Gold
Gold has been in a bear market for 18 years now. It could go on 19, or 20,
or more, I suppose. But as explosive the world situation is, I'm willing to
bet THIS IS THE BOTTOM. As much as I hate using caps because of their
tabloid overtones, their rare appearance here at what seems like a major
turning point does serve a purpose. The gloom and despair over the metal's
prospects are the bleakest I've ever seen, and I've been an observer since
gold was controlled at $35, and "experts" were tipping it for $8 if the U.S.
government didn't support it. The next move is likely up, and I think it
will turn into a moon shot. I admit to being early in voicing that opinion,
but at worst it's comparable to having bought into the U.S. stock market in
early 1982 rather than early 1983, after the trend had already turned. Not a
tragic error.
That's even more true for silver, which has been my favorite speculation
for some time, and for different reasons than gold. You may recall that the
U.S. government held a store of 2 billion ounces of silver as recently as
the early 70s. I would say silver soared during the 70s more because of the
government's sale of its hoard than in spite of it.
Incidentally, I approve of the government having sold its silver. In the
first place it's a bad idea for the state to be hoarding commodities, or
indeed owning any significant assets. In the second place, the U.S. never
had any business being on a bimetallic standard, which necessitated the
fixing of the price of silver relative to gold. Silver has often been used
as money through the ages, as have copper, salt, shells, cattle, and a lot
of other things. But gold has characteristics that make it uniquely well
suited for that role, a subject I covered in some detail in
the October 97 (Vol.XVII, No.11) issue of this letter.
That actually brings us around to the subject of central banks vis-a-vis
gold.
A bit of background
The main impetus for the recent collapse in gold prices has been the
selling by central banks that hold the metal as a reserve.
At this point it's worth reiterating an economic basic, because people seem
to think that the way things are now is the way they've always been. To wit,
historically, the "dollar", the "pound", the "lire", the "franc", the
"mark", and such were just convenient names for specific amounts of gold.
Governments didn't have monetary reserves per se because gold coins floated
in day to day commerce; the concept of "reserves" is only meaningful if you’
re issuing money substitutes, like banknotes or currency. Of course
governments had their own monetary assets, just as individuals and companies
did, but that had nothing to do with the value of the money circulating. In
those days money had value in and of itself, independent of the credit of
its minter. "Banknotes" were receipts issued by private banks representing a
specific amount of gold held on deposit, payable to the bearer on demand;
"currency" was the banknote issued by a government's central bank.
Banks which were suspected of having less than 100% reserves for their
banknotes were likely to suffer massive withdrawals. If a run occurred,
banks with 100% reserves met their obligations and went on with business;
banks without adequate reserves went bankrupt, and the world was better off
for the market cleansing itself, teaching both dishonest bankers and
imprudent depositors a lesson. Information circulating in the marketplace
kept banks honest in a way no bureaucrat ever could.
Things are vastly different today. The credit of a government is reflected
directly in the value of its currency. And all currencies are no more than
floating abstractions; none are redeemable by a specific amount of any
commodity. At best, they're redeemable with a specific amount of some other
currency, primarily the U.S. dollar, which serves as a reserve currency. But
the dollar itself is just a piece of paper that can be issued in
theoretically unlimited amounts by a manifestly bankrupt government. Of
course the U.S. Treasury does own a considerable amount of gold, enough to
make every dollar in M-1 (the narrowest measure of the money supply)
redeemable in specie, if gold was priced at about $4000. But gold has no
practical relation to the U.S. dollar today. In reality, the dollar is
backed only by the full faith and credit of the U.S. Government, which boils
down to whatever assets of U.S. citizens it's able to extract. At least if
the U.S. government won't give you anything for its dollars, they can still
be spent somewhere for whatever someone will trade them for. Some countries
keep some of their reserves in the IMF's Special Drawing Rights (SDRs), also
known as "paper gold", although they'd be better termed a "paper fantasy".
