A Proven Contrary Indicator
In early May, The Economist published an editorial on gold, ominously entitled "Buried". We wanted to comment on it earlier already, but never seemed to get around to it. It is still worth doing so, for a number of reasons.
The Economist is a quintessential establishment publication. It occasionally gives lip service to supporting the free market, but anyone who has ever read it with his eyes open must have noticed that 70% of the content is all about how governments should best centrally plan the economy, while most of the rest is concerned with dispensing advice as to how to expand and preserve Anglo-American imperialism. We are exaggerating a bit for effect here, but in essence, we think this describes the magazine well. In other words, its economic stance is essentially indistinguishable from that of Financial Times or most of the rest of the mainstream financial press.
Keynesian shibboleths about "market failure" and the need to prevent it, as well as the alleged need for governments to provide "public goods" and to steer the economy in directions desired by the ruling elite with a variety of taxation and spending schemes as well as monetary interventionism are dripping from its pages in generous dollops. It never strays beyond the "acceptable" degree of support for free markets, which is essentially book-ended by Milton Friedman (a supporter of central banking, fiat money and positivism in economic science, who comes from an economic school of thought that was regarded as part of the "leftist fringe" in the 1940s, as Hans-Hermann Hoppe has pointed out). Needless to say, the default expectation should therefore be that the magazine will be dissing gold - and indeed, it didn't disappoint.
Another reason is that the magazine has one of the very best records as a contrary indicator whenever it comments on markets. If a market trend makes the cover page of The Economist, it is almost as good as if it were making the front page of The Mirror or The Daily Mail. If you do the exact opposite of what an Economist cover story prediction indicates you should do, you can actually end up being set for life.
A famous example was the "Drowning in Oil" cover story, which was published about two months after a multi-decade low in the oil price had been established, literally within two trading days of the slightly higher retest low. The article predicted that crude oil would soon fall from then slightly over $10/bbl. to a mere $5/bbl. - a not inconsiderable decline of more than 50%. Instead, it began to soar within a few days of the article's publication, and essentially didn't stop until it had risen nearly 15-fold - a gain of almost 1,400%.
One of the most ill-timed cover stories of all time - The Economist's early March 1999 cover "Drowning in Oil". In the article, it was argued that there was such a huge oversupply of oil on the market that a 50% price decline to $5 per barrel was highly likely.
From the "what really happened" department: Within days of being left for dead by The Economist, oil embarked on a 1,400% rally.
The Economist's Disjointed and Irrelevant Musings on Gold
Unfortunately, gold hasn't yet made it to the front page, but The Economist has sacrificed some ink in order to declare it "dead" (or rather, "buried"). We hasten to add that during the recent trading range, every time we have written something mildly positive about gold, it usually felt as though we had jinxed it, often within hours. It is no secret that we are favorably disposed toward gold in the medium-to-long term, but we do, as a rule, inject some objectivity by mentioning the potential short-to-medium term downside risks that could become manifest, should important support levels give way. It doesn't seem very likely to us that this will happen (we believe a lengthy bottoming process is under way), but obviously, the probability isn't zero.
The Economist article is a typical "after the fact" denouncement - we wouldn't have seen such an article appear in August/September 2011, when gold was still trading near its highs. It is also a disjointed mess, with many irrelevant arguments and non-sequiturs - basically a hit piece. However, since some of these arguments are at times mentioned by both bulls and bears, we thought it worthwhile to discuss their merit (or the lack of the same). The article begins:
"Uncertainty is supposed to lift the gold price. But neither upheaval in the Middle East, nor the travails of the euro zone, nor startlingly loose monetary policy in the rich world is brightening the spirits of those who swear by bullion. After a big rally during the financial crisis, the price has sagged to about $1,200 an ounce, a third below its peak in 2011. Little seems likely to turn it round. "We've seen everything gold bugs could hope for: endless money printing, 0% interest rates (both short-term and long-term adjusted for inflation), rising debt and debt ratios in the public and private sectors... So where's the damn hyperinflation?" asks Harry Dent, a newsletter publisher, in a recent blog post."
(emphasis added)
We would submit that with developed market stock markets at one of their most overvalued levels in history and government bond yields recently trading at absurdly low and even negative yields, there are exactly zero signs of "uncertainty" in the financial markets. The St. Louis Fed's financial stress index is presently at one of its lowest levels in history. As we have mentioned previously, gold has primarily lost its "euro break-up premium". The question should actually not be "Why is gold down one third from its highs", but "Why is it still up by 400% from its 1999 lows?"
