Why Lower Gold Prices Won’t Last

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The gold market is an incredibly complex beast, so I’m going to try and simplify things as much as possible.

To get you in the right frame of mind, consider that the history of gold and humanity has a span of 6,000 years. Think about that. It is a long time. The history of the US paper dollar — and the global financial system that it underpins — spans just 41 years.

Right now, I want you to consider this. ‘But, this game of gold, it is not only hard, but will cost anyone dearly if they try it without all the facts!’

That quote was believed to be written by a banking insider who went by the pseudonym of ‘Another’. The background to Another’s ‘thoughts’ is a long one…it’s a fascinating story that I’ll endeavour to write to you about at some other time.

Think about what that quote means. This person had a profound understanding of gold’s monetary function.

Investing in gold without knowledge of the facts will indeed cost you dearly.

The thing to understand about gold is that it is absolutely crucial to the functioning of the global financial system. In times of market stress and liquidity crises, gold is one of the few assets that can be used as collateral (security) for US dollar loans.

For example, if a bank needs US dollars in a hurry, putting up gold as security is the cheapest and easiest way to obtain the loan. That’s because physical gold has no counterparty risk. And it’s why in times of a liquidity crisis (2008 for example) gold falls in price…because gold is sold short term to obtain dollars to meet short term liquidity commitments.

Paper Gold, Real Gold

But here’s the crucial thing. The London gold market (where most of the world’s ‘physical’ gold trading takes place) doesn’t always deal in physical gold. Unallocated gold — also known as paper gold — features heavily in this market.

Unallocated gold is gold that you think you have ownership of, but really don’t. It’s your asset but the bank’s liability. Unlike physical bullion, there is counterparty risk with unallocated gold. That is, the risk that a party won’t be able to make good on their promise and get your gold when you need it most.

No one really knows for sure, but informed opinion estimates that most gold trading that takes place in London is unallocated, or paper gold trading. As I mentioned, during a liquidity squeeze or crisis the market sells gold to obtain US dollars. As you can see from the USD index below, since the start of March the USD has been in strong demand.

USD — Rising as Liquidity Tightens

Source: Stockcharts

The swapping of gold for USD is more prevalent post the 2008 credit crisis because of the dwindling pool of decent collateral in the world. As more governments succumb to credit downgrades because they have too much debt, there is less collateral that can be used as security for short term dollar loans.

Although the price action doesn’t show it, the US dollar and gold  will be the last two currencies standing by the time this rolling crisis finally plays out.

In a cruel twist, gold falls in US dollars precisely because of its strength as bullet proof collateral. Other players who don’t know the ‘game’ see this gold price ‘weakness’ as a sign of some sort of inherent weakness and begin selling too. As a result more gold, both paper and physical, comes onto the market causing a PRICE rout.

The irony is that a great deal of gold collateral is simply unallocated (paper) gold. Physical gold exists to satisfy those who want to convert to allocated, but certainly not enough to satisfy everyone. A rush to convert to allocated would send gold soaring.

The important point to note here is that the gold price you see quoted is essentially a paper gold price. Sure, you can buy physical gold at that price too, but it is the high volume of paper gold that gives the impression of greater supply than there actually is.

When liquidity crises cause selling of paper and physical gold, the gold price gets too low and sophisticated players who know the rules of the game come in and buy. When physical gold starts to leave the banking system, the gold price MUST RISE to entice some of the gold back.
You see, the western financial system relies on the circulation of physical gold to function. It doesn’t matter what Warren Buffett or Ben Bernanke think. The ‘system’ needs gold.

The Gold Market is Massive

But I can show you that the size of the gold market is much bigger than you think. For such a ‘fringe’ investment, it’s certainly massive. If it wasn’t so important, it wouldn’t be so huge. According to the World Gold Council (WGC), the size of the gold market is third only to the US and Japanese debt markets. Not bad for a ‘small’ market.

The WGC says all the gold ever mined in history amounts to 170,000 tonnes. In US dollar terms, that’s around US$9.6 trillion (at US$1,600 an ounce).

