Sunday, December 11, 2005

Random Roger's Big Picture: Taking Me to Task

Mark Dodson, CFA at Hayes Advisors has posted several excellent points about gold. I posted the following as comments to RR's site.

The public has flooded into the StreetTracks ETF for a little better than a year now. It has been the fastest growing ETF in history. It gave the public the ability to purchase gold easily. And, 232 tones have been purchased. The fund increased in size by 10% last month! Each time a purchase is made the fund has to buy gold to back the shares.

There is a divergence that must eventually correct. Gold normally moves inversely to the price of the US dollar. It appears that some traders, who are short the dollar, are buying gold as a hedge. The average production cost of gold is only about $235 per ounce. Give the miners a little time and they will produce a lot of gold to be sold at $500 or better.

I have made the same point as Uncle Jack this way; scores of countries are now routinely increasing interest rates thus increasing the cost to carry gold. I do not use the PPI because it is extremely volatile, but using the core CPI, real interest rates are causing a real cost to hoard gold. Gold cannot go up year after year at a rate that matches compound real interest rates. Of course, if you can sell to a bigger fool, it does not matter, but once the cycle breaks, the price will fall dramatically.

Roger, in regard to correlations, there is normally a strong correlation between oil and gold. This too has diverged. The divergence sets up an arbitrage for the hedge funds, they can sell gold short, buy oil and know that the spread will eventually narrow. Believe it or not, strong gold is artificially inflating the price of oil. Heating oil, airplane fuel, and crude oil supplies are well above historical averages and yet the price went up last week (I know it was because of the unexpected cold weather in December). The good news is the invisible hand of Adam Smith will take charge to slow the consumption of oil all the more and eventually it will be oil that is dragging down the price of gold.

Another divergence is between gold stocks and gold. It appears that some players are shorting gold stocks and buying gold ETF?s. Once the turn comes, the gold stocks will fall a greater percentage than the ETF?s that track the actual metal price.

The European Central Bank sold tones of gold recently; it only takes one extra ounce to drive the price down hard. Manias can go a long way but I never want to depend on finding a fool at just the right time.

Good discussion and, who knows, the FOMC could offer a surprise this week. The response of gold to a hawkish interest rate statement could settle the issue.