Ladies and Gentlemen, it is with great pleasure that we hereby present you with…

…what is possibly the greatest gold contrary indicator ever! Ladies and gentlemen, please welcome to the stage Mr. Ananthan Thangavel (a round of applause follows as the excited crowd cheers him on)! Apart from titillating our fantasy as we imagine the scene (we recently rediscovered our always-present and yet long-lost love for acting and performing), the objective of this post is firstly to inform our readers about the extremely high likelihood that a final bottom has been printed in the PMs market (a bottom that warrants further additions to our already very large positions) and secondly to present them with what to our eyes appears to be an extremely effective timing tool for our purchases: the short calls of Mr. Thangavel. It is not our intention to ridicule Mr. Thangavel (at least not much) as we know that investing is far from an easy business and everybody is bound to make their shares of mistakes (and we’re certainly not immune to this phenomenon, as e.g. we weren't expecting the collapse in PMs on the back of already extreme levels of pessimism). What we want to show, however, is that doing fundamental analysis using horribly wrong premises, spurious arguments and a wide array of trite fallacies vastly increases the possibility of committing grave mistakes. We are convinced that unless one is motivated to learn what sound analysis really is, then one would be better off just trading technically, without concerning (and burdening) himself with any fundamental considerations. Take Peter Brandt as an example: he obviously can’t differentiate between valid fundamental arguments and hogwash and yet he goes on to trade profitably by using simple charting techniques, prudent risk management and a multi-decade experience (and kudos to him for having been on the short side of the PMs markets for quite a while).

A brief review of Ananthan’s latest article

We intend to start with a point-by-point rebuttal of the seizure-inducing nonsense spouted in Mr. Thangavel’s latest article (which he published on May the 7th, so at least he got a couple of weeks of glory as prices collapsed!). Readers are encouraged to read it before proceeding through our post, as we’ll only quote brief passages of it or simply articulate our positions assuming that readers are familiar with the other side of the argument.

• “we did briefly believe that the initiation of QE3 would be a positive catalyst for gold back in September 2012” : excellent, you demonstrated you know how to pick tops as well, as your long call arrived when prices where around 1760$/oz. and topping. 

• “As can be seen from the chart, gold rose in a fairly steady pattern (with 2008 being an extended correction), from the early 2000s until September 2011. Viewing this chart, it appears the perfect picture of an asset bubble and collapse.” : if you say so… To us it seems like a powerful secular bull market experiencing a cyclical bear market correction. This chart, courtesy of Macrotrends, seems to confirm our suspicion:
  
  

A chart comparing the percentage gains of the current gold bull market with those of other major bull markets: we can’t see any parabolic rise so far, in spite of what the hawk-eyed Ananthan says.

• “Considering there is no "right" price for the price of gold, but rather only the price that the next buyer is willing to pay, more and more investors came around to the bullish gold thesis, and this gradual realization drove the price higher.” : congratulations, you just discovered that prices are the composite result of a myriad subjective value judgments by economic actors. Unfortunately for you, this is an insignificant platitude that is true for all goods, not only for gold. No, there is no such thing as “intrinsic value”! Quick Austrian explanation: for a voluntary exchange to occur both parties need to value the goods to be acquired more than the goods to be exchanged for them (otherwise no transaction would take place, as both parties would expect a loss, rather than a gain, from the exchange): in short, this is called a reverse valuation. From this it logically follows that all values are subjective: if goods had an objective, intrinsic value, then there could be no reverse valuation (except through error). In other words, all exchanges would have to rely on the error of one or both parties to occur and this is obviously impossible (think about the coexistence of innumerable satisfied iPhone buyers and of large Apple profits: evidently they both gained from the transaction and no “right” price for an iPhone exists). 

• “However, by 2011, nearly every market participant knew or understood gold's appeal, and since gold could be easily purchased through an ETF or futures contract, everyone who believed in the thesis was in. The following chart shows the number of ounces of gold held by ETFs. […] We believe this massive accumulation of gold was the primary driver of the most recent leg of the bull market, punctuated by leveraged futures traders exacerbating the final spike. Moreover, ETF and futures demand for gold can be considered the marginal player, as central banks and other physical gold holders rarely trade in and out, so ETFs are setting the marginal price due to their relatively high turnover.” : here we have a powerful combo of specious arguments.
  A) It’s highly debatable whether in 2011 “nearly every market participant” had an interest in (much less an understanding of) gold’s appeal: there certainly was excessive speculative fervour and widespread bullishness, but certainly we saw no signs of a speculative mania (and at least we know that our good Ananthan had no interest in and certainly no understanding of gold). Moreover, we know that since gold does not get “used up” and a large stock of it exists (roughly equal to 50 times the annual mine supply), then it follows that all this gold has to be held by someone at all times: what matters is not whether “everyone is in” (in light of the above this sentence is meaningless), but whether at the current price there is or there isn’t an equilibrium between total stock and total demand to hold (which includes the demand to acquire gold and reservation demand to hold it) and whether the current price correctly reflects future anticipated conditions (if it doesn’t, then an adjustment is inevitable, in the form of an increase or decrease of the total demand to hold and hence an increase or decrease of the price until a new equilibrium is reached. The total stock bears little relevance as it’s almost a fixed constant). The heart of successful speculation is the ability to correctly gauge the current and the future relationships between supply and demand and identify meaningful discrepancies that could give rise to powerful trends in price (e.g. there currently is a large supply of sugar and hence prices are very low. Yet we anticipate a future situation in which this abundance disappears and hence we speculate on a meaningful price increase).
  B) The usual tripe about ETFs holdings… With 170.000 tonnes of above-ground gold what the hell does it matter whether ETFs hold 1.000, 2.000 or even 10.000 tonnes? All gold has to be held by someone, all that matters is at which price the market clears, i.e. at which price demand to hold and available stock match. Moreover, it’s evident that ETFs are tiny tiny players in the global gold market. They have no doubt made it easier for Joe Public to invest in PMs, but they’re still a minuscule source of demand. Moreover, the gold they buy is sold by someone else and that someone cares little whether the buyer on the other side is an ETF, a central bank, a large dealer or whatever: all he cares about is the price he can get (and whether that price is high enough to entice him to sell). So ETFs may be useful as a proxy for sentiment towards PMs, but their buying and selling most definitely does not influence the price. Have a look at the London Bullion Market’s size and then figure out for yourself whether GLD shedding a few hundred tons over the course of six months really matters much.