If the dollar can be dubbed an "I owe you nothing", the SDR can be said to
be a "Who owes you nothing"?
Central banks
The following is a list of the world's largest holders of monetary
reserves. I've priced gold at $300 for the calculation. As you can see, the
ratio of gold to currency reserves is trivial.
Country Foreign Currencies Gold Gold Value
(US$BN) (MIL OZ) (US$BN)
Japan 220.6 24.2 7.26
China 119.5 12.7 3.81
Taiwan 88.0 1.8 0.54
Germany 81.6 95.2 2.85
Singapore 80.4 0 0
Brazil 57.5 4.0 1.20
USA 57.0 261.7 78.51
The World's largest holders of gold are somewhat different. After the U.S.,
they are:
Gold Gold Value
(MIL OZ) (US$BN)
Germany 119.0 35.7
France 102.3 30.6
Italy 83.3 25.0
Switzerland 83.2 24.9
Netherlands 33.8 10.1
It is confusing that sometimes the figures are reported in ounces, other
times in metric tonnes. For purposes of conversion, a tonne is 32,150 troy
ounces.
These numbers reflect the fact the Dutch have already sold 300 tonnes
(9,645,000 ounces) in 1996; the Belgians sold 203 tonnes (6,526,450 ounces)
in March of 1996. Gold Fields Mineral Services believes another (as yet
unidentified) European central bank sold 200 tonnes in the first half of
1997. Central banks are clearly on the sell side of the market, but GFMS
observed that there were 17 buyers (273 tonnes) against 15 sellers (403
tonnes) last year.
As a note: the Swiss franc is not "backed" by gold; it's a fiat currency
like all the others, albeit historically a much better managed one. The
distinction with the Swissie is that its central bank has enough gold
relative to currency that it could be backed 100% at current market prices.
Unfortunately that doesn't seem to be the prevailing animus with the people
currently in charge of their central bank.
The recent wave of central bank selling has been justified with the
observation that, if They'd sold all their gold 10 years ago and put the
proceeds into U.S. bonds at 8%, They'd have twice as many dollars today.
This impresses me as an observation only an amateur might make, an insight
derived from looking into a rear-view mirror. If they really want to be
make-believe speculative geniuses then they should pretend they sold all
their gold at $800 in 1980, and bought T-Bonds when they yielded 12%. But
the ostensible purpose of central banks (which should be abolished anyway,
but that's another discussion) is not to speculate in the markets-entirely
apart from the fact the misplaced postal clerks manning them are likely to
always be on the wrong side of the market. Central bankers have a psychology
similar to that of the public buying mutual funds. An intelligent investor
buys or sells based on value, not on track record. A good track record is
critical when you're assessing a person, but for an investment it's usually
just an indication something is overpriced.
At its heart, my argument is that gold will necessarily be reinstituted as
money, simply because gold is the only financial asset that's not
simultaneously someone else's liability. The central banks increasingly just
own each other's paper. At some point, as most currencies look more and more
like the Thai baht or Korean won, they'll be forced to return to gold
redeemability, at much higher prices. That's entirely apart from the
question of why these people should trust the solvency of the U.S.
government, or the solidity of the dollar, which will likely become the
World's hottest potato at some point. It's always impressed me as something
approaching insanity on the part of foreign central banks to hold most of
their reserves in dollars.
Central banks’ ownership of gold has been going down for decades; in 1950
they owned 2/3 of the world supply; in 1968 about half; they are now down to
a quarter. Central banks actually hold about the same amount of gold now
that they did 50 years ago; it's just that 30 years of production has
doubled the amount outstanding. I see their decreasing ownership as a
positive trend, because the majority of gold is going into the marketplace,
where it belongs.
