“Our current Chairman of the Federal Reserve, trapped by Milton Friedman’s view of the Great Depression, and aided by the most aggressive fiscal policy we’ve ever experienced, has promised to resort to all means necessary to reflate this burst bubble and refill the gaping hole in credit, primarily through a policy referred to as “quantitative easing” – a fancy term economists coined for “printing money”. 

“It is safe to assume that if our Fed Chairman is determined to debase the currency, he will succeed.  Historically, gold has rallied in the face of geopolitical instability or inflation, but we don’t believe either is necessary to drive gold prices higher today.  Gold should move higher because investors throughout the world are becoming increasingly apprehensive holding fiat currencies.  At home, the size of the Fed’s balance sheet is exploding, and the impact is clearly seen in the Dollar’s Dive.  But unprecedented global monetary and fiscal stimulus around the world, have created a sea of liquidity to offset the deflationary forces associated with deleveraging.  Investors, who are by definition net long in paper currencies, will increasingly look for insurance in the form of gold.”

It would seem that some things never change.  In fact, it is quite obvious that the world’s apprehension toward fiat currencies has only heightened and may soon reach “the tipping point.”  Milton Friedman once advised that “US Dollars have value because everybody thinks they have value. Everybody thinks they have value because in everybody’s experience they have had value.”  We wonder what “everybody” thinks today?  We think that this is more than a dollar problem.  All major currencies have depreciated in the past decade when measured against the world’s oldest store of value – gold.

Our friends at Wikipedia tell us that Debasement is the practice of lowering the value of currency. “It is particularly used in connection with commodity money such as gold or silver coins. A coin is said to be debased if the quantity of gold, silver, copper or nickel is reduced.”  For example, the value of the denarius in Roman currency gradually decreased over time as the Roman government altered both the size and the silver content of the coin. Originally, the silver used was nearly pure.  From time to time, this was reduced. The denarius continued to shrink in size and purity, until by the second half of the third century, it was only about 2% silver. One reason a government will debase its currency is financial gain for the sovereign at the expense of citizens. By reducing the silver or gold content of a coin, a government can make more coins out of a given amount of specie. Inflation follows, allowing the sovereign to pay off or repudiate government bonds. However, the purchasing power of the citizens’ currency has been reduced. Another reason is to end a deflationary spiral. Debasement lowers the value of the coinage, causing inflation. Over time, it may even lead to a new coin being adopted as a standard currency. Note that last part, “To end a deflationary spiral.”  It’s a doozie.  We discussed it at length in our last two Broyhill Letters.  Lucky for Bernanke, he doesn’t even have to bother with “shaving coins.”  He can just hit the print button on his keyboard like a Monetarist Monkey.

Clearly, gold prices are stretched to the upside here.  As one technical analyst put it, “I have written reports on commodity markets since the 1970s and my experience has been that, when a tight upward price channel is broken decisively to the upside, the odds are 90% of the time the commodity will decline back toward the top of the channel or re-enter the price channel. The problem is that the other 10% of the time the move turns parabolic which I would define as a burst to 2300-2400 by November.” I don’t know about you, but we’d sure like to be there if the move turns parabolic!  The good news is . . . we can, and we can do it with a large margin of safety today.

While gold has risen from $250 to over $1900 in the last decade the percentage gain in the gold mining stocks has been about a third of the metal’s rise.  This extremely disappointing performance is only more frustrating when we consider that gold miners should outperform gold by a wide margin in bull markets.  This divergence has left the Gold/XAU ratio at historical extremes, indicating that gold stocks are exceptionally cheap. In addition to dirt cheap valuations, the macroeconomic backdrop for gold shares is now exceptionally strong, presenting a combination of factors that support a large allocation in portfolios.  In an article written by John Hussman in October 1999, we can see that in the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. Don’t look now, but more than a decade later, today’s backdrop is extremely powerful.

Gold equities are relatively flat this year compared to double digit gains in precious metals. The reasons for their underperformance is well known and well discounted in today’s price.  Profit margins were squeezed due to higher energy costs, but oil prices are now lower and should continue falling as economic growth grinds to a halt. The free cash flow generated by the miners is soaring with gold prices at record highs. Virtually all of the major producers are raising dividends. Gold is still a completely under-owned asset class representing less than 1% of global financial assets and institutional investors are drastically underweight. Eventually, the “smart money” will be forced to buy gold. Recall that the University of Texas recently took delivery of $1 BILLION in physical gold bullion. Net gold purchases by governments year to date have totaled 200 tons, nearly triple last year’s purchases.  Prior to that, the world’s central banks were net sellers for the past decade! But outside of the few paranoid “Spam and Shotgun” types, most committee-driven institutions are more likely to jump on the gold stock bandwagon then to stockpile bars of gold that don’t generate income or cash flow for their investors. Once the gold stocks begin to outperform as the natural forces of mean reversion assert themselves, the momentum investors won’t be able to resist the Midas Touch.