The sentence "Little seems likely to turn it around" is, well, golden in a sense. When a market trend changes, it always seems as if nothing could possibly turn the market around. Of course, that doesn't necessarily mean that a market turn in gold is imminent - we merely want to point out that the phrase used by The Economist perfectly describes the conditions found near major market turns. The above discussed "drowning in oil" article from early 1999 is a very good example of just such a situation.
Uncertainty? There is none - the "financial stress index" is near the lowest levels in the history of the data series. The faith of market participants in central banks and their policies is close to an all-time high. One should ask why gold is still trading at such high levels, not why it is down from the euro crisis peak.
The remark by Harry Dent is downright bizarre. Where was the "hyperinflation" when gold rose from $250 to $1,900? There wasn't even a single mild inflation scare over the entire period. Is this meant to indicate that Dent believes "hyperinflation" is required for the gold price to rise? If so, then he should really refrain from commenting on the gold market. Although the true US money supply has increased by a chunky 265% since the year 2000, it would be ludicrous to expect "hyperinflation" anytime soon. The probability that we will experience hyperinflation over the next several years is so extremely low, it is hardly worth mentioning.
However, the process that historically ends with hyperinflation has always begun in a very similar manner: government debt rises to such an extent that debt monetization by central banks is initiated. For many years, nothing happens. Occasionally, the pace of debt monetization is slowed down again, only to speed up again a short while later. Eventually, the price effects of the enlarged money supply begin to migrate from capital goods and asset markets to consumer goods (especially if the economy's structural integrity becomes severely compromised by incessant credit expansion). At this point, it is still possible for the authorities to arrest the inflationary trend by abandoning the inflationary policy. Only when they consistently fail to do so will the public's confidence in the currency be suddenly lost. The actual "hyperinflation" process usually plays out in just a few short months - as the final conflagration in a process that takes many years, sometimes even decades, to play out. So we would advise Mr. Dent to be patient. Hyperinflation does not seem likely from today's perspective, but a time may come when it does become likely. You will almost certainly read about it here if/when that should happen. In the meantime, rest assured that gold can easily rise to much higher prices than today's, even if "CPI inflation" remains perfectly tame.
Gold vs. the y-y change rate in CPI - the direction of the latter seems to matter empirically (see "In Gold We Trust" by Ronnie Stoeferle and Mark Valek) - falling rates of inflation ("disinflation") tend to be gold bearish, and rising rates as well as "deflation" tend to be bullish. Hyperinflation is not required at all.
The Economist continues:
"The biggest pressure on the gold price comes from the expectation that interest rates in America will rise later this year. Matthew Turner of Macquarie, a bank, says that low interest rates cut the opportunity cost of owning gold. Higher interest rates, by contrast, raise the cost of holding non-interest-bearing assets. Mr Turner thinks expectations of rising rates are already built into the gold price; if they do not materialize as quickly as expected, there could even be a rally."
While it is true that the opportunity cost of holding gold is an important factor influencing its price, nominal rates are irrelevant - only real interest rates count. The idea that fear of Fed rate hikes exert the "biggest pressure on gold prices" is largely a myth, however (even though Mr. Turner may turn out to be correct - that if the Fed fails to hike rates soon, gold could rally for a while). If the Fed were to raise rates by 15 or 25 basis points, they would still be at levels that are among the lowest in history. Moreover, if inflation expectations rise by a similar amount, absolutely nothing would change for gold. If they were to rise at a faster pace than the Fed's rate hikes, then the real interest rate backdrop would turn increasingly bullish for gold. As Steve Saville has recently pointed out, though, if one looks closely at when the gold price has put in lows and reversed upward since 2013, it turns out that whenever an announced tightening of Fed policy (tapering, end of QE3) became reality, the price of gold has started to rise instead of falling further.
Why is this so? The explanation is that the gold market is very much a forward-looking market. It senses trouble long before anyone becomes consciously aware of it. If one looks closely at the final phases of stock market bubbles in recent years, the gold price always stopped falling even while the stock market was still rising (at times sharply), but closing in on its peak. Anything that is bad for "risk assets" will be good for gold. Many people buy gold as "insurance" (even Ray Dalio has a sizable percentage of his personal assets in gold, if we can believe what he recently stated in a Q&A at the CFR). These people represent a steady stream of demand that is usually buttressed by strong reservation demand that tends to surge whenever "bubble talk" with respect to other markets becomes prevalent. In short, because a certain percentage of market participants recognizes the danger posed by the bubble, a floor is put under the gold price.
