Gold: The Ultimate bubble

FOFOA just wrote a brilliant piece on why Gold is not, never was, and never will be a bubble.
Let me work out some common ground here, as there is a lot I agree on.
1) The US Govt Bond market is a bubble. I have said so many many times. FOFOA calls it a Ponzi scheme in its final stages. I agree.
2) FOFOA says that Gold is not currently in a bubble. Yes, but it is quite fairly valued against most other asset classes. There are some ridiculously overvalued asset classes like US Treasuries and financial stocks (Interestingly John Paulson who made slightly more than FOFOA or me last year thinks both, Gold and financial stocks, are undervalued). But the bulk of the commodities are quite fairly valued to undervalued compared to Gold.

To me Gold is an asset class nothing else, and it can, and has actually become, a bubble in the past.
I do not buy into Exter's pyramid. See pic. (Actually I added Silver below Gold in the pic in the ratio of the market value of all Gold to all Silver in the world. Unfortunately you cannot see it due to the fact that the market value of all Silver is about 300 times smaller than all Gold.) I think it just a fanciful way of saying we have a lot less Gold than Real estate and Treasury Bills. So? We have microscopic amounts of Platinum compared to Gold , should I put that right at the bottom? As I have argued in the past, Platinum is a better bet for High Inflation/Hyperinflation than Gold. At best that pyramid shows relative appreciation potential WITHIN the US during hyperinflation. All liquidity will not flow in an orderly manner down this pyramid as its founder espouses.

Coming back to the valuation of Gold. Gold will likely appreciate substantially during the next few years. The reasons are numerous and have been detailed by many, however there is a limit to how much it can appreciate before it does become a bubble.
To see what that level would be we need to see what we can buy with Gold today.
Bill Downey published this recently

"How much things cost on Aug 15th, 1971" to what they cost at $900 dollar gold"

Dow Jones Industrial Average 890 or 25 oz. gold in 1971, versus 10,000 or 11 oz. gold today.

Average Cost of new house $25,250 or 721 oz. gold in 1971, versus 250,000 or 277 oz. gold today.

Average Income per year $10,600 or 302 oz. gold in 1971, versus $70,000 or 77 oz. gold today.

Average Monthly Rent $150 or 4.3 oz. of gold in 1971, versus $824 or .8 oz. of gold today.

Datsun 1200 Sports Coupe $1,866 or 53 oz. gold in 1971, versus $28,400 or 31 oz. gold today.

As we can see the difference is in purchasing power. We can buy a lot more for our gold today. The above example shows for the most part, we can buy things at about 1/2 the price of 40 years ago. Some things on the list are 1/4 the cost."

Here he is comparing the value of Gold today to that before the first Gold Bull run began.
Mind you, we are ten years into this one, and it looks by any standard Gold has done quite well.
The last bull run ended with Gold at $850/oz. That was the ultimate bubble in the price of Gold in USD terms. At that price Jewelry demand was almost annihilated. The price of Gold was atrocious in relation to its inherent demand, price of production and in relation to everything else. Most commodities had become too cheap compared to Gold. So had the Dow!
FOFOA says that Gold can never be in a bubble, however I fail to see what would you call the $850/oz price back then. It had discounted enormous amounts of future inflation and it seemed completely useless compared to 21% interest rates.
If you had put $850 in one ounce of Gold, after storage and transaction costs you would have less than $200 after 20 years. Forget the Dow, if you had bought risk free 20 year Treasuries (back then they certainly were) yielding 20% you would have made over $32,000. 160 fold difference!
That is what an end of the bubble performance looks like. When a risk free asset outperforms a legendary "store of value" by 15000% you know you have been taken to the cleaners!
Even today, for all its fanfare, Gold has performed poorly so far against risk free assets of countries where there is no chance of Government debt default or hyperinflation. For example against the 9 year Norwegian Krone treasury Bond purchased in 2000, yielding 6.5% (when 9.4 Norwegian Krones bought 1 USD, ) Gold would be up about 60% against this asset class over 9 years. Less if you factor in storage costs and bid-ask spreads. At the low point for Gold in 2008,
Norwegian Krone treasuries had almost performed as well as Gold. I am bringing this up to make 2 points.
1) Hyperinflation is bankruptcy of the Government due to money printing. Creditor Governments (like that of Norway) will never go bankrupt (at least as far out as the eye can see). Hence Gold will always under perform in those currencies.

