Are Gold Prices In A Bubble?

by: Avery Goodman

The key to understanding commodities prices is in understanding the structure of "derivatives" markets. COMEX is a "regulated" CME Group, Inc. owned futures exchange that deals mostly in "paper gold." NYSE-Liffe is another smaller futures venue also dealing in paper gold, but owned by what is a different corporate entity with mostly the same clearing members. A majority of the market believes to one extent or another, in the legitimacy the prices created at exchanges, even though they often deny that they do.

Regardless of what people think of the futures markets, prices set there have authoritative power over a large part of the gold market, even though the prices are created, in the short run at least, by a combination of group-think and capricious decision-making on the part of a handful of banks and hedge funds. None of the short-selling gold players at the futures exchanges, for example, actually possess even a tiny fraction of the amount of physical gold (or any other commodity) necessary to make good on their paper promises to deliver gold in the future.

Derivatives writers rely upon hope, prayer, a long tradition of under-capitalization among non-bank futures market participants, and so-called "performance bonds" to avoid disaster. Unlike the regulated insurance industry, there are no reserve requirements for derivatives sellers, even though they make promises they must keep in the futures just like an insurance company. Historically, however, a large part of gold futures contracts are bought by leveraged commodity funds, designed around "indexes" that are sponsored by big bank short-sellers. These habitually roll over positions, no matter where the prices flow, and never take physical delivery. The rest are mostly bought by under-capitalized speculators, who do not have enough money to take delivery. They are easily and consistently swept away by mild margin calls and rarely enforce delivery obligations.

The bottom line is that 99%-plus of all futures contracts that require delivery will never be delivered. It is a very attractive market for bank participation as short-sellers, because when you sell something you don't own, using contracts for future delivery that are rarely if ever enforced, it is a very profitable business. The invisible so-called "over the counter" (OTC) derivatives market operates under a very different dynamic, but prices take all their cues from visible regulated exchanges.

According to the Bank of International Settlements, by December 31, 2010, the general OTC markets involve a total notional value of $601 trillion worth of derivatives. This compares to about $27.4 trillion for the visible exchanges. The overall OTC derivatives market is some 22 times bigger than the regulated futures markets. Gold derivatives are a bit more oriented toward regulated exchanges. The total nominal value of all OTC gold contracts is approximately $400 billion, while regulated exchanges, like COMEX, handle gold contracts worth about $80 billion. The OTC gold derivatives market, when broken out of the general market, is about five times the size of the regulated gold futures market.

In any case, the "biggest" money is not won or lost on regulated futures markets, but in OTC markets. What we see visible at regulated exchanges, including, but not limited to gold, oil, and other derivatives may often be an inverse of what big players are really doing. One can prop up bond prices, for example, while taking big long positions in treasury futures, while, at the same time, taking even bigger short positions in the same derivatives, on the OTC market, getting ready for an eventual implosion of the treasuries market, even while propping up the price.

If a big bank is in the market to buy paper (or real) gold in the OTC market, in particular, it will be paying "spot" for it. "Spot" is considered the "official" gold price, and it is heavily influenced by prices set on visible regulated futures exchanges. Remember, even though OTC gold markets are five times the size of COMEX and all other regulated exchanges combined, they play little part in price discovery. The only effect they may have is when buyers force deliveries in the OTC market, it will cause a shortage of available physical metal with which to settle physical demands in the regulated futures markets. That is probably what happened when the price of silver went ballistic a few months ago.

Without rendering judgment as to the extent of market manipulation that occurs, suffice it to say that a huge incentive exists to try to influence prices at regulated futures exchanges, when a buyer wishes to purchase large positions in OTC paper or physical gold. Otherwise intelligent people, who comment on markets heavily influenced by futures prices, usually do not understand what they are talking about. They end up habitually wrong in gold because they see what appears to be "high leverage" and a price that has been rising too fast. They don't understand the complex interplay of cash, futures and OTC forwards markets in gold, oil, bonds, interest rate swaps and how they affect one another.

Too many people are misled by the small part of the market that is visible. They tend to look at the visible, and ignore the much larger part that is invisible. As we have already seen in part, nominal trading at regulated futures markets is much larger than cash trading in physical markets, but it is much smaller than nominal trading at the invisible OTC derivatives markets. Otherwise intelligent commentators like Noriel Roubini look at COMEX market gold leverage, even after recent margin hikes, and note that it is still theoretically 25 to 1. That convinces them that gold is in a bubble. What they fail to comprehend, however, is that, as of August 25, 2011, there were outstanding contracts promising future delivery of 53,599,600 troy ounces of physical gold, but only 1,788,136 ounces registered in warehouses as being available for delivery.

COMEX is certainly leveraged, but the leverage slightly favors the short sellers, and a reduction in prices. While it may be possible to take a position in gold that is 25 times as large as the performance bond money you put on the table, the amount of paper gold sold is 30 times the amount of physical gold really available. If all leverage was suddenly outlawed, and all transactions were netted out to cash from buyers and gold from sellers, 20% of all long buyers would not be able to receive the gold their contracts say they are entitled to. COMEX leverage favors sellers not buyers.

Making matters worse for the long buyers, COMEX short sellers, generally speaking, are the clearing members of the exchange. They have the power, through control of the exchange risk committee, to profoundly affect prices by altering long leverage through changes in performance bonds, at any time and in any amount of their choosing. Whether by intention or happenstance, they can and do destabilize long position holders' accounts on a regular basis.

