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Confusion will be this Market's Epitaph

By Brent Cook      Printer Friendly Version Bookmark and Share
Sep 14 2009 2:48PM

Sept. 9 (Bloomberg) -- Gold prices that jumped above $1,000 an ounce this week are signaling that investors are buying metals to hedge against declines in currencies, former Federal Reserve Chairman Allan Greenspan said. The gains are “strictly a monetary phenomenon,� Greenspan pointed out at an investment conference in New York. Rising prices of precious metals and other commodities are “an indication of a very early stage of an endeavor to move away from paper currencies�.

You may recall that the “Maestro’s� intimate understanding of money and markets stems from his 18-year reign at the Federal Reserve.  During this time he managed to move the US (and by default the world) from one asset bubble to the next -- none of which he saw, understood or predicted.  His keen insights, which garnered him front cover of Time Magazine, also included statements like this to the Senate Banking Committee in 2003: “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so�.  As history now shows, it was in fact the taxpayer he had in mind as the ultimate fall guy.  But not to worry, for sure he knows why gold is headed higher this time.

So does Barrick Gold.

Mega-gold miner Barrick is closing out its hedge book because, as CEO Aaron Regent puts it, “they want to be fully exposed to the price of gold as they now see monetary and fiscal reflation for years to come.� Barrick’s decision means they will recognize a $5.6 billion loss on a previous bet that the gold price was not going to increase. So in conjunction with closing out their hedge position Barrick announced a financing of ~$3.0 billion.  Anxious investors (at least the funds that didn’t blow up last year) immediately offered up another half billion in this bought deal financing because they apparently agreed with Mr. Regent’s assessment that the hedge book “obscured Barrick’s many positive developments.�

Certainly if anyone knows the gold market and where it’s going it should be Barrick.  They have been producing gold for decades and hire the best financial wizards available to steer them through these complex financial issues.  Mind you, these are some of the same wiz-kids that made a $5.6 billion mistake by putting those hedges on back when gold was trading in the low $300s, or less. This time, however, they definitely got it figured out and beyond any doubt gold is headed higher.

VM Group analyst Matthew Turner thinks this recent move by gold through $1,000 is actually due to Barrick closing out their hedges.  He postulates that dehedging has driven gold prices higher and that as the amount of gold hedged shrinks the support to prices from dehedging will begin to wane.  Paraphrasing a Dow Jones Newswire article, “Barrick had 5.4 million ounces of fixed-priced contracts at the end of June.  On Tuesday the company said it has only 3.0 million ounces remaining as of Sept. 7. Therefore, it had already dehedged 2.4 million ounces between July 1 and Sept. 7�, said Mr. Turner. The dehedging is equivalent to a sixth of global mine production over that period, meaning it is the smoking gun that explains the recent gold price move.  Turner and UBS analyst John Reade reason that dehedging is ultimately a negative for the gold price because as it slows down, the bottom falls out of the market and prices will drop.

Maybe these experienced analysts know of what they speak but there are also some holes to this thesis.  Barrick’s purchase of 2.4 million ounces over the two-month period is only about 5% of the gold cleared through the London Bullion Market during that time. According to Paul van Eeden, who has looked at the LBMA transfers in some detail, the LBMA clearing statistics are net statistics. That means it is only the net transfer between LBMA clearing members and not the total amount of gold traded. The actual amount of gold traded could be four to six times larger than the net clearing amount. In that case, Barrick’s purchases would represent only about 1% of the physical gold traded during July and August.

Gold purchases by exchange-traded funds (ETF’s) also far exceed the relatively minor purchases by Barrick.  According to the World Gold Council, Q-1, 2009 saw over 16 million ounces purchased by gold ETF’s. That would mean ETFs represented approximately 25% of the net gold transferred by the LBMA in the first quarter and perhaps 5%, or so, of the total amount of gold traded.

There is no doubt that dehedging and ETF purchases increase gold demand, and therefore put upward pressure on the gold price. But could either of them be responsible for the run-up in the gold price to over $1,000 an ounce? Was it the combination of the two? Between them they still only account for perhaps 6% of gold demand.

If it wasn’t Barrick, or the ETFs, it must have been the Chinese — it always is.

