An Inquiring Look At The Gold Market

December 7, 1998 – It would be very easy here to let one’s emotions get the upper hand and to paint a bearish picture for Gold. However, it would not only be the wrong thing to do, it would be painting the wrong picture about Gold and its prospects.

Gold looks like and feels like a market that wants to go higher. Consequently, it should not be surprising that I was very disappointed when Gold failed in its latest attempt to break through $296, despite its tenacious effort to climb above that key hurdle. Nevertheless, there should be no surprises that Gold failed in this attempt, given the technical condition of the Gold market at the moment.

I have been repeating in each letter since October that I expected Gold would trade within “a $290 to $296 trading range, trying to rebuild support for another advance to probe over-head resistance above $302.” That trading range has developed. Therefore, an unemotional reading of the market at the moment is that this process of base building continues.

This conclusion is not bad news, regardless how disappointed we may be that Gold failed to break through $296 in this latest attempt. In short, it’s not that Gold won’t move higher; rather, it’s just that Gold is not quite yet ready to move higher.

As we all too well know, Gold has been in a bear market for nearly three years. This observation explains a lot about Gold’s action. In contrast to bull markets, which end when distribution gains the upper hand over buying (and I’m talking about stocks, commodities, etc., or in other words, all markets, not just Gold), bear markets end when accumulation wins out over distressed selling. This selling is a hallmark of bear markets.

We have been seeing plenty of distressed selling of late, particularly in the Gold mining stocks. But regardless of this selling, I continue to expect that bullion and the mining stocks (as measured by the main indices like the XAU) made their bear market low in the selling climax at the end of August. Since then, Gold bullion and the mining stocks have edged higher.

As an aside, there are some mining stocks that continue to plummet, with prices making record lows. Generally speaking, these stocks are to be avoided because those mining stocks that so far have demonstrated the better relative strength are likely to be the leaders (and market out-performers) in the next leg up, when it finally arrives.

There are exceptions to this rule about relative strength though because some mining stocks with poor relative strength are being hit principally by tax-loss selling, and not by any important nor materially adverse change to their underlying fundamental position. However, these several exceptions do not negate the importance in this point of time to buy those stocks with good relative strength.

What we have been seeing over the past several months I believe is a classic example of a major bear market bottom, where the so-called “smart money” is accumulating what its opposite, the so-called “dumb money” is selling. This transfer of wealth is what makes market bottoms (i.e., when value gets accumulated, and usually it is exceptional value, which is what Gold and the mining stocks are offering now) and market tops (i.e., when over-pricedgoods get distributed). These transfers of wealth are what makes “smart money” smart – and wealthy, I might add. And when it comes to Gold bullion, smart money has been buying what central bankers and hedge funds are selling.

Now that may sound like an arrogant statement, but central banker stupidity when it comes to Gold can be demonstrated by their past record. Central bankers led by the Federal Reserve in the 1960’s parted with over 300 million ounces of Gold at the bargain price (and never again seen price) of $35 per ounce. Failing to learn any lessons from that episode, central bankers did the same thing again in the 1970’s, dishoarding millions of ounces between $135 and $200 per ounce. It seems likely to me that their dishoarding here in the 1990’s will not stand the test of time anymore than these prior examples.

As for the hedge funds, some explanation is necessary to support my statement that they are on the “dumb money” side of the equation – well, on second thought, maybe not too much support is necessary in the aftermath of the Long Term Capital Market collapse, the biggest and supposedly “smartest” hedge fund of them all. In any case, as I see it when it comes to Gold bullion, the hedge funds are confusing apples (Gold) with oranges (national currencies).

The hedge funds that have been selling/shorting Gold have confused one very important point. In contrast to the national currencies the hedge funds also short, Gold sometimes has to be delivered. National currencies can be delivered against a short sale by a bookkeeping entry, i.e., more of the national currency can always be created out-of-thin-air to cover the short (and we have now all learned from the LTCM experience that if the hedge fund is big enough, central banks will be sure to create sufficient currency out-of-thin-air to make sure all the shorts are covered). However, Gold cannot be created in this way.

