The Gold Market: Assessing the Bear Case

We cannot remember a more frustrating gold market. Seabridge was founded in 1999 when gold was trading at US$270 per ounce and that was a difficult market too, but the fundamentals for gold were largely hidden from view (although we saw them coming) and we did not expect a sympathetic response for a start-up company at the tail end of a 20 year bear market. Now, with the gold price almost five times higher, one of the world's largest reserves of gold and copper and extraordinary gold fundamentals for all to see, we find that many investors are not interested. For the last year in particular, the bears have been in control and they have been the big winners in gold and gold stocks. So, in this report, we look at the gold bear position to see what they have going for them.  

It is remarkably easy to find the bear arguments since just about every major brokerage house and research firm has been making them. The top five are as follow: (1) the US economy is recovering; (2) the Federal Reserve ("Fed") will soon taper Quantitative Easing ("QE"); (3) equities are the place to be; (4) QE has not caused inflation and gold is primarily a hedge against inflation; (5) real interest rates are rising and gold goes down when that happens.

These arguments are the consensus in the west and the cited reason why western investors have dumped a large portion of their gold holdings. For example, gold ETFs have sold hundreds of tonnes of metal this year and the open interest on COMEX has fallen sharply. Sentiment has reached all-time lows, following the price downward. In our view, the bears have been right on the price but for the wrong reasons, which we expect will come back to bite them. There is apparent logic in what has happened but we think the logic is wrong, as we will show.

Economic recovery

We continue to believe that the best measure of U.S. economic recovery is employment. The October employment report released by the Bureau of Labor Statistics on November 8, 2013 estimated that the U.S. economy created a net 204,000 jobs in the month. The reality is less positive. Half of these were minimum wage jobs in retail and hospitality. The economy still employs 1.5 million people fewer than it did in 2007 and, by some measures, has nearly six million fewer full time jobs than it did six years ago. In the October report we find that 932,000 people left the work force in that month alone, bringing the all-important labor participation rate down from 63.2% to 62.8%, a 35 year low. Employment income is stagnant. This is not an economic recovery and there is no indication that the situation will improve any time soon.

Expectations of better U.S. growth have helped to drive western liquidation of gold but, in our view, this is largely completed. Meanwhile, the health of the U.S. economy is not a factor in the minds of Asian investors who are by far the largest buyers of gold As growth expectations collide with reality, western demand should revive.

Taper or not

Will the Fed taper QE in the next several months as the markets still seem to expect? We think this is most unlikely. The Fed had the whole world expecting a reduction of its current monthly level of $85 billion in September but they decided not to proceed. The reason: we believe fear of the consequences for asset markets, especially the Treasury market where interest rates began to increase rapidly as soon as the Fed began to hint at tapering in May of this year. Our prediction was that the Fed would not taper. Now, we believe the Fed will likely have to increase QE next year to defend the Treasury market and to try to re-ignite the housing market which is once again weakening due to rising rates and poor employment income growth.

The Fed simply cannot afford to let the yield on the 10 year Treasury note rise much above the recent high of 3.0%, in our view. China has recently become a net seller of Treasuries, leaving the Fed as both the largest bidder and holder. If the Fed begins to step away from this market, we believe the consequences will be extraordinarily dire for financial markets and the economy. In short, the Fed has no room to maneuver. We think that failure to taper soon will take the heart out of the bear argument against gold, never mind an actual increase in QE.

Equities are better

Next, the bears argue that equities are the place to be, not gold, and they have been right. There can be little doubt that investors have sold gold and put their money in stocks. Will equities continue to outperform? Consider the facts. The total market capitalization of the U.S. stock market now stands at 112% of GDP. As Bonner & Partners notes, this level is higher than 96% of all the readings since World War II, higher than 2007, approaching year 2000 extremes and well above Germany (44%), China (41%) and Japan (62%). The Shiller P/E ratio (using inflation-adjusted trailing GAAP earnings) is above 25 which is higher than all but three weeks prior to the 1929 crash and the period just before the 2000 crash. The median share price-to-revenue ratio is at an all-time record exceeding the 2000 peak and margin debt is also at an all-time high at 2.2% of GDP. The stock market may still go higher (we do not have a prediction) but its outperformance surely appears closer to the end than the beginning; comparatively speaking, we think the risks/rewards now favor gold. And once again, the most important gold markets are in Asia and they are not selling gold to buy equities. This is another U.S.-centric argument that we believe has largely run its

Inflation is dead

The bears claim that gold is primarily a hedge against consumer price inflation and it has now been proved that extreme monetary stimulus does not create inflation. We think this reasoning has had an impact on western investors who likely did buy gold when QE was introduced because they thought it could be inflationary in the short term. This is another U.S.-centric argument; Asians continue to buy gold precisely because it has performed very well as an inflation hedge. And gold is not just an inflation hedge -- it is also the most effective hedge against default. Gold is universally accepted as final settlement because it is not anyone else's liability. But let's look at the inflation logic more carefully.