In an interview with the London Telegraph, Mr. Cheng, former vice chairman of China's Communist Party Standing Committee, said China has lost confidence in the dollar (nothing new there), and it is buying massive gold reserves to protect itself... "Gold is definitely an alternative, but when we buy, the price goes up," Cheng, now a global economic ambassador for China, says. "We have to do it carefully so as not stimulate the market." So as a policy, China will buy gold on dips, creating a strong floor for the metal. China's buying -- the country has doubled its reserves to 1,054 metric tons -- also explains why gold has held strong despite a soaring stock market according to this Telegraph article.

It’s also worth mentioning that Hong Kong is pulling all its physical gold holdings from depositories in London and transferring them to a newly built high-security depository at the city's airport.  The facility, industry professionals said, would support Hong Kong's emergence as a Swiss-style trading hub for bullion and would lessen London's status as a key settlement-and-storage center.  If, and I am not suggesting this is the case, London had to purchase physical gold to cover their obligations it could also have been a factor in gold’s move over $1,000.  We don't know and have no way of finding out.

So what could go wrong in this gold bull market?

According to some observers the global recovery as well as the price appreciation in base and precious metals is dependent on China and its miracle economy.  Their economy has been remarkable indeed, hardly noticing the global financial crisis as little more than a speed bump.  GDP growth during the second quarter of 2009 was 7.9% -- not bad for a country that historically derives nearly 40% of their GDP from exports to countries that are now mired in a recession.  Exports to these less fortunate countries are down around 25% meaning that, aside from China’s 7.9% overall growth rate, internal consumption had to increase by more than 10% in six months just to make up for the slack in exports. Wow, that’s a lotta toasters and t-shirts!

They have managed this rather incredible feat by way of a massive stimulus package representing ~24% of GDP.  On top of that the central government has mandated banks to lend.  Chinese banks grew their loan books by 7.4 trillion RMB in the first half of 2009. According to Frank Veneroso, “There has never been an episode like what has just happened in China.  The increase in the debt ratio has been so huge as to accomplish in a mere six months half of the entire internal national balance sheet deterioration that took a whole decade to do in Japan and the United States: both of which ended in crisis.�

Did someone say crisis?

Premier Wen Jiabao doesn't think so.  In a speech at the Annual Meeting of Champions in Davos he said, “With the world economy still mired in recession, it is by no means easy for us to have come this far. The achievements we have made are not something that dropped into our lap. Rather, they are the results of the proactive fiscal policy and moderately easy monetary policy and the stimulus package that the Chinese government and people have pursued in line with the national conditions.�  Essentially the Premier is saying that the Chinese Communist Party has successfully steered China and the US through the financial crisis.

I personally find it “interesting� that much of the same crowd that raucously derides the west for its shift toward socialism and a government managed economy can in the next breath praise the Chinese Communists’ skillful management of their economy. So much so that said Chinese government intervention in an economy representing ~7% of global GDP is capable of pulling the rest of the world out of its dept crisis. And better yet, they are doing it with debt and massive monetary inflation — sound familiar? 

China is a centrally planned economy and the key tenet of a planned economy has always been making sure the numbers reported meet the plan.  Although going through China’s statistics, how they are calculated and what they really mean is beyond the scope of this commentary, suffice to say that they may not be what they seem. For instance when the central government disburses money to state enterprises this counts as GDP regardless of what happens to the money.  Likewise, shipments to retailers count as GDP regardless of whether it sits in inventory, never gets sold or is given away.  In short, China measures their economy differently than we do so we really don’t know what to make of the data or how to check the information the Communist Party is putting out. What we do know is that the massive monetary growth and rapidly increasing debt offers the real potential for an enormous destruction of capital.  If the central planners can’t contain things any better than we did there could be real trouble.

And the evidence is mounting.

There is ample evidence that China’s massive monetary stimulus efforts are producing asset bubbles within and outside China, much the same as Greenspan’s policies did over the preceding decades.  According to Mr. Cheng, “credit in China is too loose.  We have a bubble in the housing market and stocks so we have to be very careful because it could fall down.�  He said that China had learned from the West that it was a mistake for central banks to target retail price inflation and take their eye off assets.  “This is where Greenspan went wrong and thought everything was alright because inflation was low, but assets absorbed the liquidity�.

