We wrote about the great disconnect between physical and paper silver only a few weeks ago. After the sharpest one-day price drop since 2001 the disconnect between physical and paper is becoming even larger. It is now present in both metals.
On Friday, even the World Gold Council came out with a press release in which they confirm (1) speculation in the futures market as the primary reason for the price drop and (2) the massive wave of physical buying across the globe. “We are already seeing shortages for bars and coins in Dubai, while premiums in Mumbai are at $26/oz and $6 in Shanghai, indicating that buyers are willing to pay more than current spot prices for the metal.”
Let’s quickly review what we learned in one of the most volatile weeks ever:
- Russell Rhoads points to the ferocity of the price drop. He writes: “For simplicity sake let’s call it a five standard deviation move. Statistically we get a five standard deviation move approximately once every 4,776 years. So we should not expect another move like this out of the price of gold until May 17, 6789.”
- It is likely that the bullion buying panic is signaling that the price discovery mechanism is well alive.
- Physical shortage has got a lot of attention in the previous years in the gold community. Recent facts favour that shortage is for real.
- The number of people looking for value when buying precious metals could be larger than most of us think. Inversely, the number of people that care about charts and technical patterns could be smaller than most of us think.
- All commodities were already in a downtrend since November 2012. They have been hit hard in the past week. Combined with a decline in the global interest rate (courtesy of Dan Norcini) it could signal that a deflationary wave has started. If that would be true, all easing programs (QE, nominal GDP targeting, operation twist, zero interest rate policies, and all other monetary bazooka’s) are only functioning on paper in the ivory towers of institutions like central banks.
All this leaves us with three critical questions which we try to answer in this article in an objective way.
- How are bullion owners protected, or what are the benefits of owning physical over paper?
- What does the disconnect between physical and paper mean?
- Is the “end of the bull market” for real, or when to sell your gold?
(1) How are bullion owners protected?
Jim Rickards considers physical gold holders (without leverage) “strong hands.” He believes that the recent price crash has accelerated a washout process.
Gold ownership is now divided between strong hands and weak hands. The strong hands are Russia, China, some of the other central banks, and anybody else who is buying gold for cash in physical form, without leverage. The weak hands are retail jumping into GLD, at a top, using margin, futures players, and people who don’t really understand gold. There are a lot of trend followers out there who started following gold on a trend basis, but didn’t really understand anything about gold, or how it works, etc.
The hedge funds turn out to be weak hands, not strong hands. The reason is they’ve got redemptions. Hedge funds don’t have permanent capital. They may have monthly redemptions, or quarterly redemptions, or one-year lockups, or whatever it is, but it’s not permanent capital.
In fact, owners of physical bullion have been protected up until now (emphasis because we do not know what the future will bring). So far, the premise that gold and silver in physical form offers protection still holds. We have been used to associate protection with devaluing currencies, but here is an example of protection against paper forms of the metal. The premiums of a lot of coins are so high today that the spot price + premium equals the price before the crash. Obviously that’s not the case for paper gold and silver.
Besides, suppose a deflationary wave has started (the ultimate nightmare of Western central banks), then based on monetary history we could expect that physical gold should offer protection (based on Exeter’s Golden Pyramid or Inverted pyramid). Claudio Grass referred to Exeter when he wrote: “During a period of profound deflation, the investment focus shifts from capital growth to capital preservation. Deflation thus always comes with falling confidence in the (perceived) root cause of the crisis (governments, banks, speculators, etc.) and their rating. Therefore, the purchasing power of Gold gains also within a deflationary scenario.
One should not forget the key benefits of physical gold: no counterparty risk, a hedge against devaluing currencies and a protection of assets in banking system with a sytemic risk. At the deepest level, all this is still highly relevant.
(2) What does the disconnect between physical and paper mean?