To those who think that stimulative monetary policy does not cause inflation, we suggest they are premature in their conclusion. History tells us that inflation can take many years to manifest and when it does, it usually accelerates quickly as people decide to spend faster to stay ahead of it. Furthermore, history does not give us a single example of state-sponsored printing of fiat money that did not end with high inflation and a currency collapse. Boston University's Laurence Kotlikoff, one of the world's pre-eminent authorities on government finance, notes that the U.S. price level has risen by only 15 percent since 2007 while M1 (currency in circulation) has risen by 88 percent, reflecting a massive expansion of domestic and foreign demand for "safe" dollars. The velocity of money has dropped from 10.4 to 6.6 during this six year period as people are now much more eager to hold onto dollars. What happens when they are not? When faith in the dollar wanes? Inflation. In his article "Is Hyperinflation Just Around the Corner?" (Yahoo! Finance The Exchange, Friday, Sep 27, 2013), Kotlikoff sets out his rationale for why inflation will follow from QE.

"When the Treasury prints bonds and sells them to the public for cash and the Fed prints cash and uses it to buy the newly printed bonds back from the public, the Treasury ends up with the extra cash, the public ends up with the same cash it had initially, and the Fed ends up with the new bonds. Yes, the Treasury pays interest and principal to the Fed on the bonds, but the Fed hands that interest and principal back to the Treasury as profits earned by a government corporation, namely the Fed. So, the outcome of this shell game is no different from having the Treasury simply print money and spend it as it likes.

The fact that the Fed and Treasury dance this financial pas de deux shows how much they want to keep the public in the dark about what they are doing. And what they are doing, these days, is printing, out of thin air, 29 cents of every $1 being spent by the federal government. I have heard one financial guru after another discuss Quantitative Easing and its impact on interest rates and the stock market, but I've heard no one make clear that close to 30 percent of federal spending is now being financed via the printing press. That's an unsustainable practice. It will come to an end once Wall Street starts to understand exactly how much money is being printed and that it's not being printed simply to stimulate the economy, but rather to pay for the spending of a government that is completely broke -- with long-term expenditures obligations that exceed its long-term tax revenues by $205 trillion!"

For those bears who claim that a shrinking U.S. budget deficit (due to sequestration and tax increases) is another reason for selling gold, note that the federal government engages in cash accounting which fails to include the estimated net present value of future revenues and obligations as GAAP requires. No private corporation could get away with this. The real federal deficit is climbing more than $5 trillion per year and the fiscal gap exceeds $200 trillion.

Real interest rates are rising

The bears argue that real interest rates are now a drag on gold. They point to the fact that five year Treasury interest rates are no longer negative -- the yield exceeds the current rate of increase in the Consumer Price Index. We think this is a completely spurious argument. It is an historical fact that negative interest rates favor gold. But who uses five year money to buy gold? Gold is an alternative form of money and therefore should be measured against short-term deposits of dollars and other fiat currencies; the short-term deposit rates for all major currencies remain well below consumer inflation rates despite the fact that these inflation rates are managed down by government statisticians. Negative real interest rates at the short end remain a strong argument in favor of a higher gold price and the Fed has made it clear that its policy is to keep these rates exceptionally low far into the future. Furthermore, a widening spread between short and long interest rates, as we are seeing now, has historically correlated well with higher gold prices because it is generally accepted as evidence of rising inflation expectations.

Conclusion

The bears have made some effective arguments against gold but they are U.S. oriented, ignoring the rest of the world. We believe the liquidation the bears have generated is largely complete. In our view, the bear case does not provide reasons to sell now. We have been wrong about the direction of the gold price in the last year but we do not think we are wrong about the fundamental reasons for gold to go higher. Those reasons are supported by facts which directly contradict the bear case against gold.

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