Mphm!" Why great men and women own gold

"It is related of the illustrious Sandy McHoots that when, on the occasion of winning the British Open Championship, he was interviewed by reporters from the leading daily papers as to his views on Tariff Reform, Bimetallism, the Trial by Jury System, and the Modern Crave for Dancing, all they could extract from him was the word 'Mphm!" Having uttered which he shouldered his bag and went home to tea. A great man. I wish there were more like him." - P.G. Wodehouse

Those of you who have kept up with this newsletter over the years will recognize the quote from Wodehouse gracing this issue's masthead. It's been there before -- almost always at summer's start -- and almost always with a reflection that perhaps we can learn something from Mr. McHoots.

It has been an interesting past 60 days or so. Gold cratered and no one seemed to know why. The stock market went higher defying gravity, the fundamentals and, some said, common sense. Bonds headed south because someone whispered a caution to the Wall Street Journal which passed it along to the rest of the world. It was this: The Fed might stop printing money. The Federal Reserve board clarified the matter by saying, it just might do that, but then again it might not. The politicians globally legislated, or failed to legislate, squabbled, pontificated and pandered to a citizenry that did not seem to take much notice.

In other words, not much has changed since the time of the illustrious Mr. McHoots (the 1920s). Nor has the passage of time done much to alter the reasons why the prudent citizen/investor might purchase gold. The fact of the matter, though rarely discussed, is that gold ownership has more to do with personal philosophy than it does finance and economics -- though by that I do not mean to diminish the importance of financial markets, or politics for that matter, in our everyday lives. Things, though, do need to be kept in perspective and gold helps toward that goal -- once one understands its true nature. My guess is that McHoots could afford a healthy disdain for current events because he was a gold owner -- and probably in the form of British sovereigns. A great man indeed. . . . .

This is the time of year when the markets traditionally take a break, but it is also a time when events can take us by surprise. Keep an ear to the rail (or an eye on the screen), but have a pleasant summer.

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What the charts on Eagle coin sales are telling us
The public's motivation for buying gold and silver

Editor's note: Some of you may have caught Wodehouse's casual mention of "bimetallism," a convenient segue into a couple of charts we developed at USAGOLD on American Eagle gold and silver bullion coin demand featured below.

The gold owner can take comfort in knowing that April's price jolt brought out the buyers world wide. The surge in demand came as a surprise to gold critics who see the smallest price correction as cause to take out the hammer and have at it. At the same time, it was sweet vindication for world's gold owners who understood full well why anyone would scramble for the metal at the lower prices.

The charts posted below are important for what they reveal about the public's motivation to buy gold and silver. The precious metals have always been thought of as inflation hedges, but as you can see, the huge surge in volume since 2008 did not occur during inflationary times, but during disinflationary times, when the greatest concern was the stability and viability of the financial system.

Almost completely ignored by the mainstream financial media, physical silver demand is one of the more interesting phenomena to develop in financial markets since the 2008 meltdown. Gold has always had its safe-haven adherents -- those who believe that it will get them through bad economic circumstances no matter how they are labeled. Now, poor man's gold has become the poor man's systemic risk hedge. It hints that the concern over the on-going financial crisis extends beyond the 1% to the middle class in general -- something aspiring politicians might want to take into consideration. Our volumes at USAGOLD for both the silver Eagle and silver Maple Leaf have been off the charts for over two years running.

Why 2013 could be the best year to buy gold since 2008
The connection between quantitative easing and the gold price

Quantitative easing, the oft-referenced $85 billion per month shelled out by the Federal Reserve, comes down to the purchase of two kinds of securities -- U.S. Treasury paper (bonds, notes and bills) and mortgage-backed securities. The Federal Reserve buys the Treasury paper from the federal government and the mortgage-backed securities from commercial banks. The first is a direct form of monetization (money printing); the second is an indirect form since a good portion of those funds are in turn also used by the banks to purchase Treasury paper. The two together comprise the bulk of what appears on the Federal Reserve's Balance sheet as "reserve bank credit." At the present that figure stands at just over $3.2 trillion -- up about $2.4 trillion since the beginning of the financial crisis in late 2008.

When you superimpose the gold price over reserve bank credit on a chart, it looks like this:

At first glance, it looks like reserve bank credit and the gold price are correlated, but what is really going on with this tandem is that they are both being pushed by the same force -- a bad economy. It causes the Fed to print money and investors to buy gold. The Financial Times ran an editorial the other day explaining why some top-notch hedge fund managers -- like Paul Singer, John Paulson, Stanley Druckenmiller and David Einhorn -- don't like the U.S. Federal Reserve or chairman Ben Bernanke, the father of the QE policies charted above.

