first majestic silver

Gold: Home on the Range?

CFA, Senior Managing Director, Co-Portfolio Manager
April 12, 1999

Source: Baseline

Chart: Recent massacre of gold by speculative selling

On Friday, March 12, 1999, hedging managers of gold producers received phone calls from a leading bullion dealer asserting that the gold price rally was over. At the time, the gold price had just barely broken above its 200 day moving average, a key chart point. Further upside could have damaged the equity and bond markets, as the Federal Reserve has stated that it watches gold to predict future inflation. A strong showing by gold would force the Fed to raise interest rates. Recall that this turning point was accompanied by strident calls from world leaders to sell IMF gold, a prospect already discounted by the market. Proposed quantities are too small to make a real difference, but IMF sales became the rallying cry for the bears.

In one particular call, a gold producer was advised to put on new forwards (sell short) to take advantage of the imminent decline. On the following Monday, the gold price did in fact break. Subsequently, the gold price fell to fresh lows for 1999, underscoring the clairvoyance of the bullion dealer's exhortation to sell. Similar calls to other gold producers and hedge funds were made at the same time.

Our friend responded to the bullion dealer by saying that he was more inclined to buy in his book (cover shorts) in light of the significant chart point and the fact that the most recent CFTC numbers indicated a large speculative short position of approximately 200 tons. He was told that the 80-90 tons of speculative shorts had already covered the night before. Incredulous, he asked how such a large short position could have been covered with so little disturbance of the gold price. He was told that there was "liquidity from everywhere" and "heavy producer selling."

No trader in his right mind would buy gold in the face of this information. For years, bullion dealers have terrorized the gold producers to such an extent that their market calls become self-fulfilling. We have already described how bullion dealers spread rumors to generate business. (see our recent commentary: Bullion Dealers: Spin Meisters Of The Gold Market) We estimate that bullion dealer compensation in the form of spreads and interest are as much as $10 to $20million per year from some of the larger producers. Gold producers have been lining the pockets of bullion dealers, in the name of enhancing their corporate cash flow. In the process, they have alienated investors who would buy gold shares for the upside in the commodity, not sophisticated financial engineering.

Gold shares, as measured by the Philadelphia Gold Index (XAU), are trading at the lowest levels in twenty years. This low ebb reflects investor despair that gold has become a perpetual range trade, with no real upside. Hedging by major producers has in large part created this impression by helping to cap rallies. Relying on the Pavlovian response of gold producers to bullion dealer bell ringing, hedge funds have been able to profit consistently on the short side for the past three years. What would happen if the gold mining community, when gold next approaches the top of its range, were to take a public stance against hedging in that instance? Such a statement could well be the catalyst for an upside breakout that would create more value for shareholders in one month than the cumulative effects of financial engineering of the last five years.

Despite bullion dealer claims to the contrary, this most recent rally was capped by speculative short selling. Bullion dealers borrowed gold knowing that there would be a barrage of statements by public figures calling for IMF gold sales. Central bank eagerness to lend gold to bullion dealers, at miniscule interest rates, created the cheap supply to cap the rally. For the sake of generating returns of less than 2% per annum on a small portion of their gold reserves, central banks have achieved a substantial devaluation of one their most important reserve assets. Congratulations are in order to the new, enlightened breed of central bankers for this stunning accomplishment. It is worth asking whether the voters of the various nations whose central bankers are engaged in lending, call writing, and other activities that diminish the value of this important reserve asset are aware that this is going on, and if so, whether they would endorse these goings on.

The rally was capped by speculative selling made possible by central bank lending. Producer selling was only a minor factor and there was no central bank seller. In fact, speculative short covering (at a healthy loss) by commodity traders was overwhelmed by dealer short selling. Gold is locked in a trading range dictated by the overpopulated bullion dealing community which has now succeeded in shafting all of its constituencies, commodity traders, gold producers, and central banks. This can only go on for so long. Fundamentals are lining up on the bullish side. It is only a matter of time before the bullion dealers themselves realize that their self-interest lies in taking the long side of the equation.

Gold fundamentals at this juncture are simple to summarize. The price has been beaten down to such a low level that most producers are not reporting profits. Pressure has come from a combination of producer selling, central bank selling and speculative selling, often in connection with a carry trade that shorts gold to buy financial assets. There is today a massive short interest that, in all likelihood, defies accurate calculation. The highest estimates could easily be too low. Looking ahead, central bank selling will decline sharply. The already wide deficit of supply relative to demand is growing based on the recovery of Asia. Gold producers have only limited capacity to expand forward positions. Therefore, only speculative short selling is available to hold down the gold price. For the gold market to go lower, it must get even shorter. How foolish it would be for the gold mining community to continue to aid and abet the collusive behavior of speculators and bullion dealers that has all but destroyed their equity valuations. How contrary to their respective national interests are the new age central bank management practices designed to gain a little income for the price of undermining the value of a key reserve asset.

Gold is a financial asset. The position of the financial markets is precarious. New highs in the averages mask the underlying deterioration. Almost two thirds of all stocks are already in well-defined downtrends. Valuations of the leading market issues are indefensible by any rational standard. At the same time, long-term interest rates are creeping higher. A rise in short term interest rates would lead to a severe market break. A breakout in the gold price is as good as an interest rate increase. With the recovery in Asia beginning to gather steam, the downtrend in commodity prices is coming to an end. Even traders at bullion dealers will soon recognize that gold's trading range is a distinctly uncomfortable place.

John Hathaway, CFA, Senior Managing Director, Co-Portfolio Manager

Mr. Hathaway is a co-portfolio manager of the Tocqueville Gold Fund, as well as other investment vehicles in the Gold Equity Strategy. Mr. Hathaway also manages separately managed accounts for individual and institutional clients.  He is a member of the Investment Committee and a limited partner of Tocqueville Asset Management ( Mr. Hathaway began his career in 1970 as an Equity Analyst with Spencer Trask & Co. In 1976, he joined investment advisory firm David J. Greene & Co., where he became a partner. In 1986, he founded Hudson Capital Advisors and in 1988 became Chief Investment Officer of Oak Hall Advisors. He joined Tocqueville as a Senior Partner in 1998. Mr. Hathaway has a BA degree from Harvard College and an MBA from the University of Virginia.  

With gold stolen by Conquistador Francisco Pizarro from the Inca Empire in 1532, Spain financed its conquest of Europe.
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