a very bullish sign for gold, because if it can retain value even with speculators not increasing their positions, it indicates strong physical demand. The recent support for prices in the absence of increased Managed Money participation is likely due to increasing emerging market demand, as well as the continuation of the trend of institutional investors and central banks ramping up their gold exposure in response to monetary debasing events.
We remain long gold futures as well as gold call spreads. We view any pullback as a buying opportunity, and would recommend the purchase of gold outright.
The large cap mining sector looks fairly cheap as well, but this is not our area of expertise. Since we believe in the fundamentals of gold itself, we continue to prefer exposure to the metal rather than miners.
Additional disclosure: Long gold futures, long gold call spreads.
Additional disclosure: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.