The bespectacled Robin to Buffet’s Batman is at it again. After casting disparaging remarks about the hard-money fanatics of the world with his “only old jews like gold” comment last year, in a brief interview on CNBC today, Charlie Munger explained how “bankers should not be trusted” adding that “they are like heroin addicts.” He was reflecting on the debacle that occurred in Cypriot banks of course – but his perspective is likely useful for a broader remit of investment professionals with endless fungible free money as their backstop. So that’s the pair; hard- and soft-money partakers be damned. The irony of his firm reporting dramatically better-than-expected profits on the back of a surge in insurance-selling (not at all like CDS) is not lost on us.
There were many casualties following Friday’s 4% gold rout, but none were hurt more than one-time hedge fund idol John Paulson, who according to estimates, lost more than $300 million of his own money in one day.
Per Bloomberg: “Paulson has roughly $9.5 billion invested across his hedge funds, of which about 85 percent is invested in gold share classes. Gold dropped 4.1 percent today, shaving about $328 million from his net worth on this bet alone.” This is merely the latest insult to what has otherwise been a 3 year-long injury for Paulson and his few remaining investors, whose very inappropriately named Advantage Plus is among the bottom 10 hedge funds for the third year in a row. Yet despite being a one-hit wonder thanks to one lucrative idea (long ABX CDS) generated by one of his former employees (Pelegrini), Paulson still has been lucky enough to somehow amass a $10 billion personal fortune which can have a $300 million downswing in one day, even if it is in an asset class which eventually will go only one way – up. Unless, of course, like so many other fly by night billionaires, Paulson too hasn’t somehow managed to lever up all his equity into numerous other downstream ventures, and where a $300 million blow up leads to margin calls and other terminal liquidity outcomes.
“The recent decline in gold prices has not changed our long-term thesis,” John Reade, a partner and gold strategist at Paulson & Co., said in an e-mailed statement. “We started investing in gold at $900 in April 2009 and while it’s down from its peak to $1500, it’s up considerably from our cost.”
Paulson investors can choose between dollar-and gold- denominated versions for most of the firm’s funds. In addition losses from bullion’s decline, investors in Paulson & Co. funds, including the firm’s founder, lost about $62 million today on their gold-stock investments, based on holdings as of Dec. 31, 2012. New York-based Paulson & Co.’s biggest wagers in miners include a 7.35 percent stake in AngloGold Ashanti Ltd.
Paulson’s Reade said gold will continue to appreciate in the long run because governments are pumping money into the economy at a rate not seen before.
“Federal governments have been printing money at an unprecedented rate,” said Reade. “We expect the strengthening of the economy and stock market to cause money supply to rise more than real growth and eventually lead to inflation. It is this expectation of paper currency debasement which makes gold an attractive long-term investment for us.”
That said, one doesn’t have to be a bull in gold and gold equities to position appropriately for the eventual inflationary outcome, whose arrival is only a matter of time now that not one but two central banks are injecting $80+ billion in fresh liquidity into the global markets every month.
Recall that gold bull Hugh Hendry said in October that while he is long gold, he is short gold equities, a trade which has generated substantial alpha, courtesy of the 40% plunge in GDX and associated gold miners (a pair trade we have supported incidentally), and one which may well continue generating additional returns should Japanese financial institutions be forced to continue selling off the yellow metal on margin concerns, due to the record surge in JGB volatility as we explained yesterday.
As for gold as an inflation hedge, here Paulson is certainly correct. The only question is when will the price suppression scheme of gold as an alternative currency finally end. Since various official organizations (such as the Troika) are currently doing all they can to buy the sovereign gold of insolvent nations at firesale prices, it is likely that the period of artificially suppressed prices may continue.
Which, incidentally, for all those who lament the recent price drop in gold, is a good thing: for those who see gold as an alternative currency to fiat, all the recent sell off (as well as alleged or real downward price manipulation) does is provide a lower cost basis for accumulating hard monetary assets. Which is something to be welcomed and not mourned, especially if one plans on holding on to said gold (or silver) as a currency, instead of merely converting it back into fiat at a higher price point, and thus as an asset (something all those who bought BitCoin at $260 and sold at $50 appear to have completely forgotten).
My colleague and erstwhile nemesis Gonzalo Lira posed the question above in a recent essay, and it is indeed a most puzzling one. Given that the world’s central banks — joined most recently by a shockingly reckless Switzerland — are waging all-out economic war by inflating their currencies, shouldn’t gold be soaring,? In fact, prices have continued to meander between $1500 and $1700 since September of 2011, when gold topped out at $1945 after a spectacular run-up from $728 in just three years.
What could have caused the bull market to go lifeless since then, even as more and more countries appear hell-bent on devaluing their currencies to keep their exports competitive? The answer that Lira has offered is novel and engaging, but it did not persuade me, perhaps because the underlying conceit seems forced. For he has likened the current gold market to the one for credit default swaps (CDS) prior to the Great Financial Crash of 2008. Because swaps provided insurance against bond defaults, they rose in value as the crisis mounted. But then, suddenly, they ceased to appreciate, Lira says, because “the markets collectively realized that the counterparties to those CDS contracts might not be able to pay up.” This, Lira asserts, is exactly what is occurring in gold, as paper certificates have come to greatly exceed the supply of ingots held in vaults. The result, he says, is that “the global precious metals markets are essentially a game of musical chairs, with far fewer seats than players—far less gold than gold holders. And market participants collectively know this. Which is why they don’t trust their counterparties. Which is why gold isn’t rising like a shot.”