• The paragraph titled “When bubbles burst: prices cannot catch up to unrealistic expectations” is a concentrate of gibberish. First of all, bull markets do indeed generally end when the fundamental drivers no longer are in place or when they have at the very least significantly deteriorated (reference our post on the subject).
  Secondly, as we have observed above, good luck comparing gold now with the Nasdaq in 2000 or housing in 2006…
  Thirdly, mistaking a cyclical bear for the end of a secular trend is a mortal sin amongst speculators and pretending that an asset responds in the most obvious manner to news is utterly naive: if speculation were as easy as reading the paper and then doing the most obvious thing (like buying gold on leverage the day Bernanke announces his QE program), then we’d all be Soros. Moreover, all secular bulls experience cyclical corrections: in 1987 the secular stock market hadn't ended (as the secular drivers of said trend were firmly in place), BUT the then-current circumstances warranted a temporary and meaningful correction. The same goes for gold in 1975, stocks again at the beginning of the ‘90s etc. etc. etc.
  Finally, what about his assertions that “The current fundamental problem in the gold market is that every bullish fundamental has already been revealed” and that “there is no upside surprise left for gold investors, but there remains plenty of downside surprise.”? Well, save those lines for the stock market, dear Ananthan! In our opinion, it is obvious that there are still plenty of “hidden” bullish fundamentals for gold (hidden of course only for that 90+% of people who have never heard of the Austrian School) that will not fail to make themselves evident once the current monetary madness finally delivers its results. And be assured: that will be the time to sell, as the Ananthans of this world will rush to buy! Just as obviously, it seems to us that right now there are no downside surprises left for gold, given also the recent crash (a 4-standard-deviation event): the world economy is just perfectly fine and on the road to a strong recovery, no bad consequences can possibly result from massive inflation, debts will no doubt be repaid with honest money and all the perks and amenities of the welfare state will be maintained and even increased.

• The next paragraph is another questionable one. Gold secular bull trends tend to happen during periods of economic crisis, when stocks are generally locked in a secular bear. We have discussed the matter in a previous post. There may be periods of positive correlation between the two assets, but the overall secular trend is clear. Moreover, if the Fed stops printing, good luck with trying to keep the current global financial ponzi scheme from crumbling. In that scenario (a highly deflationary one) we seriously doubt gold would perform poorly. It may decline in nominal dollar price (not very likely and mainly dependent on whether the U.S. gov’t can remain solvent), but it is certainly going to increase its purchasing power (i.e. the amount of “stuff” like oil, houses, cars, stocks, food etc. that you could buy with a unit of it) exactly like it did in 2008. If, on the other hand, Benny keeps on inflating (a very likely outcome) then good luck with trying to keep the current “Goldilocks Economy” in place for much longer: either a bust of massive proportions or a prolonged period of significant price inflation and stagnant economic activity or even the Misesian crack-up boom would likely appear and all three scenarios are bullish for gold (with the last one being wildly bullish). We’ll tell you how gold could be hurt: if Obama were to be possessed by the spirit of Murray Rothbard, so that all at once he would abolish the Fed, repudiate the debt, stop spending, cut taxes and regulations and let the free market re-establish equilibrium (of course he would have to be exorcised before being able to re-establish the gold standard, otherwise the scenario would still be bullish).
  
  
• “Future for gold”: another bit of gibberish about ETFs holdings coupled with the following: “At this point in time, with interest rates around the world staying low indefinitely, investors are grabbing for yield anywhere they can find it. Nearly every other asset, between stocks, fixed-income, alternative, and real estate, produces a higher current yield than gold's 0%. Given the fact that gold has not made a new high in 19 months, traders can no longer rely on price appreciation to make up for gold's lack of yield and utility. Therefore, they are selling the metal, and they have quite a bit more to get rid of before all is said and done.” Yes, you have got this one right Ananthan, although you couldn't resist mentioning the usual nonsense about the supposed bearishness of the liquidation of miserable gold holdings ( by the way, as far as we know sellers do not just throw their gold in the ocean, but rather sell it to buyers who become the new holders). Investors are indeed selling gold to chase other assets. The important question however is: is that likely to generate good returns? Personally, we wouldn't touch a junk bond yielding less than 5% with a ten-foot pole… Ditto for a stock market sporting a CAPE10 of 25 and a Q ratio above 1, both levels at which secular bull markets have ended, not begun.
  
  
• And now hold on to your hats, dear readers, as the two last paragraphs are riddled with enough rigmarole to make us almost pass out: “Given that gold is a commodity, most commodities eventually trade to their cost of production. Those of you that have taken a basic economics class will remember that marginal cost = marginal revenue. […] If investment demand continues to decline and gold ETF holders continue to sell, we believe a gold price below $1,000/oz is a near certainty. Gold will eventually return to its true cost of production, squeezing miners' profit margins.” It seems to us, dear Ananthan, that you are the one who failed to attend a basic economics class: please show us another commodity whose available supply pretty much equals the entire cumulative production that has taken place over the course of all of human history (save for a few sunken Spanish galleons and a few other tons that got either lost or consumed). In such a situation, the price of a real commodity, like corn or oil, would no doubt plunge far below the cost of production, since such an abundant supply would mean that nobody would need to actually produce the stuff (at least for a few decades) and hence the market, via its profit and loss mechanism, would send the signal that the scarce resources employed in the production of such a good would be better employed in other lines of production (in simple words: nobody would make a frigging dime producing that commodity). So, how come that gold prices do not plunge far below its cost of production, notwithstanding the huge above-ground supply? Well, maybe after all gold is not a commodity or, more correctly, it is a commodity whose function is to act as money, no matter how emphatically Ananthan tries to explain us how gold cannot possibly be money by babbling assorted nonsense. Gold being money, reservation demand plays a fundamental role in determining its value. This demand is of course fickle and subject to continuous changes, but all that matters to the astute investor is to correctly determine the likely direction of its trend, i.e. whether it is likely to increase or decrease meaningfully over the next few years. Truth be told, he is right in saying that gold is not a commonly accepted medium of exchange, but this happens not because it does not possess the characteristics of money (i.e. not because it lacks “moneyness”) but only because of government coercion in the form of legal tender laws. Proof of this assertion can be found in the fact that when a paper money system collapses, specie money always regains its rightful role as a medium of exchange.
  
  
• And finally Ananthan dispenses a wonderful pearl of wisdom for the benefit of the hoi polloi: “The problem with gold is that the market sets the price and there is no fundamental value. We must always be cognizant of this when investing in a psychological asset.” Ah, so now we know that gold is a psychological asset, whatever that means (we’ll no doubt interrogate a friend of us who happens to be a shrink on this and we may even put a gold bar on his couch so that he can properly analyse it)! Moreover, we also learn that gold has no fundamental value and that its price is set by the market and who cares if that is true of each and every asset on this planet (see the explanation above): certainly this only matters in the case of gold!

And with that last bit we have finished our rebuttal and we can move on to next part of the post (interested readers can spend some time overlaying the dates of Ananthan’s calls to short PMs to a chart of gold and see whether they notice any patterns). But before moving on, we want to mention that we’re not singling out Mr. Thangavel, as the drivel he spouts is usually used by a great many other analysts, nor we’re attacking him because he holds different views from us: what we’re criticising here is the shabby and shallow analysis and the careless use of specious arguments that don’t hold water. If someone were to say us that he’s short gold because the chart is bearish and there has been a breakdown, then we won’t have anything to object. We would still continue to be long (as we have our own way of investing), but we won’t engage in a debate with him: successful technical traders are very worthy of respect. But if someone comes up and says that he’s shorting gold because money printing is helping the economy and other assorted BS, then we can’t avoid dissecting his arguments and showing them for what they really are: nonsense.

