It has been an increasingly brutal ride for gold and silver, beginning around late March and accelerating through April. The gold price was over $1600 and on Monday April 15, it fell below $1350, a loss of $250. Silver did even worse, falling from $29 to $22. We called for the gold:silver ratio to rise, and since the start of February, it has risen from around 52.5 to over 59 as I write this (with a few periods over 60).
Gold and Silver Prices
Everyone wants to know why. Why did this happen? Could the prices fall further? If so, how much? In this two-part article, I address these questions and put them into perspective. In the first part, I discuss the conventional theory and in the second part the Monetary Metals theory.
In this article, I refer to the "gold bug" frequently. By "gold bug" I mean the dollar-focused speculators and traders, not the people who buy gold and silver to accumulate for the long term. The latter understand, implicitly or explicitly, that gold is money and that it is good to hold money as the world moves closer towards global bankruptcy and default.
Let's start with a question. If you knew that a casino was cheating, if you saw that there was a magnet under the roulette table, would you gamble there? Would you risk your money, hoping that on the next spin, the magnet would somehow malfunction?
It would be irrational. You would be better off going to the next casino where they obey state law and run an honest game. It is the same with the markets. If you believe that the gold and silver prices are controlled then why would you risk your capital attempting to trade them? Technical and fundamental analysis would be at best useless and at worst misleading, because there are cheaters in the game. No analysis could predict when the cheater will push the button that raises the magnet under green "00", and take your money.
We are not aware of any gold or silver analyst that called for the crash of last Friday through Monday. There are some analysts who are generally bearish, and we ourselves have predicting the rising gold:silver price ratio, and we emphasized that we were not bullish on the silver price in dollars all the way down from $35. But no one said that the gold price would drop more than 10% in two trading days.
In this paper, I shine some light onto the conventional manipulation theory and also the very idea of holding gold waiting for a higher gold price. I present my own theory of what may be happening in the markets right now, and a different view of the use and value of gold. If you want to understand the gold market dynamics, then you must understand the gold basis and the broader credit environment.
If you are firmly committed to the belief that the gold price is suppressed, then you may want to stop reading right here or else prepare to be offended. Consider yourself warned.
What follows is a sometimes-humorous and often-irreverent and hard-hitting discussion. I write this not out of a desire to insult anyone, but to help people see their way out of a no-win zero-sum game. I hope to offer a different perspective and expand your thinking about gold and silver. My other goal is to address those people who are holding gold and who are nervous about the near-term price volatility. I hope that in this article, you come away with a stronger understanding that you are in the right place, that selling low is never a good strategy, and the dollar is not a store of value.
The Conventional "Gold Bug" Theory
It is commonly accepted today that as the quantity of money rises, then prices must rise especially including the prices of gold and silver (throughout this article, I will use the word gold to refer to both metals unless I call one metal out explicitly). Prices in the real world do not move that way, so a convenient explanation has become very popular.
In this theory, there are nefarious forces, composed of various central banks plus assorted bullion banks (often called "vampires" and/or "squids"). In some versions, this dark cabal does not care about taking losses to suppress the price of gold. Other accounts accuse them of making illicit gains by causing poor old gold investors to buy high and sell low.
They are supposed to surreptitiously dump physical metal (which is finite in its supply) onto the market, in order to push down the price. Alternatively, they might be dumping unlimited quantities of futures to accomplish their evil end.
The reason they would want to suppress the gold price is vaguely given as trying to prop up "faith" in the paper dollar, or otherwise somehow "protect" their paper money.
In any case, when the price is rising, the gold bug treats it as right and natural. When the price falls, it is due to manipulation. Why would anyone be satisfied with this simplistic view? It won't help in trading, though it does offer comfort after each wounding.
I have written many times to debunk these conspiracy theories, so I do not want to dwell too much on them here, except to make two observations. First, the central banks don't have any silver. If they were dumping real metal to suppress the price, it would have to be gold only. This leads to a nagging question. Historically, the gold:silver ratio was around 16 (i.e. 1 ounce of gold could buy 16 ounces of silver). If gold is artificially cheapened--but not silver--wouldn't one expect to see the ratio fall below 16:1? Today the ratio is near 60:1.
If both metals are suppressed, then it has to be done using futures. There is an equally nagging problem with this idea. If they sell futures (but not real metal, which is typically claimed to be scarce and getting scarcer), then they tear open a large spread between the price of a future and the price of real metal. For example, if both are trading around $1600, and they sell hundreds of tons worth of gold futures--enough to drive the price down $250--then there would be a $250 spread between real metal which would remain up at $1600, and futures which would be driven down to $1350.
The term for when the futures contract is cheaper than spot metal is called "backwardation". While there is intermittent gold backwardation, the magnitude is in the cents or perhaps a dollar or so, not hundreds of dollars. Indeed, on Monday morning, April 15, the slight backwardation that had existed in the June gold contract disappeared. The Gold Basis Report (free registration required) provides weekly coverage of the gold and silver basis and other related data.
My personal opinion is that the Fed cares far less about the gold price than we do. Gold is not in the basket of goods whose prices comprise the Consumer Price Index. Dollars are not redeemable in gold, the Fed and the banks are not struggling under an obligation to deliver gold, and there is no run on the gold of the banks.
Monetary Metals Theory
Monetary Metals was founded on a single idea: gold is money, and the dollar is credit-of declining quality. One cannot profit by buying gold and waiting for the price to rise. Sure, one has more dollars, but each of them is worth less. How much less? The decline of the value of each dollar is in exact proportion to the gain in the number of them. If the amount of gold that you own has not changed, then it stands to reason that you have not gained real wealth (and in the US, you lose wealth due to the tax on capital gains).
Let me illustrate this point with an example. Imagine you have 1,000 silver coins. The silver price is about $24, so your hoard is worth about $24,000 today. What if the silver price rose 0.1% to $24.024, and you spent one coin? Your 999 remaining coins are worth ... $24,000. What if the silver price rose again to $24.048, and you spent another coin? Your remaining 998 coins are still worth $24,000. You continue this process every day (while it lasts).
Is this really like living on the interest on a bond? Or, are you consuming your capital? You are certainly reducing the amount of silver you hold, even if the dollar value of it remains constant. This is the picture of capital destruction that everyone should have firmly in mind whenever a central banker or talking head uses the term "wealth effect". Rising prices can make one feel wealthier, but it is not real wealth.
We must operate in the real world. Few people hold our unconventional view. Most Westerners think of a rising gold price as a gain, and a falling price is a loss. (attitudes are quite different in India and parts of Asia). Western gold bugs have to sell gold. They sell when the price rises, to realize their gains. They sell when the price falls, to stop their losses.
Though many call themselves investors, gold bugs are speculators. They are described aptly by John Maynard Keynes (who did not get much else right) in 1935:
"Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."¹
They play a zero-sum game, hoping to front-run the others, to buy first, and then let everyone else's buying drive up the price so they can sell. Or, often, they are the greater fools who buy from other speculators who are selling to take profits. Then, when the price drops, they sell to avoid further losses.
Although they tell the story of the falling dollar, this is just lip service. Gold bugs measure their gains in dollars, and they sell gold for dollars as their modus operandi. When they are buying en masse, the price of gold can rise sharply. When they are selling en masse, we can see precipitous sell-offs, as over the last week.
What could have caused these people to sell en masse right now?
In Part II, we address the root causes (free registration required).
¹ The General Theory of Employment, Interest, and Money by John Maynard Keynes, p. 140 (Google Books edition)