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There is a
strong probability that the correction in the price of gold has been
completed. This article has four separate sections. They are:
1. The Elliott
Wave (EW) justification for thinking that the correction in gold is over.
2. Why corrections
happen in gold from a fundamental viewpoint.
3. The extent to
which manipulation affects the gold price.
4. A possible
“black swan” event that could trigger a gold price surge.
Justification for the end of the gold
price correction:
In EW terms,
the correction consists of three waves, an A wave down, a B wave rally and a
final C wave decline. There is usually a relationship between the A and C
waves. Often they are equal or have a Fibonacci connection. The chart below
is of the gold price using PM fixings:
 
In this case,
the A and C waves are equal in percentage terms at 14.5% and 14.7%. The
overall decline from $1895 to $1531 is -$364 or -19.2%. My speech to the
Sydney Gold Symposium last November – link at http://www.symposium.net.au/files/4ec58abcb729a.pdf - showed
that the largest corrections in the previous Intermediate wave from $700 to
$1895 were about 12% in PM fixings. The forecast was that the current correction
from $1895 would be one degree of magnitude larger than 12%. A decline of
19.2% qualifies as one degree larger than 12%.
An
interesting observation is that if 12% is multiplied by the Fibonacci
relationship of 1.618, the result is 19.4%, very close to the actual 19.2%
decline for the correction. The chart below is of the gold price in Comex 2mth forward prices:
The Gold
Symposium speech suggested that the correction would be between 21% and 26%
in spot gold prices. The actual decline was from $1920 to $1523, a loss of
-$397, or -20.7%. This is just below the target range but qualifies as one
degree larger than the 14% corrections in the previous up move from $680 to
$1913.
The C wave of
the correction in the chart above reveals some symmetrical subdivisions which
confirm that the C wave was completed at $1523 on 29 December 2012. With all
the minor waves in place and with the correction being of the correct size,
that should be the end of both the correction and Intermediate Wave II.
The
probability of this analysis being correct is high, perhaps 75%? Smaller
probabilities allow for: (i) this to be an A wave
of a larger magnitude correction; (ii) the current correction becoming more
complex, perhaps reaching the lower price targets (e.g. -26%); and (iii) the
possibility of deflation, defaults and depression emerging, also testing
lower price targets.
The up move
just starting should thus be Intermediate Wave III of Major Wave THREE, the
longest and strongest portion of the bull market. The gain in Intermediate
Wave I from $680 to $1913 was 181%. The gain in Intermediate Wave III should
be larger, at least a 200% gain. A gain of this magnitude starting from $1523
targets a price over $4,500. The largest corrections on the way to this
target, of which there should be two, should be in the 12% to 14% range.
Why Gold is prone to numerous
corrections:
Gold is
unique amongst metals, partly because it is not consumed, but also because it
has some unusual qualities. It has no utility value. One cannot eat it or
drink it. It earns no income, does not corrode and does not tarnish. Other
qualities include divisibility (a quantity of gold can be divided into
smaller quantities) and it is fungible, (one ounce of gold can be substituted
for another ounce of gold of the same degree of fineness). There are large
stocks of gold available and new annual production has generally been less
than 2% of the stock of gold. These are the very qualities that caused gold
to be used as money over the millennia.
Other metals
and commodities are produced for consumption. When their stocks build up due
to supply exceeding demand, holders become forced sellers due to the cost of
storage or due to spoilage. Thus the price of the commodity drops to a level
where marginal producers go out of business until demand exceeds supply. Then
stock levels decline until they are exhausted and conditions of shortage
prevail. This results in sharply rising prices for that commodity, eventually
attracting new suppliers. In soft commodities, weather conditions can also
play havoc with stock levels, causing dramatic price changes.
The point is
that with all commodities other than gold, stock levels are important
determinants in the price of the commodity. Gold has been accumulated over
the years because it was money or as a hedge against a range of fiscal,
economic and political risks. The stock of gold relative to new annual gold
production has always been high.
In 1971, when
the $35 per ounce link between the US dollar and gold was severed, it was
assumed that all the gold produced throughout prior history was about
90,000t. This is a rubbery figure and should probably be a higher number. As
it is not important to this discussion, we will use 90,000t as a starting
point. Over the centuries some gold was lost or was no longer available to
the market. If we assume that about 15,000t was lost, it means that in 1971
about 75,000t of gold was available to the market. New production in 1971 was
1,450t, less than 2% of the available stock of gold.