2) Considering how little Gold has appreciated vis-a-vis risk free Norway treasuries, Gold is nowhere near being in a bubble and has a long, long way to go.

This brings us back to how long it will take and what will be the signs that Gold is in a bubble.
Gold still lacks widespread participation to come anywhere close to being in a bubble. Although we have yet to see any serious price deflation, we have also not seen serious price inflation. The public will not come in before we have serious inflation. Without their participation there can be no bubble. There are many stories and ideas about a sudden collapse in the dollar. While possible, I think that there are strong deflationary forces at work and in the absence of monetization the natural trajectory for the USD would be UP. So at any time the pressure on the USD gets too intense the Fed can back off from money printing. The question is what forces will be at work at the time and whether they can back off money printing at those times. Hence while hyperinflation is a strong probability it is not the ONLY possibility. Left to its own devices, the Bond market can wreck severe deflationary pressure if it moves a couple of percentage points higher on the long end. Will Bernanke step up and say he will cap the 10/30 Yr bond rates with indefinite amount of printing? You can bet your bottom ounce of Gold we will have Hyperinflation then.

Faith in the USD.
All the actions of the past year, both from a monetary standpoint and Government spending standpoint have certainly eroded confidence in the USD. At the same time its main counterpart (the Euro) is grossly overvalued from a purchasing power parity standpoint.
From a logical stance the correct investment would be to sell Euros buy USD and invest in those assets which are significantly cheaper in the US than in the Euro-Zone. While easy in theory it is virtually impossible to do in practice, hence we see all momentum money rushing into Gold. However I expect a more logical stance from at least some Central banks. While India's Gold purchase has been touted as a huge move for Central Banks across the world, China has spent more than 15 times India's purchase price on buying OIL. They are securing reserves in the Ground for under $15 a barrel rather than buying Gold at $1100. In fact they had several chances to purchase Gold and Gold companies at vastly lower prices than today but they did not move on it. Why? Because they have more sense than Gold bugs. Gold is only a means to an end. It only works as a way to protect your assets against the devaluation of paper money. It only works as a way to keep up with rising commodity prices. However if you can buy the commodities themselves for much cheaper and store them (not practical for an individual to do) it makes no sense to buy Gold.
China at national level can do this and just as India's purchase put a floor under the price of Gold, expect China's purchase to keep a lid on the Gold:Oil ratio.


In the last 2 years I made 2 calls on this ratio.The first was when the Gold:Oil ratio dropped under 7. I sold my oil holdings and purchased the precious metals. The second was when Gold:Oil ratio hit 22, when I reversed the trade. What was amazing was that when the first happened, everyone was convinced that oil would go to $200 and above ( I was convinced too, except that I felt Gold was much cheaper than oil and fortunately made the trade). When the second happened in March, those same people were convinced that Gold would hit $1500, oil would go to $10 and the S and P would go to 150. It really, really pays to stay rational and examine the value of everything and not just its price.

To put FOFOA's claim in prespective, Gold would have to rise more than 35 fold relative to oil to reach the mid-level price projected of 1 ounce of Gold to 500 Barrels of oil. Currently oil in the ground is trading around $15/barrel. Total "proven" reserves of 1.2 trillion barrels would be worth about 18 Trillion USD. If Gold did go up 35 Fold (oil remaining at these levels, we will ignore nominal changes and focus on relative ones) the total Gold market would be worth over 160 trillion USD.
10% of the world's existing Gold would be able to buy all the world's oil resources for the next 30 odd years of production. The middle east producers would take a 97% pay cut in terms of the price they got for their oil in real terms. (I have alluded to a possibility of an extreme Gold:Oil ratio in the past , I now see that as a bit less likely, however should it occur it will not last more than a year and we would be lucky to get to 100 on the ratio.)
I see ZERO chance of a 550 ratio in the next 10-15 years (once oil is no longer the primary fuel of course anything is possible, that is like saying 1 oz Gold will be able to purchase 2,000 1995 laptops in 5 years...Sure!). In all hyperinflations that we have seen in the 20th century, outside of the country undergoing hyperinflation, Gold has NOT gone up relative to other assets.
Within the country itself there is a huge demand for hard asset currencies and there is substantial appreciation relative to other goods and services. Is this time different? That is what those caught in the last two bubbles said.