Of that amount the WGC reckons around 60,400 tonnes is private investment and official sector holdings. That’s the equivalent of US$3.4 trillion. With official sector holdings of around 31,000 tonnes, that leaves just under 30,000 tonnes in private sector hands – about 1 billion ounces, or US$1.6 trillion.

In a recent report, QB Asset Management tells us that all the gold and silver ETF’s (exchange traded funds) combined hold just 90 million ounces (around 2550 tonnes) – or around US$145 billion (at US$1,600). That’s tiny in the scheme of things.

The question is, just where does all this gold reside? How much privately owned gold actually resides inside the banking system? My guess is it’s not much. My hunch is that much of the world’s privately held gold is tightly held…outside the Western banking system. I’m not talking just about individuals owning physical outside the system…I’m talking about sovereign nations (like oil producers, China etc) who have accumulated gold slowly but surely — and held it regardless of PRICE.

Less gold held outside the banking system means less gold that the bankers can sell and turn into ‘paper’ gold. If physical gold exited the market entirely, the game would be over.

To keep the game going, the London Gold market needs physical metal. For many years central banks have supplied the metal via outright sales and leasing operations (this is the practice where central banks leased gold to bullion banks). It is unclear whether these leasing operations are still in effect.

I would guess that the gold bull market itself reflects lower central bank sales and leasing. As such, the role of PRICE has come to the fore. By this I mean the London gold market needs constantly high prices to entice a steady stream of physical gold into the market. If this is the case, lower prices have the opposite effect.

At some point, lower gold prices will lead to a drain of physical metal from the market as sophisticated players take advantage of the weakness. Higher gold prices are the only thing that will keep the game going.

I know this analysis will sound like a house of mirrors to some of you, and to be honest it is. The gold market is as complex as they come. Very few people in the world understand it. I don’t pretend to be one of them.

But I do know this:

‘The game’ is not over. Do not leave the arena. When it is, you’ll know. ‘Another’ knew the endgame 15 years ago…

‘For ones of simple thought, such as I ‘gold will be repriced once in life, and that will be much more than enough’.’

Greg Canavan
Editor, Sound Money. Sound Investments.
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Greg Canavan

Greg Canavan

Contributing Editor at Money Morning Australia

Greg is the Managing Editor for the Daily Reckoning Australia. He helps investors preserve their wealth over the long term using a method known as value investing. Lucky for Money Morning readers, he imparts some of this knowledge on them too with regular guest editorial spots.

Greg Canavan is a feature Editor at the Daily Reckoning Australia and is the foremost authority for retail investors on value investing in Australia.

He is also the author of Sound Money. Sound Investments (SMSI). An investment publication designed to help investors profit from companies and stocks that are undervalued on the market.Greg is the former head of Australasian Research for an Australian asset-management group and has appeared on CNBC, Sky Business’s ‘The Perrett Report’ and Lateline Business. He has written articles for The Sydney Morning HeraldThe Australian and www.ninemsn.com.au. Greg’s aim is to help you create a portfolio of stocks based on sound, proven, investing principles. His system for identifying stocks trading beneath their ‘intrinsic’ value combines a big picture understanding of the financial markets with a thorough valuation analysis of individual securities.

Greg’s method of investing is not about taking huge risks and rushing into big positions. He investigates highly profitable companies trading at a reduced premium to their net asset value, or ‘equity’ value as he puts it – and passes that research on to his subscribers to incorporate into their financial plan as they see fit.

With Greg’s help, you can implement a long-term wealth building strategy into your financial planning, be better prepared for the tough financial challenges ahead and stop making the basic, costly mistakes that most private investors make every time they buy a stock.

To find out more Greg’s investing style and his financial worldview take out a free subscription to the Daily Reckoning here.

And to discover what a company’s profitability reveals about its true value…and more importantly how you can use that knowledge to become a better, smarter investor, take out a 60 day trial to his value investing service Sound Money. Sound Investments here.

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