Though the directors of the Bank were charged with governing the supply of credit in Britain, and by extension around the globe, they did not pretend to know very much about economics, central banking, or monetary policy. An economist of the 1920s once described them as resembling ship captains who not only refused to learn the principles of navigation but believed that these were unnecessary.
Month: February 2019
Lords of Finance by Liaquat Ahamed (pg. 76)
Once they had exhausted every potential source of loans, they relied on a technique almost as old as war itself: inflation. Unlike medieval kings, however, who accomplished this either by shaving pieces of gold and silver off the outer edge of their coins–a practice known as clipping–or of issuing coinage made of cheaper alloys–currency debasement–governments in the Great War turned to their central banks, often relying on complex accounting ruses to disguise the process. Central banks in turn, abandoning their longstanding principle of only issuing currency backed by gold, simply printed the money.
Is a VOLATILITY event in the making?
The situation the market currently resides in is one where market participants cannot decide which force is stronger…
“Powell/Mnuchin/Trump Put” + China Trade Deal Prospects
vs.
Fundamental overvaluation of equities + “U.S. Earnings Recession” + “Synchronized Global Economic Slowdown”
Let’s first look at the technicals on the U.S. equity market (S&P 500) in tandem with the VIX. We know that the S&P 500 has 3 prior failed breakout attempts above the 200-day moving average on 10/17/18, 11/17/18, and 12/3/18. We also know that we currently reside just above this powerful line in the sand once again.
Now, let’s take a look at the VIX. I have circled the prior instances that the S&P 500 was above the 200-day moving average on the VIX chart. These circles all occurred pre-VIX spikes.
From 10/17/18-10/24/18, the VIX jumped from 17.40 to 25.23 in a 45% move. From 11/17/18-11/20/18, the VIX jumped from 18.14 to 22.48 in a 24% move. From 12/3/18-12/24/18, the VIX jumped from 16.44 to 36.07 in a 119% move.
Today, 2/22/19, the VIX is flirting with the 14 mark, which is below the 10-day moving average as other pre-VIX spikes had been prior to their moves.
Some technicals are certainly in play, but now we must ask if we have any catalysts coming to fruition. The answer is yes. On 2/28/19, the long awaited Q4 2019 GDP results will be released. The market already ignored the downward revision of the Atlanta Fed’s potentially lofty estimate. We shall wait and see if confirmation of a downward revision, or a further downside surprise, will have an effect on the market.
Lords of Finance by Liaquat Ahamed (pg. 69)
Also gold coins began mysteriously to vanish from circulation. Having been burned by disastrous experiments with paper money twice before–once in the early eighteenth century during the ill-fated Mississippi Bubble, and then again by the assignats issued during the Revolution–the French had developed a healthy mistrust of banks and all but the hardest metallic currency.
Lords of Finance by Liaquat Ahamed (pg. 54)
The 1907 panic exposed how fragile and vulnerable was the country’s banking system. Though the panic had finally been contained by decisive action on Morgan’s part, it became clear that the United States could not afford to keep relying on one man to guarantee its stability, especially since that man was now seventy years old, semiretired, and focused primarily on amassing an unsurpassed art collection and yachting to more congenial climes with his bevy of middle-aged mistresses.
Lords of Finance by Liaquat Ahamed (pg. 43)
In the middle of the crisis, Germany was hit by a financial panic. The stock market plunged by 30 percent in a single day, there was a run on banks across the country as the public lost its nerve and started cashing in currency notes for gold, and the Reichsbank lost a fifth of its gold reserves in the space of a month. Some of this was rumored to have been caused by a withdrawal of funds by French and Russian banks, supposedly orchestrated by the French finance minister.
Lords of Finance by Liaquat Ahamed (pg. 42)
According to one police report, “The Paris banking house of Mendelssohn is trying to send a hundred million francs, in gold, across Germany to Russia.” The hunt for “gold cars” became a curious obsession in the countryside; vehicles driven by innocent Germans were accosted by armed peasants and gamekeepers. A German countess and a duchess were even shot by accident.
Lords of Finance by Liaquat Ahamed (pg. 31)
Now faced with the prospect of large parts of the City of London going under, the commercial bankers in a panic had begun withdrawing gold from their accounts at the Bank of England. Its bullion reserves fell from over $130 million on Wednesday, July 29, [1914] to less than $50 million on Saturday, August 1, [1914] when the Bank, to attract deposits and conserve its rapidly diminishing stock of gold, announced that it had raised its interest rates to an unprecedented 10 percent.
How to get exposure to gold?
Bullion
The classic way to own gold is through bullion (the actual physical metal). Not only is the classic way, but it is arguably the least risky. If you own gold that is in your hand, then you do not run the risk of any counter party failing to fulfill its obligation. This will make sense in the examples to come as trust in this “counter party” with your gold exposure becomes necessary. Since, gold is viewed by many as an insurance asset against the financial system, I question those who hold all of their allocation in the financial system. Don’t plug your back up generator to your house.
