Turning Paper Into Gold

by: Doug Eberhardt

I have seen many more investors coming to us saying they are selling their gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) ETFs and wanting to buy physical gold and silver. What would be there reasoning to do so?

One reason is that gold and silver ETFs should be viewed as trading vehicles, and not counted as real wealth ownership. Here is what I wrote about these gold and silver ETFs in my book, Buy Gold and Silver Safely:

ETFs are a lower-cost way to invest in gold and have a lower expense ratio than other ETFs. But these ETFs offer only paper promises if the dollar were to collapse, as the investor does not have actual ownership of gold whereby they can take delivery by turning in their shares. What investors do have ownership of is multi-level custodians, including The Bank of New York, HSBC and J.P. Morgan, who are in control of the gold. Please note these are banks. If push comes to shove with the dollar, do you want a bank in control of your gold?

If one does trade the gold and silver ETFs, and we see issues pop up with these custodians, like with JPMorgan Chase's (NYSE:JPM) $5 billion-plus trading loss from earlier this year, then caution may be warranted, and a move to the physical metals may make sense in protecting one's wealth. But investors in these gold and silver ETFs like GLD and SLV need to consider one other aspect of whether to buy paper gold and silver or physical gold and silver, as I further point out in my book:

Something else to think about when it comes to the supply issue during a real push higher on the price of gold is, where will these ETFs get their gold? When the price of gold moves from its current second stage to its third stage of euphoria, it will be impossible for these ETFs to find the gold needed to deposit for each investor who wants shares. There are other issues that one has to consider, that relate to whether the ETF who has all that gold is at the same time leasing it out.

Gold's Third Euphoria Stage

This third euphoria stage is what veteran Dow Theory Letters writer Richard Russel has written about over the years when he says gold will go to "undreamed of heights." I imagine many reading this article couldn't have imagined 10 years ago that our national debt would have reached these current "undreamed of heights" of over $16 trillion, but we already know this debt is headed to over $20 trillion in the next four years, and that's just using today's projections. Since when has government ever projected anything correctly?

When we enter this third euphoria stage as a result of staggering debt and an uncertain future, the premiums for the various ETFs to acquire the gold will also rise. But from the "this time it's different" club, if gold is rising quickly in price, it will be because of a banking crisis that will make the 2008 crisis pale in comparison (remember, gold finished 2008 year over year higher in price, as it has every year for what will be 12 years running at the end of 2012). The power of gold's move higher can't be understated. Remember, during this entire run up in the price of gold, including the year 2008 when the stock market got hammered and fear was in the air, Central Banks were net sellers of gold through the Washington Agreement on Gold. Today European Central Banks have put a cap on gold sales:

The European Central Bank and 18 other banks agreed to sell no more than a combined 400 metric tons of the metal a year through September 2014. That's less than the annual cap of 500 tons in the current agreement, which expires Sept. 26.

The IMF in that last Central Bank agreement has decided not to sell any gold. What will Central Banks do with their paper money they create out of thin air when all currencies devalue at a faster pace? Will they become net buyers?

Banks In Control of Your Gold - Read The Prospectus

Banks needed bailing out just four short years ago, and collectively hold more sub-investment grade derivatives today than they did in 2008. So much for the Financial Reform Act. Does anyone not think that JPMorgan, king of the sub-investment grade derivatives today, and its $5 billion loss from July was anything but a bet it made with no counterparty to it? But if you stick a London whale's name to it or fire a VP, all is well, right? These banks are the custodians of your gold and silver held with ETFs. While you are pondering that, there's more to consider.

The Prospectus of GLD, for example, is full of loopholes for the Sponsor and Trustee, including the following (these are all listed right in the prospectus);

1. Suspending the right of redemption
2. May not have adequate sources of recovery if its gold is lost, damaged, stolen or destroyed and recovery may be limited, even in the event of fraud
3. The Trust is not registered as an investment company under the Investment Company Act of 1940 and is not required to register under such act. Consequently, Shareholders do not have the regulatory protections provided to investors in investment companies.

I have covered the lack of insurance by the gold and silver ETFs previously in Is The Gold and Silver Held By ETFs Insured?

