29 October 2008

Bron's Mega Trend Chart

My response to a few questions on this Kitco forum thread about potential COMEX closure, the spot price and my unrequested speculations on the supply/demand situation:

Any regulated market, be it COMEX or stock markets, are subject to closure/suspension/rule changes. Just look at the no short selling changes for financial stocks and the ability of COMEX to change margin. What will cause it to close? I suspect if trading on it starts to shift significantly towards using it as an actual way to purchase physical and not just some leveraged speculation game where everything is netted out in cash. As long as they can continue to perform the basic function of a futures market, which is to allow people to buy commodities for future “use” (ie delivery), they will be OK. But they need physical to do that, so watch the warehouse movements.

The advantage of the OTC market is that it is not regulated (that is also a disadvantage re transparency) - it is just person to person dealing, much like what is happening on ebay, just at a bigger level and for the big wholesale bars. As a result it can't be closed and will adjust itself as required.

Note that a lot of OTC trading by professionals is just buy and then sell, ie turnover is the game. They are not buy and hold (at least not in the long term); they don't care for gold and are happy to sell it into rallies to make money. This is OK as it provides liquidity. But if you want to move the price, there is only one thing that can spook the professionals and that is physical being taken off the market. By this I mean non-professionals as they care for gold and won't necessarily sell it into rallies. It leaves the OTC "trading game", either in the form of retail coins or bars, or the big bars by high wealth investors.

The problem I think at the moment is that demand for retail stuff is restricted (whether you want to believe it is deliberate policy or industry inertia or industry incompetence I leave for another discussion) which restricts physical being taken off the market. Having said that, a hell of a lot of retail stuff is being made, more so than ever before, everyone is at capacity, so some impact is being felt as manufacturers suck up the big bars to feed their production lines, but it could be more.

While this retail demand continues it will continue to suck physical off the market and at some time it will create a tipping point where physical buying demand exceeds physical selling supply. When? Don’t know because the market is complex, but consider (some) of these simplistic factors over the medium/long term:

S1. Mine supply: let’s assume somewhat constant
S2. Central bank supply: lending has tightened up, which tightens up short selling, also doubt many central banks would be selling gold reserves or have much left to sell, if you believe they have been manipulating the markets for, since, ever and ever. But let’s assume they are still selling what they have
S3. Institutional/hedge fund investors: they have certainly been liquidating all their “commodity” play positions to pay back their debt or cover other losses.
S4. Individual investors: no selling going on here

D1. Jewellery/Industry: by this I mean western, not India because that is really investment purpose. In a recession jewellery & industry demand is going to go down.
D2. India: they are very canny buyers (because they are investing) and even though prices relatively high in their currency, their normal demand returns once they feel prices have stabilised at a level and are unlikely to retreat. In medium term I see this up.
D3. Individual investors: at this time with retail shortages, only way is up.

So which is the key driver for an increasing gold price? Let’s go back in history a bit.

In 2002 the World Gold Council (WGC) appointed James Burton as CEO. Mr Burton was the former CEO of the California Public Employees Retirement System (Calpers) the leading and the largest public pension system in the USA. Any coincidence that the WGC then made a strategic shift away from trying to increase the gold price via increasing jewellery demand towards the investment side? This is why they sponsored the creation of the first gold ETFs and have aggressively rolled them out into 12 countries.

The theory is that jewellery demand, while it may go up and down in line with the economy, is base demand, consistent in nature, and cannot be expected to increase significantly, or at least increase enough to make an impact on price. For that to happen would require the per capita buying of jewellery to increase, which is just another way of saying that jewellery has to increase its “market share” of the consumer’s discretionary income. This requires big bucks to be spent on advertising and other marketing support. WGC tried it for many years and I think came to the conclusion that the “return on investment” did not pay off in terms of an increased price.

Investment demand, in contrast, has the power to go up significantly – just look at the amount of money invested in shares compared to the size of the gold market. It was realised that shifting even small amounts of that money into gold would have a big effect. In addition, the cost of making this happen was lower compared to trying to increase jewellery demand. Creating an ETF may require big bucks, but once done it doesn’t need ongoing expenditures and in a lot of cases you can dual-list, saving more money (at http://exchangetradedgold.com/ you’ll see that there are actually only 4 “funds” trading in 12 countries). Increasing jewellery demand, however, requires continual marketing support to compete against all the new toys (iphones, plasmas TVs etc) competiting for consumer spending.

Now in general I agree with the “investment demand is the key” theory, but the ETF approach is potentially a double edged sword. The question is whether its holders are predominantly the buy and hold type individuals or just institutional types and myopic share traders. At this time we are not seeing any significant holdings drops across the key ETFs. However, my view is that because it targets share investors, they have more potential for outflows compared to personal physical holdings (ie in the form of retail coins and bars), which I feel are more sticky. Therefore I think it is unfortunate that some of the WGC money spent on ETFs was not directed at ensuring the industry’s capability to meet retail coin and bar demand.