Disclosure: At the time of publication, author was long SPDR Gold Trust Shares, Market Vectors Gold Miners and Market Vectors Junior Gold Miners, although positions may change at any time.

And on a completely unrelated note, we found this illustration between the correlation of sovereign debt risk and men living with their parents, entertaining if nothing else.  As a man named Homer once advised, “It’s funny ‘cause it’s true.”

Source: www.bondvigilantes.co.uk

Disclosure: At the time of publication, the author was long Gold and Silver, although positions may change at any time.

• During inflation, an undervaluation of paper money develops compared to gold, silver or copper. It’s difficult for us to argue with this point, except that we’d caution investors not to assume that rising gold prices necessitates a coming inflation.  Precious metals are rising against all paper currencies today.  We view this as more of a sign of mistrust for the developed world’s reckless fiscal and monetary policies.

• An increase in the money supply first stimulates economic activity, whereas price increases lag.  On the other hand, if the rate of growth of the money is substantially diminished or even becomes negative, then depressive consequences are felt before the price level recedes. We’d ask that all the Inflationistas out there re-read that last sentence, which appears to be completely lost by Milton Friedman and Company who focus solely on the supply of money with no respect for the multiplier.  With that said, we’ll reproduce an important chart from our last post, which should be somewhat of a recurring nightmare for our Federal Reserve Chairman, except that he no longer pays attention to what he does not want to see.

Source: www.shadowstats.com

• The developments just sketched lead to political reactions which may even strengthen or bring about sequences of events. Hmmmmm.
• If a moderate inflation turns into a high inflation, economic activity is adversely affected. This minor detail appears to be lost on our policymakers who are determined to create “just the right amount” of inflation to offset the economy’s post-crisis, deflationary tendencies and avoid Great Depression 2.0.  Needless to say, we have our doubts.  Bernanke is so set on not repeating the mistakes of 1937-1938 – when the punch bowl was removed too soon – that it is almost a near certainty that he will err on the “too late, too long” side of the inflation coin.  Will give handsome odds, to anyone willing to take the other side of that bet.
• Wage increases usually lag behind the rise of the price level. Translation for tomorrow’s domestic economy: Structurally high unemployment and declining real wages.  Ruh Roh!

• Currency substitution plays an important role if inflation is progressing and the fixed exchange rate can no longer be maintained.  Finally, the bad money will be driven out of circulation, and the unstable money becomes worthless.

Bernholz concludes by constructing a picture of a full inflationary cycle.  First, paper money with no intrinsic value is introduced – initially convertible at a fixed rate of course.  These notes are a welcome addition at first as they are not as heavy and easier to store and transport than gold bars.  But with more and more paper money, convertibility becomes difficult since official reserves dwindle (just ask Roosevelt), and ultimately, convertibility can no longer be expected.

We’ll be spending the next few weeks reviewing the meat of Monetary Regimes and Inflation – Characteristics of Hyperinflations.  One lovely trait is that people try to spend their money as quickly as possible, since they expect that it will soon lose its value by future inflation.  As a consequence, prices rise more quickly than the supply of the paper money and the real stock of money decreases.  Lovely.

Disclosure: At the time of publication, the author was long Gold and long MarketVectors Gold Miners ETF, although positions may change at any time

- Alan Greenspan, “Gold and Economic Freedom,” 1966

We used the above quote from Alan Greenspan to kick off our Third Quarter 2007 Broyhill Letter.  Amazingly, in 1966, Alan Greenspan “got it.”  We wonder when he “lost it” between then and now.  In any event, friends and family know well enough that we have been consistent and confident gold bugs since the early part of last decade.  The investment thesis has only strengthened today with proliferate government spending no longer limited to our friends in Washington.  Despite the yellow metal hitting new highs in the face of a surging dollar (so much for historical correlations), sentiment remains depressed and most investors we speak with have yet to purchase a single ounce of gold.  Our Bottom Line outlined in that Q3-07 Broyhill Letter is as relevant today as it was three years ago:

Charles Kindleberger set out three preconditions for a mania where prices overshoot the bounds of rational valuation, in his classic, “Manias, Panics, and Crashes: A History of Financial Crises.” First there must be plenty of liquidity to fuel the asset price rise. This is as true as ever today, given the global tendency toward low real interest rates and strong money growth. Second, there must be a “displacement,” which is defined as a fundamental shift that makes the focus of the mania attractive. In the case of gold, this involves the incentive for competitive devaluations of paper currencies, as well as persistent geopolitical uncertainty. Finally, there must be uncertainty about how the asset in question is properly valued, which allows for “new era thinking” to take hold. Especially true for gold. Valuation and gauging extremes is an art rather than a science as the metal is heavily influenced by hard-to-measure factors such as central bank intentions, political risk, policy irresponsibility, etc. It is easy to argue that proper fair value is substantially higher than today’s levels when one considers the jump from $600 to $700 has not yet spurred much enthusiasm.

