Rick Rule, Senior Market Strategist
After a reasonably long period of sustained and occasionally dramatic escalations, commodity markets in general, and precious metals markets in particular, have declined. This is normal and healthy behavior, even if it is uncomfortable for some market participants. Readers with a long memory will remember the 1970s gold bull market, where the gold price advanced from $35 to $850 per ounce – though in 1975, in the middle of that epic bull market, the gold price declined by 50%. While a 50% decline is a near-religious event for many market participants, particularly those on margin, it is instructive to note that at the bottom of the retrenchment the gold price was up threefold from its $35 low, and that gold went on to increase eightfold in price after the bull market resumed. It is thus important to recognize that cyclical retrenchments are a normal and healthy feature of a secular gold bull market.
Readers should consider whether the reasons for the gold market are intact. Has gold's decline made it more likely that sovereign debts can be serviced or that unfunded obligations can be met? Does it mean that insolvent banks are now healthy? Does it mean that creating trillions of unbacked dollars and euros and renminbi will have no consequences? Of course not. We are simply uncomfortable with volatility.
Gold's Current Weakness
Let's examine some factors that may have contributed to gold's current weakness and think about the probabilities of those factors contributing to further weakening in the gold price.
For the past ten or twelve years, the gold price has been in a steady state of advance. In the near term, some participants probably took some profits, and high prices also probably contributed to demand destruction in industrial fabrication and jewelry demand. A softening of the gold price is likely to reverse the effects of price-induced conservation and substitution, even while investment demand, measured by gold funds and the ETF industry, continues to be strong.
Equity and debt markets appear to be stabilizing as a consequence of quantitative easing in Europe, the US, and China, and the apparent easing of concerns in Greece. This flood of liquidity has forced interest rates down as well as bond and deposit yields, pushing savers into longer durations and riskier instruments – including equities – and lowering servicing costs for debtors, which in turn has lowered perceptions of default risk. The markets appear more confident, and hence gold's attractiveness as insurance is fading. Some of us believe that the root word of confidence is "con," just as I believe the correct phrase for quantitative easing is "counterfeiting." It would appear that in excess of $4 trillion of new currency units have been introduced into the system, with no concurrent increase in underlying wealth in the form of goods or services. This does not make me find gold less attractive relative to fiat currencies or sovereign debt. How about you?
Physical demand in India and Vietnam has been constrained by excise and import taxes on gold in the case of India, and increased regulation in Vietnam. The constraints on physical demand in India has had an important impact on overall gold demand, and has become a hot political issue in India. Gold merchants were on strike concerning the excise tax, further constraining demand. It is worthy to note that South Asian societies have a deep-seated, cultural attraction to gold, and that the fairly recent removal of the taxes they just reinstated was a consequence of widespread smuggling and informal trading in gold. I suspect that central government interference in the Indian gold market will be ineffective and ultimately inconsequential.
Small, commodity-oriented institutions such as hedge funds have experienced strong outflows of equity capital and constrained access to debt financing, which has caused them to engage in forced liquidation of precious metals holdings. This is true, and in my opinion will continue. I believe, however, that if black swan style events destabilize other markets, the gold ETF industry and gold trusts like Sprott Physical Gold will easily absorb the remaining institutional bullion hoards. Further, Sprott has firsthand knowledge of the strong interest among sovereign wealth funds in increasing their bullion holdings.
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