Monday, August 20, 2007

Two Roles for Gold in a Liquidity Crunch

20 August 2007

Overleveraged investors holding spurious and repackaged paper assets consisting of promises to pay by debtors who have no means of payment in a deflating US real estate market are presently feeling the inevitable pinch. In such situations, what do these overcommitted and undercapitalized individuals and organizations do?

There are at least two models to predict their behaviour.

One model is that they sell their bad assets and purchase better ones. The implication of this model is that behaviour governed by this principle would drive gold-buying, as this would represent a flight from uncertainty and risk to quality and security.

The second model is that they sell their good assets in order to meet their immediate financial obligations, in many cases because this group are likely to be overextended speculators. This latter scenario implies gold-selling, not gold buying. Further, such financial speculators would hold no inherent respect for gold as a bulwark of safety or quality.

Joe Nicholson, known as Oroborean,
maintained the following on August 18, 2007:

"Financial market conditions did deteriorate further this week and, as expected, the metals did suffer. Readers of this update will have long abandoned the notion that gold or silver would receive flight to quality benefits in a liquidity crunch. To the contrary, metals are an excellent source of liquidity, particularly when so many hedge funds hold substantial profits in their ETF holdings, and naturally these were sold to accommodate the funding needs of a rapidly unwinding carry trade, imploding corporate debt market, and investor redemptions."

Due to various covenants assuring privacy, no one knows for sure who is buying and who is selling gold.

Certainly mainstream investors have been far more enamoured of shares in corporations and riskier derivative products than they have in gold, as businesses are seen as making money, while gold “just sits there,” not even paying interest.

Generally, it is only the contrarian minority who hold a more jaded view of the mainstream economy as out of balance and over-extended (read bloated).

Contrarians view mainstream corporate shares and more speculative derivative investments as over-valued and susceptible to unacceptable structural economic risks deriving, at root, from inflationary government policies founded on excessive debt accumulation and corresponding inordinate money-supply growth.

That is, the contrarian minority believe that the business mainstream confuses liquidity – presently manifested in the form of dramatic money supply growth – with wealth generation – which is the actual increase in the quantity and quality of goods and services. Contrarians hold that what is presently increasing is the money supply – offering an illusion of increasing wealth, but offering no enduring substance to undergird that illusion.

At this juncture, what would cause us to believe that over-extended speculators have suddenly been converted to a 180-degree inversion of worldview?

In particular, we are this year concluding our second decade of a United States Federal Reserve Board leadership which by conditioned reflex rides to the rescue at every hiccup in the market. What in this environment could possibly spark such a conversion?

It will be a slow process, and, sad to say, more pain than has yet been felt will be necessary to bring about behaviour modification and the inevitable shunning of financial excess at the government, corporate and household levels.

In the meantime, what is the evidence telling us?

1. Certainly since February 2001, there has been a visible shift in favour of gold over paper assets. Gold has outperformed virtually all of the world’s financial markets during the 2001-2007 period.

2. Gratifying though this development may be to gold bulls, the shift remains gradual, and it is surely still driven by a slim minority of gold investors. This sector – by comparison to the global equity market – is absolutely miniscule by any standard. That is, a tiny minority of investors can – and are – driving the gold market to new highs, but this group remains a negligible component of the global investment marketplace. The gold investor has not yet registered on the radar of international markets.

3. When the going gets tough, the not-so-tough don't get going to gold and silver – but to the Federal Reserve Board for a handout by way of interest rate cuts to make the cost of borrowing money cheaper – in actuality – cheaper than the hidden toll of escalating monetary inflation.

4. This enabling and ultimately self-defeating policy encourages continued dysfunctional behaviours, and among these dysfunctional behaviours is the selling of gold to cover the costs of speculation, rather than the buying of gold to assure the soundness of investment assets.

5. The evidence is before us, as in last week’s liquidity crunch, both gold and gold mining shares were sold aggressively. We simply aren't there yet, in terms of seeing mainstream investors turning to gold as a sounder alternative to “bloated” and unsound mainstream financial assets.

The above being said, there are certainly a cadre of “smart money” insiders who recognize that, by the classic playbook, lowered interest rates in an inflationary environment imply rising gold prices – and these savvy insiders can be shown to be buying gold through such “insider” sources as Commitment of Traders reports in the futures market.

To draw my argument to a close: My analysis is that we are presently at a juncture where, in a pinch, gold will be sold, but as the (gold) dust settles, gold will gradually be bought again. This assertion is based on the behaviour of the gold market since February 2001, when the collapse of the tech bubble began to turn a growing cadre of investors to the gold and silver markets.

I suggest that the present uncertainty will gradually turn more investors in this direction. It will not – not yet – be a rush to the exits from mainstream investments into gold, but a gradual, gentle flow of mainstream investors seeking diversification from the shrinking pool of investible mainstream assets.

That is – when you simply can't buy subprime mortgages anymore – you have to buy something else. I am no optimist that there will be a rush to quality in such circumstances, but the pool of investible mainstream assets is indeed shrinking, and gold remains as a survivor. Thus, the trickle will continue – and, because the precious metals market is so small, even a trickle of interest drifting our way can in fact produce outsized gains.

So, interestingly enough, and precisely because the precious metals market is so small, the almost imperceptible shift from risk to quality could potentially produce quite dramatic results in the gold, silver and precious metal mining share markets.

Keep your eyes open. There may yet be surprises in store for gold and silver investors, despite the fact that mainstream markets are far more interested in almost anything but quality. Our market is so small that even a trickle of increasing interest can produce very dramatic results.

And we remain in the very earliest stages of the precious metals bull market. There are many years and considerably more drama lying ahead than we have seen so far! In fact, there is every indication that the "tsunami" I wrote about on June 1, 2007 may now have reached the low tide that precedes its inevitable advance to shore.

(By the way, it now appears that gold may be a better catalyst to regulate hydrocarbon emissions from diesel engines than platinum. Click here for more information.)

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