The current technical and sentiment picture

Right now, after a series of endless plunges and crashes that no doubt helped clear the market from all kinds of even remotely weak hands, we see that both gold and silver have put in nice reversal candles. It is of course too early to say whether this will really be “it”. What we want to say, however, is that this time the bounce has a different feel attached to it: it just seems to us to be a bottoming process. A weekly close above 1400$/oz. for gold would most likely seal the deal in our mind. In any case, investors are now presented with an excellent opportunity to increase their exposure to this asset class. Sentiment of course is in the gutter, with newsletter writers now recommending a record-breaking average short position of 44% according to Hulbert Financial Digest and with Sentimentrader’s public opinion survey now showing widespread bearishness. Positioning shares sentiment’s place in the gutter, with small speculators almost net short in gold and with the lowest exposure ever to silver (and this does not even reflect the recent plunge). Moreover, if one spends a bit of time lurking around in forums and blogs, then he’ll certainly notice that most people there are talking about shorting PMs, increasing their shorts etc. (nobody is talking about selling their longs as they already did during the last crash).

A chart of gold via Stockcharts: notice the reversal, accompanied by momentum divergences.

The reversal (after fresh new lows) is even more evident in the case of silver.

Conclusion

We cannot possibly know whether the bottom is in or not, but we know that the fundamental arguments used to support bearish views are fallacious and that sentiment and positioning both scream for a bottom (although in all honesty they have been screaming for a while). We now have a reversal that looks convincing and we have to make do with it. We are buyers, knowing that the rewards far outweigh the risks and more importantly knowing that the secular bull market has not ended, not by a long shot, and that as such being long here is a sound proposition likely to deliver excellent returns over the coming years. Of course, readers need to remember the importance of using their own brains and of prudent risk management (read: don’t be heroes who leverage to the hilt in hope of becoming the next Paulson).

A Quick One

The objective of this post (whose title is likely to ring a bell with rock enthusiasts) is to provide our readers with a brief update on the markets which we follow and in which we currently hold positions. It is not difficult to surmise that we’re not busy popping bottles of Pétrus to celebrate our winnings. As contrarians, we’re accustomed to coppering the public’s bets and we’re also used to being early and to suffering drawdowns that generally last anywhere from a few weeks to a few months. We rarely have the pleasure of picking exact tops and bottoms. We have however to admit that this time around the stubbornness with which the various markets persist in following their current trends is nothing short of amazing. This can either mean that A) we’re spectacularly wrong on all our major calls so far; B) for once in their lifetime, the herd is being granted by the market’s gods the privilege of being right in spades; C) the degree to which the current trends are being overstretched is going to guarantee equally strong and long-lasting trends in the opposite direction. We’ll let our readers make their own choices re the above.

Precious Metals

Since our analysis of the sector dated the 13th of February and our More-on trades of the 26th of February and the 6th of March, Gold experienced a crash of historical proportions and Silver did its best to keep up Gold’s pace.

As we mentioned we were alert to the possibility of a final washout of weak hands, although we must admit we weren’t expecting such an effective cleansing. However “shit happens” in the markets as well. We aren’t concerned in the slightest that the fundamental, long-term trend is over: we consider this correction to be just part and parcel of a secular bull market and the longer and more severe it is, the better. Those who sell in a panic always have the opportunity to regret it and those claiming that during the ‘70s Gold halved in price and that as such it now has to go below 1.000$/oz. forget the different dynamics of the last bull market and the fact that Gold experienced a much stronger advance in a much shorter timeframe, thanks to the fact that it had just begun to trade freely. As a basis for comparison, please consider that during the same period Silver (which was already trading freely and which of course has a higher beta than Gold) declined roughly the same percentage: a testament to how overbought gold was.

That said there are more than a few facts and factoids that point to the possibility that a major low has just been printed (or that at least a remarkable window of opportunity has opened up). [A retest of said low may or may not occur: we don’t now and, quite honestly, we don’t care. In case it does, it’s guaranteed to scare most people shitless.]

Here are some of them, in no particular order of importance:

• Record-high volume on GLD both on Friday and on Monday;
• Continued outflows from GLD notwithstanding a meaningful price recovery (those claiming that ETF selling is bearish and impacts the market need to remember that the total stock of gold roughly amounts to 170.000 tonnes vs. roughly 2.500 tonnes held by ETFs);
• Record-high volume in the GDX ETF;
• Record-high volume in the Gold futures market as well;
• Record-low readings on the Hulbert Gold Sentiment indicator and very low readings on the Sentimentrader Gold and Silver Public Opinion surveys;
• Extremely good CFTC CoT reports for both metals for the week ending on the 26th of April, with Small Specs in Gold basically erasing their Net Long position. To quote Sentimentrader: “In gold, small speculators have gone from holding a net 60,000 contracts in October of last year, to very nearly being net short now for the first time since 2001. They've reduced their positions over the past two weeks more than any other two-week period since 1988.”;
• A flood of bearish articles, reports and recommendations appearing on a variety of prominent financial sites, newspapers and magazines.

And here are some charts that highlight the severity of the decline and the sheer volume that accompanied it:

 Weekly Gold chart via Stockcharts. Notice the nice long “wick” at the bottom of the last red candle: it usually signals buying pressure and a bottoming process.

 

A daily chart of GDX via Stockcharts: notice the staggering volume.

Daily Chart of GLD via Stockchats: you can observe that just a wee spike in volume took place here as well.

Weekly chart of Silver via Stockcharts: way less inspiring than Gold and yet some support can be detected there as well.

A chart showing the outright collapse in Small Specs’ positioning, via Gotgoldreport.com.

Softs

Both Sugar and Coffee have experienced further declines since our posts dated 14 January, 1 February, 26 February and 13 March. Fundamentals continue to remain decidedly bullish, in particular for Sugar, and sentiment and positioning are extremely favourable to the bullish case as well. An interesting development is the marked reduction in volatility in Sugar, as measured by the width of its Bollinger Bands: our experience is that this usually signals that a powerful trend is the makings.

A slow bleeding accompanied by a marked reduction in volatility: a powerful trend change may be in the offing. Otherwise, hold on to your hat, as we may see a repeat of the Gold near-death experience (extremely unlikely an yet still possible).

The decline of Coffee prices from their 2011 peak now amounts to almost 60%. As Pater Tenebrarum likes to joke, there’s no need to worry, as it exists strong lateral support at 0. More seriously, we have now retraced exactly 100% of the previous advance (you can see the breakout area at the far left of the above chart).

Yen

This is the market where the most interesting changes have occurred. Soon after taking on the role of BoJ Chief, the apparently inebriated Kuroda decided to double Japan’s monetary base on the spot. This may very well turn out to have killed the bullish case. We shall see. We just mention that risks continue to exist and actually abound in various currencies like the CAD and the AUD and that at least a decently-sized correction is likely to occur, to erase the oversold readings and the sentiment excesses. We hold long-dated options that have indeed turned out to prove effective in protecting us from ruinous losses.

Kuroda cheering at the thought of destroying an entire country, right after having smoked some good stuff. He also seems to need a dentist quite badly, a sign that he may very well be addicted to Meth.