No one knows for sure how much gold is actually in existence; 130,000
tonnes (about 4.2 billion ounces) seems a fair estimate. The central banks
(including the IMF, with 103 million ounces) own 32,800 tonnes (about 1.05
billion ounces); at current prices of under $300 that's less than $300
billion. Not chump change, but not a lot in today's world either; even Bill
Gates is worth $35 billion. it's likely, for instance, to take a multiple of
the current value of all the central banks’ gold to bail out all the problem
loans in the Orient. Which would be a bad idea, but that's yet another
discussion.
The dollar will be dethroned
The advent of the Euro, which will replace the national currencies of 15
European countries come Jan. 1,1999, will serve as an additional complication
for both gold and the dollar. A European Central Bank is being established
with capital of 50 billion ECU (US$55 billion) in gold and foreign
currency-mainly dollars. The exact amount of gold won't be determined until
mid 98; the conventional wisdom is that they'll sell more. The EU
collectively own about $400 billion U.S. dollars, and they will likely get
rid of lots of them; after all, the Euro has pretensions to being a reserve
currency competitive to the dollar. Since the EU economy is 15% bigger than
that of the U.S., and collectively runs about a $90 billion surplus, versus
a $150 billion deficit for the U.S., a lot of people might prefer the Euro
to the dollar. Even though most international accounting is done in dollars
today (an estimated 80% of international transactions in the Orient and 92%
of OPEC's ), and though several dozen countries use the dollar as the de
facto national currency in day to day transactions, that can all change.
Eventually both the dollar and the Euro are on the road to becoming
wastepaper.
One of the main reasons there has been so little inflation in the U.S. is
that since the early 80s we've been exporting hundreds of billions of
dollars, and getting actual wealth in return. At some point that trend will
turn around; we'll get the dollars back, in exchange for real wealth
currently in the U.S. At that point inflation will skyrocket. And that could
trigger a wholesale panic out of dollars. The question is, into what will
they panic? I don't think it's likely to be another paper currency at that
point, especially since they're all backed by dollars.
New production
As you know, Ive long made the point that current supply/demand and
production/consumption figures aren't very meaningful for gold in the way
they are for most other commodities, simply because most gold is held in
bullion or coin as a financial asset. And people don't typically think of
melting down their jewelry just because the metal's price is either up or
down. Unlike foodstuffs or oil or most goods, new gold production is trivial
compared to the amount of past years’ inventory potentially available for
sale. The gold price isn't determined by how much is produced and consumed,
but by whether holders of inventory want to buy, hold, or sell. Plenty of
big mines are going to close if prices stay down here for long, but that
will be only fringe influence on gold's price.
Still, the figures are interesting. In 1995 mine production was 2274
tonnes; fabrication (meaning mainly jewelry, industrial use, and coins) was
3266 tonnes-a deficit of 992 tonnes. In 1996 production was 2346 tonnes;
fabrication 3240 tonnes-a deficit of 894 tonnes For the first half of 1997
production was 1161 tonnes and fabrication 1857 tonnes- annual deficit
rate of 1392 tonnes. Where is all this supply to cover the deficit coming
from? How can the price of gold go down in the face of such large
production/consumption shortfall? The only answer would seem to be short
sellers and professional bullion dealers who’ve borrowed gigantic amounts
from central banks. At some point the market will reach bottom and turn
around; when it does there could be a real short squeeze. One estimate of
the total short position by Frank Veneroso, who's made an occupation of
keeping track of such things, is that there is a net short position that's
built up of about 8000 tonnes of gold, over three years’ current production,
or about one-fourth of central bank holdings. When the market turns around,
it's likely to be truly explosive.
POST MORTEM
As it turns out, I think I was right about the bottom in gold; it hasn't
gone any lower since then. But just because the bear market has ended
doesn't mean the bull market has begun. But the longer it stays in this
bottom area, the stronger the inevitable bull market it likely to be. And,
as unlikely as it sounds now, I expect during the next bull market, the
price of gold isn't just going through the roof-- it's going to the moon.