Big picture: Paper money vs. Gold
The past few months have been really challenging for anyone invested in gold or silver; for me personally as well. Despite serious warning signs in the economy, staggering debt levels and a multitude of significant geopolitical threats at play, the rally seemed to continue unabated. In fact, I was struggling with this paradox myself. As I kept looking at the state of the markets, I couldn’t help but wonder “what if they just keep kicking the can down the road for the next 20 years, or more?”.
Since 2011, gold and silver went into a strong correction period and overall, prices haven’t benefitted from all the trillions that have been injected in the markets since 2008. Total credit growth was approximately $80 trillion, climbing from $160 trillion to around $240 trillion in merely 10 years. The major central banks combined increased their balance sheet by buying government and institutional debt from $6 trillion to $21 trillion (FED, ECB, BOJ, PBoC), but none of it went into gold. However, even though these days we read and hear these numbers so often, it is still almost impossible for the true meaning of these sums to really sink in. A trillion is hard to truly take in and understand; $80 trillion in debt is something already so far beyond our grasp, that it might as well be $100, $200, or $300 and it would almost make no conceptual difference. A good way to correct this dissonance is just think about the fact that 1 million seconds are 8 days, 1 billion seconds are 35 years and 1 trillion seconds translate into 32’000 years – bringing us back to the stone ages.
Instead, the volume of paper contracts on gold and silver spiked massively and reached absurd levels, i.e. 500 paper claims leverage per oz ready to be delivered in physical form. On average, the paper gold traded in London in a single day exceeds the entire global production of the metal for that day by 600 times. Paper bets are always speculative, so when one looks at the leverage in the gold and silver market, it becomes clear that this is one of the most liquid markets with the highest volume for decades. This just proves that the mainstream narrative is wrong in proclaiming that gold is dead. Much to the contrary, it makes one wonder why such a “barbaric relic” commands such incredible trading volumes? Unless, of course, those trading it understand that “gold is money, anything else is credit”.
The graph below shows the coverage ratio of the USD vs Gold. As you can see, the coverage ratio is much smaller than it was back in 1999, meaning that in these terms, gold price is in fact cheaper today than it was at end of the 90s. Everyone that missed the last bull market can be sure that the right time to buy is now and in the coming months.
The importance of cycles
An incredibly widespread mistake that many people make, even seasoned investors, is buying when prices are rising instead of when prices are still low. This “herd mentality“ or “bandwagon effect” is triggered by the fear of missing out on the profits they assume other people will make. The reverse, i.e. panic-selling when prices are hitting rock bottom, instead of holding and waiting, is easily understood as the result of a base instinct to “cut your losses and run”. Attitudes like this have little to do with rational evaluation, or with appreciating the bigger picture. An objective analysis and any worthwhile effort to plan ahead, should take into account the cyclical nature of the markets and the economy under our current system. We have regular booms and busts, fueled by aggressive monetary policies and trillions in debt and thus, it is of the outmost importance to develop an understanding of cycles.
From a historical perspective, we have a long-term cycle that is approaching its end: the credit bubble that was kick-started in the US by moving away from the gold standard from 1914 – 1971 and switching to the petrodollar. At the same time, we are also standing at the end of a paper bull market (short-term debt cycle), inflated by trillions in fiat money injections over the past 10 years. The current bull market is now the second longest in history. Lasting for 109 months (the longest one, 1990 – 2000, lasted for 114), there might still be some way to go, but the bust is definitely closer than the boom.
The correction in October served as a useful indicator that things are changing and we should get used to it. I believe that this was a signal of transition and that we have now entered the next phase in the cycle, switching from a “managed bull market” to a “managed bear market”. There is no doubt that the FED and other central banks try to avoid hitting the iceberg this time as well, however, the outcome will lead to losses for participants in the stock market and negative consequences in the labor market. The bubbling real estate market is already showing clear signs of the deleterious effects of cheap credit, which is nothing more than a financial illusion, or “eine Sinnestäuschung”, as we would put in German, as significantly lower prices are more likely than the other way around.
Thus, it is essential for investors to understand what a bubble looks like and to be able to identify it in time. Once clarity is achieved on this issue, it is easier to adopt a contrarian approach, meaning to sell the bubble and buy what is undervalued and cheap. This case can be very confidently made for gold today, as the current bull market is approaching a cliff edge. Every bubble is followed by a downswing and based on the total credit in the system, which is unprecedented in history, a massive, equally unprecedented bust is in the cards.
