THE BIG PICTURE FOR GOLD
The Big Picture for Gold
This is a very frustrating period for gold investors. Global financial and geopolitical risks appear to be very high but gold has not responded. Gold and gold stocks are range-trading and have been since early March of this year. Gold is in a roughly $150 range (about 15%) while the HUI, a gold stock index, is in a 60 point range (about 30%).
In our view, gold has actually performed quite well this year given the enormous upward momentum of the stock market. Its price is up from a year ago, holdings by the world’s ETFs are higher and both volumes and open interest on the CME have also risen. On the other hand, the gold price has not responded as positively as expected to a falling US dollar.
Gold stocks are near their all-time low against gold and volumes are very low reflecting the fact that gold itself has not developed any upward momentum. Gold stocks are essentially leveraged options on gold and gold is stuck in a range.
The Potent Director Fallacy
The key to a positive environment for gold is investor perception of risk. Gold is a risk-off investment and perceptions of risk appear to be rising. Financial markets are wildly overvalued, overbought and over bullish by historical standards. Stock market breadth is poor, leverage is very high and debt is growing much faster than the economies that must service it. Economic growth has not returned to levels before the financial crisis despite immense amounts of stimulus. Political instability is elevated and rising in the Middle East, Europe and Asia while US policy has never been more unstable. Yet the markets have dismissed all these risks, in our view because of investor faith in central banks.
The perception remains that gold is not needed to mitigate risk because investors believe central bank policies can manage the economy and overcome financial system problems if they arise. At Paramount Gold Nevada, we think this faith in monetary authorities is misplaced. We agree with Jim Grant that the price of gold has become the reciprocal of confidence in central banks. For gold, the only risk that matters is instability in financial markets because that’s what will undercut market confidence in central banks. Many investors know that central bank policies have not generated the fundamental economic results they once hoped for…the expected evidence failed to materialize years ago… but as long as markets remain strong, so does their faith.
Robert Prechter called this the Potent Directors Fallacy. It describes the popular belief that some powerful group of people such as the Treasury Department in 1873 or a banking consortium in 1929 can direct financial markets and the economy at will. Specifically, it refers to the fallacious conviction – always extremely popular after markets have risen for a long time and become egregiously overvalued – that “they” will be able to stop the good times from ending.
Despite the fact that all the central banks have been woefully wrong about nearly every single forecast they have made on GDP growth, inflation and labor markets for decades, they enjoy an aura of infallibility which would be the envy of any medieval Pope because they succeeded in doing what governments by themselves were unable to do in 2008-9, namely stop and reverse the financial crisis.
Some Risks in Waiting
There are any number of issues which could trigger this shift in sentiment. Can the Fed undertake to reduce its balance sheet, as promised, without causing a major reversal in financial markets? The Fed has admitted that QE was designed to drive markets higher in order to create a wealth effect (which it did) that would rejuvenate economic growth (which it did not). Can this stimulus now be removed without a reverse effect? We think not. Meanwhile, the US Treasury must increase its issuance of securities to finance a growing deficit. We think increasing sales of Treasuries into the market by the Fed and the Treasury will stress the market and force the Fed to reverse the ‘normalization’ of its policies. In our view, such a reversal would substantially weaken investor confidence in the central bank and stimulate demand for risk-off assets.
Can the ECB reduce its asset purchases by half to €30 billion monthly (to begin in January) without a significant increase in rates and a crash in some sovereign bond markets? Would a collapse in Italian or Spanish bonds crack the weak balance sheets of the banks which own these securities and already have unsustainable levels of NPLs? The ECB has been the overwhelming, price-insensitive bidder of first and last resort for these securities. What happens when this bid is reduced and ultimately comes to an end as the ECB has promised? And if this bid cannot be ended, what does that say about the effectiveness of ECB policy?
Can the Chinese government implement its new, slower growth, pro-environment policies without exposing extraordinary levels of debt to default? Chinese credit market debt has grown from $1 trillion in 2000 to more than $30 trillion now. Can it be sustained without continuing to grow rapidly? Repeated infusions of fresh credit have been required to keep this bubble aloft but the resulting speculation is exactly what the new policy is meant to reduce.
Investors have reached for yield without regard for risk. In every economy, very low interest rates and unending credit supply have loaded up the marginal borrower—corporate and individual—with unsustainable debt. Money is now flowing out of high yield debt which has been priced as if defaults will remain very low. These assets can quickly become illiquid, forcing into insolvency borrowers who needs to roll debt. The marginal borrower can fail with astonishing speed when higher risk credit markets begin to unwind. So do overleveraged lenders. In 2008, the result was contagion and a collapse in credit generally.
One final point: Market structure is highly skewed towards long equities and short volatility. Financial market volatility has set new records this year. Always in search of new product, Wall Street has invented ‘short volatility’ products which have attracted as much as $2 trillion in capital. There is no one on the other side of this boat. Hedge funds are now almost entirely long equities, not hedging anything. Investor net cash positions are at record lows. Short positions are well below normal levels. Massive equity ETFs are long the same short list of stocks irrespective of valuation. A normal correction could become a waterfall.
We see a crisis coming soon in financial markets. We think that the most important consequence of a new crisis will be risk aversion and enormous demand for gold. When gold breaks out of its current trading range, we believe gold stocks will perform disproportionately well. Returning to historic gold/gold stock ratios, the average gold stock should rise at least three times faster than gold. Companies that have high ratios of gold ownership per share will do much better than that, based on historical experience.
We do not think that a return of monetary crisis management will restore market momentum after a new crisis has emerged because then we will all know that central banks cannot fix the underlying problems and there are no potent directors.