"His [Druckenmiller's] concern," the editorial explains, "is not the risk of inflation, which has prompted investors such as Mr Singer and John Paulson to load up on gold. Instead, it is a broader concern that has been voiced by growing numbers of the most powerful and influential professional investors: that by pushing down interest rates and buying up government bonds, the Fed is warping the norms of economic behaviour."

Most importantly capital, according to this group, is being misallocated driving investors into dangerous financial waters. "What kind of entity," warns Seth Klarman, another hedge fund manager, "drives the return on retirees' savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy."

It is these kinds of distortions, though, that create opportunities in investment markets, which leads me to the reasons why I went to the trouble of compiling and publishing this chart:

First, reserve bank credit has gone vertical since November's near-term bottom -- up over 15%. The Fed might reverse or moderate its purchases at some point in the future, but at the moment, it has the pedal to the metal. That alone might be worth the cost of admission when you consider we are told daily that quantitative easing might be ending soon. Pay attention to what the Fed does, not what it says.

Two, the gold price, as a result of its recent plunge, has crossed decisively under the reserve bank credit trend line. The two developments together have made for an interesting chart divergence -- the sort of thing that catches the attention of technicians and value investors alike, particularly if it defies logical explanation. This latest correction, more than any I can remember, has the experts scratching their heads. (Please see "Illogical dumping. . ." below.)

Three, should the quantitative easing program finally ignite price inflation, we might see an entirely different chart pattern emerge -- a different kind of divergence. Gold could go vertical while reserve bank credit stays level or heads south depending on the Fed's ability sell-off the securities it accumulated during the quantitative easing stage.

That same Financial Times editorial concludes with this important observation on the behavior of hedge funds and hedge fund managers:

"Part of the pressure comes from knowing, or sensing," says Richard Fisher, president of the Dallas Federal Reserve, "that at some point you are going to get a reversal. If I was in my old business I'd be looking around [asking] how am I going to make money without taking undue risk?" It is a big problem for the masters of the universe. They live for distortions in markets, which provide them with opportunities to throw billions of dollars at a brilliant trade that will push prices back in line with reality. Successful hedge fund managers make their reputations by being clever, brave or fast enough to seize on these chances."

One of those distortions looks like it may have materialized in the 2013 portion of the gold-reserve bank credit chart. The press greatly emphasized the withdrawals at the gold exchange traded funds over the past several months. What it failed to mention is that there are two sides to every trade. Someone was selling, but someone else was buying (and I'm not talking about just Chinese mothers and Japanese housewives). Even now the gold price has rallied off its lows, and someone is buying the mini-corrections we have seen since the big dump in April. If the longer term pattern on our chart reasserts itself, a significant upward adjustment in the gold price could be in the cards -- a change of course that could end up making 2013 the best year to buy gold since 2008.

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Illogical dumping raises questions about causes of metal's sharp decline

"So extraordinary was the 9.4% collapse on April 15, wrote Howard Simons of Bianco Research at the time, that the odds against such a move were 20 trillion to one -- 'a lower probability of occurrence than randomly selecting a [particular] $1 bill out of pile of singles representing the U.S. national debt.'

These improbable moves have made gold bugs suspicious, which isn't unusual. Folks who own gold do so because they don't trust the status quo, especially when it comes to government-issued paper money. But just because you're paranoid doesn't mean somebody isn't out to get you. They point to bursts of selling on Friday, April 12, which resulted in prices plunging by more than 5%, and to dumping that resumed the following Monday in Asia, early in the day when markets are illiquid. That culminated in a 9% collapse by the time the New York market had settled. But a seller who wanted to unload a large position at the optimal price would have done precisely the opposite—liquidate as discreetly as possible. Instead, sellers dumped the equivalent of more than 300 tons of the metal in staccato-like blasts during those sessions."

--Randall Forsyth, Barron's, This time, the gold bugs may have a point, 5/18/2013

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Short & Sweet

The Reserve Bank of India has asked banks to stop pushing gold coins. The request ""stems from a need to draw customers back towards financial saving instruments, which, in turn, are good for the economy." Gold demand in India is off the charts the result of a depreciating rupee and the Indian peoples' traditional attachment to the yellow metal. The World Gold Council reported that it expected India to import 350-400 tonnes of gold for the second quarter – a 200% increase over last year. It also reported that it expected India to import 965 tonnes by the end of 2013 -- about one third the world's annual mine production. One more price drop like the one we saw in mid-April and India just might clear the decks of any available.