We might not know when this will happen exactly and trying to divine the future on this level of detail or to time the market has largely been proven to be a fool’s errand. The only thing we know for sure is that the current uptrend is clearly running out of steam. Volatility is back with a vengeance, while even the most complacent of stock market speculators are starting to have anxious doubts over how much longer the Wall Street denial of facts can last. What can also be said with certainty, is that once the reversal begins, a massive shift will follow, away from a wealth creation to a wealth preservation perspective. The risks are enormous and other than precious metals, nothing else offers accessible, straightforward and reliable protection from the imminent fallout.
What can we expect from here on out?
The graph below paints a very telling picture, perhaps fore-telling one as well. In a nutshell, it simply depicts what happens when people lose faith in their currency. The currency devaluation in emerging market currencies is only the latest confirmation of the historical relationship between fiat money and gold. People might be persuaded to forget about precious metals for some time, but when their fiat money crumbles, as is its wont, gold prices, as expected, rise – and rise fast.
Gold always prevails over fiat money during times of financial stress and currency devaluation. The USD is still the predominant world reserve currency, with 65% of all the global central bank reserves held in USD, as most countries are still backing their local currencies with the Dollar. In fact, I only know of one country that has been diversifying into gold on a massive scale for decades to create an alternative to the USD, and that is China. However, the USD’s dominance in this scale also means it is the biggest bubble of them all and most likely will be the last one to pop before we enter into another era of hyperinflation and the destruction of the current debt-based monetary system. Alternatively, in the words of Paul Getty: “If you owe the bank $100 dollars, that’s your problem; if you owe the bank $100 million, that’s the bank’s problem.”
To quote Ray Dalio: “We look at the world reserve currencies, the dollar in a sense is risky, the euro is risky. We are dealing with a whole set of things that makes the euro risky. The Japanese yen is risky in terms of that money. There is a lot of debt around and there is a challenge in terms of that money. Given these risks, investors could get into a situation where bonds, stocks and currencies don’t appreciate, as stocks and bonds are tied to a similar financial structure. Hence, gold may act as an important hedge.”
Nevertheless, it is also a well known fact that shares and bonds are reversely correlate; when one rises, the other decreases and vice-versa. For many years, bonds lost their attraction for investors, but now that stock prices are close to an all-time high and market participants are starting to feel uncomfortable with their valuations, they might move back into bonds again. In addition, central banks understand that they have to increase interest rates even further, as inflation is picking up.
This leads us to a deflationary environment for all countries except for the USA. Global liquidity is tightening further with higher interest rates and a dollar shortage that has existed for many years already. These conditions are bound to finally expose the illusions in the stock market and accelerate bond purchases; especially US bonds. The biggest and only market which can absorb huge capital flows will be the US, as the ECB keeps postponing interest rates hikes. Therefore, the US might profit in the short-term, while emerging markets as well as the EU will suffer. As money flows out of these markets and into the US, the missing liquidity in the Eurozone will have a strong impact on the banking system, that has few buffers in place and is build on dangerously fragile foundations. Right now, we are down to a mandatory 1% of reserves for the banks within the Eurozone, meaning the fractional reserve system has been and still is able to print an additional €100 million for every €1 million deposited in the banking system.
In the meantime, there is also an abundance of additional risks for the monetary union. Political friction continues unabated, with social and economic tensions persist in dividing the population within member states and throughout the EU. The new government in Italy, Merkel’s weakening leadership, Brexit and the ticking time bomb that is the Visegrad group, are only a few sources of the uncertainty that currently makes a toxic cocktail. Trade wars will only add to the problem, and so will the sustained geopolitical tensions with the East. Eventually, the combined pressures will inevitably lead to a shrinking economy. Higher interest rates will lead to credit defaults also among the multinationals. Think about AT&T, for example, with its $250 billion debt and the impact of steadily rising interest rates. Today, so-called “Zombie companies”, that only exist because of cheap credit and low interest rates, are numerous and widespread. In fact, approximately 10% of all the companies in the Eurozone are falling under that description.
As is historically the case, the biggest bubbles are generated and perpetuated by governments. This time is no different, with the US being the main driver. Whenever a system over-centralizes, the periphery is the first to break apart. Repayment of US debt is extremely difficult with a stronger dollar and refinancing is becoming a problem as well. Of course, in the short-term, a rising USD will put pressure on the gold price. However, short lived fluctuations like this do not make a difference when one is focused on the big picture. If anything, they present a rare buying opportunity, as long as you don’t fall in the timing trap. Waiting on the sidelines, trying to predict the right time and to buy exactly when gold reaches its bottom, can be costly mistake. When the USD breaks apart, you will be surprised how fast it will go and how hard it will become to buy physical gold or silver. Therefore, preparation rather than futile prediction is a wiser approach.
Claudio Grass, Hünenberg See, Switzerland
This article has been published in the Newsroom of ProAurum, the leading precious metals company in Europe with a independent subsidiary in Switzerland. All rights remain with the author and ProAurum.