January 27, 2014

What’s the Safest Way to Hedge Against Inflation With Gold?

Posted in Ben Bernanke, Big Banks, Economy, Europe, Foreign, gold, investment advisor, investment banking, investments at 11:02 PM by Robert Barone

Until inflation becomes recognized, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period.

Historically, the price of gold protected the purchasing power of the currency invested in it, as the price rose in some reasonable correlation with existing or expected inflation of that currency. But today, the price of gold is set in a speculative market where traders and hedge fund managers make bets, and little or no attention is paid to gold’s traditional role. (See the first part of this article, Why Gold Prices Dropped in 2013.)   According to John Hathaway of Tocqueville.com, in 2010, the physical gold market consisted of 121 million ounces. With a growth rate of about 1.5% per year, there are currently about 127 million ounces in existence, as of Hathaway’s writing. Using futures and options data, and OTC clearing data from the London Bullion Market Association, Hathaway calculates that the paper gold market is 92 times that of the underlying physical market. If each investor in a paper gold ounce believes it is backed by an ounce of physical gold, then each physical gold ounce must have been loaned or hypothecated, on average, 92 times. If everyone decided that they wanted physical possession, which of the 92 paper gold ounce owners really owns the physical metal?
That, of course, explains why it took so long (17 months) for the London banks to deliver the physical gold that Hugo Chavez’s Venezuela demanded. They either didn’t have it and had to purchase it in the open market, or they had to unwind trades where the gold was loaned or pledged as collateral, or both. As for the seven years that it will take for the US Fed to deliver Germany its gold, the only conclusion can be that the web of hypothecation must be long and complex.

Let’s now consider the characteristics of the London financial markets, where gold’s price is fixed twice each day. Nearly every well-known financial calamity over the past 20 years has originated from London offices of major financial corporations. That’s because in the UK, financial institutions have little regulatory oversight. Just think about JPMorgan’s (NYSE:JPM) $6+ billion 2012 loss from its London trading office. We learned from the MF Global (OTCMKTS:MFGLQ) fiasco that client assets can be hypothecated and re-hypothecated an infinite number of times, and that there are no customer protection rules. If you have been wondering what happened to Jon Corzine’s (MF Global’s CEO) clients’ funds, you now have a pretty good idea.

Recently, we’ve seen major UK financial institutions pay hefty fines for manipulating certain commodity prices and for fixing the price of LIBOR, a short-term rate that plays a key role in the world’s financial markets. Apparently, the illegal activity had been going on for years. There are five London banks that control the two daily London gold price fixes. Given the known shenanigans of the London banks regarding LIBOR and other commodities, and the infinite re-hypothecation allowed, how much confidence should we have that the daily gold price-fixing is impartial, that in a crisis or panic the hypothecations can be unwound with every paper claim on gold made whole, or, in fact, that some of the underlying gold even exists in the vaults? As Hathaway says, “It would be hard to imagine that the culture of [London] did not extend to gold.”

There has been a great deal of political angst by Bernanke and Co. over the demand by some members of Congress for a Fed audit, and great political maneuvering to avoid it. Some commentators, like John Williams (Shadowstats.com), believe that the Fed and government officials disdain rising gold prices because that suggests that the government and the Fed are not doing their jobs in maintaining price stability. Hence, Williams believes that heavy selling in 2013 was an orchestrated government intervention. In his January 8, 2014 issue of Hyperinflation 2014 – The End Game Begins, Williams says, “A number of times, very large sell-orders from one customer were placed in the global markets before the open of US trading. For someone looking to move out of gold, orderly sales would make the most sense in terms of getting the best prices. Instead, these actions were designed to pummel the gold markets, and they did.”

Remember what happened to credit default swaps, issued by AIG (NYSE:AIG), just five years ago? Remember what happened to AAA-rated mortgage-backed securities that turned out to have a lot of sub-prime loans? Could something like that happen to the paper gold market?

If it’s discovered that some of the underlying gold has disappeared from the vaults, or in a panic the competing hypothecations for the underlying gold ounces tie up the assets in a long-term court battle, or, as in the case of General Motor’s (NYSE:GM) senior secured bondholders and some depositors in Cypriot banks, it becomes politically correct to single out a class to bear losses, some holders of paper gold could be out of luck. It might be very painful one day to wake up to find that the paper gold investment you thought you had turns out to have not been collateralized.

So, what should gold investors do?

First, understand the difference between hedging and speculating. If it is your intent to hedge against an inflation that you believe will inevitably come due to current worldwide monetary- and fiscal-policy excesses, then the systematic purchase of gold, like mutual fund dollar-cost averaging, is a good practice.

In what form should you hold your precious metal assets? What about the ETFs traded on the exchanges? If you want to keep the gold in your brokerage account, there are some funds or ETFs that say that they hold bullion in a vault and do not hypothecate it. You need to do careful research to make sure this is the case and know if the paper you hold is convertible into the underlying asset. Gold mining stocks are another way, since the gold is there in the ground. Unfortunately, the typical gold mining company continuously dilutes shareholders with new rounds of equity offerings as they continue their search for the “mother lode.” So, research here is also essential.

The safest way, of course, is to hold the gold yourself, i.e., take physical possession and put it into a safety deposit box or in your own safe.  Many Americans are doing this, but the Chinese and Asians are way out ahead in this area. To do this you need to find a reputable gold or coin shop that will sell to you for a reasonable commission, say 3-4%.

Today’s gold investors must also understand that the price of gold is currently a 100% function of hedge fund speculation. In the future, as inflation becomes recognized, this may change, but until it does, the investor holding gold as a hedge must have both patience and the ability to hold for an extended period — oh yes, and the ironclad belief that the laws of economics haven’t changed, i.e., that “this time is different” is a lot of bunk.