Our friends at WJB shared these pictures with us earlier today.  We’ve been smiling since.  Interestingly, we saw a very similar sentiment set-up in September-October 2009, when we wrote A Gold Mine is a Hole in the Ground with a Liar on Top.

Disclosure: At the time of publication, the author was long Gold and long MarketVectors Gold Miners ETF, although positions may change at any time.

-  Jesse Livermore, Reminiscences of a Stock Operator 

As Gold accelerated past $1200 per ounce in early December, we cautioned investors that after such a rapid gain, we would not be surprised to see precious metals take a breather.  Extreme optimism is now evident in various sentiment measures, so a consolidation period is likely at a minimum. 

Gold prices quickly retreated by more than ten percent in the blink of an eye, but encouragingly, bullish sentiment for the precious metal collapsed just as fast.  We view this as a constructive set up from a contrarian perspective as longer term tops are more easily identified by stubborn bulls in the face of declining prices.  The fact that sentiment has quickly retreated to levels best described as extreme pessimism, can be viewed as evidence that weak hands have likely been shaken out and increases the odds that the worst of this correction is likely behind us. 

Source: Goldstockanalyst.com

Jesse Livermore reminds us that the Big Money is made through the proper identification of long term trends.  We can relate.  It is all too easy to get distracted by the day to day noise in the markets, but more money is made by sitting than by active trading.  The chart above illustrates the inverse relationship between Gold and Real Rates.  This is the only picture that matters folks.  As long as “He Who Sees No Bubbles” (Keith McCullough’s affectionate nickname for our Beloved Fed Chairman) continues to sit on Zero Interest Rates, investors can continue to sit on their gold positions. 

We plan to do the same and continue to view weakness as thoughtful little gifts from Uncle Ben.  Given gold’s sharp correction and sharper fall off in bullish sentiment, we are getting ready for “One More Round.”  We didn’t hear no bell either Rock. 

Disclosure: At the time of publication, the author was long SPDR Gold Shares, although positions may change at any time.

Back in October, we outlined our long-term constructive view on gold here.  Let us be clear – we are in no way altering our thesis and remain quite happy with the label “gold bug.  In fact, we could easily make the case that the fundamentals are stronger today than when we first discussed the yellow metal.  However, what has changed, is price.  And what a mighty change in such a short period!  As a proxy for the space, GLD, GDX and SLV have rallied 20% – 25% to their most recent peaks.  After such a rapid gain, we would not be surprised to see precious metals take a breather.  Extreme optimism is now evident in various sentiment measures, so a consolidation period is likely at a minimum.  We shall see . . . but a part of us is hopeful for a large enough pull back to add to our core position in the oldest store of value. 

Recent comments from Gluskin Sheff’s David Rosenberg support this view: 

Gold just capped off its best month in a year – ±14% in November and 34% year-to-date. It’s not just the middle-class in China that is starting to buy gold, but the central bank, which has very deep pockets, is going to do likewise. We just came across a Bloomberg News article quoting an official from the state-owned Assets Supervision and Administration Commission (Ji Xiaonan, the Chief) as saying “we recommend China increase its gold reserves to 6,000 metric tons within three-to-five years and possibly to 10,000 tons in eight to 10 years.” China’s reserves, after a 76% buildup since 2003, currently stand at 1,054 tons, so we are talking here about the prospect of some pretty heaving buying in coming years. 

If China were to lift their gold reserves to 5,000 tonnes, which is equivalent to about two years of global production, that shift in demand would boost the gold price by $800/oz to around $2,000 ($1,978) based on our models. If China moves towards 10,000 tonnes, well, that would end up taking the gold price to $2,623/ounce if our calculations are in the ball-park. 

Make no mistake, we are gold bulls. Central banks have deep pockets and production of gold is stagnant so the demand-supply backdrop for bullion is bullish. At the same time, we have to pay respect for market positioning over the near-term. The market for precious metals is overextended right now after the parabolic move of the past two months. The net speculative long position has swelled to a record 273,552 contracts (100 ounces each) on the COMEX. Open interest has never been higher, at 693,661 contracts. So this is one crowded trade – as is the short-trade on the USD against all the major currencies, especially the commodity-based units. 

