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Back in the Saddle, With Gold on the Upswing
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(August 12, 2013) As promised, after a week's vacation in cooler parts of the country, our entire staff has returned tan, fit, and re-energized. With gold now at its highest level since mid-June, we bring you a few words about backwardation, paper gold versus physical gold, demand trends, the two kinds of risk in this world, and the difference between fine art and refined art.
The sharp drop in gold prices since mid-April has reversed over the past few weeks, and gold has now staged a $150 comeback since bottoming out at a 4-year low of $1,179.00 just a month ago.

Gold Demand Trends – US & India

In April, when gold first fell off the $1500 cliff and began its tumble to $1,179.00, sales of 1-ounce gold Eagles from the mint soared to 187,500 pieces, the highest monthly sales total since May of 2010. In the three months since then, US retail demand for gold in the form of bullion has ‘tapered’ considerably. In May, 61,500 Eagles were enough to satisfy demand, which fell further in June to only 49,000. And as of July 29th, the Mint has sold only 30,500 coins (61 boxes) this month, reflecting the reduced bullion demand usually seen during the summer doldrums.

While US gold bullion demand is sluggish, demand in India is so robust that the government has taken steps to tax and hinder gold imports. Today, India is one of the strongest gold markets in the word. India imports more than 800 tonnes of gold every year, which is approximately 30% of all the gold mined annually in the world. Yet, these imports weaken the rupee, and the government has stepped in. Attempting to suppress gold demand in a country whose citizens value gold highly, India has restricted the use of bank credit by gold importers, and raised import taxes from 2% to 8% over the past two years. The results are not surprising: smuggling of gold into India has increased tremendously.

Backwardation - Paper Gold versus Physical Gold

Worldwide, demand for physical gold bullion (mostly in China and India) is so strong that gold futures trading went into ‘backwardation’ a few weeks ago, for the first time since 2008. Backwardation is when the futures contract trade at a discount to the spot markets, a situation that usually indicate physical shortages. Under backwardation, physical gold today can be sold for more than gold for delivery in the future. The seldom-seen situation means that a holder of physical gold could sell that gold while simultaneously buying gold for future delivery, and book the difference as pure profit. As long as future deliveries can absolutely be counted on, this is just free money for those bold enough to do the trade. Backwardation indicates some level of doubt about the reliability of future deliveries.

Backwardation in gold prices has happened before, and they signal gold shortages or the perception of gold shortages looming in the future. But, over the past few decades, backwardation has repeatedly resolved itself, with physical gold prices coming back in line with the futures markets. Backwardation is the ‘tell’ that having gold in hand is fundamentally different from owning gold futures, contracts, ETFs, or unallocated gold held in trust.

The truth is, much of the action in the precious metals markets involves gold being leased, loaned, pledged, swapped, shorted, sold forward, and otherwise subjected to paper-shuffling among central banks, commercial banks, speculators, trading desks, mints, miners, refiners, and jewelry manufacturers.

Gold enjoys a free market, and is traded easily around the world. But much of this gold trading is based on faith – the belief that the counter-party to your trade can actually live up to the commitment made. In the world of paper gold trading, this often means that you are making a deal with a counter-party that is actually relying on the word of another party, who in turn may have made a trade with some other very reliable entity, one who may hold a certificate for the gold which is believed to be valid and enforceable, although the issuer of that certificate most likely made that commitment without actually possessing any gold, based on his experience over the decades that anytime he needs physical gold, he can go out into the market and buy it and take delivery, thus fulfilling his end of the bargain.

No one involved in this often complex chain of transactions actually has the ability to visit a secure vault and see a stack of bullion bars that back up the trade. This may seem unsettling, but really, it’s the way that all businesses are run - on trust and faith. For example, General Motors promises its dealers that it will manufacture cars and trucks for them to sell. GM makes that commitment because it has faith that its hundreds of suppliers will deliver the necesary batteries, tires, upholstery, copper wire, electronics, nuts and bolts, glass windows, and so on. Just like Ben & Jerrys Ice Cream, a company that commits to delivering their product to stores all over the country, yet they don’t own a single cow, sugar plantation, or berry patch.

Gold trading is also made possible by trust and faith. But no system is foolproof, particularly when it comes to gold. Trading in gold involves a greater degree of counter-party risk than GM, Ben, or Jerry could ever imagine.

So how does Onlygold conduct business so that our customers are assured of delivery?

Simple - we only sell what we have in stock. Our firm starts every day with a substantial inventory of gold bullion in coin and bar form, and sells and buys throughout the day. Our commitment to our customers is absolute – the product ordered is in our vaults, ready to ship. As soon as you place an order, your bullion is transferred from our inventory into a box with your name on it, awaiting your payment. And before the day is over, we order from mint distributors that same amount of gold in order to replace what we sold to you. We are not brokers who take your order, and wait for some other party to come through with your bullion – we are dealers selling to you what we already have.