My view is that S2 & S3 are the main forces behind the big drop in the gold price as they have overwhelmed the other positive forces. A lot of this would be happening in the OTC market, so isn’t necessarily visible. Whether they have more gold still to sell is the key question, but I’d guess not much more to go. With the key force in the story being “investment” demand, continued D3 demand plus a D2 coming back will tip the balance towards a higher gold price.

For silver:

S1. Mine supply: recession pushes other commodities down, by-product silver also goes down
S2. Central bank supply: no such thing
S3. Institutional/hedge fund investors: same story about liquidating “commodity” play positions.
S4. Individual investors: no selling going on here

D1. Jewellery/Industry: In a recession industry will go down, maybe jewellery up as people switch from gold to silver.
D2. India: 50c premiums on silver into India proves demand strong/supply shortish.
D3. Individual investors: also only way is up, probably more so than gold.

My view is “investment demand is the key” theory also applies to silver, more so considering no massive central bank holdings. Supply story looks good (short) and again, as long as D2 & D3 hold, price must move up.

While I’m bullish on PM’s, it isn’t going to happen overnight. There is big money moving around distorting the base trend and no doubt that a bubble in PMs is working its way out. In all the commentary on the price I’ve seen, very few charts go back past 2005. Too myopic in my view – because gold is not a transparent market you can only play the main trends. See below my Mega Trend Chart :).

The recent few years look like a 1980s bubble to me off the real baseline established from 2001 to 2005. I also find it interesting that the Mega Uptrends all have the same slope. Anyway, my extention of the 2001 to 2005 Mega Uptrend out into the future is what I would expect in a normal market situation: the bubble would come back down to this and probably overcorrect like in 1982 before continuing up. But this credit (or more accurately, trust) crisis may have changed the game. Consumers lose faith in these virtual financial products, and they shift to wanting “real stuff”. PM demand moves to a new level as a result and thus the dotted lines are now where the price will go?

Of course if I'm proved right I will take all the glory and if not, I'll blame the manipulators for having seen this penetrating analysis and reacted to prevent my prediction.

1 comment:

  1. A couple of comments


    Latest news from WGC is gold supply down 4% YOY & 6% for second half http://mineweb.com/mineweb/view/mineweb/en/page34?oid=71491&sn=Detail


    There's been little reported selling - they have reduced stocks to sell - a reduced monetary environment to sell and currently there's whispers on the block that gold needs to be held for a new currency. It's only gossip but have a listen here http://www.youtube.com/watch?v=e0NE6W_aV8w&feature=related


    As far as investment fund go - they sold out & the USD rose. I will also bet that they ones left will just as quickly get back into gold. Every trader worth his salt in TA recognises that the next leg up should be the major leg up in gold and as such is one you don't want to miss out on. So S3 is cyclical like the tide - the tides just gone out & the next move is......

    Also another aspect that's not been mentioned is that gold stocks have been hugely weighted down the last few years by naked shorts. Considering that the sector has sold off from 70 to 90% I would presume that the naked shorts are gone. If there's a serious rise in gold stocks then it could well follow into the physical markets. Historically stocks outrun physical by 2-3:1 - this has been absent the last few years. A return here now could spark off something.

    As to ETFs - I do believe that most institutional buying here is not speculative but rather very long term. For years the adage of having 5-10% in gold to offset traditional investments was never available to institutions as they couldn't hold physical. Now with ETFs a major fund can put 5% of it's investment portfolio in gold & simply forget about it. As the fund grows they will slowly add more. So I do believe that 90% of GLD would fit this bill. As long term holdings these tonnes of gold will not return to be sold for any reason. They are base core holdings.

    Another aspect that isn't mentioned is the continual deficit between mine supply & total demand. With such a huge ongoing deficit excess stocks (whether piled away in Central Banks or in private vaults or other storage) have been brought to the marketplace over the years to meet the gap.

    In the past there may have been a 10% float of old stocks churning & coming back to the marketplace - I do believe that this float through the years has wound itself down to the stage where there's little float left at all & hence why a tightening in supply & a large increase in demand has floored the industry. I would seriously doubt that the Perth Mint would see or find these problems as it is too close to the supply chain of the WA Goldfields. But for Switzerland or London these could be major problems if that float dries up.

    So though the last two decades I have a belief that excess supplies have been wound down and that the market is a lot less resilient to shocks & that more volatility is on the way. Excessive demand will exacerbate these problems. If the world does bumble into a recession/depression demand will tail off & production will slow. This is already happening with base metals & mine production. Some mines being closed due to lower prices - other demand being curtailed due to global demand. Some WA companies have been asked to withhold ore promised delivery for a year or two.

    So the float is dry - CBs have sold off too much - little excess available. Production looks to be curtailing & demand is well. Just call me a bull.