 

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

January 14, 2014

Why Gold Prices Dropped in 2013

Posted in Banking, Big Banks, Economic Growth, Economy, Europe, Federal Reserve, Finance, Foreign, gold, Inflation, interest rates, investment advisor, investments, Robert Barone at 6:39 PM by Robert Barone

Most seasoned investors have some allocation to precious metals in their portfolios, most often gold. They believe that such an allocation protects them, as it is a hedge, or an insurance policy, against the proliferation of paper (fiat) money by the world’s largest central banks. Fiat money is not backed by real physical assets. In concept, I agree with this sentiment. Most investors who invest in precious metals ETFs, such as the SPDR Gold Trust ETF (NYSEARCA:GLD), through the supposedly regulated stock exchanges (“paper gold”) believe that they actually have a hedge against future inflation. In what follows, I will try to explain why they may not, and why their investments in paper gold may just be speculation.

On February 5, 1981, then Fed Chairman Paul Volcker said that the Fed had made a “commitment to a monetary policy consistent with reducing inflation…” Contrast that with the statement of outgoing Fed Chairman Bernanke on December 18, 2013: “We are very committed to making sure that inflation does not stay too low…”

During 2013, the price of gold fell more than 28% (from $165.17/oz. to $118.36/oz.) despite the fact that other assets like real estate and equities each rose at double-digit rates. It is perplexing that the price of the hedge against inflation is falling in the face of a money-printing orgy at all of the world’s major central banks. Despite the fact that these central banks have fought the inflation scourge for half of a century, suddenly they have all adopted policies that espouse inflation as something desirable. The fall in the price of gold is even more perplexing because there are reports of record demand for physical gold, especially in Asia, and that some of the mints can’t keep up with the demand for standardized product. In his year-end missive, John Hathaway of Tocqueville.com says that “the manager of one of the largest Swiss refiners stated that after almost doubling capacity this year, ‘they put on three shifts, they’re working 24 hours a day…and every time [we] think it’s going to slow down, [we] get more orders…70% of the kilo bar fabrication is going to China.'”

One would also think that the price of gold should be rising because of a growing loss of confidence in fiat currencies. Here are some indicators:

The growing interest in Bitcoin as an alternative to government-issued currencies. One should ask, why did the price of Bitcoin rise from $13.51 on December 31, 2012 to $754.76 on December 30, 2013 while the price of gold fell? As you will see later in this essay, the answer lies in leverage. The gold market is leveraged; Bitcoin is not (at least, not yet).

The volatility that the Fed has caused in emerging market economies by flooding the world with dollars at zero interest is another reason the price of gold should be rising. The Fed’s announced zero-rate policy with a time horizon caused huge capital flows into emerging market economies by hedge funds looking for yield. The inflows caused disruption to the immature financial systems in those emerging markets. And then, with the utterance of a single word, “tapering,” all of the hedge funds headed for the exits at once. The Indian rupee, for example, which was trading around 53 rupees/dollar in May 2013, fell to 69 near the end of August, a 30% loss of value. Such behavior has stirred up new interest on the part of major international players (China, Russia) to have an alternative to the dollar as the world’s reserve currency. Don’t dismiss this as political posturing. It is based on irresponsible Fed policy in its role as the caretaker of the world’s reserve currency. As the world moves toward an alternative reserve currency, the dollar will weaken significantly relative to other currencies, and, theoretically, to gold (and even Bitcoin).

The loss of confidence on the part of some sovereign nations that the gold they have stored in foreign bank vaults is safe. Two examples immediately come to mind: Venezuela and Germany. In August of 2011, the President of Venezuela, Hugo Chavez, demanded that the London bullion banks that were holding Venezuela’s gold ship it to Caracas. (Again, don’t dismiss this as political posturing.) Despite the fact that the shipment could have been carried on a single cargo plane, it took until late January 2012 (17 months), for the London banks to completely comply. One should wonder why. Then, the German Bundesbank asked for an audit of its gold holdings at the Fed. One knows how the Fed has resisted audits from Congress, so why should a request from a German bank meet with any different result? After political escalation, a German minister was permitted to see a room full of gold at the New York Fed. In early 2013, the Bundesbank publicly announced that its intent was to repatriate its gold from the vaults in Paris, London, and New York. We have now learned that it will take seven years for the New York Fed to ship the gold earmarked as belonging to Germany in the Fed’s vaults. One should wonder why such a long delay.

In the face of all of this — unparalleled money printing, the rise in the prices of real estate and equities in 2013, and the creeping suspicions regarding the real value of fiat currencies — how is it that the price of gold fell 28% in 2013? The answer lies in leverage and hypothecation, the modus operandi of Wall Street, London, and financiers worldwide. The paper gold market, the one that trades the ETFs such as the SPDR Gold Trust, is 92 times bigger than the physical supply of gold according to Tocqueville’s John Hathaway. Think about that. It means that each physical ounce of gold that actually exists has been loaned, pledged, and re-loaned 92 times on average. Each holder in the paper gold market thinks that the ounce of paper gold held in the brokerage account is backed by an ounce of real gold. But there are, on average, 92 others who apparently have a claim on the same real, physical ounce.

The answer to the question, why did gold fall 28% in 2013 when, theoretically, it should have risen, is that Wall Street, London, and hedge funds have turned the paper gold market into a market of speculation, where the price rises or falls, not based on the purchasing power of currencies (the hedging characteristic of gold), but on such things as whether or not the Fed will taper, what impact Iranian nuclear talks will have on oil flows, if the interest rates in the eurozone periphery are likely to rise or fall, etc.

In my next article, I will explain how all of this occurred, and what investors who want to hedge and not speculate should do.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.