When trading for profit in the precious metals market, if you are good at it, the gold and silver ETFs for now are a good vehicle in which to do so. If you are buying gold and silver ETFs to protect your wealth, then you might consider hedging with personal ownership of some physical gold and silver.

Gold Pricing Over the Years - What Led to Gold's Explosion in Price?

People buy insurance for their home and car, but many don't think about protecting their nest egg -- their personal wealth. What is missing is the insurance that gold provides in protecting one's wealth from banking shenanigans, Federal Reserve madness and future inflation. But also, gold represents real wealth like no other asset. Throughout the history of mankind, gold has represented wealth. Gold's price was controlled since the creation of the Federal Reserve in 1913 up until Nixon took us off the Gold Standard in 1971. Since that time, and with the ability of Americans being allowed to buy more than $100 of gold in 1975, gold shot up in price rather quickly, moving from the fixed government controlled price of $40.62 in 1971 to $160.86 by 1975, and an all-time high of $850 by 1980.

From 1980 to the year 2000, the price of gold languished with higher interest rates and double digit returns. The U.S. economy was producing things in those years and in 1986, when government didn't have too much to fear about people buying gold, we saw the introduction of the American Eagle Gold coins with the passing of the Gold Bullion Coin Act of 1985.

Many of those who despise gold will point to the 1980 to 2000 years as proof that gold can return to a time when it didn't really matter. But the evidence shows otherwise. One could compare how much debt the U.S. had in 1980 versus how much debt we have today and be convinced that the U.S. dollar is in trouble as the debt load goes higher every year, but it was the introduction of the euro that saw real competition to the dollar beginning in the year 2000. No longer was there a one-world currency -- the U.S. dollar -- but now two. Gold started to move higher as the dollar sank after the euro introduction as investors looked to hedge their U.S. dollar investments; U.S. stocks, U.S. bonds, and U.S. Treasuries. But gold didn't really start to shoot higher until the introduction of the various ETFs like GLD that one could invest in, allowing for an easier path to gold ownership. The amount of gold held by GLD alone today amounts to what some of the largest Central Banks in the world own. All of a sudden, those who wanted protection from the possibility of inflation had an easy way to acquire gold and silver.

Exchange Traded Funds - A Further Explanation

Since there are now so many ways investors can play markets, one has to consider that we are in an unprecedented arena where many different types of assets can be bought and sold in minutes with the introduction of ETFs. There are over 1000 ETFs today, representing 25% of the trading volume on the U.S. national exchanges and over $1 trillion of value. But one has to wonder about some of these ETFs, like the exotic or leveraged ETFs, that are coming into fruition.

In the case of silver, for example, there is the VelocityShares 3x Long Silver ETN (exchange traded note) with the symbol (NASDAQ:USLV) that can get an investor three times the return of the price of silver (or lose three times the return should the price of silver fall). In my opinion, this is akin to gambling. Why stop at 3x leverage? Why not 10x leverage? Pretty soon we'll have the tradable market and one's investment portfolio look like a craps table. Put $1,000 on XSLV for me please (I just made up that symbol to represent 10x the silver price).

Earlier in this article, I pointed out how there are some issues to consider when investing in the gold and silver ETFs. I said that while ETFs can be good trading vehicles, they should not be considered as an alternative to protecting one's wealth with physical gold and silver. Besides the ETF taxes and fees that eat away at one's holdings, the fact that banks are in control as custodians is what scares me the most. Holding physical gold in your possession, you have no fees and you don't pay taxes on it until you sell it -- not every year, whether you want to or not with ETF redemptions that trigger a tax. This is just one reason to invest in physical gold over the various ETFs.

What Is Keeping The Gold Price Down?

What I want gold bugs to consider -- and believe me, I am one, but for different reasons than most -- is a few of the following observations as to what is really keeping the gold and silver price down:

1. VIX - Volatility & S&P 500

2. TBT - 20-Year Treasury Short

3. U.S. Dollar Index, Euro and Yen

VIX - Where Is the Fear? - It Is Coming

Looking at the VIX chart below, we have seen what a good job those who want you to believe that all is well with the markets have done in keeping this market propped up.

