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Fundamental Flaws

By Jon Nadler       Printer Friendly Version Bookmark and Share
May 20 2009 4:27PM

Good Afternoon,

Wednesday's market action took gold prices to a two-month high of just above $941 per once. Why, today, there was nary a sinister gold price suppressor in sight. It was all a one-way buying spree. The main gold price driver of the day was (once again? for a change?) the US dollar, which fell an entire point on the index, reaching to near 81.00. A $2 rise in crude oil to six-month highs above $62 per barrel helped matters for gold on the day, as well. Seems like old times, again.

Clearly, at least as far as the upside price point to pierce is concerned,  according to Mizuho Corporate Bank analyst Nicole Elliott, the $950 figure is the one to keep an eye on. “While we continue to favor an eventual break to new record highs, only when it holds clearly above $950 per ounce will bullish momentum kick in,? Ms. Elliott opined, without giving a timeframe. “This may be due to generalized U.S. dollar weakness, courtesy of U.S. government largesse, rather than renewed appetite for precious metals.? She added that: "“gold bugs are currently two a penny -- always a worrying sign,?  referring to backers of the precious metal as an investment. “More so, when prices are going broadly nowhere and one adds in storage and opportunity costs."

Well, that 'generalized dollar weakness' was manifest today, although not for the reasons one would conventionally ascribe to it. Sure, there was some dollar selling in the wake of news items that revealed that at least some Fed officials felt that there was a need to augment the central bank's purchases of assets in order to get a US economic recovery into the post- 'green shoots' phase and into 'full bloom.' But, the bulk of the dollar selling came for other reasons. Namely, the growing certainty that this crisis, well, it's a cooked and browned one.

If you need more proof of dinner being ready than what the VIX index is doing of late, well, you will have to look really hard elsewhere. Fear is out. Right out. At least some types of fear. Hard money newsletter fodder such "bank nationalization and frozen credit markets on a stick" are now so...2008-ish. Here is what CNN Money finds in today's VIX-based dissection of current conditions:

"Investors are not nearly as afraid about the economy as they were a few months ago. How do we know this? There is a market barometer called the CBOE Volatility Index, or VIX for short, that people on Wall Street commonly look at as a gauge of fear. Technically, the VIX (VIX) doesn't really track fear. Instead, it measures market expectations of risk and turmoil.

But the general rule of thumb is that the higher the level of the VIX, the more panicky investors are. On Tuesday, the VIX closed below 30 for the first time in more than eight months. This is significant when you consider the reason why the VIX had been so elevated as of late: The VIX has not been this low since a little investment bank you may have heard of called Lehman Brothers went kablooey.

The VIX peaked near an all-time high of 90 in late October as investors fretted about the demise of Lehman, subsequent blowup of AIG and the possible nationalization of large banks like Citigroup  and Bank of America. As concerns about an imminent financial meltdown waned, the VIX began to decline. Still, as recently as early March, the VIX was hovering around 50, a level more reflective of dread and anxiety than hope and optimism. So the fact that the VIX is back near a pre-Lehman level is good news. Sure, it's still probably premature to sound the all-clear and declare that the nation's banks are once again healthy and that the economy is on the upswing.

But if nothing else, people are no longer assuming the worst about the economy. That shift in sentiment is encouraging. Even though the current level of enthusiasm might be a tad unwarranted, investors are compensating for the overdose in negativity from late last year. As long as the VIX doesn't get too low, then there is a good chance that this recent rally is actually the start of a new bull market and not merely a temporary blip in the bear market. "

And thus, the dollar fell. Risk appetite makes a comeback, the temporary safe-haven that the dollar offered loses some appeal. The dollar fell to its lowest level in nearly five months against the euro and a basket of currencies on Wednesday, as hopes that the worst of the global slump may be over, dented the greenback's safe-haven appeal - so says Reuters. So, we come to observe a $13 gain in bullion, which was last seen trading at $938 as the afternoon hours wore on. Silver gained 12 cents to end near $14.27 an ounce, while platinum and palladium kept adding to their recent rising spree on the back of spec fund money inflows. Platinum climbed $4 to $1143 but palladium showed no change at $232 per ounce. Wonder what next week's Bloomberg price survey might reveal as sentiment amongst its participants.

