If there is a credible rumor
that the Fed is planning to further extend its "Quantitative
Easing", how would you expect the monetary metals to react? Typically,
the gold price would rise and the silver price would rise even more. The
question is why.
Traders read the headlines and
they know how the price "should" react to such news, and they begin
buying. For a while, the prophecy fulfills itself. But then what happens
next? It may take an hour or a month, but sooner or later some of the new
buyers begin to sell. What can be bought on speculation using leverage must
eventually be sold. Traders who buy gold and silver futures think of their
"profits" measured in dollars. They cannot profit from the rising
gold price until they sell. So, sooner or later, they must sell.
Alternatively, if the price goes down, they must sell because they are
incurring losses at a multiple of the price drop due to their use of
leverage.
Nearly all buyers of futures
are speculators. They could be called "naked longs" because they
have neither the intent nor the means to take delivery. Their predictable
behavior when a particular contract heads into expiry has a characteristic
behavior. One can see this in the gold and silver bases.
One way to debunk the
"naked short seller" conspiracy theory is to watch the basis heading
into First Notice Day. Naked longs must sell the expiring contract, and if
they wish to remain long the metal, they must buy another farther-out
contract. Right now, for example, we are in the late stages of
"rolling" from the March silver contract to May (there were about
80,000 contracts open a month ago, and now about 30K).
Anyway, getting back to the
topic, speculators are frequently driving up the price by buying news and
rumors and almost as often driving down the price. In the short run, they can
have an enormous impact on the price. But in the long run, they have almost
none.
There are an estimated seven
billion people on Earth. Most of them don't read about the US stock market,
the press releases from the Governor of the Bank of England, or the latest
politics surrounding the appointment of a new head at the Bank of Japan. They
don't know how the price is supposed to move when earnings estimates for the
S&P 500 are raised or lowered.
They are doing one of two
things with physical metal. They are either slowly hoarding it, as the only
safe store of wealth they can understand. Or they are performing arbitrage,
each with his notion of the "right price". When metal is priced
lower than their threshold, these latter folks buy. When the price rises above,
they sell. Most of them, of course, don't even look at the price measured in
dollars. They are using another currency, such as rupees.
The actions of the hoarders
will sooner enough cause the final descent into permanent
gold backwardation. But don't count your paper "profits" just
yet. This is not a time when gold owners get "rich". Sure, the gold
will have a high value indeed, though it may be worth your life to show
anyone that you have it as occurred throughout history.
Permanent gold
backwardation--the withdrawal of the gold bid on the dollar--will lead to bad
times. Certainly, government policies are causing the capital base that
supports our society to be hollowed out. If it can no longer support us, if
the debt-based currencies no longer work, and if industries such as food
distribution seize up due to lack of credit, then even the best case is
pretty bleak.
For now, the actions of the
arbitragers drive the price. Gold and silver are totally unlike any other
commodities. Both metals have a stocks to flows ratio that is
extraordinarily high. Stocks to flows is total global inventories
divided by annual mine production. For gold and silver, this number is in the
many decades. For other commodities, it's measured in months.
All of this inventory is
potential supply at the right price. If the price rises above the threshold
set by a large number of owners, then metal comes into the market. If the
price falls below this threshold (or the threshold ratchets up) then metal is
taken out of the market.
The speculators can drive the
price quite far in either direction, in the short term. But it is the
hoarders and arbitrageurs who drive the price in the long term. A century ago,
gold was worth about $20 an ounce. Now it is worth about $1600. This is
another way of saying that the dollar has gone down to 1/80th its value. This
trend is not going to end soon (or indeed end at all). But it does not move
in a straight line, as these past few years have proven once again.
Wouldn't it be nice to have an
indicator that can help one determine whether hoarders and arbitrageurs are
driving the price at the moment, or if it's just the speculators again? This
is precisely what the basis shows (among other things). In other words, are
you buying your physical gold or silver into a speculative move (bad), or are
your purchases part of fundamentals-driven move (good)?
Monetary Metals is now publishing
graphs of the basis for gold and silver along with our commentary. Click
here to view the Last Contango
Basis Report (free registration required).