In order to understand the reasoning of gold buyers and gold holders who don't sell at current prices, we only have to gauge our own demand for bullion, including our reservation demand, and consider what motivates it. Would we sell any bullion here? There isn't a snowball's chance in hell of that happening. What is the motive? We regard the monetary experiments performed by central banks in recent years as extremely dangerous. Furthermore, we believe that most of the Western world is suspended in a state of "pretend solvency".
A giant confidence game is underway, in which a critical mass of people still pretends that governments are fiscally sound and that the banking system is in fine fettle. It seems to us that the reality is a tad more sobering, and while we have a lot of faith in the ability of what remains of the market economy to generate real wealth, we doubt it will suffice to stave off a less-than-happy outcome. On the day a sufficiently large number of people stops keeping up the pretense, we will have reached a fork in the road: either much of the world will get the "Cyprus treatment", or we will indeed see hyperinflation emerge. It will be a default either way. Is there any possibility to hedge against such an outcome - or even a slightly less apocalyptic one - that still involves a great deal of financial and economic distress? If anyone has a better idea than gold, we'd love to hear it.
The Economist continues:
"That cannot come soon enough for gold producers. Nikolai Zelenski, the boss of Nordgold, which has mines in Africa and the former Soviet Union, says that half of all producers have negative cashflow. Some are heavily indebted, too. If the price does not rise, production could fall on a scale not seen since the two world wars."
That is, of course, irrelevant for the gold price, but we would point out that gold producers somehow survived the bear market from 1980 to 1999 as well, and their production actually surged rather dramatically that time period. What Mr. Zelenski seems to be forgetting is that mining margins are a moving target. They depend not only on the gold price, but also on input costs.
The article continues:
"Gold bugs are determinedly optimistic. Gold is priced in dollars, so the fact that it stayed stable while America's currency was rising (making gold more expensive for buyers in foreign currencies) is cause for cheer."
With closed-end bullion funds trading at discounts of almost 10% to NAV, we have our doubts about the size and importance of this allegedly "determinedly optimistic" group. Anecdotal evidence actually suggests that most "gold bugs" are, at best, frustrated at this point. It is, however, true that it is a bullish sign when gold stays strong in the face of a strengthening dollar.
"Chinese consumers are buying more gold, after a sharp decline sparked partly by an anti-corruption campaign. So are Indians, the world's biggest consumers of gold, after the government removed restrictions on imports last year. Yet the fact remains: gold is in a rut."
This is one of the points often made by gold bulls: see how much gold China is importing! This is, however, at best of tangential importance, roughly on a par with the ups and down in mine supply. Gold is not an industrial commodity, it is a monetary commodity (for an explanation of the difference between the two see our previous missive "Misconceptions About Gold"). When gold moves from COMEX warehouses to warehouses in Shanghai, it is not a bullish event, but a completely irrelevant event. Having said all that, we do believe that Chinese investors could play a role in the eventual blow-off move we expect to occur a few years down the road. However, this is just speculation on our part.
The assertion that "gold is in a rut" is clearly a matter of perspective. It is certainly back in a bull market both in euro and yen terms, while going sideways in dollar terms. The chart below illustrates the current situation. Note that both in euro and yen terms, it is impossible to not see that a textbook technical bottoming process has taken place. Of course, The Economist hasn't exactly lost its magic touch either: Since the article appeared, gold has risen by $45 in USD terms as well.
Whether one thinks that gold remains in a "rut" clearly depends on where one happens to reside. Could it be that all that money printing in the euro area and Japan does have an effect on the gold price, after all? Just asking.
The Economist continues:
"One reason may be that investors have so many more options nowadays. Humble citizens who distrust their own currencies can buy assets ranging from shares to bitcoins. Laurence Fink, the chairman of BlackRock, the world's biggest asset-management firm, said in March that gold had "lost its lustre", thanks to the wider availability of property and even contemporary art. "It's become much more accessible for global families worldwide to store wealth outside their country."
