Behind the Panic Selling in Gold

In our January newsletter (please contact us for a copy), we argued that gold was in a major correction phase, and that over the next 12 to 18 months, gold will correct to the $1,100 to $1,300 range. Over the last five days, June gold has hit an air-pocket–declining by over $200 an ounce to trade at just over $1,350 an ounce.

Speculators in gold tend to overuse the term “money printing,” and why “money printing” will inevitably lead to higher gold prices. This is a patently false and misleading idea. First of all, global central banks (through the high-powered monetary base), commercial banks (through the traditional money multiplier), and investment banks (through balance sheet expansion and esoteric product creation) have essentially been “printing money” since the United States left the (quasi) Gold Standard for the final time in 1971.  The price of gold made a major peak at $850 an ounce in January 1980. For the next 20 years, the price of gold fluctuated between $250 and $500 an ounce–despite an increase in the nominal global GDP from $18.8 trillion in 1980 to $41.0 trillion in 2000. In fact, if one was to draw a regression line from 1981 (excluding the 1980 peak) to 2000, the long-term trend in the price of gold would have been depicted as a downward sloping line! Clearly, the price of gold suggested no correlation to the amount of “money printing”–and was certainly no inflation hedge.

Second of all, our turning bullish on gold in late 2000 rested on a couple of simple ideas: 1) The last seller had left the gold market. Gold bugs were capitulating. Central banks were selling en masse, while gold producers further reinforced the downtrend by hedging (i.e. shorting) a substantial portion of their future production. Everyone I spoke to in late 2000 thought I was crazy for buying gold coins and precious metals mining stocks. Treating it as the perfect contrarian indicator, I bought more; 2) The Greenspan-led Fed would ease monetary policy in an unprecedented way. More important, we believed the excess liquidity would directly fuel commodity price inflation as the United States has dis-invested in natural resource production (including energy production) since the early 1980s oil bust. It is not a coincidence that the price of Henry Hub natural gas rose above double-digits for the first time in late 2000.

That is, we bought gold because it was: 1) the most unloved asset class, and 2) we believed the excess liquidity created by the Greenspan-led Fed would flow to this asset class. We also made a bet that investors’ perception would shift from hating gold to beginning to treat the precious metal as an alternative currency. Gold has been treated as money in most societies for the last 5,000 years, but other commodities had once been in the same coveted category, including tobacco, sea shells, tulip bulbs, copper, large stones, alcohol, and cannabis. As we argued in our January newsletter, there are few iron-clad rules, if any, when it comes to economics or the financial markets. Yes, gold had been the predominant medium of exchange for centuries. But Classical (Newtonian) Physics was in the same category, and that eventually gave way to General Relativity and Quantum Mechanics in the early 1900s. In a capitalist society, the trick is to gradually and consistently inflate, and to broadcast one’s intention/plan to inflate to economic agents well in advance. For the last several years, investors have piled onto the long side of gold because of its increasing perception as an alternative currency. Over the last five days, this perception has shifted. This shift in perception caught a substantial amount of long investors on the wrong side and by surprise. That is all.

We will leave you with one final comment: So little is understood of the implications of the BOJ easing. It is no surprise that BOJ easing has done little for gold. The purpose of the BOJ easing was to meet its 2% inflation goal through importing inflation from the rest of the world. This has been partly achieved through a devaluation of the Yen. By definition, Japan is thus exporting deflation, especially to countries such as the United States, Germany, China, and South Korea (i.e. countries that either compete directly with Japanese exports or consume Japanese goods). Deflationary pressures in the United States, Germany, China, and South Korea would only put further downward pressure on the price of gold, to the extent these countries (especially China) purchase gold as an investment or inflation hedge. Such deflationary pressures would only be offset if Japanese investors–spooked by higher inflation expectations–decide to purchase gold as a hedge. Unfortunately for gold bulls, neither Japanese investors nor consumers are significant purchasers of gold. In fact, the Japanese only made a net purchase of $394 million of gold in 2012, equivalent to just 0.9% of Chinese net purchases and 0.8% of Indian net purchases (see below table). Preliminary data also suggests that Japanese investors are more interested in purchasing the Nikkei, U.S. Treasuries and Ginnie Mae securities, German bunds, and Japanese and U.S. real estate in light of BOJ easing. I anticipate a bounce in gold prices as soon as tomorrow, but long-term gold bulls would need to wait a little while longer.


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