The Gold Bull is Dead. Long Live the Gold Bull!

Sheesh. What was that? Markets are cracking all over the place. Confidence in the Federal Reserve to make it all better is evaporating faster than a proverbial snowflake in summer. Confidence in the Bank of Japan to make it much worse is growing by the day. And confidence in the People’s Bank of China to have even the vaguest idea of what they are doing is out the window too.

Money is a con game. It requires confidence to keep the game going. And confidence in our monetary central planners just turned on a dime.

The conventional view is that this is all because the Fed is set to unwind its stimulus program. Apparently, the US economic ship is turning around.

Don’t buy it. Something else is going on that is not quite apparent. We don’t know what it is exactly, but we’ve been warning about it for a while. Over the past month or so, we’ve been working on a new report and video presentation warning of a crash. You can see it here . We didn’t know the crash would come so soon, but we do know that it was inevitable.

The global monetary system is straining. China, which is integral to the system’s functioning, is in all sorts. Yesterday was the day when China’s credit bubble definitively popped. The interbank lending market froze as rates soared. This is how a credit crunch starts.

The rumour was that the market pulled funding from the ‘WMPs’, the ‘Wealth Management Products’ marketed by the banks to get around lending restrictions imposed by the government last year. These products were classic credit bubble vehicles…borrowing money short term on the promise of attractive returns and lending it long term. Back in October, the Chairman of Bank of China said these products were like a Ponzi scheme.

The thing with Ponzi schemes is that they collapse when the flow of credit stops. And yesterday the flow of credit stopped.

China’s central bank, the People’s Bank of China (PBoC), has yet to act to provide liquidity to a parched market. They want to send a signal that they are serious about curbing the credit boom. This could prove to be a grave error. The time to get serious is before the credit boom gets out of control. That moment is long gone for China. It now must manage the as best as it can. And it can’t do that by standing around acting tough.

In this environment, you’d think gold would soar, right? Instead, it’s getting smashed along with everything else. But as we’ve written before, the gold market is not what it seems. The physical market follows the paper market. The ‘paper gold’ market consists of the COMEX futures market in the US and the OTC (over the counter) market in London. OTC means trading occurs privately between two parties, not via an exchange like stocks.

And most of the trading that occurs privately in London is in ‘unallocated’ gold. This is gold deposited into a bullion bank account but not ‘allocated’ to a specific account. Therefore, the bank can lend this unallocated gold to multiple parties. That’s because they’re not lending physical gold, but a paper claim on gold instead.

So physical gold trading is minimal. For example, the London Bullion Market Association (LBMA) tells us that OTC market gold turnover for the month of April was 24.1 million ounces, or 289.2 million ounces annualised. That equates to around 8,200 tonnes, about 4 times the level of annual gold production. It’s clearly not physical gold trade trading place, but rather paper claims to physical gold. This means the price is set by the ‘paper gold’ market.

Like conventional banking, the modern gold market is a fractional reserve market. Think of it as an upside down pyramid. Physical gold is the reserve base at the bottom of the pyramid. Paper gold expands on top of this base. This market, as far as we can tell, began developing once the US abandoned its official link to gold in 1971.

The fractional reserve system in gold grew in order to provide additional supply to meet growing demand, so as not to blow the price sky high. But demand became so great that the fractional reserve gold market nearly blew up in 1999. That’s when gold last traded around or below the average cost of production…similar to its situation today.

But something saved the fractional gold system at that time, and the gold market entered into a bull phase to relieve pressure on the physical market. It was a paper bull market, physical just went along for the ride.

Now, here’s the important bit…

In a paper gold bull market, the tendency of the Western trader (who effectively sets the price) is to be long paper gold and short physical gold. That is, the trade is to sell physical and go long a futures contract or some sort of paper derivative.

But, when the paper bull market ends and all the momentum traders (who simply wanted leveraged exposure to gold…not gold itself) exit the market, the dynamic changes. It goes from bullish to bearish.

Remember back in April when the gold price plunged? While the paper holders dumped in a panic, there was a global rush to physical gold. That is, there was a run on physical gold reserves. And like any run, when reserves deplete they bring down the credit instruments that pyramid on top of these reserves. Hence the collapse in paper gold prices.

So now the gold market has gone from bull to bear, the trade has gone from ‘short physical, long paper’ to ‘long physical, short paper’. In other words, if you want to hedge your physical exposure, what do you do? Short paper gold! And because the paper market sets the price…well, that’s why the ‘gold price’ is falling.

But with each fall in price, the demand for physical will increase, which heightens the bank run and puts pressure on the fractionally reserved gold system. To relieve that pressure, the paper gold price needs to rally. If the ‘long physical, short paper’ trade continues to gain momentum, we’re not sure how much longer the existing gold market can survive.

So if you’re holding physical, hold on tight. Long physical is the trade, it just doesn’t look like a winning trade while the fractional reserve system crumbles down around it.

The gold bull is dead, long live the gold bull!


Greg Canavan
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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