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Dear Mr. Northwest:
Thank you for asking the provocative
question whether the current bull market in gold is stage-produced by the
powers-that-be in order to divert attention from the deliberate devaluation
of all currencies. Your letter has given me an opportunity to sort out my own
thoughts on the subject. Here is the result.
Supply and demand
My analysis of the gold and
silver market is very different from the conventional. I am a monetary
scientist. Supply and demand equilibrium analysis means nothing to me. For a
monetary metal both supply and demand are undefinable.
There is no way to quantify speculative supply, still less demand. Yet
without it the gold market is like Hamlet without the prince, to
borrow a phrase from Samuelson.
Speculators
can jump back and forth between the long and the short side of the market at
a moment’s notice, and in case of monetary disturbances they do. If you
insist on using these concepts, the most you can say is that both the supply
of and the demand for the monetary metal or its paper substitutes are infinite.
Therefore the price can approach any conceivable figure, including infinity
for the metal, zero for the paper substitutes. Of course, the banks and the
government want to maintain the myth that futures markets provide a reliable
link between the two. The fact remains, however, that this link is tenuous
and illusory.
It
follows that any scientific analysis of the gold market must sidestep
concepts such as supply, demand, equilibrium price and replace
them with concepts such as asked price, bid price, spread, basis, contango, backwardation.
Corner and short squeeze
The literature on corners
is scanty. Yet it is the possibility of corners and short squeezes that must
be analyzed if we want to understand the present situation. The facts are as
follows. While short squeezes are common, true corners are exceedingly rare.
So much so that some authors flatly deny that successful corners are possible
save under siege or blockade. By a corner I mean the attempt of longs in a
commodity exchange to prevent the shorts from making good on their
contractual obligations by forestalling supply. However, the shorts are going
to move heaven and earth to get supplies to the market in time for delivery.
The higher the longs have bid the price, the greater the incentive for the
shorts to deliver. If we examine the historical corners in the Chicago wheat pit we
shall see that every one of them was a short squeeze that fell short of being
a successful corner. The shorts used every available means of conveyance from
dinghies to triremes, from barrows to lorries to move supplies from distant
places to the appointed elevators in time.
Contrary
to popular beliefs, the shorts are not stupid. Nor are they suicidal. They
are responsible businessmen well able to calculate, including calculation of
the cost of transportation by the fastest conveyances
available such as supersonic aircraft if need be to carry supplies half-way
around the globe. Whenever they sell short, they are not acting on impulse.
They act on cold facts. They know full well that the futures markets fail to
be symmetric. They know that there is a built-in bias favoring
the longs at the expense of the bears: the risk shouldered by the former is limited
(as the price cannot fall below zero) while that shouldered by the latter is unlimited
(as the price can theoretically go to infinity). Whereas an individual short
seller might miscalculate, it is virtually impossible that the shorts
collectively would.
Are the shorts really
naked?
It is a fatal mistake to
underestimate your opponents, in this case the short sellers in precious
metals, arguably the smartest lot on earth. They know how to do what
Aristotle and latter-day economists have said was impossible: to make gold
beget gold. I don’t for a moment give credence
to the fable that the commercials are selling short naked. Most of their
short position is hedged most of the time, if not directly by metal in their
possession, then certainly indirectly by metal in
the possession of the principals, i.e., for whom they act as a man of straw.
The commercials are agents. They act on behalf of their customers, be they
wealthy individuals who want to sell call options or futures on their gold
hoard anonymously, or banks and governments that do not want you to find out
what they are up to. The fact is that selling covered calls and puts is a
more efficient way for a bull to husband his resources than buying gold and
sitting on it.