That is indeed a very important question, one week after the crash. At this point, simply nobody knows the answer. We can only make educated guesses for the time being and work with probabilities. One of those guesses is that markets do correct over time, no matter if and how distorted they are. The longer they remain artificial or distorted, the stronger the correction. Extreme examples of distortion include the .com and real estate bubbles. From that point of view, we believe Jesse described the situation correctly in his latest commentary:
If there is a large divergence in which physical is more expensive than paper, and the supply of physical is tightening, then you have that oddest of conditions where the futures market is grossly miscalculating things as they are and may be. And this is what has just happened. There are several reasons for this. One primary reason is that some market participants who are predominant in the futures markets are acting on hidden information. This again could be several things, but it almost certainly involves the willful distortion of the markets for personal gain. This may or may not be technically illegal.
The current physical shortage will be resolved but it will continue to worsen and become systemic if the distortions in the market, ie. an artificially low price, continues. At some point if not relieved there will be a market break and the paper market will lose all credibility and effect except where imposed by force.
Nobody knows the direction of the market and the prices of the paper and physical metal. We can only rely on the day-to-day evolution which will improve our understanding. The coming weeks and months will key in determining what today’s situation really means. In that respect, Sprott released an excellent analysis concluding as follows:
The days to come will prove if this surge in physical demand is an aberration, or the beginning of a new chapter for the physical gold market. If it represents the latter, precious metals investors may be wise to ignore the ‘paper’ price of gold altogether. The line-ups in 1980 represented the top of the gold bull market. But what do line-ups for gold represent when the price has already fallen 30% from its all-time high? That’s the question, and we’re guessing it means this current gold bull market isn’t close to being over.
Dan Norcini adds to it that hedge funds need to return to the long side of the market to take prices higher again. “For that to transpire, we must see fears of inflation displacing fears of deflation or slowing growth. Falling interest rates globally are showing that currently there exists no fear of inflation from Central Bank money creation at this point.”
(3) Is the “end of the bull market” for real, or when to sell your gold?
“What if” indeed the reports from Goldman Sachs, Société Générale and the likes prove to be correct? After all, they made a perfect call a couple of weeks ago with their forecast of 1,300 dollar per ounce. As we wrote, their reports lacked any correlation between gold and the debt crisis. There is an almost perfect correlation between the debt ceiling in the US and the dollar gold price. It seems very unlikely that the gold bull has run its course, but never say never.
Jim Rickards looks at it from another point of view. In his latest interview on Business Insider, he answered the question when he would sell his gold.
If the President and the Chairman of the Fed came out and said, “We’re going to raise interest rates, we’re going to stop quantitative easing — in fact, we’re going to reverse it a little bit — we’re going to cut corporate taxes to zero, we’re going to eliminate the capital gains tax, we’re going to reduce regulation, we’re going to make America a magnet for savings and investment. We’re going to have an investment-driven model rather than a debt and consumption-driven model, and we’re going to have positive real rates.” I would say, “Great. Sell your gold, or put it to one side, because gold is over.”
Going forward, Darryl Schoon believes that the recent volatility is simply part of the path of the bull run. He distinguishes five stages in his book. We are currently in stage 3 which is marked by increasing highs and lows as large investment funds move in and out of gold as global economic uncertainties wax and wane, a sign that gold is increasingly a haven in uncertain times. Stage 4 is characterized by an explosive ascent in the price as a result of a monetary breakdown driving investment capital towards the safety of gold. Darryl wrote this week: “The recent 20% fall in the price of gold indicates we are currently still in Stage 3. Thereafter follows stage 4 with its explosive ascent in the price of gold. When Stage 4 happens is anyone’s guess as prediction is always an uncertain art—unless, of course, you’re Goldman Sachs.”
All these angles should be watched carefully going forward. It seems very unlikely that government debts are about to stabilize or decrease. After all, the interest rates cannot go lower, only higher, aggravating the servicing cost of the debts. Nor is it likely that the Western consumption driven society will turn into a savings driven society. If Darryl Schoon his model is correct, then we should see even more volatility in the near future, in both sides.
We know what to look for.