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Gold: The End of a Megatrend by Markus Mezger

Gold: The end of a megatrend

In December 2000, the BW Bank released a study prepared under my supervision. Its tentativesounding title was "Gold: A New Megatrend?", with a question mark at the end. After all, the gold price was still below 300 USD per troy ounce at the time. By January 2003, the analysts at the BW Bank had grown more confident that such a new megatrend was underway and produced a report with a more assertive title: "The Gold Megatrend: Latest Developments." Nearly nine years have passed since then, and we have seen a several-fold increase in the gold price, along with far-reaching changes on the gold market. Yet many of the original buying arguments have by now turned into selling points, and golds long-running megatrend is in all likelihood near the end of the road. Had I erred on the side of caution, as I did in 2000, I might have entitled todays presentation "Gold: Is the End of the Megatrend in Sight?" But in doing so, I would have downplayed the very real risk of price exaggeration now looming over the gold market, for a number of key criteria indicate that the shiny metal is highly overvalued. 1. Ways of looking at gold Gold, as we all know, has many facets. If we ask gold investors what motivates them to buy, we will get a lot of different answers. Thus, some investors see gold primarily as a precious metal. Like other metals, it bears no interest and its yield consequently depends primarily on an appreciating spot price. Such appreciation in turn depends on scarcity factors, i.e. the dynamics of supply and demand and the volume of above-ground inventories available to cover any market shortfalls. Other investors see gold mainly as a currency, one that been able to hold its purchasing power over thousands of years. This point of view is supported by the fact that gold coins were among the first forms of money, and that the first paper currencies could be issued only with gold backing. In fact, many of the leading central banks still hold the precious metal as a part of their currency reserves. Yet a third group of investors see gold as an alternative investment, especially in relation to the traditional asset classes of stocks and bonds. To them, gold looks more promising in an environment where stocks and bonds appear to offer negative returns. For the purposes of this analysis, I will therefore proceed to evaluate gold from all these differing points of view. 2. Gold as a metal The attractiveness of metals can be measured by two main criteria the level of inventories and the ratio between physical supply and physical consumption. Precious metals can of course not be consumed in the normal sense. Thus, we define the physical "consumption" of gold as any use or application (for example, in dentures) that makes a reverse transformation into marketable gold impossible or highly expensive. As far as inventories go, there has never really been a shortage of gold, given its historical use as a monetary metal. Thus, the central bank gold reserves built up during the heyday of previous monetary systems still add up to around 30,000 tons. To this we can add a roughly equivalent volume of private gold holdings, as well as roughly 85,000 tons of gold jewelry inventories. By contrast, industrial consumption of gold, which is mainly driven by demand for jewelry, amounts to a mere 3,000 tons per annum. Thus, marketable gold reserves are about twenty times larger than the annual consumption volume. By comparison, the available inventories of industrial raw materials like crude oil, copper, nickel, lead or tin do not cover even one quarter of annual consumption. If we examine the historical trend of physical supply and demand, we see that there have been times when gold has been decidedly attractive as a commodity. As recently as ten years ago, a supply deficit hung over the gold market. Thus, excess demand for physical gold could only be satisfied insofar as central banks sold off some of their gold holdings. Gold had bright prospects as a commodity, given that prices could barely fall further without removing additional production from

Gold: The End of a Megatrend by Markus Mezger

the market. Back in 2000, moreover, only a few gold mines could operate profitably. Many gold mines had already sold their output forward, and the unwinding of these transactions promised to generate a hefty, one-time boost in excess demand. Today, the picture looks altogether different. The gold market is characterized by a huge, structural supply glut. In addition, industrial demand for gold is around 1,500 tons lower than the physical supply, which in 2011 should total roughly 4,100 tons. Thus, the current gold market is essentially living off the willingness of investors to absorb this excess supply. The gold mines have also reversed their forward sales and now enjoy above-average margins. A cost-induced reduction in supply is not on the horizon. Yet from a purely scarcityoriented, active-management perspective, the most attractive commodities would be those likely to exhibit a market deficit, one that cannot be cushioned by existing inventories. This scenario is currently applicable to copper, lead, zinc, tin and palladium but not to gold.
2.000 1.800 1.600 1.400 1.200 1.000 800 600 400 200 0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Gold market balance (physical supply - physical consumption) in tons

