Gold Is Golden

 | May 10, 2013 | 1:00 AM EDT  | Comments
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Fight Club is back, and could there be a better opening bout than to duke it out over gold?

The barbarous relic is always controversial, but the battle lines are being drawn after the April stash crash that caused the price to return to levels of two years ago. (I call it the stash crash because the correction, apparently, was caused by odd disruptions in the physical market trading systems.) Normally in a Fight Club we argue over the fundamentals, valuations, sentiment and technicals, but gold is a special case. There are no fundamentals, no earnings or cash flow. With gold, the analysis relies on macro factors (including monetary policy) combined with non-quantifiable sentiment factors. 

My bull case for gold cannot rely on the chart, because it does not look pretty.  But the monetary rationale for gold is still firmly in place, and the broken chart does not reflect the real sentiment around the metal.  Before I tick off the bull case, keep in mind that gold should be viewed as an alternative currency, not as an investment in the same sense as owning a share of a productive business.  Warren Buffett is absolutely right that gold is an inert metal that just sits there doing nothing.

Of course, paper money is also an inert material that sits there doing nothing.  The point of owning gold is to protect yourself from the purposeful devaluation of that inert piece of paper.

I doubled my position in gold this week, using the SPDR Gold Trust (GLD). I first bought gold on Nov. 6, 2009, a bit below $1,100 an ounce. My original purchase was motivated by concerns of accelerating inflation as the Federal Reserve's money-printing operations went into full swing. I trimmed my position in February this year, based strictly on the cases made by many of the technicians that gold had topped and was due for a correction. (How right they were!) The bull case for gold that I envisioned in 2009 is still in place, and this correction is just that -- a correction -- and now feels like the buying opportunity to build a position at attractive prices.

If anything, monetary conditions are getting worse for sustaining the value of fiat money. First, the Fed started pumping like crazy, then the ECB was forced into it by their debt crisis and now the Japanese are pouring it on in a mad race to the bottom for the major reserve currencies. The chart below circulated most recently by Gluskin Scheff demonstrates the magnitude of asset purchases by the Fed. (Asset purchases create new circulating dollars.) As long as the federal government is running multi-hundred-billion-dollar deficits, which they will based on CBO projections, the Fed will need to continue to finance that deficit.  I believe the monetary conditions supporting gold will continue for the foreseeable future.

What happened the last time gold crashed? Monetary conditions reversed massively when Paul Volker started to fight inflation. The chart below from Gluskin Scheff also illustrates where we are now (and also emphasizes my case that Bernanke is the new Arthur Burns, whom I have dubbed Burn-anke.)

Absent a new Fed chairman that reverses monetary course, I expect this replay of the 1970s to continue, supporting gold as a safe-haven currency in the process.

Sentiment is highly negative among the punditocracy, with many viewing the stash crash as the technical damage that puts the nail in the coffin of this 12-year gold bull market. I humbly disagree. Astute investors are reading the crash not as the end, but as a market malfunction akin to the flash crash in equities three years ago. Various analysts have pointed out that the decline in mid-April was a 7.5 standard deviation event, the probability of which is approximately 20 million to 1. Evidently, there were computer issues with a physical trading exchange that created some huge imbalances between the paper and physical markets. (Read the sagacious Grant Williams' "Things That Make You Go Hmmm" for more detail.) Should we really read anything more into this particular crash?

More generally, gold regularly goes through these cycles in which it becomes hated, traders follow the trend and become negative, yet greater forces --monetary policy -- eventually overcome the sentiment. In his most recent newsletter, the brilliant Fred Hickey recounts a number of corrections in which the world seemed to turn on gold, only to be early (aka wrong) in its bearishness. As recently as 2008, gold lost 30% of its value during the Great Recession as deflation fears too hold, prematurely. The media, pundits and strategists all declared the end of the bull. Hickey points out a notorious Time Magazine article about the end of gold in 2010 too, which mimicked a similar one at the exact bottom of the 1976 correction. Fred notes: "The HGNSI, Daily Sentiment and Market Vane gold indices hit all-time record lows for bullish sentiment" recently. A recent Commitment of Traders report shows the short position at the record high set in the 1999 gold market bottom. When sentiment is this negative, there is nowhere to go but up.

This chart from ex-SocGen strategist Dylan Grice shows the extent of the 1976 correction and the subsequent action. Keep in mind that sentiment was horrible, but the Gluskin Chart above shows how similar monetary conditions are to today.

The final piece of the puzzle is physical demand. Paper traders are bombing the price now, but is this striking fear into the hearts of people that hold physical gold? Evidently not. Comex inventories are declining as more funds and traders take physical delivery, reducing supply in the sense that physical possession usually implies a long-term holding that is not easily fed back into the market.

Furthermore, Williams also gathered various pictures and anecdotes from gold dealers around Asia, documenting the response to the stash crash. As he notes: "During my 30-odd years in finance, I have somehow weaved my way through many crashes, beginning with the 1987 stock market crash and including LTCM, NASDAQ, the Asian Currency Crisis, the Mexican Tequila Crisis, 9/11, and everything in between; and I can promise you that not a single one of those crashes, collapses, or crises ended up with retail investors stampeding to buy the asset that was supposedly cratering." In the U.S., the mint sold more gold in April than any month in its history at $311 million dollars.

Below are some of his pictures from around the world. Something is wrong here, if you are a bear. A sustainable bear market does not bring out this sort of buying response. While pundit and trader sentiment may be low, most people who are not trend followers know a bargain when they see one.

In case you are worried about a supply response from miners, forget it. The U.S. Geological Survey reports that U.S. gold production was down 8% in February (latest data available) on top of a 10% decline in January.  IntierraRMG reports that the gold mining industry exploration activity also fell to a new low in March, continuing to drop for 17-straight months.

So, my bullishness on gold as a replacement currency and inflation hedge is renewed and I am a buyer at these levels. The looseness of monetary policy -- and inevitability of several more years of QE -- combined with overly bearish sentiment among traders and a constricting supply of easily tradable gold means this correction is likely to be just that, a correction that has probably run its course.

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