(click images to enlarge)

But speaking of the "exotic ETFs" I mentioned earlier, compare the above chart to the 2x leveraged TVIX below. Notice any discrepancies to the downside over the last two years? (TVIX began trading November 30, 2010 at 112.35.) I am sure that many investors in TVIX, a favorite of daytraders for awhile until it was halted for a month by Credit Suisse, aren't too happy with their returns. A good explanation of this divergence between the VIX and TVIX can be found here.

Part of the reason for gold's struggle has been this complacency in the markets. With interest rates at such a paltry return, more money has flowed into the market, chasing any return an investor can find. In September, when the S&P was at 1435, I started warning investors of a stock market bubble based on the data I saw at the time. Today, the S&P 500 has fallen 85 points since that warning, as seen in the chart below. Perhaps we are due for a bounce, but what economic reasoning would there be for such a bounce? I really don't see any miracles coming, but the Fed can pounce at any moment, as they have in the past.

The VIX has been rising of late, and smart money has been accumulating gold by dollar cost averaging into a position all along, waiting for the next move up. As I have said many times in my articles, it's the tortoise vs. the hare when it comes to gold.

TBT - 20-Year Treasury Short

I follow TBT to get an idea of how relevant the Fed and their various programs really are, while gauging how confident the investor is in the U.S. economy and the Fed. TBT represents two times the inverse (-2x) of the daily performance of the Barclays U.S. 20+ Year Treasury Bond Index. Because it was getting so low (or perhaps they didn't want traders to be able to buy more shares at lower prices?), ProShares did a 1:4 reverse split on October 5th and since that time, the price has fallen $6.26 a share).

I don't believe the confidence -- as seen in the losses investors have taken in TBT over the past few years -- is warranted, but one cannot fight the data before them. We are approaching a bottom in TBT, as the Fed can't play this game as well as Japan has over the years. The U.S. is not a net exporter like Japan, and Japan holds U.S. debt on their balance sheet while the U.S. owes everyone else. While we are both fighting deflation, with sprinkles of inflation (mostly government involved related industries like student loans and health care costs). Food costs had been driven higher from the drought, and grain prices are settling back down along with oil.

U.S. Dollar Index, Euro And Yen

While many of the gold bugs have been saying "weaker dollar" in their daily monologue, I have stuck with my stronger dollar outlook for the short term. This goes against what any gold dealer would say to their clients, but I just call it like I see it.

The fact is, the euro and the yen make up 70% of the U.S. Dollar Index, and Europe and Japan are in deep trouble. I pointed out the problems in Europe (although I have been negative on the euro all year) in a September article, "Did Bernanke Implement QE Infinity to Save the Euro?" Just look at the chart in that article dealing with the high external Debt to GDP ratios for every single country in Europe, including France at 286% and Germany, the alleged savior of the euro at 213%.

People are protesting in the streets against government imposed austerity, primarily in Spain, where the unemployment is 25%, and Portugal at 15.8%.

The EUR/USD chart below shows a possible double top that has formed with what I believe to be a continued fall against the dollar:

Meanwhile, over in Japan, another country with over 200% Debt to GDP, we saw today a big jump in the USD/JPY of 1.19%.

Everyone knows we have massive debt and future obligations here in the U.S. While the U.S. Debt to GDP ratio is hovering around 100%, we are still in better shape than Europe and Japan, which is why I am dollar bullish. This could still have some ramifications for investors in gold moving forward, as the dollar and gold have historically traded opposite of each other.

It's a simple understanding of what makes up the Dollar Index that allows me to say that a stronger dollar may still be in our future.

71.2% of that U.S. Dollar Index (euro and Japan/yen) represents areas that are hurting from an economic perspective. Perception is what investors look at when deciding where to put their money. The above data tells us that fear has been complacent and is entering the market. Treasuries have remained strong, and the U.S. dollar isn't crashing.

Trade your GLD and SLV, but know the dollar, U.S. Treasuries, gold and silver are where investors will be headed. I will explain how this will all unfold and why in an upcoming article.

Disclosure: I am long physical gold and silver, and I own a Precious Metals Broker/Dealer. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.