For years we have heard talk that the day will come when ‘paper’ gold and physical gold no longer trade in sync. If this unlikely nightmare comes true, it will happen like this: during one of our many phone calls to our distributors during a trading day, we will be told that despite the posted spot price, unfortunately there are no sellers of physical gold at that price, or any price near that level. The ‘market’ at that point will have become invalid, and the uncertainty would cause sales of physical gold to grind to a halt.

To be sure, we think such a market failure is highly unlikely. Gold will always have a price. There may be future disruptions in the physical gold market (that would start with backwardation – and then, get worse), especially if proves to be true that there less physical gold available out there than today’s market prices indicate. If the daisy chain of gold ownership collapses, because too much gold has been leased out, swapped out, or simply is not as available as promised, then prices will go much higher, and quickly.

Until that time may arrive, whatever gold we have in stock, (or silver, platinum, or palladium) we’re happy to sell to you. We have every expectation that that will always be the case - that gold markets will continue to perform price discovery, and accurately reflect the availability of physical gold.

Risk, Deep and Shallow

Risk, as in downside risk, was not a familiar concept to precious metals investors for most of the 21st century. But since the middle of 2011, the concept of risk has been re-introduced to the world of precious metals, with a vengeance. Just ask anyone who spent the past few years filling his gun safe with silver bullion.

But according to investment manager Willliam Bernstein, precious metals holders have, so far, only experienced what he calls shallow risk, or what famed securities analyst Benjamin Graham referred to as ‘quotational loss’ – that is, a fall in price of something fundamentally and permanently valuable. If you own a sound investment that tumbles in price, but you are able to resist selling it in a panic, then your 'quotational loss' doesn't turn into a real loss. And down the road, you will find its price restored as its ultimate value is once again recognized by the market.

Quoting Jason Zweig’s column in the July 27th Wall Street Journal (“’Shallow Risk” and “Deep Risk” Are No Walk in the Woods’):

”In a forthcoming e-book, “Deep Risk: How History Informs Portfolio Design,” Mr. Bernstein sifts through decades of financial data and global history to identify what creates deep risk. The four causes he came up with sound almost like lyrics to the old Temptations song “ball of Confusion,” but they are deadly serious: inflation, deflation, confiscation and devastation.”

“…Devastation -war or anarchy- is a long shot with horrific consequences, but there isn’t much you can do about it. If you hoard gold, you are as likely to be killed for it as to be protected by it. “For Armageddon, what you really need is an interstellar spacecraft”, Mr Bernstein quips.”


Fine Art versus Refined Art

Some say that governments fear gold. Whether out of fear, or a simple respect for gold as the ultimate in money, most governments operate under the principle that private gold ownership is a privilege granted by the state, not a right. And of course, in times of war, or with a declaration of economic emergency, this privilege can be altered, taxed (see India above), or even withdrawn.

In 1933, when FDR took the US off the gold standard, not only did that action change the dollar forever, but private contractual commitments having to do with gold were invalidated. At that time, many corporate bonds in circulation were specifically payable in gold coin, but Roosevelt’s executive orders struck those ‘gold clauses,’ and made such obligations payable in Federal Reserve notes instead of gold. In essence, in 1933 all prior contracts having to do with gold were simply overturned by government fiat.

In the middle of the Depression, the average Joe and Jane didn’t give much thought to gold, but for the truly wealthy, the new, broad restrictions on gold ownership were often taken as a personal insult. Not surprisingly, there was some resistance to the new gold order.

Which brings us to our little story:

Many years ago we were contacted by a major art museum in the Midwest. A large donation that they had received (which came from an old industrial family whose name you would recognize) included many important works of art as part of the bequest, but also a set of odd gold items. It seems that back in the 1930s, the patriarch of the family had a set of 18-karat gold medals made, struck on one side only with a sort of unfinished likeness of the fellow himself. They were about four inches in diameter, quite thick, weighing several ounces each. In the opinion of the museum’s board of directors, these gold discs were not ‘art’ at all, and should be sold for the scrap value. We can only imagine that they were produced from left-over gold coins, and perhaps unwanted jewelry, during the days when possession of gold coins or bullion was illegal for US citizens. For this fellow, having gold medals made picturing his noble self was a way to have his gold, and pass it off as art. Seventy years later, we recycled these crude gold discs, sending them off to our refiner to be melted down, and paid the museum based on the gold assay.

 

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In addition to gold, silver, platinum, and palladium in coin and bullion form, we also purchase a wide range of numismatic coins and currency for our retail business. Feel free to call us for quotes or price indications on anything in coins, bullion, and paper money.

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