Consider
the hypothetical scenario that the government of Israel
wants unobtrusively accumulate gold. Or, to furnish an example of a
more populous country, let’s assume that the government of China wants
unobtrusively to accumulate silver in any conceivable amounts. The task is
cut out for both countries. They have respectable hoards to begin with. Gold
is the most portable form of wealth and the most frequently mentioned word in
the Bible after God. China
has been on a silver standard since time immemorial and did not participate
in the silver-demonetization farce of the 19th century. The best
course of action for a government wanting to accumulate gold or silver is to
mislead the market by fomenting the bearish case. The net short position in
gold represents its stake that it is willing to risk in an effort to get more
gold and silver through market manipulation. In other words, the net short
position is only apparent, a red herring to throw gold bugs off the scent. It
is the tip of the iceberg that you can see and touch. What you don’t
see and can’t touch is the bulk of the iceberg submerged: the huge physical
gold and silver hoards that the owner wants to increase further by hook or
crook. It can be done by hiring agents in the commodity pits. The commercials
sell the metals short in excess of visible supplies, acting on behalf of
their faceless principals. They sell more gold than the future output of the
mines going out five years. They sell more silver than the total inventory
held in exchange warehouses. The longs take the bait eagerly. They buy and
hold in the hope that the shorts are overextended and will not be able to
deliver. The point is that this is exactly what the shorts want them to
believe.
It
is easy to predict what will happen in such a situation. The longs are
sitting ducks and the shorts keep preying on them. They raid them periodically
so that, after the shake-out, they can pick up gold and silver dropped by
weak hands. Not only do they buy back what they have sold short as bait; they
pick up a lot more. It is a wolf in sheep’s skin or, if you like, a
bull in bear’s skin. The name of the game is to mislead the public and
induce it to give up monetary metals for a pottage of lentils. I am not
putting this forth as a thesis. It can never be proved or disproved. It is
merely a hypothesis more plausible than the one suggesting that the shorts
are as stupid as they are suicidal.
Ted
Butler believes that mountains of surplus silver, remnants of silver
demonetization six score years and fifteen ago, that were still around in
1945, have long since been dissipated and “consumed”. Of course, the
shorts welcome such beliefs and help foster them by all means. Aided by this
myth they accumulate still more silver by fleecing the naive and
overconfident longs who are cocksure that they are facing naked shorts in the
pit. Meanwhile the watchdog agencies know that physical silver exists and can
be delivered if necessary. One should not be so sardonic as to think that he
was the only one to discover that silver was dirt cheap at $3. The
“wolf pack” has also discovered it and started accumulating,
albeit very, very quietly. Theirs is quite different from Butler’s “buy and sit”
strategy. They are not waiting for the miracle of silver in four digits to
happen. They do something in order to start drawing benefits from their
investment immediately. From their vantage point the longer the price rise is
stretched out, the better. Why? Because they know something that Butler apparently
doesn’t: how to make silver yield an income provided that you can hide
it under a bushel.
There
is no need to cry “foul play”. It will do nicely if you credit
the shorts with more wits than you assign to the longs.
Short covering and profit
taking
Granted that the shorts are
bluffing to tease, taunt, and bait the bulls, it is clear that at one point
short selling must become counter-productive. Large bait tickles small fish.
When it does, the shorts pull in their nets. They cover. But the fact stands
out that it is they, the shorts who call the shots even though their paper
losses appear to be staggering, not the longs. Unknown to the public, these
losses are far surpassed by gains on physical gold that
the shorts have been amassing clandestinely at the expense of the longs for
half a century. When the shorts pull the plug and cover their position, the
longs are jubilant amidst cries of “cornered rats”.
Yet all the longs can show for their effort is paper gold, while the shorts
control an increasing slice of physical pie. The price of paper gold is
destined to go to zero; that of physical to infinity. Who is fooling whom?
The
shorts realize that in any bull market there is bound to be periodic
profit-taking. They don’t have to induce one. It will happen on its own
accord. It is spontaneous and unpredictable. While it scares the daylight out
of the longs; it is picnic for the shorts. It provides a reliable steady
income for them, one that the longs sorely miss. Moreover, the shorts tend to
sell into strength and buy into weakness. This is their strength. The longs
typically buy into strength and sell into weakness. This is their weakness.
Backwardation and basis
Instead of the COT reports Butler should
concentrate on such direct indicators as backwardation and basis.