I think there’s a more convincing explanation for why gold isn’t rising, and I will get to it in a moment. But first let me say that my intention is not to assail Lira or his ideas. Even though we had a nasty spat on the Web a couple of years ago over the inflation vs. deflation conundrum, I’ve always found his essays insightful, original and well wrought. Putting aside our differences over whether the inevitable collapse of the financial system will be brought on by hyperinflation or deflation, we probably agree on 90% of the things we write about.
This time, however, his logic would seem to equate apples and oranges. To begin with, the swaps he would compare to gold are a contractual form of insurance against default risks in certain types of financial instruments. As such, it is at least theoretically possible to calculate exactly how much risk is insured, even in a market as large as mortgage securities. Gold, on the other hand, and relative to inflation, offers only a vague kind of insurance. Moreover, unlike swaps, gold does not give its owner a claim on anything.
Lira’s argument might have been more persuasive if he had simply asserted that an effectively unlimited supply of “paper gold” has been absorbing enough demand to suppress the price of physical. But if, as he evidently believes, ruinous inflation, never mind hyperinflation, were immediately in prospect, then we should have expected to see the demand for bullion soar, pushing up paper gold no matter how large the supply.
Physical vs. Paper Gold
Lira lumps paper and physical together to argue that “the current spot price of gold is reflecting market uncertainty as to who has actual gold, and who has worthless paper certificates of gold.” Again, if this were so, then we should have expected uncertainty itself to have spiked the preference of investors for physical over paper, overwhelming carry-traders and other feather merchants playing gold from the short side. And if investors were indeed worried about whether the insurance they hold is properly matched to the endgame, would they be buying the Treasury paper of a country that owes so much more than it will ever be able to repay? In fact, the risk of a U.S. default is the last thing on their minds at the moment, and it will likely remain so until the day when events no one can predict cause creditors or debtors – it will have to be one or the other – to get stiffed.
In the meantime, whither gold? My own theory as to why prices aren’t bounding above $2000 is simply this: the central banks have so far failed to produce any meaningful inflation. The untold trillions worth of stimulus they have shot at this goal have barely kept deflation at bay. Granted, prices for groceries, health care and some other necessities have gone through the roof. But the inflationary impact of all of these things together is inconsequential in comparison to the deflationary down force of a quadrillion dollar financial edifice that remains in a state of incipient collapse.
Under the circumstances, I continue to believe that deflation, rather than hyperinflation, will wreck the global financial system. I did not, by the way, “switch sides” in this argument as Gary North asserted in an essay he wrote for LewRockwell.com. It was when the debate turned unendurably ugly that I was impelled to take a closer look at what some of the hyperinflationists were saying. Peter Schiff, for one. In his scenario – which, along with the running debate at FOFOA blogspot is the most persuasive case for hyperinflation that I’ve come across — a run on the dollar would force the Fed to absorb the entire supply of Treasury paper at auction. An unintended result, says Schiff, is that ostensibly unsupported bond markets such as corporates and municipals would collapse, forcing the Fed to extend open-ended buying to all fixed-income securities.
This would most surely trigger a hyperinflation – would in fact be a hyperinflation. However, this scenario, and virtually every other hyperinflation scenario of which I am aware, envision hyperinflation occurring as a result of political decisions made, Fed actions taken and markets “rescued.” My gut feeling, however, is that the collapse of global markets will be so swift as to preclude intervention, let alone rescue. Pent-up forces will take their course, and the entire financial system will experience an instantaneous collapse for which the May 2010 Flash Crash will seem to have been just a warm-up.
Whatever we might predict about the outcome, one result that seems entirely likely is that banks in the U.S and elsewhere will not open for business the next day. Over the short-run — a few weeks, perhaps — this would be ruinously deflationary, since a hitherto inexhaustible supply of digital money will have become inaccessible via checks, ATMs or charge cards. The fragility of the clearing system that allows such money conduits to function will be tragically obvious by then, as will the distinction between cyber money and the real stuff. And you had better have some of the “real stuff” stashed away in your home, by the way, since, The Morning After, that’s the only kind of money Safeway cashiers and gas station attendants will understand. Nor should you expect them to be up to speed right away on the junk silver you’ve socked away, since, at the retail level, although perhaps not in barter circles, pre-1964 coins are likely to be treated the same as the pot-metal coins that have driven silver dimes, quarters, halfs and dollars into secure storage.
Gold Hoarders, Beware
A couple of caveats for gold hoarders. Don’t count on exchanging gold at $5000 an ounce for something with high intrinsic value, such as farmland. For all we know, supply-chain disruptions could be so severe that you’ll pay a Krugerrand just for a loaf of bread. And while it has always been possible in theory for short-squeeze pressures to push gold well above the $5000 level, this is most unlikely for reasons that Lira’s essay implicitly recognizes. Consider who is short all of that paper gold: carry-traders such as Morgan Stanley, J.P. Morgan, Goldman Sachs and other bullion bankers who have always been able to borrow gold for next to nothing. The likelihood of regulators forcing them to make good on their paper gold obligations can be dismissed in advance as negligible
Despite the seeming paradox of intrinsically worthless fiat money gaining traction in a post-apocalyptic economy, there will remain the possibility of a hyperinflationary spike. It could happen if, say, the Fed were to attempt a lump-sum pension payment to all government workers. For political reasons, this would have to be matched by similar windfall benefits to private-sector workers in the form of Social Security, welfare payments, unemployment compensation and food stamps. The Catch-22 of this approach is that any benefits in excess of what is needed to keep the economy functioning, if only barely, would touch off an inflationary spiral. Imagine how the world would react if someone in Congress merely mentioned that The Government was going to cover all of the obligations and liabilities of public and private pensions and health plans. If and when that day arrives, I will have no argument with Lira and the hyperinflationists about the likely outcome.