Obviously, the chairman of BlackRock is at odds with the chairman of Bridgewater, which is another one of those "largest asset management firms" in the world. Judging from what Fink says, we actually doubt that he has any expertise with respect to gold. Shares and Bitcoins? Property and contemporary art? Three of these four asset classes are in egregious bubbles, which clearly depend on confidence being maintained. The fourth is, at the moment, pretty much a burst bubble (Bitcoin has declined from $1,200 to a little over $200, so if people indeed see it as an "alternative to gold", it has proved to be a rather poor one). It is, in principle, true that all these asset classes compete with gold to some extent, but it is a bit misleading to call stocks, property and works of art an "alternative" to gold. Gold is sought after when these assets are not - it is not merely an "alternative" to them, it is their antithesis.
Bitcoin - A bubble that has burst for now (it may well make a comeback, though, and as we have previously noted, Bitcoin is likely here to stay).
Gold is currently dormant precisely because people are confident enough to pay absolutely ludicrous prices for assorted "risk" assets (recently, a Gauguin painting sold for a record $300 million - a sign that some sectors of the economy are indeed displaying almost "hyperinflationary" characteristics by now). At the same time, the fact that these bubbles have grown to such exorbitant heights (there are countless breathtaking property bubbles underway around the world, along with those in contemporary art and stocks) is a major reason why it makes sense to hold gold as insurance.
Gold is akin to money - although it is currently not money in the strict sense, as it doesn't serve as the general medium of exchange, the market "knows" that it would be money if the market were free, and treats it accordingly. So Fink's statement is simply yet another non-sequitur. People were able to buy stocks and art works between 2000 and 2011 as well, and yet, gold was the preferred asset in most of that time period, because confidence frequently faltered.
Gauguin's "Will You Marry Me" - certainly a nice picture, but 300 million smackers? Come on...
Finally, The Economist cannot fail to get one last dig in by letting us know that only the evil Vladimir Putin and his henchmen in Moscow are buying gold (either they are stupid, or it is a sign that gold is only bought by foaming-at-the-mouth crazies - take your pick!):
"The main exception to the trend is Russia, where the central bank has been a notable buyer of gold, tripling its holdings since 2005. It bought 30 tonnes in March alone, bringing its hoard to 1,238 tonnes. The Kremlin's growing stockpile does not so much reflect a belief in gold's prospects, however, as a distaste for the American dollar. Whatever Vladimir Putin's other qualities, most investors would hesitate to take him on as a financial adviser."
First of all, neither The Economist nor anyone else can properly judge Putin's qualities as a "financial advisor". Russia's central bank may have very good reasons for buying gold. As Alan Greenspan once remarked, gold it is the only form of payment that will always be accepted. He dissuaded the US treasury from selling its hoard, precisely because extreme situations can arise when gold ownership can prove very useful. We would assume that strategic reasons are the Russian government's main motive for buying gold as well - we doubt it cares much about where gold trades next week, next month or even next year.
Secondly, just because the Russian central bank is one of the few known big official gold buyers certainly doesn't mean one has automatically hired Putin as one's financial advisor when investing in gold. Incidentally, what Russia's central bank is doing is not directly relevant to the gold price. What it buys in an entire year trades in London and Zurich in a few hours every trading day. It is a pittance compared to the total supply of gold.
Lastly, we still remember how Bloomberg, another viciously statist mainstream financial medium that disses gold at every opportunity, tried to scare less well-informed would-be gold buyers by asserting that Russia would be forced to sell its gold reserves! See "Will There be Forced Official Sellers of Gold" for our assessment at the time. We have so far been proved right, but obviously we can't win, because now Putin is our "financial advisor"!
Conclusion
We enjoy picking on The Economist, of course, but our main motive for dissecting its editorial on gold was to show that the gold market remains widely misunderstood. Moreover, given the publication's record as a contrary indicator, it might prove to be a useful marker - although we don't want to make too much of this (if it had been a cover story, we'd recommend mortgaging the house and renting a vault). In the meantime, the fundamental backdrop for gold remains largely in neutral, with some factors improving and others not. However, buyers seem to be willing to step in every time gold dips below the $1,200 level. Technically, it remains in no-man's land in dollar terms, but continues to look encouraging in euro and yen terms. Maybe The Economist has managed to ring the bell after all? Stay tuned...
Charts by: StockCharts, St. Louis Federal Reserve Research, Bitcoincharts