Backwardation is the market phenomenon whereby nearby futures are selling at
a premium over the more distant. The normal condition for monetary metals is
the opposite, contango, indicating that supply is
plentiful. Backwardation in monetary metals is a foolproof indicator that
supplies are getting tight. Basis is the name for the spread between the
nearby futures price and the spot price. Its shrinking reveals that short
selling is becoming counter-productive so that the shorts may be getting
ready to cover. Conversely, the widening of the basis tells you that
shortages may soon end the shorts are likely to start selling once more. Butler will write a
hundred pages about the COT reports while writing half a sentence about
backwardation. As far as I can tell, he has never written even a quarter of a
sentence about the basis, in spite of a challenge I issued to him privately
two years ago. Perhaps he has never got around to take
a refresher course, so busy he was poring over reams of COT reports. Be that
as it may, the basis is a most sensitive market indicator. When negative, it
is a red-hot alarm indicating that offers to sell gold are drying up fast,
and may be withdrawn at any time. Please don’t take me wrong. I am not
against studying COT reports. All information is useful if you know how to
interpret it intelligently. But it is not a very intelligent construction to
put on the COT reports to assume that the bulk of the short position of the
big commercials is naked.
Having
said this, I must credit Butler
for advocating the ownership of metal fully paid for as against futures
positions or ownership of unallocated metal in public warehouses. He also
admits the possibility that the “wolf-pack” may engineer another
sell-off even after having suffered horrendous paper losses during the latest
run-up of the price.
Can depression be averted?
Where does all this leave us?
The short-covering and profit-taking charade will continue, possibly for
several years to come. There will be no disorderly cut-and-run by the shorts
and no meteoric rise in the price. Spectacular rises, yes. But they will be
followed by equally spectacular and sometimes protracted corrections testing
the stamina, staying power, and intestinal fortitude of the longs. Volatility
will increase faster than the moving averages. Exchange rules may be changed
unilaterally favoring the shorts, prejudicial to the
longs.
Obituaries
of the dollar are a bit premature. We cannot rule out the possibility that
policy-makers favor a controlled devaluation of the
dollar in terms of gold. By now they must realize that bilateral devaluations
against selected currencies will never work. They would provoke trade wars
and competitive currency devaluations. By contrast, a 1979-80 style
devaluation of all currencies against gold should be acceptable to all
governments, even though the outcome would be the same. The dollar would be
devalued against other currencies at various rates, higher for the yen, less
for the euro, and least for the renminbi. The
trading partners of the U.S.
would tolerate that without retaliating with discriminating tariffs and
quotas.
You
see, my position is close to your own. Yes, as you say, there is an iceberg
of gold and silver which is unseen that never enters the market. Yes, the
watchdog agencies know this (as well as the identity of the principals of the
short sellers who fool the market in posing and parading naked while in full armor, in a reversal of Andersen’s amusing tale)
but they are sworn to secrecy. And yes, it is not impossible that this bull
market in gold is stage-produced in order to devalue all currencies
deliberately without the policy-makers making a scape-goat
of themselves. The purpose of the exercise? Why, it
is to get rid of the debt-incubus short of deflation, defaults, and
depression. Come to think of it, a measured devaluation of all currencies
against gold is the only hope to avoid an enormously destructive and
protracted depression of the world economy that would be triggered by the
sudden toppling of the Debt Tower of Babel. A planned melt-down,
well-entombed inside of a golden sarcophagus, is the preferred way to go.
What
if I am wrong and
policy-makers are getting more band-aid out of the medicine
cabinet to patch up the disintegrating international monetary system? In that
case may God help us survive the coming Armageddon.
Yours, etc.
A.
E. F.
May 4, 2006.
_________________________________________________________
Antal E. Fekete is Professor Emeritus
at Memorial University
in St. Johns, Newfoundland. Born and educated in Hungary, he emigrated to Canada after the Hungarian
Revolution in 1956 and taught for 35 years in the field of mathematics. Over
the years, he has been a visiting professor or Fellow at Columbia University,
Princeton University,
and Trinity College
of Dublin. He
worked in the Washington office of Congressman W.E. Dannemeyer
on monetary and fiscal reform for five years in the nineties; and in 1996, he
won first prize in the prestigious International Currency Essay contest
sponsored by Bank Lips Ltd. of Switzerland. He is the author of Gold and
Interest and Monetary Economics 101. In addition, his scholarly articles have appeared on
numerous Internet sites throughout America.
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