A daily chart of the horribly oversold Yen: after a 30% decline in a bit more than 6 months a rally is just par for the course, even if the bear market were to continue. A double bottom may be in place.

Stocks

This is the market that is frustrating us the most. After all, PMs have been great performers for years on end and they’re now experiencing a run-of-the-mill cyclical bear market; Softs are also in the last and hence tricky part of cyclical bear and the Yen is now managed by a band of lunatics. But the stock market is now in the late stages of an extremely powerful cyclical bull market, with money printing that does nothing but create unsustainable bubble activities, with macro data that now obviously point towards a recession (in the U.S.: the rest of the world is already deep in doo-doo), with earnings that are now clearly deteriorating and with sentiment and positioning that have now been signalling for quite some time a speculative frenzy and yet it refuses to beak down. Each and every time it tries to do so, there you have support coming in and, presto, new highs are achieved. Not even the DAX can manage a half-decent decline. The only positive development we’ve seen so far is the recent increase in volatility and in daily ranges, something that usually accompanies the distribution process that takes place at a top.

A chart of the DAX: after tagging the 200-day SMA a bounce occurred and now we’re again above the 50-day SMA. The chart doesn’t look very bullish though.

 Here we have the S&P500: it refuses to break down. Notice however how choppy the recent action has been: generally it is not a good sign when it occurs after long and powerful advances.

Conclusion

We need to exercise patience and wait for our investment theses to play out. The more the various markets keep going in the current direction, the more they’ll need to play catch up once the reversal occurs. The only notable exception may be the Yen, given that there’s now been a catalyst powerful enough to change the secular trend.

Killing me “softly”…

The title of this post reflects what an investor in “Softs” (i.e. Sugar, Coffee, Cocoa, Cotton and Orange Juice. There’s also Lumber, but it has been on a tear and is very likely close to a major top connected with the housing cycle.) might be thinking of his holdings right now…A lot of nothing/nowhere action with a slight downward bias that wears out the vast majority of market players. This might ring a bell with gold bugs as well…
Of course, we as contrarians are delighted to see this kind of action, since more often than not it accompanies major bottoms (we are obviously also humans, so we’re also bored out of our skulls and frustrated by this indecisiveness like everybody else). This is particularly true when strongly favourable fundamental conditions are present as well, as is the case with Sugar.
The objective of this post is to detail the main reasons why we think the delicious and addictive white powder (the folks at the D.E.A. need not worry…) is ripe for a major multi-year bull run that has the potential to bring it back towards its old all-time highs in the 40 to 60c$/pound region. As a general rule, we do not like to make predictions or give price targets, as we think that this is often an exercise in futility, but in this case we want to point out our strong conviction that the coming bull market in Sugar is bound to take out the interim high established in 2011 around 36c$/pound.
And now, without further ado, let’s see what’s brewing in the market…

The Fundamental Backdrop

A) Economics 101

It’s often said that “The cure for low prices is low prices” and indeed this statement is correct. The main problem lies in determining whether a certain price is sufficiently “low” to put the supply/demand adjustment process in motion. With regard to sugar the reality is that very few people involved in the global supply chain (from growers to mills in different countries) can turn a profit with a price of 18c$/pound (of course we’re not oblivious to the fact that in most countries sugar is a very heavily subsidized commodity: it’s simply not relevant to our discussion). So yes, it’s low enough: let’s then see how this impacts the market on both sides.

1. Demand

It should be obvious that a low price generally entices demand, both new and old. Current users of the product/commodity can increase their usage of the product without suffering an increase in costs, whilst users of similar products/commodities (like HFCS in the case of sugar) may find it’s economically advantageous to engage at least in partial substitution. Finally, new sources of demand that didn’t exist before may be created altogether.

2. Supply

On the other hand, producers of the commodity have no incentive to increase production and in fact may even be forced to cut it. Moreover, they’ll strive to find new, alternative uses for their products which can either provide a greater margin or at least partially absorb their surplus (this is happening with bio fuel in Brazil).
Readers interested in exploring the subject, can take a look here, here and here.

B) The Bizarre Case of Chinese Buying

This point is partially related to the one above: whenever sugar prices reach the 18c$/pound area, Chinese buyers step in and take delivery of large quantities of sugar. The reason is quite simple: producing sugar there costs about 30s$/pound and out-of-quota imports are subject to a 50% tariff, so 18c$ + a 9c$ tariff + some spare change for shipping and handling < 30c$ = a nice, risk-free profit for the importer. There are talks of restricting the ability of importers to engage in this arbitrage play, but so far nothing meaningful has been done, thus the market enjoys a strong floor at this level.
See here and here.

C) The Brazilian Milling Industry and its woes

This point really is the most important one. Brazil is both the largest producer and the largest exporter of sugar. Troubles there mean troubles for the world sugar market.
And in the Brazilian milling industry big troubles are looming on the horizon. Actually, they’re already there and getting worse by the day. Let us explain: it all started many years ago, at the beginning of the last decade, when mills embarked on ambitious expansion projects in a race to gain market share, building new facilities and upgrading existing ones. How did they finance such heavy investments? By taking on huge debts, of course: after all, those were the credit bubble years…
In 2008, problems started to surface: the financial crisis hit and numerous mills all of a sudden found out that they were struggling with debt servicing. Some of them went bust or were forced to sell their operations to more financially sound multinationals. Many just kept on going in the hope that things would somehow get better. Fast forward to today and we have low sugar prices, rising costs, rampant overcapacity and plenty of nearly-insolvent mills: instead of getting better, things actually got a whole lot worse.
The main issue is that fixed costs (like e.g. the amortization of plants and equipment) account for the vast majority of mills’ costs and, in order to reduce their unitary cost of production, mills need to operate at or close to full capacity. Unfortunately, overcapacity is so huge that even bumper crops aren’t enough to satisfy the mills’ needs. The end result is that mills are forced to compete between them for cane to process, thus further driving up their input prices. To add insult to injury, a sugar price of 18c$ basically ensures that the vast majority of mills will be selling their product at a loss, further exacerbating their already precarious situation. Of course, even the most efficient ones, capable of turning a profit at the current low prices, won’t be drinking Pétrus to celebrate: their margins are razor-thin.
To us this means only one thing: either prices will have to go up a lot on their own for some exogenous reason, thus allowing mills to regain their financial footing (prices of 20/25c$ won’t make any substantial difference), or they will go up much more as a result of a wave of bankruptcies amongst mills which will bring about a marked reduction in the available supply of sugar. This is not something that is going to happen overnight: our best guess is that it will take approximately 2 to 3 years to bring this problem to the forefront. Obviously a new financial crisis/globalized recession could accelerate the process markedly. Regardless, we have no problem waiting, particularly given that we believe the downside to be severely limited.
Here, here, here and here readers can find additional information.