Random Thoughts

I had sent this to my buddy Greg Jeffers on November 30 2009 on my thoughts on all markets. I did not get a chance to put it up until now.

Debt Defaults at Every Level
Last week saw the beginnings of investors realizing that no debt no matter how highly rated was safe. The rating agencies did not see Dubai's default coming and the CDS market certainly did not either. Investors and Speculators that piled into debts of all standing have to ask whether anything (or everything as they were pricing in) is safe anymore. We would watch the corporate debt prices carefully for clues on how this will unravel.

Greece looks like it will be next. What would Plato say?
The CDS markets are now pricing in some sort of a default from Greek bonds. the spread over German bonds suggests that the market has little faith in the ability of the Plato disciples to pay their debt back. An event of that magnitude would be a Category 6 hurricane right when Moody's and the other 2 stooges were Forecasting that every sovereign debt should be rated a minimum of 18 A's.

EuroZone interest rates. Rate hike? NAFC
While the market participants get excited at the prospect of leveraging themselves 20 fold on the Euro because they believe that rates hikes are about to come from Trichet’s quiver, we remain highly skeptical. Considering the fact that barring Germany and France, all other Euro-Zone economies are in horrible shape, we would not be surprised with a 75 basis point cut within 18 months.

Go for Gold?
While we remain incredibly bullish longer term, one cannot brush aside the impact of such a huge move in Gold on Indian Jewelry demand. To put this perspective, at the top of the last Gold bull run at $850/Oz (Somewhere over $7000/oz in today's dollars) 95% of the Gold demand was for investment. The jewelry buyers were completely priced out. At the $250 bottom that ratio was exactly reversed. Today the ratio is around 35% for investment and 65% for Jewelry. So while a long term top is nowhere in sight, one cannot ignore the impact of 25% price moves on the appetite of jewelry buyers. While investment demand has increased, a lot of it is still momentum chasing which will run for the exits at the first sign of trouble.

Central Banks will always buy Gold from this point?
While the world seems convinced that Central banks will power the next phase higher in Gold prices, we are skeptical that they will chase prices higher like Gold was the only investment in town. Gold is an important asset for them, however should the price of Gold go up much more in relation to other commodities I trust they will sell Gold and buy other assets. For example if Gold moves up to $1500 while oil moves down to $50/barrel, and oil companies are trading at $15/barrel of reserve, look for a nifty exchange.
While Central banks may buy Gold they would destroy themselves if they chose to buy Gold at any price possible. This is similar to insurance. While it is sensible to spend a portion of your income on Health and Car insurance, it would be ridiculous to spend 50% of your after tax income on it. If Central Banks insist on pushing the price of Gold higher and buying at all costs, I trust they will injure themselves. We would monitor the value of Gold is relation to other assets rather than its absolute price in sinking fiats to decide whether it is fairly valued or not.

Natural Gas...the Natural choice.
Longer dated Natural Gas Futures continue to price in complete abundance for the commodity as far as the eye can see.
While we would not bet the farm for the next 2 years consider us in the strongly bullish camp longer term. Our current natural gas rig count is abysmal to say the least. Combined with significant oil shortages in the next 5 years we see
Natural Gas trading at under $45 a barrel of oil equivalent longer term to be an enormous opportunity. We would not be surprised to see the entire heating oil region being retooled to be heated with Natural Gas if such BTU discrepancy were combined with oil shortages. At $200/barrel and BTU parity, longer dated Natural Gas futures could return almost 400% with very little downside risk.

