October 18, 2008: Why gold is falling, and why gold will spike up in November

by JDH on October 18, 2008

Gold: Why is it that you can’t buy physical gold anywhere, but the price keeps going down? Why is it that the laws of supply and demand don’t appear to apply to gold? Am I completely wrong in believing that gold will be the best investment in 2009? I have spent the week pondering these questions, and I conclude that gold has been manipulated downward, but gold prices will be substantially higher by the end of 2008.

Reasons why the price of gold will fall in the short to medium term:

1 An object in motion stays in motion. As gold falls, people sell, and keep on selling all the way down. Of course the opposite is also true; as gold rises, an increasing number of people jump on the bandwagon.

2 Market sentiment. The gold bugs are still stubbornly bullish, and using that as a contrarian indicator, that probably means gold is more likely to go down than up, in the short term. To quote Mark Hulbert:

According to contrarian analysis, there’s been an excess of bullish sentiment in recent weeks and months, in effect forming the veritable golden slope of hope that makes it easier for the market to decline than advance.
Consider the Hulbert Gold Newsletter Sentiment Index (HGNSI), which reflects the average recommended gold market exposure among a subset of the shortest-term gold-timing newsletters tracked by the Hulbert Financial Digest. As of Thursday night, the HGNSI stood at 37.9%.

To put that level in perspective, consider that the HGNSI was seven percentage points lower when I wrote my most recent column on gold sentiment (on October 5), despite gold bullion being some $25 per ounce higher. It’s not an encouraging trend, according to contrarian analysis, when market timers become more bullish as the market declines. That suggests a significant amount of stubbornly-held bullishness, which is just the opposite of the kind of sentiment environment that supports sustainable rallies.

Yes, it is possible that the upheaval in the world has destroyed traditional economic thinking. It is possible that gold is in fact a barbarous relic, and has no place in a modern portfolio. It pays no interest, can’t be eaten or burned for fuel, and it costs money to store. The financial world is now very sophisticated, and as a result gold no longer serves it’s traditional function as a store of wealth. It is, therefore, quite possible that gold will continue to fall in the short term. However, read on….

Why gold is falling now, but will increase in the future

Here is the alternate viewpoint, and the reasons why gold is falling now, even though we are still in a long term bull market:

1 The laws of supply and demand still apply, and the reason the price of gold is falling is because there are more sellers than buyers. It’s classic Economics 101, and the law of supply and demand is working perfectly. Specifically, all of the hedge funds and mutual funds that were buying gold all the way up got caught in a cash squeeze when the markets tanked; they had to sell whatever they could to fund customer redemptions. European central banks sold 7.6 tons of gold in the week ending October 10th, which is bound to depress the price. Massive selling drives prices down. Classic economics, nothing more.

Note that this explanation does not mean that gold will be going down forever. Once the funds have sold their gold to raise cash to fund redemptions, they will be out of gold, and therefore will not be able to further depress the price.

2 Gold lease rates are rising. Stay with me on this one: Central banks lease (or rent) out gold. This allows them to earn a return on the gold in their vaults. Lease rates are currently around 2% per year. The gold is loaned to a bullion bank, who then sells it on the spot market.

Here’s a simple example: I borrow $1 million worth of gold; I pay a lease rate of 2% per year, or $20,000 per year. I sell the gold for $1 million, and invest the cash at 3%, thereby earning a profit of 1% on essentially a zero investment. Pretty good, eh? And what’s the effect of me selling that gold on the market? Obviously selling drives down prices, so the more the Central Banks lease out, the more gets sold, and the lower the price goes. That’s a great way to drive down the price without actually selling your gold. Because the gold is “leased” out, you can still count it as being in your vaults, even though it isn’t.

Here’s the interesting part: Since 2004, lease rates have averaged around 0.5% per year, meaning that banks would lease out their gold for virtually nothing. However, starting around October 2007 (the vertical green line on the chart) the price of gold started to increase, and so did the lease rates. Even at the $1,000 peak in March of this year, lease rates were still in the 0% to 0.5% range.

But then, around September 15 of this year, lease rates spiked up, and are now over 2%, their highest levels since 2001. (You can see short, medium and long term lease rate charts at kitco.com). The brown vertical lines show the range before the spike. In mid September (the first vertical red line) gold was at $750 per ounce, and both the spot price and the lease rates (at 0.5%) were at low levels. By early October gold was up to $900 per ounce, and lease rates were up to almost 3%.

Intuitively, you would expect that as the spot price of gold is rising, the lease cost would also increase, because the lease rate is actually a short on gold. (The person leasing the gold has to return the gold at the end of the lease, so they are betting that they can buy back the gold they borrowed for less than they sold it for originally, thereby earning a profit on the transaction). Obviously, that’s exactly what has happened over the last two months.

So, now for the million dollar question: do high lease rates lead to high gold prices, or vice versa? Based on everything I have just said, it would appear that lease rates are a way to manipulate the price of gold.