D) India: a complete mess

If trouble is brewing in Brazil, then what about India, which is the second largest producer and the biggest consumer of sugar?
The situation there is messy, and this is a euphemism. Why is it so? Thanks to heavy government meddling. We won’t delve into the details: we have already bored ourselves to death with them and we do not want to inflict the same punishment on our readers. We’ll keep it short and say that in India sugar production pretty much equals consumption. There has been a surplus in the last couple of years, but our impression is that this is more the temporary result of a series of favourable phenomena than the product of careful long-term planning that is here to stay. As such, we think it’s very likely that India will at some point in the next 2 to 3 years be forced to import rather large amounts of sugar. The last time this happened prices rallied handsomely. Masochistic readers can have fun here, here, here and especially here. There are many other sources of info on the web, but the main takeaway is always that self-defeating “Fair and Remunerative Price” policies, coupled with other idiotic rules and regulations, do not allow the sugar industry to develop and thus leave it vulnerable to a few-years-long boom-bust cycle and to the occasional drought/whether catastrophe.

Technicals, Sentiment and Positioning

The technical picture looks constructive and sentiment and positioning data lend credence to its validity.

Chart of Sugar via http://stockcharts.com/.

The market continues to be stuck in a “falling wedge” consolidation pattern, which is bullish. The recent breakdown below the lower trend line (and below the important level of support around 18c$) appears to us to have been a classic “bear trap”. Price has now rallied convincingly and is back into the pattern and above the 50-day simple moving average, which has acted as strong resistance in the recent past. Further levels of resistance can be identified around 19c$ and 20c$. Both MACD and RSI show positive divergences, with the latter having broke out of a triangular consolidation and above the level of 50.

Sentiment remains subdued and below neutrality, something which has pretty much been the rule since late 2011. CoT data are very bullish, with commercials continuing to hold a small net long position (like in 2007, just before a major bull was born).

CoT data via http://cotpricecharts.com/.

Conclusion

The sugar market continues to be very attractive. In fact, we think it currently offers one of the best risk-reward propositions available to long-term investors. We have bought it quite heavily in the recent months and we remain convinced that it has the potential to generate a very profitable multi-year bull market. Patience is of course always required, as it might continue to consolidate for a while more. What really matters is that we do not envision serious downside (i.e. we really doubt it would ever make it to 16 or even 15c$ as some analysts speculate). A powerful breakout above some key resistance levels might have us buying even more, but this time around with strict trader’s discipline (i.e. with a tight stop loss in case things do not go as planned).
A unrelated note: we’ve only made sparse updates to the blog recently and we haven’t produced any major articles (even this one is rather brief by our standards), because we’ve been quite busy following markets during the recent PMs turmoil and more importantly because we’re packing up for a very nice trip to the Seychelles, only slightly spoiled by the fact that we do not enjoy flying very much, to put it mildly. We’ll of course publish some photos of the trip, assuming we'll survive… The goal is obviously to cause some serious liver damage in over-worked readers currently stuck in their cubicles with no hope of breaking free before the summer (we are of course just joking).
As such, in the next two weeks readers can expect only occasional posts from us, which we’ll publish only in case there’s something going on in the markets which requires our attention.

“You know, it’s a Bull Market!”

The wise words of old Mr. Partridge undoubtedly apply today to both Gold and Silver and the objective of this post is to outline the main fundamental reasons that determine the metals’ long-term bullish trend. We will also provide a brief overview of the current technical/sentiment situation, which is in our opinion neutral to slightly positive. We’ll focus mainly on gold, but much of what we’ll say applies to silver as well, with the important caveat that the poor man’s gold is much more volatile than the yellow metal and its performance is more strictly dependent on the ebb and flow of speculative demand.

Before starting, however, we have to ask an important question: is gold money? The answer is yes and no. Yes, because it possesses certain characteristics that make it fit for the role of money, the very same characteristics that prompted its use as a medium of exchange in ancient times (see Carl Menger’s seminal work on the origins of money). These features cannot be stripped away from gold by means of government decree: it will continue to hold them and people will continue to be attracted to them whenever and wherever the need for sound money will arise. No, because money is correctly defined as “the general medium of exchange, the thing that all other goods and services are traded for, the final payment for such goods and services on the market (Rothbard, Austrian Definitions of the Supply of Money)”. Clearly, you can’t pay for petrol with a nice gold bling-bling (unless maybe you happen to be a gangsta rapper). We must therefore keep the above in mind when analysing gold and the determinants of its price. We may sum the above concepts up by saying that gold is a commodity until it isn’t.

A final note on the usage of some words: when talking about gold we’ll use the terms money or the money commodity, whilst when referring to the fancily coloured pieces of nothing that we all keep in our wallets we’ll use the terms paper money or fiat money.

The Fundamental Backdrop

A) A brief introduction to the Austrian Theory of Money

As hard-core Rothbardians, we are of course biased in our assessment, but let us tell you: the Austrian Theory of Money kicks ass! Well, at least in the realm of economics…

In this field, the main achievement of the Austrian School (hat tip to Ludwig Von Mises) has been the successful application of Marginal Utility Theory to the analysis of money, its demand and its value. This has allowed the Austrian School to treat money like all other goods (even though it clearly recognizes money’s peculiar function and its specific characteristics) and thus offer a comprehensive and coherent body of economic theory based on the laws of praxeology and the action axiom. As Murray Rothbard so aptly put it: “No longer did the theory of money need to be separated from the general economic theory of individual action and utility, of supply, demand, and price; no longer did monetary theory have to suffer isolation in a context of "velocities of circulation, " "price levels," and "equations of exchange".”

The supply and demand relationship can thus be represented graphically in the usual fashion (total demand-stock analysis): a falling demand curve intersects at a certain equilibrium point (where supply and demand meet) a vertical line which represents the total stock of money at the given time. On the horizontal axis we find the quantity of money (its supply), increasing rightwards, and on the vertical axis its price (in this case the purchasing power of money or PPM), increasing upwards:

We can’t refrain here from singling out the economic ignoramus Antal Fekete, founder of the “New Austrian School”, and his equally ignorant disciples, who claim that money doesn’t have declining marginal utility (or if it has it, its rate of decline is “negligible”): this is hogwash and we wonder how come they still use the adjective “Austrian” when they reject one of the core tenets of the Austrian School and thoroughly ignore one Mises’s most important contributions to economic theory. Not really surprising: after all they’re a bunch of monetary cranks and their ignorance certainly does not limit itself to the above.

B) Supply of and Demand for Money and their determinants

1) The Supply of Money

The supply of the money commodity tends to grow steadily and modestly over time: each year mining adds a small percentage to the total stock, whilst non-monetary uses and wear and tear reduce it. Fiat money on the other end is conjured into existence by the Central Bank and the Banking Cartel, either via outright money printing or via the more subtle process known as fractional reserve lending. They can increase its supply at will and, since the process allows the early recipients (the banks themselves, big business and the the well-off) to gain at the expense of the late recipients (workers, pensioners etc.), they are likely to do so.

It is obvious from the graph above that ceteris paribus an increase in the supply of money will determine a decrease in its purchasing power and vice versa.

2) The demand for Money

The demand for money has three subcomponents.