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"It's understandable that the process will be gingerly handled so as to dovetail into the currency world without causing crises there. We have to always remember that China will do what suits China and not the outside world. But the inescapable conclusion we have to reach is that the Yuan is set to replace the U.S. Dollar to a greater or lesser extent as it arrives on the world stage. This will inevitably lead to more global uncertainty and instability as dollar hegemony is cracked and more currency volatility batters the currency world. Market reactions could well discount the future and cause premature reactions that, we believe, will benefit gold." Julian Phillips, The Gold Forecaster

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"When you're at your best health, you're feeling good, that's the time when your insurance policies are actually the cheapest. It's been very volatile and painful on the way down but as a whole, a small allocation to gold as part of an overall portfolio still serves its purpose. Once you find out you're sick it's going to cost a lot more, it's going to be a lot more expensive." - Steve Laird, Franklin Templeton, Lead Portfolio Manager

Editor's note: You do not want be underinsured. Under insured is very nearly the same as being uninsured. We recommend a diversification of 10% to 30% of your assets (not including your primary residence). The level between those two numbers depends upon your own reading of the overall economic situation. Over the past several years of economic uncertainty and outright asset destruction, gold has strengthened, even saved, personal balance sheets buffeted by the ill-wind that still blows through contemporary finance. In fact, we have had very little selling all the way up, and plenty of additions to existing gold savings positions. Peoples' attitudes haven't changed despite all the hoopla about gold in the press these past several weeks.

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"While mainstream news sources continue the war against gold and gold-related investments, three of the world's top performing hedge fund managers have been busy at work building speculative gold positions during the first quarter. George Soros, John Paulson, and Steve Cohen, who in aggregate control over $60 billion dollars, have been aggressively buying the most speculative vehicles associated with gold: call options on gold mining stocks." - Bull Market Thinking, /Tekoa da Silva

Editor's note: So all the negative hype about Soros selling his ETF gold position is just that "hype." Hedge funds are charged with maximizing returns and beating the market averages (seeking alpha). To do this, they employ often times complicated strategies, usually with leverage, and go where assets are undervalued. This trio of hedge fund managers would not be buying yellow metal in various forms and representations, if they didn't think the gold story rested on a solid foundation -- a position the opposite of the tale the mainstream financial press and Wall Street have been weaving the past several weeks.

about gold in the press these past several weeks.

"This prebubble euphoria only undermines the Federal Reserve's fragile credibility. It reinforces the notion that it seems to know only two things: how to inflate bubbles and how to studiously not recognize them." - Jesse Eisinger, ProPublica

Editor's note: Inflation no longer "besieges" economies so much as it rolls through them consuming one segment of the markets or another in what we have come to term "bubbles." Now the inflationary bubble appears to be rolling anew through the stock and real estate markets. This article, if nothing else, serves as prewarning about the prebubble -- a well-written, provocative look at why the hedge funds, and other major market players, no longer trust the Fed to provide a heads-up when this roller-coaster ride might be heading over the top.

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"The windfall from the commodity boom which began in 2002, has been huge. The IMF estimates it was equivalent to an extra 15 per cent of output a year. But now China's slowing economy has undercut commodity prices, raising questions about how long the 'commodity supercycle' will last. The average length of these supercycles is 30 years, estimated José Antonio Ocampo, a Columbia University economist, in a recent study. 'That puts us about halfway through this one,' he says." - John Paul Rathbone, Financial Times

Editor's note: As you can see, the starting date for the commodity boom is, as Financial Times says, in the vicinity of 2002-2003. As such we are not even half way through the 30-year cycle (The midway point would be in the vicinity of 2017-2018.) The end to the cycle by professor Ocampo's formulation would not come until about 2032-2033! Anyone who follows gold knows that it is generally thrown in with the rest of the commodities — soybeans, lead, aluminum, crude oil, et al — even though the purists among us regret that designation. For discussion purposes, let's at least assume that gold benefits from commodity booms and suffers from commodity busts — even though I am sure there have been occasional exceptions to this relationship. If so, we may have a long way to go before gold's bull market is over.

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"Paulson & Co. Inc., run by billionaire hedge fund manager John Paulson, maintained its holdings in the SPDR Gold Trust for the quarter ended in March, according to a Securities and Exchange Commission filing late Wednesday. It made no changes to its holdings in the gold-backed exchange-traded fund even as the value of its holdings fell by roughly $165 million for the quarter. Paulson reduced some of its stakes in gold miners, including Agnico Eagle Mines Ltd., Allied Nevada Gold Corp., Barrick Gold Corp. and Iamgold Corp." - MarketWatch

Editor's note: Paulson maintains that he hasn't lost any money in gold at all. He bought at the $950 level.