One reliable
figure available in 1971 was that gold held by central banks and official
institutions was about 37,000t. By deduction, the remaining 38,000t of the
available stock must have been owned by investor/hoarders in the form of
bullion, coins or jewelry. New production of 1,450t in 1971 was meaningless
when compared to stocks of 75,000t. The future gold price was going to be
determined by what existing holders of gold did with their stocks and what
the level of demand would be from new buyers. For several reasons there was
considerable new buying of gold during the 1970’s, resulting in a
sharply rising gold price.
Fast
forwarding 40 years to our current situation, new mine production over this
past 40 year period may have been about 90,000t, of which perhaps 10,000t has
been lost or consumed by industry or in jewelry not suitable for reclamation.
That leaves 80,000t to be added to the 1971 estimated stock level of 75,000t,
giving a current total gold stock of 155,000t. Recent annual production has
been about 2,500t, which is still under 2% of the available stock.
Whereas the
gold owned by central banks and official institutions in 1971 was a reliable
amount of about 37,000t, we no longer have accurate figures for gold held by
official sources. We know that central banks have reduced their holdings over
the years, either by selling or leasing.
Central banks
no longer publish accurate figures of their gold holdings, but for purposes
of this discussion, let us assume that the current level is 30,000t, a
decline of 7,000t from 1971 levels. The central bank sales of 7,000t must
have been absorbed by the investor/hoarders, taking their adjusted total to
45,000t before adding the 80,000t of new production since 1971. That means
that new buyers have entered the market over the past 40 years and have
swelled the total gold held by investor/hoarders to perhaps 125,000t. (38,000+7,000+80,000).
That is a lot of gold!
These numbers
are guesstimates as there is no way to substantiate them. The important thing
is that the trend indicates that investor/hoarders must own a considerable
amount of gold, at least several times larger than the quantity held by
central banks. Whenever gold goes to new all time
high prices, all investor/hoarders have a profit on their holdings of gold.
When the gold price rockets $400 per ounce from $1500 to $1900 in just seven
weeks, as it did last July and August, the profits available to
investor/hoarders are vast and mouth watering. Not
surprisingly, many decide to take some profits while new buyers become
cautious due to the rapid price rise.
The result is
a correction in the gold price. This is a normal occurrence and will happen
from time to time, especially when the gold price pushes to new highs. The
natural result of a large stock of gold held by investor/hoarders is that
occasional corrections must be expected.
Extent of manipulation in the gold market:
It is hard to
visualize much manipulation in the physical market for gold when
investor/hoarders own 125,000t and the volume traded is
large. The futures market is another story. Gold futures trading became
popular in the 1970’s when the price was freed from its $35 per ounce
collar. It was possible to control a large amount of gold for a deposit of
10% or less, enabling punters to gear up their positions substantially.
There are
many similarities between casinos and futures markets. In a casino the house
holds the punter’s money and issues plastic chips for them to gamble
with. The odds offered by the casino always favor the house so that there are
always more losers than winners, the difference being the profit margin for
the casino. In the futures market, every transaction requires someone else to
take the opposite bet. Both parties put up the necessary deposits which are
held by the market operator. Again losses will always exceed gains, the
difference being accounted for by the brokerage and market costs.
In a casino,
if one had an unlimited amount of money, one could devise a method of
escalating bets so that when one eventually had a win, all prior losses would
be recovered plus the desired percentage profit. For example, in roulette
over a lengthy period all columns or dozens (the 2 to1 shots) come up
slightly less than 33% of the time. A player betting on one of these with
unlimited funds would know
that sooner or later a winning bet would occur. When it does, the player
recovers the cumulative losses plus the desired percentage profit. A
foolproof system? Not quite. Casinos impose limits on each table for every
bet, which prevents this.
In the
futures market it is possible for players with unlimited funds to operate a
similar system on the short side of the gold market. As explained in the
previous section, corrections do happen in the gold market, especially after
the price has risen to new highs. If the player knows that a correction will occur eventually, with
unlimited funds he can increase his short position at higher prices until the
correction happens. Then he closes his position, hopefully banking a profit.
This could be
circumvented by imposing limits on the size of the position that a player can
build, just as the casinos impose limits on each type of bet. This is
extremely difficult to regulate and monitor in the futures markets. The
authorities probably rely on the knowledge that every contract sold short has
to be bought back at some time, thus the position is self-correcting. This is
true, but the manipulation aspect occurs when the correction has started and
the player with the big short position gives the market a nudge on the
downside, triggering stop loss orders.