A) Non-monetary demand

This is the demand to use the money commodity for purposes other than monetary exchange (e.g. the use of gold in electronic circuits). If gold were actually used as everyday money, this demand would very likely be lower than it currently is, as the opportunity cost of using the metal would probably increase sharply. In any case, even now, as the price of gold increases, non-monetary demand tends to decrease, as the opportunity cost rises. Silver is much more dependent than gold on the vagaries of such demand.

Obviously non-monetary demand is nonexistent in the case of fiat money (apart from tragicomic situations: e.g. people in Weimar burnt marks in the stove as they were cheaper than wood).

B) Exchange demand for Money

This is the demand to acquire money for exchange purposes by sellers of other goods and labour: people sell their surplus in order to obtain money with which to engage in indirect exchange (thus avoiding the limits of direct exchange, a.k.a barter). Sellers of goods will tend to have a perfectly inelastic demand curve (as they have no reservation use for their goods), whilst sellers of labour will have a falling demand curve (since they could always trade work for leisure): the combined exchange-demand curve for money is thus falling (as the PPM increases, the exchange demand for money falls). It’s clear that in the current situation, this demand is almost nonexistent for gold (nobody asks to be paid in gold for his work). It is however an important determinant of the value of fiat money, given that this demand exists only as long as paper money is the accepted medium of exchange.

C) Reservation demand for Money

The third subcomponent is the most volatile and thus most important one: it is the demand to hold money by people who have already acquired it. Money acquired on the market (by selling goods or labour) can be spent, either on consumption goods or investment goods, or added to one’s cash balance. Money already in the cash balance can either be kept there or dishoarded (i.e. spent on consumption or investment goods).

Ceteris paribus an increase in the PPM will result in a reduction in reservation demand (as the value of money in terms of other goods increases, a lower quantity of money can now perform the same functions earlier performed by a greater quantity) and vice versa. There is an extremely important exception to this rule and that is when the Misesian crack-up boom appears: as people become aware of the deliberateness of the inflationary policy, their reservation demand to hold paper money falls dramatically as the money supply increases, thus exacerbating the inflationary crisis (see also further below). This of course can’t happen to gold, unless we were to really find the philosopher’s stone.

We will see below what could alter people’s decisions to hoard or dishoard money (i.e. what could cause a shift of the reservation demand curve, as opposed to a simple movement up or down the current demand curve as in the example above), but it’s important to note that the values of both the money commodity and fiat money are heavily influenced by such shifts in demand.

3) Influences on the reservation demand for Money

All people familiar with praxeology know that it is of course impossible to formulate a law that precisely and quantifiably predicts how economic actors will react to given changes in the surrounding reality, as each man has his own scale of values and preferences and is constrained by his own set of circumstances. The deluded refusal to acknowledge this simple fact of life is also know as “Mathematical Economics” or “Econometrics” and has so far only managed to produce untold misery, by way of justifying idiotic interventionist policies with fancy “scientific” formulae.

It is however possible to infer certain general “rules of thumb” that can help us in making qualitative assessments on a certain situation. With that in mind, let’s see what can have a meaningful influence on people’s reservation demand for money and, as a consequence, on the value of money itself.

A) Uncertainty

Life is uncertain. We do not know what the future holds. But what if we were suddenly catapulted in a world of certainty, in an Evenly Rotating Economy (ERE) where equilibrium has been reached and nothing can possibly change (i.e. all prices are final prices and remain constant, production and consumption patterns repeat over and over again etc.)? What would happen to money in such a case? We’ll let Rothbard answer these questions:

“It is true, as we have said, that the only use for money is in exchange. From this, however, it must not be inferred, as some writers have done, that this exchange must be immediate. Indeed, the reason that a reservation demand for money exists and cash balances are kept is that the individual is keeping his money in reserve for future exchanges. That is the function of a cash bal­ance—to wait for a propitious time to make an exchange.

Suppose the ERE has been established. In such a world of certainty, there would be no risk of loss in investment and no need to keep cash balances on hand in case an emergency for consumer spending should arise. Everyone would therefore al­locate his money stock fully, to the purchase of either present goods or future goods, in accordance with his time preferences. No one would keep his money idle in a cash balance. Knowing that he will want to spend a certain amount of money on con­sumption in six months’ time, a man will lend his money out for that period to be returned at precisely the time it is to be spent. But if no one is willing to keep a cash balance longer than instantaneously, there will be no money held and no use for a money stock. Money, in short, would either be useless or very nearly so in the world of certainty.” (Rothbard, Man, Economy, State with Power and Markets, Chapter 11)

Luckily though we do not live such a dull existence, but a more spicy one. And, as Rothbard says:

“In the real world of uncertainty, as contrasted to the ERE, even “idle” money kept in a cash balance performs a use for its owner. Indeed, if it did not perform such a use, it would not be kept in his cash balance. Its uses are based precisely on the fact that the individual is not certain on what he will spend his money or of the precise time that he will spend it in the future.” (Rothbard, Ibid.)

It is therefore clear that uncertainty plays an important role in determining people’s reservation demand for money. It is safe to say that, ceteris paribus, an increase in uncertainty will most likely cause an increase in the reservation demand for money. This is intuitive: what do you do when you are faced with an economic emergency (e.g. you lose your job or your business fails, or you are faced with a large unexpected expense)? The most likely answer is: you raise cash, that is you either restrain your consumption or you sell your investments or a combination of both. The same holds true when such an unforeseen event affects all or the vast majority of people (e.g. an economic crisis, a bear market, a war, acts of god etc.): in the face of growing uncertainty people generally choose to increase their cash balances (i.e. their reservation demand curve shifts to the right).

Now we guess we don’t have to tell you what might go wrong in a world where increasing state intervention in the economy, endless money printing, gigantic malinvestments and growing social unrest rule the day…

B) Speculation

This is an easy point to make: if people expect the value of money to increase in the future, they’ll increase their hoarding now (i.e. their reservation demand will shift to the right), thus bringing about the change in the PPM in the present. Of course the opposite is true as well: “an expected future fall in the PPM will tend to lower the PPM now.” (Rothbard, Ibid.)

This is what has recently happened to the Yen: speculators anticipating massive devaluation of the currency by the BoJ rushed to sell it, thus causing the fall to occur in the present. Unfortunately for them, all the relevant data point to a rather serious misunderstanding of the BoJ’s real intentions on the part of the speculators. But no worries: erroneous speculations are self-correcting, not self-fulfilling as the minions of the State would like us to believe. Correct speculations, on the other hand, are beneficial as they speed up the market’s adjustment to the new equilibrium conditions.

In the case of gold, it is not difficult to see what could happen should a renewed economic crisis wreck havoc à la 2008/2009 on U.S. government finances at a time when debt and deficit monetization by the Fed and foreign central banks is already rampant, both in absolute and relative terms:

 

 

YoY Percentage Change in U.S. government Receipts and Outlays superimposed to a 12-month rolling measure of the Deficit. Chart via Michael Pollaro. Could that nasty divergence happen again? Of course it can: we only need a nice crisis! Problem is, the deficit’s current level is already way higher than in 2007, both in absolute and relative terms.