Derivatives, Default and Deflation

There has been constant chatter that the vast amounts of OTC derivatives will lead to hyperdeflation. Why? Did OTC derivatives exploding from 1 billion to 1 quadrillion over 35 years lead to Hyperinflation? Why would contraction lead to Hyperdeflation.
Let us say that we made a bet for $500 billion with JPM that the sun would rise in the north tomorrow. JPM is also counting on this bet paying off for them as they have inside information that the East is where the action is.
Now tomorrow the Sun does rise in the East and I default, what happens? Loss of jobs in my company and a possible domino effect through the industry. Directly money supply would not be changed. Loss of jobs could be argued to lead to deflation, however nowhere near the impact of the actual collapse of 500 Billion USD of M6.Jamie Dimon will just fleece someone else However since 97% of the bets are actually made by the bug banks like JPM, let us reverse the above example where I have made the big bet on the east and JPM is hoping the Federal reserve will change the definition of east by morning. What happens here? Bailout 101. I get paid by 500 Billion USD as JPM will not be allowed to go under. Suddenly 500 Billion of M6 becomes M2. Such a scenario would Hyperinflationary not Hyperdeflationary.

Taking the leverage out of Gold

Sticking with Gold has been extremely rewarding and will continue to be over the medium to long term. At this point I am selling all my leveraged Gold positions, including my $1250-1500 Call spread which has a nice 100% gain in 6 months.
Note this is an exit only of leveraged positions which can hurt quite badly ina downdraft. Gold and Silver ETFs and Physical bullion are not for sale.

All in Balls Out

The very long dated Natural Gas futures are now finally at a point where the risk reward is quite quite compelling. The May 2014's at 6.33 represent a barrel of oil energy equivalent in 2014 at about $38. I expect to accumulate a good percent of my position over the next few weeks and eventually I expect that it would represent more than 50% of portfolio on an unleveraged basis.All in Balls Out.

Denninger marking the USD bottom

After months of saying we will have massive deflation because the USD will appreciate (read other countries are much worse than the US) and Gold will depreciate (read Jim Willie is an idiot) Denninger has recently decided he ain't buying his own crap anymore. I have counted a total of 10 posts from him recently about how worried he is about the USD. When you have convinced someone as pig-headed as him about the USD, then perhaps the bottom (short-medium term) cannot be far.
As I have mentioned a few times recently, I still think Gold and Silver appreciate in non-USD terms. However considering that they have made large moves in non-USD terms a rest and a correction would not be very likely at this point.

Move over Dennis Kneale ..here comes Jon Nadler

Jon Nadler wants to share in Dennis Kneale's 30 seconds of fame. In an interview on the Gold Bull run, Jon proved once and for all that common sense is surprisingly uncommon.
The entire interview , should you wish to torture yourself, can be read here .
Some highlights...

First and foremost, you have to have demand that far outstrips supply. Like any commodity in higher demand than supply makes available, you'd obviously see a price reflection.

Secondly, you'd have to have a falling stock market. The old adage is that gold is an inverse asset to currencies, stocks and other assets—so where's the bear market in stocks? Stocks have been up 50 percent-plus this year.

Third, you'd have to have an actual, tangible inflation level, and the threat of much higher inflation on the horizon as well. We don't see that either, which we'll talk about later.

And fourth, you'd need an increase in the price of gold across all major currencies—no exceptions. You can't have Aussie dollars and the South African rand going one way, while the euro and U.S. dollar is going the other.

Those four factors are not satisfied by the current picture in gold—not even remotely. What we really see is a momentum- and index-fund-driven speculative move that started almost on cue on Sept. 1. They've been piling in, hand over fist, with margin positions and futures positions that have now mushroomed to a level that's unreal—historic highs, on the order of 750 tons of long positions. They outnumbered the shorts 9:1 as of the week before last; it has since narrowed to 7:1 [as of Tuesday, Oct. 27]. Still, that's way distorted.

But I have to say from the get-go, I'm not a gold bear. I know that anybody who doesn't say "$2,000 gold!" is automatically a bear, but I'm just a realist who looks at supply and demand.