I know we are getting technical here, but stay with me for one more minute. You are a central banker. You want to keep the price of gold down. You lease it out for virtually nothing, to encourage speculators to borrow it from you and sell it on the open market to pocket the cash for themselves, and drive down the price of gold. This strategy worked great up to September 15 as the price of gold bottomed around $750. But then, gold started to increase. Why then did the lease rates also increase? Why didn’t the Central Banks drop the lease rates even more, to encourage even more sales, to keep the price of gold down?

They have. Take a look at this chart of current lease rates, again from kitco.com:

The 1 month, 6 month and 1 year rate are all in the 2% range as seen in the previous charts. But, the 2 month and 3 month rates are actually negative, meaning the gold owner will actually pay you to borrow their gold! Imaging going to a car dealer and being told the car dealer will pay you $300 per month to drive their car; that’s what’s happening now in the 2 and 3 month gold lease market.

As kitco says, “the degree to which lease rates may be displayed as negative would suggest the degree to which there is a lack of demand to borrow the metal.” Why would there be a lack of demand to borrow the metal 2 and 3 months out? Why would I not want to borrow gold even if someone was paying me to do it?

The answer is obvious. I would not borrow gold, even if you paid me to do it, because I know I would have to return the gold at a higher price.

Gold closed Friday at $782.90 (or $787 depending where you get your quotes), the lowest price since September 15. If I borrow the gold today and sell it on the open market for $787, and I must return it in two months, I will only make a profit if I can buy it back for less than $787 in two months. Obviously all of the players realize that the price will be higher in 2 months, so they don’t want to borrow for that time period. They assume the price will stay low perhaps for a month, and 6 months or a year from now it may also be lower, but in the short term they assume it’s going higher.

So why don’t the gold holders lower their lease rates? For the same reason. They realize they can’t keep a lid on the price forever, and they don’t want to run the risk of leasing out gold and not getting it back due to higher prices, so they are charging a higher premium. Also, if they believe the price is going up, it’s better to hold it yourself, so that you get the price appreciation.

It appears obvious to me that gold lease rates are a tool to depress the price of gold, and that tool is now indicating a short term increase in the price of gold.

3 The price of gold isn’t falling. The price of gold traded on the COMEX is falling, but that’s not the real price of gold. COMEX is paper gold; it’s paper traded by speculators. They almost never take delivery of the gold they trade; they simply pass the pieces of paper back and forth amongst themselves. A speculator invests in various financial products and derivatives, and to hedge their bets they buy gold contracts, in the belief that if everything else falls, gold will go up. Since everything else is down, it’s only logical to sell one of the few investments that is still up over the last year: gold contracts on the COMEX.

How do I know the price of gold isn’t really falling? Because if you go into any coin shop in the world, there is a shortage of gold. The premium charged over the COMEX spot price is higher than ever. The real price of real gold (not paper COMEX gold) is increasing. There is lots of anecdotal evidence about the disconnect between spot prices and physical gold, like this article, or this one. Here’s an even better one.

4 The gold markets are manipulated, big time. My favourite is this one from the Underground Investor; Here’s an excerpt from the Underground Investor:

Today there have been four distinctly and differently priced markets established for gold: (1) Futures markets in Asia that consistently establish prices $20 an ounce to $60 an ounce higher than the prices established in (2) Futures markets in New York; (3) Physical bullion bars which dealers are starting to price at healthy premiums above both daily spot prices established in Asia and London/New York; and (4) Physical coins which dealers have always priced at premiums above bars and spot prices, but that are now selling at soaring premiums above spot prices.

Since the July 14th correction in gold and silver markets began, waterfall declines have occurred in gold prices in New York futures markets that trade paper gold where physical delivery of real gold occurs with less than 1% of all paper traded futures contracts. The differences in spot prices in Asian futures markets and in New York futures markets for gold have been staggering for the past 10-12 weeks, so much so that two distinct and separate future markets for gold have been established, one in which the gold price is significantly higher in Asia and another, where the gold price is significantly lower in New York.

He goes on to give numerous examples over the past few months where gold was rising in Asia over-night, and then, as if by magic, got crushed at 10:00 am in New York. He presents charts that show that this is not an unusual occurrence. It appears that July 15, 2008 was the start of the most obvious manipulation (about the same time the Feds started playing with the markets; you can read my thoughts on July 13 here in a September post). The 10:00 am time period is significant, because that’s when most waterfall declines happen. Price increases happen throughout the trading day, as one would expect, but big drops only seem to happen at 10:00 am. Here’s another quote:

As a control, I graphed all Sunday markets in gold since the start of this correction on July 15th, 2008. There are 11 such days. Sunday is a great day to see how the gold futures markets work because only Asian markets are open and my guess is that the elements in New York opt to stay out of the Asian markets on Sunday. Though all 11 weekends I have graphed fall within one of the steepest correction periods of this 7-year gold bull (July 15th to Oct.1, 2008), 8 weekends, or 73% of the time, Hong Kong gold markets were higher.

Though I am assuming that trading volume in Hong Kong markets is light on Sundays compared to the rest of the week, it seems odd that 73% of the days that are apparently free of NY players were positive.

In other words, even with the gold market falling, the markets are up in Asia when the New York players are not involved. Interesting.