 

The result of the U.S. government profligacy is a record-high level of debt monetization on the part of both the Fed and foreign central banks. Guess how they finance their purchases?! And what if they have to buy even more, due to resurgence of the 2008/2009 dynamics outlined in the chart above?! Again, thanks to Michael Pollaro!

 

In the case of the dollar it’s certainly more difficult to foretell what the market’s reaction to such a situation might be, as people’s reservation demand to hold it ultimately rests on a precarious foundation, as Mises pointed out in Human Action:

“The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796 and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.”

As such we can by no means know in advance whether the next crisis and the official response to it, likely constituting of a large dose of new inflation, are going to determine a shift in people’s perceptions dramatic enough to seal the fate of the dollar. In fact, we tend to doubt it. What we are strongly convinced of is that although the dollar could very well gain in value against other currencies, it is unlikely to make much progress, if any, in terms of gold.

4) A real-life example: the panic of 2008

Now that we have described the components of the demand for money and their main determinants, let’s see if we can manage to explain, using these instruments, what happened to both gold and the dollar in 2008.

Between July and November of 2008 the value of the dollar increased more than 20%, whilst the price of gold plummeted more than 30%.

The reservation demand for the dollar was clearly pushed to the right by both uncertainty and speculation that deflation would increase its PPM.

The case of gold is a bit more complex, as there were opposing forces at work: on the one hand, its price declined as speculators bet on a deflationary outcome; on the other hand, uncertainty pushed many people into the market (as demonstrated by the record surge in GLD holdings at the height of the panic, between September and October, which not accidentally coincided with Lehman’s bankruptcy). Once the deflationary scenario proved to be incorrect, its price soon returned to equilibrium: gold was by far the fastest asset to regain its pre-panic value and by February 2009 it was already close to it previous all-time high. It’s also important to note that during the panic it did either gain substantially or lose modestly against other currencies (with the exception of the Yen) and it also increased its PPM when measured against other goods (like e.g. crude oil, copper, equities etc.). Even if the deflationary outcome had come to pass, we suspect that gold would have not continued to lose value against the dollar, but its price would have most likely stabilized or even increased, as uncertainty would have become even greater as the financial system would have rightfully collapsed, thus pushing more and more people in the gold market at a time when sellers would have probably been rare (in fact the “Lehman demand” did indeed generate a meaningful rally in the price of gold). In any case it would have most certainly gained immensely in real terms (i.e. when measured against other goods, like houses, cars, food, energy etc.).

We can then conclude that both gold and the dollar benefited from an increase in people’s reservation demand for money, with the former temporarily succumbing to speculative forces (which subsequently self-corrected) and the latter of course profiting from its status as reserve currency (as well as the deflationary scare).

When the next crisis strikes, we fully expect gold to experience an even greater increase in reservation demand, as uncertainty will again increase and probably quite dramatically, given how unquestioningly people have put their faith in central bankers and their monetary tricks. Should (when, actually) the modern-day heirs of Count Cagliostro fail in bringing about prosperity by means of inflation, what would the poor saps do? Buy gold, that is. Moreover speculative forces should now be firmly on the same side, as it’s apparent that the default response to every problem is to “paper it over”.

C) Popular fallacies regarding Gold and its Bull Market

In light of the above, we can now embark on debunking some popular fallacies about gold and what drives its bull market.

1) Gold is a commodity

Although, as we have seen above, gold is not entirely money at this point in time, it is erroneous to then assume that it’s just your average commodity: it isn’t. And it follows that it’s dangerously misleading to apply conventional commodity-style studies to the gold market. Firstly, the existing stock dwarfs annual production, thus rendering traditional supply-side arguments useless (unless one correctly recognizes that the supply of gold is indeed its existing stock and not the annual mining output); secondly, as we have outlined before, there exists a reservation demand to hold gold, which is almost nonexistent in the case of other commodities (i.e. we have yet to meet sugar bugs or coffee hoarders) and which upsets standard demand-driven analysis that focuses just on those who want to acquire gold (without considering the far more important influence of those who already own it and want to keep it). This is always true, but becomes even truer when gold is, as is the case now, in a secular bull market, because it is at this precise time that gold takes on its monetary role with far more authoritativeness than before.

2) Indian demand and Chinese demand

The misconception that Indian or Chinese buying is an important force behind this bull market is the offshoot of the above “Gold is a commodity” fallacy. The reality is that there is more than enough gold available to meet both Indian and Chinese demand and the price at which it will do so depends not so much on the size of such demand as on the reservation demand of those who hold it (and have to sell it to the Indian or Chinese buyers). This is no surprise for those who understand that price is set at the margin.

Sceptical readers might want to peruse the data published by the World Gold Council and see whether they can find any significant correlation that lasts over the years between the vagaries of Indian and/or Chinese demand (or even global demand for that matter) and the gold price.

D) Miners ≠ Gold

That mining companies are different from gold is a truism. From this it should logically follow that the reasons to buy (or hold) gold are unlikely to also constitute valid reasons for buying mining companies. And yet many people view an investment in said companies as a way to somehow “leverage” their exposure to gold’s gains: the sad reality is that more often than not they only manage to leverage gold losses, while underperforming its gains. Sure, miners can and often indeed do rise together with gold, sometimes even exceeding its advance, but the reality is that people buy and hold gold to satisfy very specific needs that can’t be fulfilled by owning miners and the stronger these needs grow, the larger the discount at which mining companies trade relative to gold is bound to be. And this does not even begin to address all the myriad specific risks and pitfalls that mining companies present to investors…

Readers wanting factual proof of this need to look no further than the last big gold bull market of the ‘70s: at their respective peaks at the beginning of 1980, both gold and silver had outperformed the miners (as represented by the Barron’s Gold Mining Index) by a wide margin (gold returned almost 4 times more than the BGMI and silver almost 6 times more). Once the bull market ended (and so did the particular reasons to own precious metals) miners did skyrocket higher, doubling in less than a year an peaking in October 1980, as their profit margins were indeed being boosted by still very high gold prices (and yet their total return for the bull was still less than half that of both gold and silver).

Of course peddlers of mining stocks or of investment newsletters of questionable quality will point out to some specific miners which indeed saw returns higher than the metals, but the fact remains: an average investor would have been much better off owning the metals outright rather than owning miners or, worse yet, trying to turn himself into a superstar stock-picker (remember that the aforementioned peddlers have the benefit of hindsight).

That said, miners are indeed very oversold and very cheap at the moment and as such they might present a legitimate investment opportunity. Yet, we are not interested in taking it: we own metals primarily for safety and mining companies do not offer it. Moreover, history is on our side and we should see returns way in excess of those delivered by the miners. And after all is said and done, we could always buy them after the end of the bull and maybe still manage to reap gains larger than those of all the people who kept them for the whole period… We do not however exclude the possibility of trading miners, particularly at this very juncture, as their risk/reward profile appears excellent (in fact, we’re currently busy analysing a few mining companies).

E) The ‘70s Bull Market vs. the current one

We have already mentioned what happened to gold and silver relative to miners during the last bull market. There are however a couple other points worth mentioning that explain why we think this bull market is going to deliver larger gains than the past one and with lower drawdowns.