So, we could get a meaningful gold correction at any time, and we are talking about a correction in what is still a secular bull market – the 200-day moving average is $970/oz, which means we could get as much as a 20% pullback and no fundamental trendline would be violated. We remain long-term gold bulls, and our commentary remains fundamentally bullish, but anything that could spark a countertrend rally in the U.S. dollar, which is our principal near-term concern, would put gold at a much better price point for investors than the peak we are at today. 

Source: Gluskin Sheff

Source: Gluskin Sheff

Disclosure: At the time of publication, the author was long streetTRACKS Gold Trust Shares, Market Vectors Gold Miners and iShares Silver Trust, although positions may change at any time.

While that may be true in certain instances, the hole investors should be most concerned about is the one with Helicopter Ben Bernanke standing proudly on top – the cavernous hole in household net worth created by the bursting of the Greatest Credit Bubble in our history.  Our current Chairman of the Federal Reserve, trapped by Milton Friedman’s view of the Great Depression, and aided by the most aggressive fiscal policy we’ve ever experienced, has promised to resort to all means necessary to reflate this burst bubble and refill the gaping hole in credit, primarily through a policy referred to as “quantitative easing” – a fancy term economists coined for “printing money”.

It is safe to assume that if our Fed Chairman is determined to debase the currency, he will succeed.  Historically, gold has rallied in the face of geopolitical instability or inflation, but we don’t believe either is necessary to drive gold prices higher today.  Gold should move higher because investors throughout the world are becoming increasingly apprehensive holding fiat currencies.  At home, the size of the Fed’s balance sheet is exploding, and the impact is clearly seen in the Dollar’s Dive.  But unprecedented global monetary and fiscal stimulus around the world, have created a sea of liquidity to offset the deflationary forces associated with deleveraging.  Investors, who are by definition net long in paper currencies, will increasingly look for insurance in the form of gold.

Undoubtedly, our favorite View from the Blue Ridge is looking down on Wall Street analysts chasing immaterial changes in corporate earnings or economic indicators.  Perhaps our greatest advantage is being nestled away in the mountains of North Carolina, where we are better able to focus on the big shifts and important trend changes that drive markets over the long term.  We believe it is here, that the greatest opportunities lie.  Let’s take a quick look at such shifts in the supply and demand picture for gold:

The official sector became a net BUYER of gold in Q2-09, a significant change of heart for a market accustomed to absorbing substantial volume by central banks over the last two decades (see chart).  Note that this shift was largely due to a sharp decline in sales from the Central Bank Gold Agreement but purchases were sufficient to push the sector into positive territory. We think it is likely that purchases continue for the foreseeable future as concerns surrounding the Buck’s status as the world’s reserve currency continue to mount.

Source: GFMC

China and a growing number of large holders of our increasingly worthless Treasuries have been increasingly vocal about their concerns for the almighty buck.  The State Administration of Foreign Exchange announced this year that China boosted its gold reserves to 1054 tons.  A trend we expect to continue.  To put this figure in perspective, consider that this investment represents 1.9% of China’s $2.1 trillion in reserves.  The US, for example, holds 77.4% of domestic reserves in gold.  The Euro Area comes in at 59.7% whereas the global average is 10.3%.  It’s not hard to imagine the impact that Chinese purchases would have on a gold sector with total supply and demand of roughly 3500 tons over the past three years.

We’ll assume for a moment that most investors understand the potential for significantly higher demand for gold as discussed above.  So naturally, the next question we should be asking concerns supply.  Surely, as gold prices have risen from a low around $250 per ounce in 1999 to today’s price over $1000 per ounce, miners have aggressively expanded production to maximize the gold they can sell at all time highs, right?  Wrong.  Gold production has steadily declined annually, since gold prices bottomed around the turn of the century (see chart).

Source: GFMS

Since rational miners (note we are talking miners here, not investors) would logically aim to sell more gold at higher prices, we can only assume that they cannot find more gold, or it is much harder to find and taking them a lot longer to increase production.  Either way, until we begin to detect shifts in these underlying secular trends, we will ignore the short term noise in daily gold prices, and refer back to the most fundamental concept in economics, which even Helicopter Ben and his trusty sidekick Timmy can understand – increasing demand, plus declining supply, equals higher prices.

Disclosure: At the time of publication, author was long streetTRACKS Gold Trust Shares, Market Vectors Gold Miners and iShares Silver Trust, although positions may change at any time.