Sometimes commodity markets experience a short squeeze. In that environment, sometimes the commodity itself, and not just the promise to pay the commodity, is required to fulfill the obligation of the short seller.

For example, in a Gold squeeze, there are more obligations to deliver Gold than there is Gold available, at current prices. Higher prices are required to induce those who hold Gold to part with it, in exchange for some national currency. Some current Comex statistics can put this analysis into perspective.

The open interest on the Comex is about 148,000 contracts, which means longs are willing to accept potentially 14,800,000 ounces of Gold, and shorts potentially may be forced to deliver 14,800,000 ounces. It never works out the way, though, because most longs and shorts close out their futures contracts well before maturity date, the point at which “making” or “taking” delivery is required. At the moment, Comex has only 825,000 ounces of Gold in its warehouse. What if enough longs hold out for delivery absorbing all the available Gold in the warehouse and then some, forcing the shorts to buy in the market?

There is not a lot of Gold available at these prices. Contrary to what you may hear, at these prices Gold is in tight supply. Any squeeze would send the price considerably higher, which brings me to one very important point.

I have written before about Alan Greenspan’s July 24th testimony before Congress. He said “…central banks stand ready to lease [i.e., lend] gold in increasing quantities should the price rise”. Can central banks prevent a squeeze in Gold?

There have been differing interpretations of Greenspan’s testimony before Congress. Some people say that he was letting the market know that central bankers are putting a ‘fix’ on the Gold price. I agree with this interpretation. Others, however, argue that Greenspan was talking only in a theoretical way to answer a question about commodity squeezes.

Let’s assume for the moment that my interpretation is right. The recent action of the Gold market, and its inability to climb above $296, at least so far, adds credence to this point of view. In short, there was a lot of selling each time Gold poked its head through $296, and each time the selling swamped the buying. Was it central bank selling?

Further, every time Gold poked its head through $296, there was an increase in liquidity. In other words, someone (namely, one or more central banks) was lending Gold in seemingly whatever weight the market was willing to absorb, knowing that this Gold would be sold, thus helping to keep the price below $296. But for how much longer?

I don’t want to underestimate the power of central banks, but nor should we overestimate it either. As big a force as the central banks are, we all know from their often ineffectual involvement in the foreign exchange markets that the market is much bigger than all of the central banks put together. This same logic also applies to the Gold market. The central banks may have their way with Gold for awhile, but sooner or later the market will win out. It is basic economics 101, namely, supply vs. demand, and in contrast to national currencies, the supply of Gold cannot be created out of thin air.

Though in bear markets it is understandable to focus on the selling, it must be remembered that for every seller there has been a buyer. And that buying I believe has been undertaken by the “smart money” looking for value.

Right now, the central banks have a tiger by the tail. The Gold market may look dormant, but in reality, the volume of trading going on within such a narrow price range indicates that the opposing forces are rapidly building. Further, with so many occasional traders and Gold buyers on the sidelines, as measured by the drop in Comex open interest, plenty of latent buying is waiting in the wings.

We are, I expect, witnessing the calm before the storm. When the Gold price finally breaks out of this narrow trading range, we may get a moon-shot, as (1) the shorts run for cover in a mammoth short squeeze, (2) new longs enter to ride the new uptrend, and (3) when the central banks eventually realize that they have lost their ability to keep a lid on the Gold price, they step out of the market to let the price seek its own natural course to some much higher level. How much higher?

Long-time readers of these letters know that since the end of 1994 I have felt $500 to be a reasonable price for Gold. Noted Gold-watcher Frank Veneroso believes $600 is required to clear the market, namely, to bring supply and demand back into balance. I continue to think these prices represent reasonable upside targets, and that sooner or later – and probably sooner than most people think – Gold will get there.