Bullish on Physical Gold

Did you ever play “follow-the-leader” when you were a kid? Yeah, well, don’t do it with your investments.

Many like to see what the big-boys are buying and selling, and as soon as they catch wind of it, they follow suit. There is just one problem with that investment strategy… the lag time. By the time their trades hit the blogs and papers, it’s already old news.

So now we hear that John Paulson, the largest single holder of SPDR Gold Trust (NYSE: GLD) shares, sold more than half his holdings in Q2. Another leader everyone likes to follow is George Soros, who sold more than half a million of his GLD shares last quarter.

What is scaring these long-time gold faithful? Should you be scared of gold too?

Insufficient News

If Paulson and Soros had been selling today, we might be tempted to follow their lead. But all we know is that their sales took place in Q2, sometime between April 1^st and June 30^th.

Come to think of it, there was that precipitous plunge in early April when GLD fell from $150 to $130 in a couple of days, which coincided with gold’s fall from $1,600 to $1,350. Then there was that other plunge in June, when GLD fell from $135 to $115 as gold keeled from $1,400 to $1,200. Is that when these guys dumped their holdings?

If they averaged a sale price of $140, or even $130, might they have bought some back by now, perhaps while GLD spent 4 weeks below $125? Perhaps. But we won’t know about any such purchases until November, when Q3s 13F filings with the SEC are released to the public.

Those 4 weeks from mid-June to mid-July were crucial for the gold price. They were long enough to establish a floor, which was tested the first week of August and held, giving gold investors the go-ahead to add to their positions. Hence gold’s rapid jump by over $100 these past two weeks.

For all we know, Paulson and Soros could have picked up some gold futures last month, which require only 5% margin as opposed to GLD, which requires 30%. By the time we find out about it, it too will be ancient, non-tradable news.

Which Leaders Do We Follow?

Asians certainly don’t care one iota what Paulson, Soros, or anyone else in the West is doing with their gold holdings. From the Middle East to the Far East, the Orient is buying what the Occident is selling off.

The World Gold Council reports that as $18.5 billion worth of gold ETP (exchange traded products, aka paper gold) holdings were unloaded in Q2 of this year, jewellery purchases were up 37%, while gold bar and coin purchases were up a significant 78% over the second quarter of 2012. The largest buying sprees were India’s 188 tons, China’s 153 tons, and the Middle East’s 58 tons.

Another important piece of the picture is to differentiate between the investment objectives of paper buyers and physical buyers. While investors buying physical gold do so with a view to hold for the long term, traders of paper gold are generally in it for the short haul. That’s why they prefer the paper — because it’s much easier to jump in and out quickly. Paper traders can open and close a position within weeks, days, or even hours. And by the time we hear about it, they could have already jumped right back in again.

Given this understanding of the mindsets of these two contrasting investor groups, a massive sell-off in paper gold does not mean the bull run is over. Yet by the same token, a massive frenzy of physical buying does not necessarily mean gold is going to continue climbing without another correction. Buyers of physical could be buying for weddings, for long term appreciation, or simply to hedge against their local currencies which have the tendency to depreciate over time.

So the caution against playing follow-the-leader can apply just as much to following the buyers of the physical as it does to following the sellers of the paper. We have to be fair and balanced in this.

A More Complete Picture

The rise of gold over the first dozen years of the new millennium was predicated on one primary scenario – rising inflation as governments rescue their economies with low interest rates and bond purchases, which weaken currencies and strengthen gold.

Yet many believe conditions are about to change with one of the most highly anticipated U.S. Federal Open Market Committee meetings in years, scheduled for this September 17^th to 18^th. If at the end of the meeting on the 18^th, the Federal Reserve announces the beginning or even just the decision to reduce the Fed’s monthly bond purchases, the USD will likely rise while everything else falls – equities, bonds, and yes, even gold. Maybe the ETP liquidators mentioned above are expecting precisely that.

But that’s not the entire picture. We need to zoom out a little further. Remember, paper traders have their timescales set to days and weeks. We want our scales to be set to months and years.

Assuming bond tapering is announced next month, how much will the scene really have changed? Is the employment situation really any better? The current U.S. unemployment rate at 7.4% is still far above the Federal Reserve’s target of 6.5%, and it has been since the end of 2008. Let’s think about that for a moment… there has been no satisfactory improvement in the jobs situation for nearly 5 years. Employment isn’t calling for the end of stimulus.

Let’s zoom out a little more to see if inflation enters the picture. At 1.1% according to the government’s last reading, inflation is well below the Fed’s 2% target. And the Fed has stated it will tolerate as much as 2.5% inflation to make up for some lost years of GDP growth. Inflation isn’t calling for the end of stimulus either.

Let’s zoom out even more to see if a depreciating USD enters our field of vision. Although the USD has fallen a little lately, the US Dollar Index (DXY) has been neatly range-bound between 79 cents and 85 cents compared to a basket of major foreign currencies – for nearly two whole years. Such stability means the USD can tolerate continued stimulus at the current pace, so the dollar is not putting out a call for the termination of bond purchasing either.

Well, then, let’s zoom out even further to capture a snapshot of the entire U.S. economy. Stock indices, though still near their all-time highs, have relatively low valuations ranging from 7 or 8 at the low end to 15 to 16 at the high end, for the most part. Nothing overheating there. Several quarterly reports showing many top line numbers failing to meet expectations betray a still limping recovery and are not issuing a call for terminating stimulus themselves.

And what can be said of the enormous gains in bond yields lately, with the 10-year Treasury note yielding over 2.86%? It was less than a year ago when the Fed introduce monthly bond purchases in an effort to drive yields down… when they were less than 1.9%. Has the economy improved enough over the past 12 months to withstand a full percentage point higher? The Fed wants lower rates, and to get them, Bernanke might just have to appeal to the provision allowing the Fed to actually increase stimulus – yes, increase – as outlined in all their communiqués since May.

Even if we zoom out to maximum range to include the entire global economy, we still see an economic picture with just too much red in it. Europe and Asia are still hurting, and they are still not consuming nearly as much as they once used to.

What’s Next for Gold?

So what is there that would warrant the end of stimulus? Or even an aggressive bond purchasing reduction schedule? Even if bond purchases were reduced by an expected $15 billion per month from the current $85 billion, the gas pedal would still be pressed down some 82% of its current rate. Can this really spell the end of the gold bull run? Hardly.

A temporary set-back for metals, yes, that is possible next month, along with equities and bonds. But once the dust settles, and if gold manages to hold above its recent low of $1,180, then we will once again see all those sellers of paper gold immediately jump right back in again, possibly pushing gold upward toward $1,500 by year’s end.

And if gold does hold next month, don’t be surprised to hear a loud roar of cheers out of Asia, from Turkey to Japan, traversing the atmosphere and encircling the globe, as all those buyers of physical gold in the East realize they just put one over on the West.

Joseph Cafariello

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