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.

Fractals, Chaos Theory and Black Swans

Unallocated vs Allocated

On this Kitco forum thread, a question was asked about whether one should be converting from unallocated to allocated. Many years ago I wrote up the following text on this page of the Perth Mint website:

The Perth Mint maintains finished goods inventory of its coins and bars at all times to meet normal demand from its distributors and Depository clients. Accordingly, unallocated clients will usually be able to convert their metal within a few days of giving notice.

However, it is important to note that if you request a physical product that is not in stock, or a very large quantity, the Mint may need to manufacture it. The lead times for manufacture will depend upon the size of the order, current demand and production capacity. It is because of this uncertainty that some clients choose allocated storage - as their metal has already been fabricated it is ready for collection at short notice.

Clients worried about potential delays in collecting metal in extreme circumstances, but with concerns about the cost of allocated storage, usually take a staged approach:

1. While the world environment is benign, they hold unallocated. They do not incur ongoing storage costs and fabrication charges.
2. When the environment becomes uncertain and risky, they convert to allocated.
3. When the world is at a crisis point, they take delivery of their physical metal.

This approach can save clients significant amounts of money as it may be some time between stage 1 and 2. Clients who do not feel they can judge the shift from stage 1 to 2, or feel it may be sudden and unpredictable, opt for allocated as they are using precious metals as "insurance" and see the storage fees as the cost of that insurance.

Each person will have a different assessment of what stage we are at. One thing to note is that the Perth Mint has a legal obligation to do conversions/collections, so those orders will always take priority over any other orders in the system, which gives some people comfort.

There were a few other questions raised that may be of interest.

"If the demand continues to be high then production capacity will rise and premiums will fall in the end. But will this coin/bar demand ever be big enough to influence the spot more than marginally?"

I have speculated in this blog that the industry will eventually respond, but it won't be quick as two things need to happen: 1 bosses in refineries and mints "get it" that the demand is staying high; 2 takes months to buy and commission equipment. High premiums are here to stay for at least 6 months if demand continues.

I think if the current demand was able to be filled then it would have an impact on the spot price because it would take physical off the market. Coin and bar demand is somewhat sticky. The fact that demand has not be able to be met has resulted in buying power being "wasted" on high premiums instead of on buying more ounces.

There is also no doubt in my mind that the US ETF has also impacted on the price by providing an easy way for the average person to buy gold. That was the whole reason the World Gold Council (run by miners) paid to get it set up - they wanted a easy way for physical to get taken off the market. Problem is that it is also easy to sell, and i think that is what is causing the volatility in the gold price. Compared to coin and bar buyers, ETF investors are more fickle in my opinion. The World Gold Council would have been better off ensuring the industry was ready to meet retail demand for coins and bars, because that also takes physical off the market, but for a much longer time.

"when do you think the paper spot price may be reconciled with the physical spot price + premium? Do you think there is an intentional cornering of retail market by big players, or is it just a priority of serving wholesale customers first. If there is a real shortage, why not charge wholesale customers more?"

In my experience, and this may just reflect the type of clients I've dealt with, but new highs in the gold price drive new account openings so the price drop will cool things a bit, but just a bit as the key driver now is still uncertainty about the financial markets and banks.

There isn't any cornering of the retail market by big players - all "wholesale" deals for coins and bars are to dealer who resell to the public. If a mint is at capacity selling product to a wholesaler or retail customer doesn't actually change anything really, because it all ends up with retail customers in the end. The big private clients I know who go allocated may well buy some smaller coins and bars, but the bulk of their metal is in 400oz and 1000oz bars as they are the cheapest.

Misinterpretation of Gold Lease Rates

Brian Kelly (founder and CEO of Kanundrum Inc, a private investment firm and research boutique) recently posted an article on Seeking Alpha called Misinterpretation of Gold Lease Rates and Why Gold Could Rise. In the article he says that “lease rates reported in the press are a derived rate and actually represent the amount that can be earned from the gold carry trade” and goes on to posit a relationship between lease rates and gold prices. Unfortunately it is Brian who has misinterpreted lease rates, and has done so quite badly.

The gold carry trade involves borrowing gold at, say 1%, selling the gold, and then investing the cash at, say 3%. If the gold price doesn’t change, you earn a net 2%. The bigger the net difference the more carry trade return you can earn (assuming a stable price) and therefore more attractive short selling of gold should be – as long as there is an expectation that the gold price won’t rise too far to wipe out the profit from the interest rate differential.

The point of a carry trade is, therefore to “capture the difference between the rates” (see Currency Carry Trade for a further explanation). The question then is what are the two “rates” and what represents the net difference. The formula Brian mentions in his article is Lease Rate = LIBOR – GOFO. He therefore assumes that the net difference is the lease rate. However, that same formula can be restated as GOFO = LIBOR – Lease Rate. Which is the net difference?

Regrettably for Brian, it is GOFO, not the Lease Rate. How can I be so sure? Well when I worked in the Perth Mint’s Treasury and we borrowed gold, we were charged the Lease Rate, not GOFO. But don’t take my word for it. I quote from a booklet titled “A Guide to the London Bullion Market” issued by the London Bullion Market Association (who you would think would know what they are talking about): “Forward rate = Dollar interest rate – metal lease rate”

Therefore the fact is that it is GOFO which represents the “amount that can be earned from the gold carry trade”. GOFO is the measure of the net difference, “the amount that can be earned from the gold carry trade”, not the Lease Rate.

