An overview of the history of gold
Gold is probably the most controversial and talked about asset. We’ve all read about or witnessed heated arguments involving the yellow metal. There are two hardcore camps as far as gold is concerned:
- The Gold Bugs (or their most extreme version, the “preppers”): These are people who believe that gold is the most important form of money, with thousands of years of monetary use in humanity’s history. They are convinced that there will come a time when the “reset” will come. When all fiat money will be massively devalued (given the relentless money printing that started in force during the financial crisis), and when gold will rocket higher to $2000, $5000, $50000 – take your pick on a price with many zeros. Preppers believe that humanity will reach a point where the world’s financial (and social) system will blow up and the most valuable possessions on the planet will be gold, weapons, water and canned food.
- The Gold Haters: These are people who believe that gold is, to use John Maynard Keynes’s famous description, a “barbarous relic”. Many world-class investors (such as Warren Buffett) believe that gold is just a shiny rock that has little or no intrinsic value. Others dislike the metal so much that with almost every sentence they write, they close with a sarcastic “buy gold” comment.
I’m going to disappoint preppers, but I think that we can safely say that if the world apocalypse comes, people will have much bigger problems than having enough gold. On the other hand, gold has been a monetary metal and/or store of value for thousands of years, and its price has been steadily increasing broadly in line with money supply. All major central banks hold considerable amounts of gold reserves, the Fed in particular storing its 8133 tonnes of gold inside the most secure building complex in the world. China is being super-secretive about its gold reserve levels, which have been increasing considerably in the past decade. So it’s a near zero possibility that it will ever become worthless (sorry Warren). For the purpose of this blog post, we will ignore these two extremes.
So, what is it about gold that makes it so special? What are the underlying trends of the past decades? Where could it be heading? Let’s take a few steps back and examine it in more detail. Money supply used to be linked to gold (or silver) from ancient times. In modern history, the US Dollar was linked to gold and the two were fully convertible at $20.67 per ounce for several decades. In 1934, President Roosevelt confiscated Americans’ gold and then conveniently revalued the price to $35 the same year. Then came the Bretton Woods system: a system of payments based on the US Dollar, in which all currencies were defined in relation to the Dollar (itself still fully convertible to/from gold at $35 per ounce). As US money supply grew and physical gold stock couldn’t keep up the pace, it was unavoidable that the gold/US$ convertibility eventually crumbled. In 1971, President Nixon shocked the world and unilaterally cancelled the direct international convertibility of the US Dollar to gold.
What actually drives gold prices
We’re now going to propose some big assumptions and then try to refute or confirm them:
- Gold is an extremely important resource, being one of the most reliable (if not the most reliable) ways to store value.
- It’s the most important reserve asset of most countries.
- The price of gold vs. the local currency is a direct indicator of how well the country’s central bank handles monetary policy and how well the government handles fiscal policy.
- Most of the major central banks want to have possession of significant amounts of physical gold.
Assuming that all the above are true, what would major central banks do? Their goal is to increase their gold holdings but they can’t simply go in the market and start buying, because that would increase prices dramatically and then they’ll get into all sorts of trouble (the monetary policy effectiveness indicator would be flashing red). The obvious way to get it is to confiscate it from the public, making it illegal to own gold. The Americans tried this in 1933 and it worked relatively well, but such an executive order would probably be much less effective today.
While central banks are on a gold-buying programme they actually want prices to drop, giving them better levels to buy the physical asset at. So, in a stroke of genius, they came up with derivative products that can be sold with no physical gold changing hands. This way they can push the price lower using only fiat currency and when the price is low enough they exchange their currency for the real thing. Having done that, they then buy back the derivatives they’re short of – et voila – job done. It’s worth noting (although it’s probably evident by now) that derivative products can move the price of an asset regardless of the physical interest in it. In the past 5 years, physical gold demand has been steadily increasing; this is totally at odds with the underlying price. Another interesting point is that the COMEX (the primary market for trading metals such as gold) paper to physical ratio has gone through the roof. This ratio used to be in a “normal” range of 30-50 times, but in 2016 it smashed through 100, 200, even 500+ at some point. With so much paper (derivative) gold out there for every 1 ounce of physical gold, it will only take a few demands for physical delivery to bring the whole system to a crashing halt.
In a world of fractional reserve banking and money creation on a massive scale, creating fiat money is the easy bit. The hard bit is converting it into an asset of real value. Following the financial crisis, many types of real assets have been on a tear: prime location real estate, fine art, rare wine, classic cars among others. A well-known saying is “follow the money”, and these are the items which are in hot demand among the top 1%. Meanwhile, although gold saw a steep rise leading into the crisis, it’s nearly back to 2009 levels.
Imagine a market where this derivative-led price suppression of gold goes on for years. Let’s say that the price drops from $1900 to $1160 in just under 5 years, while money creation increases at an unprecedented rate (any resemblance to actual figures may be totally intentional). Such prolonged price action will surely frustrate your average Joe individual who wants to own some physical gold for investment. Many weak hands will be shaken off and a lot of physical gold will be sold in exchange for Dollars, Euros, Pounds or other currencies. It’s no coincidence that in many major cities, shops that buy & sell gold have multiplied like mushrooms. Conspiracy theorists assert that these shops are certainly not small family-owned ventures; the ultimate receivers of this gold are unknown.
Let’s now go back to the original assumptions we made a few paragraphs back. If they are not valid, why would central banks go into so much trouble storing it and in many cases repatriating it? Why would there be massive gold derivative sell orders – often over a whole year’s physical production equivalent – during the most illiquid time of the day? If there were a legitimate desire to sell such a big order, wouldn’t the seller want best execution and best price achieved? Selling the whole lot in one go, taking out several price levels below is definitely not the way to do it.
So what’s the conclusion here? Should we sell everything and buy gold in anticipation of 5-figure prices? The answer is no. Gold is still an asset that has relatively limited use other than investment & store of value. For this reason, human psychology will always play a very big factor in determining its price. Its value will effectively be what the person next to you thinks it’s worth.
Having said that, the behaviour that we’ve been seeing in the past few decades (and certainly since the financial crisis) tends to confirm the assumptions we made above. Gold is a finite, real asset. Its production numbers are quite specific and it takes a lot of effort to produce an ounce. Certainly, a whole lot more effort than pressing a computer key and conjuring fiat money out of thin air. It’s probably a good idea to keep a portion of investable funds into gold. Fundamentals and the macro picture strongly indicate that gold is in a long consolidation phase and coiling for the next big leg higher. The fact that the markets are currently fully pricing a Fed hike next week while also expecting a relatively hawkish tone, makes it a very good long entry point. Let’s see if the shiny metal can finally fly.
Basic Technical Analysis
Technically, gold is at 127% extension of the summer lows to the summer highs. We are in a strong downtrend, but we need to point your attention to a couple of things. a) the RSI looks to be oversold and divergent, which suggests new lows from current levels will be a little tougher to accomplish. b) While gold keeps registering fresh 10 month lows, silver has not followed and we need to stress that divergences like this, can often be found near market turns. If the gold market can hold $1150, a recovery back above $1200 would be a good sign we may be headed back to attack the multi year trend line near $1300.
Harmonics analysis is more bearish on Gold. Like many we expected the sharp sell off after the US election to find some support in the $1172 area but the failure after a few attempts to hold this support means that $1172 is now resistance and we look for a drop. The target is at least the $1116-$1120 area but more likely $1085, where we see a bullish bat pattern. Bat patterns retrace hard and we should then see a $100 jump from there to $1182. In the bigger picture we still like selling rallies.