Most players
on the long side are operating on margin. That is the attraction of the
futures market, to gear up profits. These players are operating with limited
funds, so they either have stop loss orders in place, which become market
orders when triggered. Or they fail to provide additional cash when their
brokers ask for more margin, which causes the broker
to sell out their positions, once again placing sell orders “at
market”.
“At
market” orders are sold at whatever the best buying price is available
at that time in the market. If this happens when markets are thin and the
major markets are not operating, this can cause an avalanche of selling. The
sharp downward spike on 26 September last year is typical of what can happen
in these circumstances. That is the time when the “deep pockets”
player will probably be covering his short position.
It should be
obvious from this that the futures market is an extremely dangerous place in
which to participate in the gold market. There are other risks that have only
recently come to light regarding futures markets. Sticking with the casino
analogy, assume that you have had a bit of luck in the casino and decide to
cash in your plastic chips. When you get to the cashiers counter it is closed
with a sign saying “Run out of money. Come back tomorrow
morning”. You return the next day only to find a sign saying that the
casino is bankrupt and is closed! Enquiries elicit the information that the
cashier took all the casino’s money, went to a
nearby casino and lost the lot.
In the
futures market, the operator holds all the cash while the punters have
contracts. The operator uses the cash to pay out the winners and cover
expenses. Assume that the futures operator decides to take a risky position
for the operator’s own benefit in another market but uses the cash
contributed by the punters. The risky venture goes sour and the operator goes
bankrupt. The punters are left high and dry. While all the facts have yet to
emerge, it seems that this is possibly what caused the demise of MF Global.
As the world
navigates this period of great financial and economic crisis, we need to be
extremely vigilant and cautious with our investments. Be wary of paper claims
on gold and always be conscious of the old saying: “Gear today, gone
tomorrow”. Limit investments to what one can afford to pay for in cash.
A possible “black swan”
event that could trigger a sharp gold rally:
To achieve
the EW target of $4,500 on the next upward move will require something to
trigger substantial new buying of gold. What could that event be? By
definition, it will be a surprise to all market participants, a “black
swan” event. That doesn’t prevent us from making a guess.
One likely
area from which problems could emerge with very large numbers are derivatives. The Bank for International Settlements
produces a list of outstanding derivatives twice a year. The latest report
can be found at: http://www.bis.org/statistics/otcder/dt1920a.pdf. This
reveals that the total notional value increased from $601 trillion (with a
“t”) at December 2010 to $707 trillion at June 2011. Nearly all
of the increase was accounted for by interest rate contracts which now have a
notional value of $553 trillion, some 78% of the total.
As we
discovered in 2008, derivatives are benign until losses occur. Once losses
emerged from credit default obligations, it was game on for the GFC. Interest
rate derivatives protect banks from interest rate rises. Most banks borrow
short but have large loan books at fixed rates for long periods. Thus a big
rise in interest rates could trigger claims on these derivatives.
For the time
being, rates seem to be locked at virtually zero in the USA, but this is not
the case in Europe. Europeans are learning the lesson that rates rise when
investors become concerned that the borrower can’t repay the amount
borrowed, let alone the interest on the capital. When we drill down further
into the BIS statistics at http://www.bis.org/statistics/otcder/dt21a21.pdf we discover
that $219 trillion of the interest rate derivatives are denominated in Euros,
compared with $170 trillion denominated in US Dollars.
If just 10%
of the interest rate derivatives in Euro’s produce losses, the
world’s banking system would be looking down the barrel of a loss of
$22 trillion. That is enough to bankrupt the entire world’s banking
system, something that the politicians of the world could not tolerate. What
would a bail out of $22 trillion do to financial markets? What would it do to
the gold price?
If it is not
interest rates, there are $64 trillion of foreign exchange derivatives and a
“mere” $32 trillion of credit default swaps outstanding that
could produce “black swan” surprises.
Alf Field
12 January 2012
Comments to ajfield@attglobal.net
Disclosure
and Disclaimer Statement: The author
has personal investments in gold and silver bullion, as well as in gold,
silver, uranium and base metal mining shares. The author’s objective in
writing this article is to interest potential investors in this subject to
the point where they are encouraged to conduct their own further diligent
research. Neither the information nor the opinions expressed should be
construed as a solicitation to buy or sell any stock, currency or commodity.
Investors are recommended to obtain the advice of a qualified investment
advisor before entering into any transactions. The author has neither been paid
nor received any other inducement to write this article.
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