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"There are very few mega-sized gold mines currently in production in the world. In terms of a cross-section of total gold mines by size, there are about 400 gold mines producing. Only 156 of these, or about 40%, produce over 100,000 ounces per year. . .Twenty-one mines produce over 500,000 ounces per year. . .Only six mines produce over 1 million ounces. . .It is also interesting to note that although there have been some gold discoveries, none can be described as a super giant — that 20-million-plus ounce deposit. They are harder to find and that is directly impacting production growth because those super-giant discoveries are really the ones that can have a material impact on supply." - Jamie Sokalsky, CEO, Barrick

How the bear is preparing for a global currency war
Russia: The sleeping giant of gold producing countries

"The more gold a country has, the more sovereignty it will have if there's a cataclysm with the dollar, the euro, the pound or any other reserve currency." -- Evgeny Fedorov, Russian lawmaker, United Russia Party

As it stands today, the top seven global gold producers, according to the U.S. Geological Survey, are:

1. China (370 Metric Tonnes)
2. Australia (250 MT)
3. United States (230 MT)
4. Russia (205 MT)
5. South Africa (170 MT)
6. Peru (165 MT)
7. Canada (102 MT)

When you take-in this table, it inspires little beyond a shrug until you consider the monetary policies, and the policies toward gold, in the countries listed. China, for example, is the world's biggest producer of gold, but its production is essentially sequestered, i.e., it stays in the country and forms part of its monetary reserves. The same is true with Russia. Thus 21% (575 tonnes) of the world's gold production in 2012 did not see the light of day on international markets.

In addition among the countries that still make their gold production available to world markets, four of the top seven are in long-term decline -- the United States, South Africa, Australia and Canada, some would say <em>precipitously</em>. Three enjoy rising production -- China, Russia and Peru. Among the declining states, South Africa suffered the worst cutbacks, down 52% from production in 2000. U.S. production is down 39% over the same period; Canada is down 38% and Australia, 24%.

So what does this mean with respect to the long-term, overall supply-demand picture?

Obviously there is substantially less gold actually reaching the market today than there was 12 years ago, and by a wide margin when you consider the tonnage sequestered as mentioned above. In 2000, none of the gold production was sequestered by nation states to build monetary reserves (at least none that we know of), now, a significant portion is going into reserves in what might be considered a trend, or the first baby steps, toward a 21st century version of a gold reserve standard. (Think where South Africa would be as a nation state today if it had kept even one-third of its production as a monetary reserve.) The world of gold from a supply perspective has changed remarkably over the past dozen years.

Given the problem of money printing on a global basis, the trend of rising official sector gold reserves is likely to continue as more and more emerging countries see it in their best interest to diversify their monetary reserves. I wouldn't be surprised to learn at some point down the road that Peru, for example, decided it might be in its best interest to retain production.

Russian Gold Reserves Chart courtesy of Sharelynx/Nick Laird

Russia's gold production is an important piece of the overall supply puzzle in terms of both production and reserves. Few people know (or remember) that in 1980, Russia was the second largest global gold producer at 21% of the total global output (258 metric tonnes) South Africa was number one at 55% of the total global output (675 metric tonnes). With respect to future gold production, Russia is a sleeping giant that could leap-frog the United States and Australia soon.

Reuters quotes Sergei Kashuba, head of the Russian Gold Industrialists' Union as saying, "If gold prices remain at a high level, gold output in Russia will continue to grow by 4-5 percent per year, which will allow it to become the third largest producer in the world in 2015."

After the collapse of the old Soviet Union in late 1991, gold production plummeted. In 1995, Russia produced only 133 metric tonnes -- 5.9% of the global total output. South Africa, still number one in 1995, produced 524 metric tonnes. Overall production globally more than doubled between 1980 and the present from 1220 MT in 1980 to about 2700 MT today. The United States (with its vast deposits in Nevada), Australia, Peru and Indonesia were primarily responsible for the increases in overall production.

Now Russian gold production is on the mend, and building its gold reserves is part of the Putin government's attempt to shield Russia from a potential currency war between the yen, yuan, dollar and euro -- the first volleys for which we have seen over the past few months. Keep in mind too that in terms of known reserves Russia reports 5000 metric tonnes. It ranks third behind Australia (7400 MT) and South Africa (6000 MT). The United States reports 3000 MT.

Michael J .Kosares

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