Oh Nadler, how is it that you can start an interview with four erroneous points? I mean, don't people believe in putting their best foot forward anymore?

Point 1: Have you seen Gold production(supply) numbers? Falling year after year relentlessly since 2002. Have you seen demand for 1 ounce Gold coins and Gold bars? 3 years back such premiums would be unheard of, now they are required to keep a check on this market as investors clean out all forms of bullion in small sizes. Seems to me demand and supply are quite favorable.

Point 2: You can shove that old adage where the sun don't shine Nadler. Since the US went off the Gold standard, there has been a massive bull market and a massive bear market in USD terms in Gold prices. During the bull market, the DOW went nowhere. It did not go down. It was at 1000 in 1970 and it was at 1000 in 1980 while Gold went up 26 fold. Non-Correlated is not the same as inverse. I can send you a dictionary on the house if you wish. During the gold bear market Gold went down (duh) and stocks went up. So you are basing your evidence on 1 out of 2 phases of a complete market cycle.

Again all analysis is made in USD terms. If you had actually looked at other currencies, as I and many other have, you would have seen that correlation with stocks just does not exist over any long time periods.

Point 3: No tangible inflation threat? No we have a bigger threat, the threat of a currency collapse, or multiple currency collapses and threat of Government debt default.

Point 4: Now that is plain ignorance. What Mr. Nadler wants is new highs in all currencies simultaneously. That is the only interpretation I can think of. Because Gold has made new highs in all currencies, just not recently. Unless all currencies are fixed relative to each other then Gold will make new highs in different currencies at different time points.

There are errors galore in the rest of the interview but I do not have the time for posting it.

Funnily enough Jon ends with,

Nadler: Ultimately, I think there's a lot less mystery in gold that adds up. If you dissect it all, you can come down with something more realistic. That realism compels me to say "reversion to the mean." We're trading some 30 percent above long-term averages. But if we take away the fear premium, take away the funds and the ETFs, and put in fundamentals, you're left with a range of $680-880—which isn't a bad level, by the way. It still gives producers double the return on their cost of production.

But Jon you were even bearish when Gold was more than $200 below the low end of your projection, weren't you? So now that is a price it will fall to. Sounds like some deflationist calls I have heard over the past 8 years.

Cit Files for bankruptcy

http://finance.yahoo.com/news/CIT-files-for-Chapter-11-apf-1202955938.html?x=0&sec=topStories&pos=main&asset=&ccode=

CIT made the filing in New York bankruptcy court Sunday, after a debt-exchange offer to bondholders failed. CIT said in a statement that its bondholders have overwhelmingly approved a prepackaged reorganization plan which will reduce total debt by $10 billion while allowing the company to continue to do business.

"The decision to proceed with our plan of reorganization will allow CIT to continue to provide funding to our small business and middle market customers, two sectors that remain vitally important to the U.S. economy," said Jeffrey M. Peek, chairman and CEO. Peek has said he plans to step down at the end of the year.

It received $4.5 billion in credit from its own lenders and bondholders last week, reportedly made a deal with Goldman Sachs to lower debt payments, and negotiated a $1 billion line of credit from billionaire investor and bondholder Carl Icahn. But the company failed to convince bondholders to support a debt-exchange offer, a step that would have trimmed at least $5.7 billion from its debt burden and given CIT more time to pay off what it owes.

It is unclear what the filing will mean for the nation's small businesses, many of which look to CIT for loans to cover expenses like buying materials at a time when other credit is hard to come by.

Analysts have warned that already ailing sectors, like retailers, could be hit especially hard, since CIT serves as the short-term financier for about 2,000 vendors that supply merchandise to more than 300,000 stores.

This is really a big blow to small businesses coupled with all the increased taxes being proposed to be added on them for health care spending. Expect the programmed traders to quadruple this stock over the next few days if what happened to GM is any indication.
I have been quite busy, but I hope to have some thoughts up Gold and some high tech bullshit (Stoneleigh's interview) nonsense coming out of The Automatic Earth website, soon.