Meanwhile, the number of contracts in the invisible OTC market, similarly promising "forward" delivery, is about 100 times the amount of physical gold available there. OTC derivative sellers do not even keep any known amounts of physical gold in warehouses, nor are they required to do so. One of their expert witnesses admitted, during a CFTC hearing, that the OTC derivatives are issued on the basis of physical gold stocks at a ratio of 100 to 1.

Let us first assume that prices at COMEX are inflated by 25 times because of positive leverage, reducing the price down to $70. Then, let us multiply by 30, giving us a true price of $1.2, accounting for the negative leverage of 30 at COMEX, giving us $2,100. That is the current "fair market value" of gold if we ignore OTC markets. However, we cannot ignore the OTC gold market, because it is five times larger than the sum total of all regulated futures exchanges in the world. Multiply $2,100 by 100 and you get $210,000. This is the price that gold would go to, in U.S. dollar terms, if, suddenly, everyone lost complete faith in the U.S. dollar. Mysteriously, this is remarkably close to the amount that gold would need to sell for, if, suddenly, the entire world lost confidence in all fiat currencies, and everyone was required to pay off in gold, rather than in dollars, pounds, euros, yen or francs.

Frankly speaking, I do not believe that gold will ever sell for $210,000 per ounce. So, is gold in a bubble? Not likely, given that the uppermost valuation is more than 100 times the current price. Historically, before the advent of derivatives trading, the price of gold was far more stable than the price of anything else. Price stability was disturbed only by the factors that affect all currencies, such as wars, famine, etc. When and if visible futures market performance bonds rise to near-100% of the purchase price of gold futures, would-be manipulators will have no further power over the price. The price will rise slowly and steadily, until central bankers stop "adding liquidity" and debasing paper currencies, which means for a very long time.

Over-leveraged long oriented traders at COMEX, of course, cannot look at the long term. They are busy trying to get rich quick. They are easily panicked because their dreams of quick money are exquisitely vulnerable to vicious price attacks by their ancient enemies, the short sellers. Gold trading was turned into chaos, for example, when information leaked out that the COMEX "exchange risk committee" was going to impose a hefty increase in gold performance bond levels. As a result of the panic, gold lost $104, or 5.6%, in one day, on August 24th, as all the weak hands rushed out the door at once. The yellow metal ended the day at $1757.30 an ounce, which was the worst day since March 19, 2008, when it declined 5.8%. Those who took advantage of the big price drop in 2008 have doubled their money in three years. Those who take advantage of this latest price decline will also profit handsomely.

You can buy gold in many ways. Small bars and coins are available from a myriad of coin shops, as well as from the huge brokerage firm, Fidelity Investments, which is willing to send gold by FedX to your home. You can also buy through the bullion sales division at what is otherwise known as a futures broker, PFG Best, which also delivers by FedX and registered mail. You can take a position in gold through various ETFs like GLD, but a controversy exists as to whether the ETFs actually have as much gold as they claim. You can also buy shares in one of the closed end mutual funds, like Sprott's PHYS. They guarantee to deliver even relatively small amounts of physical gold to buyers upon a proper request. The main problem with Sprott funds are the charges. They were originally sold with a hefty commission to brokers of 5%, and small redemptions below one 400 ounce bar, get hit with another 5% fee.

Another option is buying gold stocks like Newmont (NYSE:NEM), Yamana (NYSE:AUY) and others. But you must weigh the risk of executive overcompensation, political instability, expropriation of foreign properties, and executive errors in addition to the performance of the metal itself. These increasing risks in an unstable world have caused gold equities to underperform the actual commodity lately. Because you put yourself at risk of being taken advantage of by games by derivatives sellers, you must avoid leveraged gold ETFs and especially leveraged ETNs (which are subject to high levels of counter-party risk). Over the long term, even though the price of real gold may rise sharply, leveraged ETFs and ETNs can lose value. They are created from derivatives contracts which are extremely unstable, and often need to be "rolled" over to the next expiration date, at a very high cost to participants.

You can buy deliverable futures directly at COMEX or NYSE-Liffe. But, there is a lot of danger there. The performance bond can be changed while you are not paying attention, and your position will be sold out from under you unless there is enough cash in your account to cover the increases. If you do buy there, always keep enough money to offset at least a tripling of margin requirements. Keep in mind that you'll need enough money to take delivery of a minimum of 100 ounces or more of gold if you buy gold futures. Otherwise, you'll be a "pie-in-the-sky" speculator and they always lose.

If you choose the futures route, open a futures account at one of the full service commodities brokers like PFG Best, Lind-Waldock, RJO etc., and not at a stock brokerage house that does futures "on the side" to make extra commissions. If you use TD Amertrade's ThinkorSwim division, interactive brokers, and most other securities brokerages, you will not be allowed to take delivery. They will sell your position out from under you as soon as it matures without being rolled, and will point you to some infinitely tiny small print in your contract with them that allows them to do that.

The bottom line is that gold has no central banker, but it is money. It always has been and always will be. It doesn't matter what governments tell you. It doesn't matter where a manipulator moves the price in the short term. Don't worry about the short to medium term manipulations. Even former Chairman of the Federal Reserve, Alan Greenspan, is a "gold bug." But, no one remotely like Greenspan will ever be able to debase the supply of gold. The "chairman" of the earth's "gold reserve" is God himself. You need not do much thinking to complete the picture. In a world of capricious and unstable manipulations and market movements, you need to have a significant part of your investment portfolio in gold if you want to financially survive the hard times to come.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.