You want more? How about this:

The above seems like compelling evidence to me that something is seriously amiss in the futures markets for gold (notably paper markets and easily manipulated because physical delivery of gold to settle these contracts happen less than 1% of the time) and that rampant manipulation for profits by just a few players is occurring in an unchecked fashion. According to data recently released by the Office of the Comptroller of the Currency, a division of the US Treasury, of the $135 billion of gold derivatives contracts (including futures and options) controlled by financial institutions, JP Morgan controls $96 billion (71.11%) of these contracts and HSBC Bank USA controls $34.4 billion (25.48%) of these contracts. In other words, just two players control almost all gold derivatives contracts in the entire United States.

Many of you have heard of JP Morgan. They’ve been in the news a lot lately. I can’t find a recent report, but this link to the Office of the Comptroller of the Currency has the June 2008 report (here’s the pdf link; look on page 29, in Table 9). It appears that, yes, in fact, JP Morgan controls a huge amount of derivatives, and HSBC controls most of the rest.

Think about it: you are a bank, and times are tough. You short gold (through derivatives); you crater the market in the morning, then cover your shorts at some point in the future. Or, you crater the market to depress the price, then buy contracts to sell at a higher price. It’s easy to do if you control the market.

Am I seeing a conspiracy where none exists? Perhaps, but it doesn’t take a genius to conclude that it’s easy to play with a market when you are 71% of it.

To be clear: the government, in the midst of a financial crisis, did not want investors doing what they traditionally do in a crisis, which is to sell financials and buy gold as a safe haven. If there was even more selling of bank stocks, that would make a bailout even harder, so the government engineered the gold collapse to keep money in the financials.

Why gold is still a good investment

So, we all agree that the market is being manipulated, and that’s perhaps the reason why gold has fallen as low as it has. As the banking crisis deepens, JP Morgan needs to do the only thing it can do to make money and stay solvent: manipulate the gold market. That being said, what’s to stop them from continuing to manipulate the market, downward, for many months or years to come? Here are my reasons why the manipulation cannot go on forever:

1 Investors are still buying gold. Investment in the SPDR Gold Trust, the biggest exchange- traded fund backed by bullion, reached a record 770.6 metric tons on Oct. 10. If people keep buying, the price will eventually increase.

2 With the price of gold this low, new mines will not be developed, which will further restrict supply in the future. (Thanks to sunseeker for the link to John Embry’s article on gold manipulation and future supply).

3 The governments of the world have injected a ba-jillion dollars of liquidity into the system over the last month. The massive printing of money will be inflationary. The purchasing power of each dollar will decrease, and so ultimately something that holds it’s value (gold), will increase in relative terms.

4 You can’t short the market forever. As I noted above, lease rates 2 and 3 months out are negative, meaning the insiders expect the price of gold to rise in the next two to three months. They won’t even borrow gold if you pay them to do it, and that’s a very bullish sign. I may be a cynic here, but two months from now is after the election. The current government wants to keep the price of gold (and all commodities) down to give the illusion of U.S. Dollar strength to help get them re-elected. Two months from now re-election is not an issue, so they can let the price of gold increase.

How to Play the Rise in Gold

My conclusion, quite simply, is that the price of gold may remain stagnant for the next two or three weeks, but after the November 4 election we are likely to see a big spike upward during November and December, at which time it may fall back again. I will therefore hold all of my gold stocks.

For added fun and excitement, I may also purchase some out of the money options for either November or December, and perhaps sell some puts against what I already own.

NOTE: The example below has been edited from the original version (the original example was backwards; thanks to pinetree on the Forum for questioning my incorrect math).

For example, let’s assume I own 1,000 shares of AEM.TO – Agnico-Eagle Mines Ltd. that closed on Friday at $42.90 I could sell 10 contracts of the November 48 put for $8.20, (using the shares I already own as margin); I would receive $8,200 in cash (before commissions). I could then buy a November 48 call for $3.65, which would cost me $3,650 (before commissions on 10 contracts for 100 shares each). I would then own my shares, plus have $4,550 extra in the bank (ignoring commissions). If by the third Friday in November Agnico-Eagle is trading above $48, the puts expire worthless, and I keep the $8,200. I still own my November $48 calls, so if the price goes on a big run, I keep the profits. If it’s trading below $48, I’m required to sell my shares for $48.  Of course if AEM closes below $44, I lose on the deal, since the calls are worthless but I’m paying out on the puts, which are in the money.

That strategy would work better if I could buy puts and calls lower than $48, but at the moment that’s all that’s available. (You can get quotes for options on Canadian stocks on the Montreal Exchange). I’ll decide on Monday whether or not I make the trade.

If the gold price will spike, now is probably also a good time to buy physical gold, if anyone is selling it.

It’s very annoying that the price of gold has fallen over the last few months. We all know it should be going up. I believe, more strongly than ever, that it will. Now is the time we separate the wimps from the winners. We can whine about our loses, or we can suck it up and thank the big boys for this wonderful buying opportunity.

I realize this was a longer and more technical post than usual, but I needed to walk through in my own mind the reasons for the recent action in the price of gold, so thanks for reading, and feel free to respond below or on the Forum.

See you next week.

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