1) In the ‘70s, Gold had just started to trade freely

The bull market in gold officially started in 1966 (the year of the Dow/gold ratio high), but until March 1968 its price was artificially suppressed by the infamous London Gold Pool, which of course miserably collapsed as soon as market forces became too powerful for the high priests of interventionism to counter (by the way, the Gnomes of Zürich have to thank this fateful event for their now buoyant local gold market). Moreover, artificial pressures persisted until 1971, as the so-called “gold window” (the spread between the fixed gold/dollar exchange rate and the actual market price) allowed some of the shrewdest pool participants to convert their currency reserves into gold at the fixed price of $35/oz. and then sell it on the open market for a nice, risk-free profit. As a result, gold had quite a bit of catch up to do after the definitive end of the Bretton Woods system: it more than quadrupled in less than 3 years (it broke above 50$/oz. in the spring of 1972 and peaked at the end of 1974 at roughly 200$/oz.). This time around it took gold 7 or 8 years to complete the same feat, depending on whether one considers the 1999 bottom or the 2001 bottom as the starting point. This different behaviour also partly explains why in 1975 gold entered a two-year cyclical bear market that halved its price, whilst in 2008 it only corrected approximately 35% notwithstanding an epic panic and widespread liquidation that literally obliterated many other assets.

If we exclude three brief +20% corrections (two during the powerful advance of the early ‘70s and one towards the end of 1978), the mid-‘70s bear was the only one that occurred during that powerful bull market: apart from that, gold only experienced run-of-the-mill corrections of 15% or less. This should put things into perspective and help calm the fears of all those who are currently expecting 1400$ gold (or lower) on the basis that charts tell them this…The current bull has advanced in a much milder and more regular fashion and has already had four +/- 20% corrections (2003, 2006, 2008 and 2011/2012, the last two qualifying in our opinion as outright bear markets), hence it doesn’t strike us as in need of some sort of collapse to “wipe the slate clean”. The same is even truer for silver, which has always generously purged speculative excesses with 35% to 60% plunges.

The unexpected can of course always happen, but the above is one of the reasons why we tend to think that the current consolidation is all we will see: people waiting for 1400$ gold might end up being disappointed.

2) This time it’s much worse!

This is a quick point: the crisis of the ‘70s was undoubtedly a serious one, but we can guarantee you the current one dwarfs it. We won’t enter into details, suffice it to say that the fundamental backdrop is much less inspiring this time around (think of a secular crisis as opposed to a cyclical one: i.e. we’re now at the end of the rope). As such we expect gold to benefit from a much larger increase in reservation demand and, consequently, in its price.

This contributes as well to our scepticism towards claims that gold ought to “collapse” before being able to resume its advance.

Technicals, Sentiment and Positioning

The technical picture is rather benign for both metals:

Gold chart, via http://stockcharts.com/.

Silver chart, via http://stockcharts.com/.

As can be seen in the charts above, both have been spending quite some time in triangular consolidations from which they broke out higher during last summer. These bottoming processes have been accompanied by rising RSI and MACD indicators, with the latter showing remarkable bullish divergences in both cases. The metals are now in the process of recreating these formations on a smaller scale, significantly reducing their trading ranges in the process (a guarantee that a strong move is in the  makings). Strong support can be found in the 1550/1650$ area for gold and in the 26/30$ area for silver. Major resistance levels are 1800$ for gold and 35$ for silver: anything in between is just noise. Time also plays an important role here: the gold bear is roughly 18-month long and the silver one is approaching the 2-year mark. This all combines into a bullish picture: a long correction/consolidation with positive momentum divergences and strong support right underneath it in the context of a powerful secular bull market doesn’t sound so bad, does it?

So let’s see if sentiment and positioning agree with the above.

The former, as reported by Sentimentrader, is hardly buoyant: the readings on gold are currently below neutrality and actually close to levels only seen at major bottoms, including those of 2008, mid 2012 and December 2011. More importantly, they have been spending there quite some time since the 2011 top: another guarantee that there certainly isn’t any speculative mania going on (and if you still doubt it, then just spend some time on a few PMs forums…). The picture on silver is good, but less rosy: sentiment is below neutrality, but not particularly depressed. Moreover, it rose to relatively high levels during last autumn’s rally. Somewhat counterbalancing this is the fact that during last summer’s doldrums sentiment on silver plummeted to levels not even seen during the outright scary 2008 panic and stayed there for a relatively long period. All in all, we consider the sentiment picture positive and supportive of higher prices.

Positioning, on the other hand, is a bit more mixed… ETFs flows show that there has generally be a slow bleeding away from the precious metals sector, with GLD and GDX leading the way (SLV actually recorded its highest ever daily inflow on the 15th of January). Major bottoms tend however to be signalled by some sort of capitulation selling, where large amounts of money are withdrawn all at once from the ETFs. Rydex funds data also confirm that a notable retreat from the sector on the part of dumb-money investors took place during the recent correction. CoT reports unfortunately do not (yet) agree with the above: although both large and small specs have reduced their gold longs to a neutral level, we still do not see the hoped-for washout. And silver is even worse: both large and small specs continue to hold dangerously high levels of longs. We can only hope to see improved data this coming Friday. We want to point out that this fact does not make us bearish at all: it merely means that there could be scope for further corrections/mini-crashes to flush the specs out of the precious metals market.

A final note: we’ve been delighted to see a resurgence of the historical negative correlation between equities and gold, which was thrown under the bus during this last cyclical stock bull. It’s now obvious that gold is again ready to act as a “risk-off” investment, as it is fundamentally designed to do (and as in fact did in many prior instances, both recent and remote).

Conclusions

We are very bullish on gold and silver over the long term and we hold large positions in both metals (although we are overweight the former as it tends to deliver lower volatility and smoother, more regular returns). We intend to accumulate more should favourable circumstances present themselves (e.g. a washout bottom like last summer’s one or a convincing breakout above important resistance levels).
The current picture is however mixed: on the one hand, it’s clear to us that unless and until a new crisis phase opens up, precious metals will very likely continue to be the speculators’ “discarded toys”, abandoned in favour of hotter assets like equities (which on the contrary are currently sustained by the delusion that monetary hocus-pocus can possibly engineer prosperity); on the other hand technicals, sentiment and to a lesser extent positioning appear consistent with the notion that prices are way closer to a bottom than to a top. This week’s Commitments of Traders will help in ascertaining whether we are indeed ready to turn higher or not, as a marked reduction in speculative fervour is the last important ingredient still missing. We also remain convinced that last summer’s bottom was a major one, as it presented all the important characteristics that generally accompany a meaningful intermediate-term low: it’s very unlikely that it will turn out to be violated this year.
As always, we’ll keep our eyes open to spot important developments, but in the meantime we advise our readers to keep in mind the Golden Rule (“He who has the gold makes the rules”), as we believe it will be applied once again in a not-so-distant dystopian future where central banks’ and governments’ actions actually have consequences (and nasty ones to boot)…And of course we encourage them to engage in their own research!