It is hard to bet against the King.
July 2013 I made a friendly wager with Dennis Gartman, author and editor of the Gartman Letter. Market participants aware of his prescience and trading skills respectfully call him “The Commodity King” – a moniker well deserved.
Here’s the wager: I'll bet you a chunk of gold-bearing slag from Eureka's 1890s mining heydays for a cup of Virginia Beach sand that gold will test June's low ($1,179.4) before breaking May's high ($1,488.5).
Home base for Gartman is Virginia Beach and I own the 150,000 tons of slag at the north end of Eureka, Nevada. Although there is probably more gold in my slag chunk than Gartman’s beach sand, it’s not much more. The old timers at the Eureka Consolidated Mill were pretty savvy about extracting most of the lead and precious metals from their mining district’s bountiful ores. Estimates of gold content are upwards of 1,000 ounces but the economics and environmental consequences of extraction make my slag pile safer than storing bullion at Fort Knox.
From the standpoint of most active Comex futures contracts, I’d come within a few dollars of winning twice but no cup of sand—$1,181.4 Dec. 31, 2013 and $1,183.3 Oct. 6, 2014.
The deadline for this piece is Halloween. A witch’s brew of global turmoil had elevated gold price nicely above $1,200 per ounce until the U.S. Federal Reserve Oct. 29 announcement to end their third quantitative easing program (known as QE3, the printing of money to buy bonds). Although the outcome was widely expected, Comex gold dropped to $1,195.50 the following day but stayed above the steadfast $1,180.
It is hard to bet against the King.
The King has an ace up his sleeve
The golden coup de grâce came on deadline day. The Bank of Japan surprised everyone with a trick-or-treat bag chock full of new stimulus—a commitment to accelerate purchases of Japanese government bonds to an annual rate of 80 trillion yen. To ensure there would be enough candy for everyone, the central bank also promised to increase purchases of exchange-traded funds, real-estate investment trusts and buy longer-dated debt. In response, Comex gold blew though the June 2013 bottom to post a new intraday low of $1,160.5 per ounce - wager won, at least in U.S. dollar terms.
Janet Mirasola, director of the Wells Fargo Securities Metals Group, said it best in her early morning market brief, “…the Shiny One has been shut out as the need for safe haven is eliminated by traders who are happy to add equities and other risky assets to their portfolios…”As the U.S. equity markets opened, the S&P500 soared above its all-time closing high and the DOW Jones Industrial Average made a new intraday high.
On Oct. 20, I asked Mr. Gartman for his thoughts on gold. He replied, “I do believe that the lows have been seen; I’m especially certain of that in terms of gold priced in EURS [euro currency] and of gold prices in [Japanese] Yen terms.” He sagely prefers to take gold positions in currencies weakened by the recent strength of the U.S. dollar. The King may have lost a cup of sand on dollar price but his trades remain intact. October's lows in euro and yen are both more than 6 percent above their 2013 bottoms.This morning the euro dropped to lows not seen since August 2012 and the yen touched late-2007 levels.
Long live the King!
Let’s hop in the cage and go down a few levels to find out what happens next…
Although Federal Reserve Chair Janet Yellen intends to maintain low interest rates for a “considerable time,” the end of QE3 marks a significant pullback in monetary accommodation in response to an improving domestic economy and labor market. By stark contrast, the European Central Bank is just beginning its own peculiar form of QE on rising fears of triple-dip recession and deflation in the Europe. Similarly, Japan has now unleashed a tsunami of loose monetary policy to energize an economy moribund for decades.
The dynamic of other central banks moving in a direction different from our own benefits the U.S. dollar versus the euro and yen, but generates new headwinds for dollarized commodities -- including gold. However, year-to-date gold has fared far better in 2014 when compared to other key commodities. One ounce still buys more ounces of silver, pounds of copper and barrels of oil than it did in late-December. Outpacing a 2.6 percent loss in U.S. dollar price, glitter is up 17 percent over the white metal, 8.6 percent over the red and 19 percent over oil.
It is hard to bet against King Dollar but gold presently has a stronger hand than these commodities. Why?
The 2011-2012 China syndrome
China is now the number one producer and consumer of gold. That gives it a major vote in the supply and demand calculus of price. An indirect but no less important influence on the value of the yellow metal is China’s voracious appetite for raw materials.
Consider this statistic: In just two years, from 2011 to 2012, China produced more cement than the U.S. did in the entire 20th century, according to historical data from the U.S. Geological Survey and China’s National Bureau of Statistics.
Think of the Interstate Highway System, skyscrapers in major cities, suburban sprawl on slab foundations and the the Hoover Dam -- Uncle Sam and his citizens poured a lot of concrete in 100 years.
A second thought: Building a high-speed rail from Beijing to Guangzhou requires lots of steel reinforcement in fortified cement and you don’t make rebar without iron ore. A full two-thirds of seaborne iron ore goes to China. A familiar number for Nevada miners is its 40 percent share of global copper demand to support lightening growth and juice for those 380 km/hour projectile-shaped trains filled with a booming middle class.
The cement statistic is alarming but clearly unsustainable. Chinese commodity demand has fallen precipitously with declining gross domestic product growth rate since the 2011-2012 heydays and so have prices. GDP growth peaked at a breathtaking 14.2 percent in 1992 and by 2012 was still roaring at 8.9 percent; in 2014 it will be lucky to achieve 7.1 percent according to the International Monetary Fund. At the beginning of 2011, iron ore in China topped $190 per metric ton – now spot prices struggle to stay near $80. Copper in that same period surged above $9,900 per metric ton; in October the red metal fell briefly below $6,600.