Gold ETFs
An ETF is an exchange traded fund, and it trades on the stock market with its own ticker symbol. Gold bullion ETFs typically hold quantities of gold in a vault based on how many people purchase the ETF. The common gold bullion ETF is GLD. There are other options of tickers that one can use that track the spot price of gold, but this is the most notable. Read prospectuses if you want to know the exact details of how the gold spot price is tracked, if bullion is redeemable for shares, and if there is potential force majeure language. It should go without saying that you do not physically possess the bullion, so in a worst case scenario your insurance may not work. On the other hand, you relinquish the risk of misplacing the gold or having it stolen.
Gold Miners
This option is not for your everyday individual. I consider the gold miners to be a leveraged play on the spot price of gold. The idea behind the leverage is that a gold mining company’s cost of good sold is relatively constant, so a rise in gold should lead to a more rapid rise in earnings per share. On average, gold company share prices move 2-3 times the spot price of gold in both directions. The enterprising investor may seek out the best gold mining company to try to maximize the leverage, but this is no easy task. For the investor who wants to put on an extra level of risk to potentially maximize their returns, an ETF that is a basket of gold miners should be used. The most common one is GDX.
Part 5: The Cases for Gold
In part 4, I had shown that Russia and China have been buying gold. Below is a chart of all global central bank purchases since 1971. The 651 metric tonnes is multi-decade record. In my most simplistic argument, if those that create policy are buying gold, then you should probably have an allocation as well.
I have also laid out fundamental reasons why the dollar will fall. Most people do not think about prices in this way, but the price of gold in the US is effectively the price of gold divided by the price of dollars. With that in mind, if the denominator in the equation was to fall (dollars), then the price of gold will rise. This is demonstrated below. As the dollar rises, gold tends to fall and vice versa. There is a potential scenario where both rise in tandem due to a race to safe and perceived safe haven assets in a time of distress.
Historically, gold was always tied to the US dollar. This meant that for most of history dollars could be exchanged for gold. This forced the government to spend within its means because if too many dollars were ever created, then there was the potential for too many gold redemptions to bankrupt the US. In 1913, $20 would buy an ounce of gold, but the US spent its way out of being able to hold that promise. Then, in 1933, the US said we can no longer allow gold to be redeemable at $20, and gold was revalued to $35 an ounce. This trend continued over time until 1971. The US government in the 1960s was spending too much money on the war in Vietnam and Lyndon B. Johnson’s “Great Society.” The rest of the world was skeptical that the US would be able to repay gold to all dollar holders at $35 an ounce, so there was basically a run on the gold at the United States treasury. In 1971, Nixon basically defaulted on the promise to repay gold at $35, and removed the dollar from the gold standard. Gold in the coming years would rise from $35 to over $800. The brief sequence of events demonstrates that gold has precedent as an insurance asset against government over spending.
During the 2008 financial crisis, the US deficits exploded and so did gold. Below, you can see a different chart showing forecasted deficits exploding going forward. Also, the data is sourced from government sources, and does not forecast a recession in the next 10 years.
Another case for gold is the rising cost to mine it. This is due to inflation and gold becoming harder and harder to find. If gold were to dive below 1000 for a lengthy amount of time, then some miners may need to cease operations due to not being able to produce gold at a profit. If some supply goes offline, then this will be bullish for prices. With this in mind, it is quite likely that there is floor around $1000 an ounce for gold.
Gold also appears to serve as an insurance policy against the inevitable failure of global quantitative easing. Until 2012, gold was rising in tandem with central bank balance sheets. I would speculate that around that time the market basically decided “quantitative easing worked, all is well,” and stopped buying insurance in the form of gold.
The chart below is the gold to dow ratio. This is a historical chart of the amount of ounces it takes to buy the dow jones industrial average. Over time, the ratio tends to revert to below 5. My suspicion is that we were well headed for that reversion prior to “quantitative easing working.” For this chart to revert properly the dow will either need to come down to around 6,000 from 25,000 or gold will need to rise to about $5,000. Some combination or the two is the most likely scenario.
One should not bet the farm on gold or any investment for that matter, but if you do not possess an allocation towards gold it may be unwise. There is a great deal of uncertainty in the world at this moment. By many metrics gold is cheap. If you know that the odds of recession are increasing, which is going to weigh on the dollar in long run, then it makes sense to buy the insurance before the storm hits. Once the economic storm is upon us, then it will be too late. Unfortunately, many individuals do not own gold because conventional wisdom has been brainwashed into hating it. They say, “it doesn’t produce a yield,” “it’s just a dumb rock,” or “it has no uses.” To me this ignorance is the buying opportunity of a lifetime.