Bullish (?) newsflash: The World Gold Council, using GFMS-supplied figures, notes that Q1 net retail investment demand for gold was up 33% to 131 tonnes despite some dishoarding in eastern markets (India). Recently, GMFS also indicated that mine production on Q1 was equaled by scrap supplies - 500 tonnes each. Let's not talk about the gold ETFs which added to their previously just large gorilla proportions on the quarter, and have now turned themselves into King Kong. Do not irritate the beast, at any cost.

The largest investor in coin and bar on the quarter was Germany, where inflationary fears saw demand quadruple to 59 tonnes, while Swiss growth was even higher at 437%, taking it into second place at 39 tonnes. The US came in third, more than doubling to 27 tonnes as investors hedged against financial and economic risk. Countries such as Japan, Indonesia, and Thailand turned into net disinvetors during the period. Oh, if one could peer into the psyche of the average buyer and/or seller...For our money, Western buyers are typically about as far behind the curve as the Fed has been on inflation and/or deflation. Eastern buyers have had the edge...but we cannot put our finger on the origin of their sense of timing and value. It must be an intuitive thing.

Mineweb offers further details of the facts and figures unearthed by GFMS. Pay close attention. India keeps coming up in these discussions. Again.

"Investment demand for coins and bars in India turned to disinvestment as 17 tonnes were returned to the market.  In percentage (and tonnage) terms, the largest fall in jewellery demand came from India, which more than halved to just 35 tonnes - and the first quarter of 2008 had itself been relatively weak.  For at least twenty years India has been the world's largest jewellery consumer as gold has a religious significance as well as maintaining its role as an investment-come-risk-hedge, but in this past quarter demand for new gold dried up with consumers generally preferring to exchange or sell gold jewellery rather than making fresh purchases. 

The domestic economy has started to be affected by the global downturn, especially in terms of unemployment among expatriates; this has affected income levels and constrained discretionary purchases such as gold jewellery.  Furthermore, the Council argues, gold fulfilled its role as an investment as consumers "took profits" on existing jewellery holdings that had been purchased at lower prices.  As a result Indian demand in the first quarter of this year was just 10% of total, while China, where conditions were buoyant, increased its market share to 26%.  

Countries other than India that registered a substantial fall were concentrated in the Gulf, along with Turkey (-40%), Russia (-27%, a notable change in trend from a country whose jewellery demand had been growing rapidly) and the US, where demand for jewellery fell by 30%.  The US' fall stemmed from high unemployment. poor credit conditions and an elevated gold price, and the US jewellery sector continued to experience bankruptcies.  

Supply, meanwhile, increased by 34% against the first quarter of 2008, driven by a surge in scrap supply, which reached 558 tonnes, an increase of 55% or almost 200 tonnes.  Mine production was up by just 16 tonnes, but a sharp contraction in dehedging meant that mine supply effectively increased by 135 tonnes. 

With low central bank net sales, total supplies of gold in the quarter amounted to 1,144 tonnes, an increase of 292 tonnes against Q1 2008.  With demand up by 266 tonnes, the market was arguably slightly tighter in the first quarter of this year than it was in the first quarter of last.  Even so, there was an effective surplus of 115 tonnes in the quarter, that would have been mopped up by institutional investment, stock movements and other elements. 

The Council states that anecdotal reports suggest that jewellery demand picked up in the first few weeks in the second quarter as the gold price stabilised at levels slightly below the highs that prevailed in the first quarter.  The current "extraordinary" global circumstances imply that the prospects for a recovery in jewellery demand will remain doubtful and demand could well remain under pressure."

Whatever you do, do yourself a big favor and do not ignore the tremendous fall-off in jewelry demand and concurrent surge in scrap during the period in question. Nice and robust though the investment demand may be, it is no (and especially NOT permanent) substitute for global jewelry demand, which normally accounts for over half of total gold demand.  This portion of bullion offtake fell 83 per cent year-on-year (!) to 17.7 tonnes for first quarter of 2009.

We have said it before, we will say it again; the gold market remains in disarray. Its fundamentals are deeply flawed at this time. It has become totally dependent on one (cyclical and emotional) pillar. And if the VIX is telling you that fear is leaking out of the system, then at some point other safe-haven assets beyond the US dollar might lose a portion of the premium that such fear(s) bestowed upon them hitherto.

Until tomorrow,

Jon Nadler
Senior Analyst
Kitco Bullion Dealers Montreal



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