(One-year Shanghai Composite index)

Is China’s mandated bank lending responsible for the dramatic rise in the Asian markets and metal prices? Does it make sense that the copper price has more than doubled in the face of falling end demand and rising inventories? The US debt problem was only the result of greed. What happens when a government forces that money out the door to a population that for the most part has no credit history and less transparency?

China’s growth was predicated on lending money to the USA, which in turn used that money to buy Chinese goods. That trade is over and China has no choice but to push money out the door in the hopes that the bubbles it creates can float it over an economic chasm filled with social unrest. If China pops then fear will re-enter the market big time and money will quickly seek safety. 

That puts the US dollar right in the impact zone.

(Uh-oh, we got US a problem)

The big question for the gold market then becomes: Does the US dollar perform its historic role as a safe haven, or is it different this time?  If the US dollar once again becomes the recipient of fear-driven investment then the dollar’s exchange rate could again soar like it did in 2008, and that means the gold price could very likely take a dive, since it’s quoted in US dollars.

Last year the US was the epicenter and root of the financial crisis yet money flowed into the US dollar and it rallied relative to gold.  If China’s centrally planned economy is unable to contain the madness of markets and execute a smooth economic takeoff then what happens?

Cheap money, greed and government policy are responsible for the financial crisis that shook the West to its core.  Has China somehow discovered the magic balance between fear and greed; easy and tight money; inflation and deflation; and Keynesian versus Austrian economic policy?  If you think so you are bestowing a fair amount of faith on the Chinese Communist Party. If they get it wrong and the Chinese economic miracle blows up, which way does money flow for safety?  The US dollar, or gold?

Fortunately, or unfortunately, you get to make the call. The information age has put googols of data at our fingertips and virtually overloaded our capacity to screen and process said information. There are experts on all sides of any issue with sufficient supporting facts, figures and charts to leave anyone quite dazed and confused.

Is the US economy on the mend or headed over a cliff?  Uh… yes.

Is it speculation or end use that is responsible for the rise in metal prices?  No; I mean yes.

Is China going to implode or lead the global economy out of its mess?  Of course!

Is gold on the verge of a major breakout or about to roll over?  Definitely; unless it’s range-bound.

The big unknown is what the next bit of data will be and how it will relate to all the other bits of data and paradigms. However, the next data point is more often than not massaged to fit into the prevailing paradigms and charts of the various gurus. The data can be bent and selected almost any way someone wants in this Cargo Cult Science culture the modern world has become (as discussed in the August 30 Exploration Insights letter).

There is no sure way of knowing what the future holds or how the mass psychology of markets will deal with new information and events. When successful experts in the field such as Warren Buffett, George Soros, Alan Greenspan and Ben Bernanke can get things so wrong, I suspect the rest of us have to humbly admit we could too.

Nobody knows for sure and I fear Confusion will be this market’s Epitaph!

If, however, I am willing to accept that confusion reigns then other things become clearer.

Like focusing on subjects I understand, and on which I can form reasonable expectations for the future is a more productive use of time than pondering the unknowable.  Ultimately what really matters, and what the bottom line on making money in the junior gold market is all about, is stocks and rocks. Is the geologic setting right for the discovery of an economic deposit or are there fatal flaws? Does the exploration company understand the mineral system or are they basing their interpretation on hope and desperation?  These are issues an educated and diligent speculator can potentially evaluate.

There is no doubt that the major and mid-tier gold mining companies need new gold resources -- regardless of the gold price. That is a fact. Making money then only involves positioning yourself in the way of a gold discovery. That is much, much easier than figuring out how China, the US and the rest of the world will respond to events that we realistically cannot predict in an economic climate that changes daily. If your objective is to make money then what happens in China is little more than an interesting distraction between hockey and football games. You only have to know where the puck or football are going in your small game and situate yourself accordingly. 

That’s the way I see it

Brent Cook
September 14, 2009



Brent Cook is an independent exploration analyst and advisor. He currently serves on the Advisory Board of several junior exploration companies and acts as a consultant to several institutional investors. Brent Cook produces the weekly investment newsletter Exploration Insights. For more information on Brent’s letter please visit

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