As a result not much store should be put to Brian’s subsequent analysis about the relationship lease rates and the gold price. The chart below shows the relationship between the real “carry trade” indicator (I’ve chosen the 6 month GOFO rate) and the spot price. I take a more longer-term strategic view and looking at the chart there is no clear relationship or correlation that I can work with. For example, in 2002-2003 GOFO was low and the gold price rising. But 2004-2006 GOFO was rising but the price also went up. I don’t see any tradable signals one can rely on.



Brian has also developed what he calls the Kanundrum Model of Markets, which explains the way people and markets behave. Below is a summary of his key “stages”:

Discovery – Stage 1

Stage 1 of any emerging trend is first characterized by a change in direction. It is usually preceded by a surge in volume as the asset makes a new low. This is the stage where major investors are establishing new positions.

Disbelief/Confusion – Stage 2

Price retreats after the initial surge and often the retreat is significant. Investors who did not buy when they heard that Stage 1 investors were buying believe that this is the time the Stage 1 investors are going to be wrong.

Belief and Proof – Stage 3

In this stage the asset makes its largest price move. It is by far the most important part of the trend for an investor to be a part of. Volume is huge and price moves are beyond what anyone expects. This part of the trend usually lasts much longer than anyone expects. This is also where almost every type of investor has a reason to be involved in the trade.

Complacency – Stage 4

Price begins to retreat from the unbelievable prices achieved during Stage 3. However few participants are concerned. Market participants are accustomed to the asset price and many investors use the pullback to add to or establish new positions.

Mom and Pop – Stage 5

The price begins to move back up and individual investors invest. The price moves may be less than during Stage 3 primarily because individuals do not have the buying power that larger professional investors have. As well, Stage 1 and Stage 3 investors are taking profits.

In this blog post dated 13 October, Brian believes that gold is currently in Stage 2: Disbelief/Confusion. Now I’m not so sure about his model and the stages one has to choose from but it is an interesting and fun way to view the market. Using his model, I would suggest we are in the middle of Stage 4 (see chart below). What stage do you think we are at?

Bank Runs

I find the recent Australian Government guarantee of banking deposits (and the Treasury briefing of the leader of the opposition) very interesting. Briefing opposition leaders does not occur very often and I would assume was done because they wanted the opposition leader to know that the problem was serious and not to be used for political point scoring. The problem, then, must have been the real chance of a bank run developing.

Speaking to the Perth Mint's Depository and Shop staff about the reasons why people were buying gold and silver and how they were doing it leads me to believe that Australian banks were seeing the beginnings of a bank run developing. Stories of people not wanting to wait for cheques to clear and going to the bank to withdraw cash so they can get immediate delivery of metal may be reflective of wider cash withdrawals from Australian banks.

This report on ninemsn.com.au certainly would scare your average central banker: "according to Officeworks, the retailer has noticed a 'significant' increase in the sale of personal safes in recent times ... a number of people who feel nervous and consequently are pulling their money out" (see also this report from The Times)

I doubt the cash withdrawals would have posed a significant risk at this time, but I suspect that the banks were seeing abnormally high cash withdrawals and/or a trend developing and wanted the Government to stop it. It is interesting that this was necessary considering that "depositors in authorised deposit‑taking institutions (ADIs) already receive preference in any liquidation" (2 June 2008 press release by Treasurer).

Maturity Crisis in Gold

Excellent blog at Unqualified Reservations about the lease rate.

It should be noted that the primary driver of lease rates has been miner hedging. Have a look at the chart at this blog and then compare to chart of lease rates.

You will see that as miner hedging increased from 1994, lease rates moved from average 0.75% during early 90s to 1.5% during mid 90s to early 00s. They then drop to historically low levels when miners started to de-hedge, all wanting to meet investor calls for full exposure to the gold price.

Doubtful this time miners will be hedging again so this lease spike totally dependent on when central banks regain confidence in bullion banks. Funny how they are prepared to throw fiat money around to any bank that needs it, but not so keen to do the same with gold.

James Turk says there is no shortage ...

... of wholesale precious metals, that is. In this GATA dispatch, James Turk says "So far the London and Zurich markets continue to operate without problems, but I sense some strains are developing" and "we are giving retail investors the opportunity to buy alongside big institutional firms operating in these markets and to gain the advantages of these markets -- deep liquidity and transparent pricing"

This is what I have been trying to say all along - physical metal in the wholesale markets is not in shortage, it is the conversion of that metal into retail coins and bars that is causing a shortage of retail product, pushing up their prices.

He goes on to note that his clients "are purchasing metal based on the spot price in London and Zurich for both gold and silver. Thus they are able to buy metal without the huge premiums now being charged on eBay, for example, for fabricated product like coins and small bars"

The unfortunate thing for precious metals is that because people don't trust Mr Turk's system or ones like it, they are "wasting", in a way, their purchasing power on premiums instead of on the metal itself. If the spot price for bulk silver is $10 p/oz but is $14 p/oz for retail silver, then those who spend their $14 on a GoldMoney type system create demand for 1.4 oz whereas those buying retail forms only create demand for 1.0 oz.

Could it be that the reason the silver price (or gold) is not as high as some would like is because all this demand to spend fiat dollars is not being fully channelled into silver but partly spent on premiums instead?

I am a strong advocate of holding physical metal, but once you have a reasonable stash if you want to make an impact on the price maybe continuing to pay incredible premiums may not be the way to go. Of course it does come down to trust in these systems, so I understand why people may not want to buy stored metal. However I can't help but think that a lot of dollar buying power is ending up as profit in the hands of coin dealers instead of into silver and gold itself.