A 7.1 percent GDP may seem robust for Western developed countries striving to attain 2 percent but hyper-economies like China carry a different benchmark. A rule-of-thumb for GDP following such explosive growth is 7 percent—below that number recession-like symptoms are likely to occur. One example is the predicament of rural folks that swell urban areas to provide labor for industrial expansion. A slowing economy leads to high unemployment for those least equipped to deal with the harsh realities of city life. The nascent middle class that benefitted the most from expansion also feels the pinch and expects more say in their future. The plight of both working and middle classes increases the potential for social unrest – the demonstrations in Hong Kong are an early example.
For a Chinese economy moving from an export focus to domestic consumption, additional overhangs include a slowdown in infrastructure spending, tightening credit, a looming property bubble and wobbly banking system.
A Europe facing another recession and China possibly slipping into a recession-like period does not bode well for global commodity demand, not to mention slowing or contractions in other emerging economies like India, Russia and Brazil. The S&P Goldman Sachs Commodity Index, which covers everything from copper to cattle, followed oil down in October to make new lows and there may be further to go. On slowing demand and oversupply, Goldman Sachs just revised their first quarter 2015 crude oil target for international benchmark Brent, from $100 to $85 per barrel; domestic crude (WTI), from $90 to $75.
The force of gravity
My column, in the summer 2014 edition of the Mining Quarterly, discussed the connection between the price of gold and key commodities. It works like the force of gravity. Without the propulsion of safe haven or monetary hedge, the yellow metal falls back in line with commodity prices and historical norms. That article presented a “commodity value” of gold in U.S. dollars based on the price of silver, copper and oil.
Here is an updated plot from that analysis comparing the actual price of gold (blue trace) to its commodity price (red trace) from January 2010 through Halloween 2014:
When gold price trades at a premium to this basket of commodities the blue trace is above the red; at a discount, the blue trace is below.
The commodity value of gold peaked at $1,838.5 per ounce in April 2011, just after the start of the 2011-2012 period (light yellow box in the graphic). Driven by China's demand and the inflationary tailwinds of QE2, copper enjoyed $4-plus per pound prices. Arab Spring was also in full swing moving WTI prices above $110-per barrel on supply disruption fears. Gold traded at $1,500 per ounce, priced at a discount to both in terms of historical ratios.
The tables turned after the disastrous U.S. debt downgrade that August -- gold was propelled to premium on a safe haven play as oil and copper prices fell. On a closing basis, Comex gold peaked in late-August at $1,891.9 with its intraday all-time record of $1,920-plus per ounce following in early September.
Notably after 2012, gold took its plunge from $1,675 to present levels with a procession of lower highs and lower lows. As the yellow metal entered a bear market in 2013, money rotated away from safe haven assets to blazing equity markets – a trend that continued this October. China’s waning appetite for natural resources, European recessionary/deflationary fears and regional conflicts took their toll on silver, copper and oil, bringing gold’s commodity value down with dollar price.
This forms a declining value wedge, which has proved quite accurate in predicting future price ranges. Extending the dashed lines, given Halloween’s new low, suggests a commodity value range of $1,010 to $1,170 per ounce for next year’s first quarter (1Q2015).
Several hours before the Federal Reserve QE3 announcement, I asked Kitco Global Editor Debbie Carlson if improving physical demand in both India and China is expected to continue through the Lunar New Year. She said yes, but with a caveat, “Bullion dealers said there was decent demand during Diwali, and they expect Chinese demand to be decent. However.... they said that there is so much supply around that premiums barely moved, meaning that the physical demand didn't push around prices much. Also, physical demand in China picks up, but only at lower levels, which is generally seen as a bearish sign.” After today’s steep declines, bargain hunters will no doubt come out of the woodwork – but at what level?
Investment interest in the yellow metal has been lackluster since money flows began to favor equities in 2013. The popular SPDR Gold Trust ETF (GLD), which is backed by bullion, is a decent proxy for investment activity. Tonnage peaked in December, 2012 at 1,353 metric tons, at the close of the 2011-2012 period. By Oct. 1, 2014, those stores had fallen to 768 or roughly equivalent to the inventory in December 2008. To reinvigorate investor interest, the safe-haven trade must come back to life or inflation expectations begin to rise or both.
On the positive side, gold still carries a premium to the aggregate of key commodities mentioned and this has been mostly true since August 2011. Using the gravity analogy, gold needs to achieve escape velocity from the value wedge with increasing premium. If that premium declines, gold will follow commodities lower early next year. Oil and copper prices stabilizing, revived investor interest and renewed physical buying can in combination break the curse of the wedge.
One year after our wager, Mr. Gartman observed, “…although there shall be a great deal of conversation in the media today about gold’s weakness, it is worthy of note…that gold even in U.S. dollar terms has held its lows for the past full year…” He further pointed out that subsequent lows were constructively higher than the last; a trend that continued through this October – until the Bank of Japan surprise. These are words of wisdom, worthy of repeating if the Halloween low is remembered as the beginning of a new bottoming process for U.S. dollar price. Importantly, Mr. Gartman has been spot on with respect to his gold positions in euro and yen – another positive for the yellow metal’s 2015 outlook.
Feeling better about gold price in U.S. dollars starts with knowing the lows are in the rear view mirror—that process may already be underway."