-200 -400 -600 -800

This lack of physical scarcity is the reason why gold has featured negative roll yields on the commodity-futures markets for many years now. In fact, the analysts at Tiberius Asset Management have been able to determine that many commodities exhibit a stable correlation between roll yields and the volume of inventories available to cover short positions. During economic booms, many of the commodities with industrial uses including crude oil, crude-oil products, copper, nickel and platinum have such low inventories that their forward curves shift into backwardation. During such periods, investors in commodity futures are usually able to reap positive roll yields. In the case of gold, however, this has almost never occurred in recent decades. This lack of positive roll yields is attributable to the far above-average level of above-ground inventories, which can be effectively transmitted to the market via a highly liquid gold-lending system.

Gold: The End of a Megatrend by Markus Mezger



GSCI Petroleum Roll Returns GSCI Copper Roll Returns GSCI Gold Roll Returns






-75% 1987













3. Gold as a hedge against inflation Gold has a long history as a monetary metal. By the end of the 19th century, gold had developed into the sole monetary benchmark. During the era of the so-called Gold Standard (1880-1913 and 19241932), the money supply in the major currency zones was limited to the level of national gold reserves. Thus, the precious metal was able to fully preserve its purchasing power, even as some paper currencies (notably Germanys paper Mark) became practically worthless in the wake of hyperinflation during the interwar period. Also after the Second World War, gold was able to retain its purchasing power in terms of US dollars. Thus, gold is the archetypal form of real money which, over the long haul, compensates for the inflationary devaluation of paper currencies. Over the longterm horizon, gold should therefore yield a real interest rate of zero percent. Notwithstanding the above, gold has by now become relatively expensive as a hedge against inflation. As recently as the late 1990s, gold was still undervalued. This was due to the gold selling and lending activity of central banks, which opened up a gap between the rate of inflation and the price of gold. Over the past 10 years, however, gold has not only closed this gap, but has overshot the target by a wide margin, leaving other commodity prices far behind. Thus, the Goldman Sachs Commodity Index Spot Return has increased sevenfold since 1970, while gold is now almost 37 times more expensive than 40 years ago. There is an important caveat here: Although the old maxim that an ounce of gold always buys you one good suit still holds true, it is also true that an ounce of gold will not buy you two good suits, at least over the long run: Either the other raw materials will catch up with gold in a rapid price surge thus manifesting the inflation already reflected in the gold price or inflation rates will remain moderate, in which case an elevated gold price will not be tenable.

Gold: The End of a Megatrend by Markus Mezger


Gold as inflation protection already overvalued

US consumer goods prices (indexed to 110) Gold price (in USD per ounce, indexed to 110) S&P Goldman Sachs Commodity Index (spot prices, indexed to Gold, since 1970)

2nd Oil Shock 1.000


WW2 WW1 1st Oil Shock

Gold Standard I Gold Standard II

1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010


Allowing for all these factors, Tiberius has come up with a simple model based on the ratio of the gold price to the US Consumer Price Index (US CPI). Both of these time series begin in the year 1860, and the ratios baseline value has been set at 1. Our model generates a buy signal when the ratio falls below 0.5, and a sell signal when the ratio rises above 2. Using just this simple model, one would have achieved a rate of return comparable to that of gold, but without any of the nerve-racking drawdown phases, such as in the 1980s and 90s. As of September 2010, our model has again switched into short mode. In contrast to the over-exuberant early eighties, the model suggests that the gold price now has only a few months of appreciation left before a multi-year bear market sets in.

Gold: The End of a Megatrend by Markus Mezger









Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Admittedly, the clear short signal derived from our model is qualified somewhat by recent developments on the Asian emerging markets. Recall that India and China are among the largest retail markets for gold jewelry. When measured against local inflation and currency trends, gold is actually still inexpensive in these countries. This is partly because the national currencies of China and India have gained ground against the US dollar in recent years, while local inflation rates have significantly outpaced US levels. On the other hand, these trends do not invalidate the basic logic of our model. Even if gold still appears attractive in Indian rupees or Chinese renminbi, this holds all the more true for oil and copper. For the rapid growth in income levels in emerging Asian countries can only be maintained with equally rapid growth in their consumption of raw materials. In the oversaturated industrialized economies, on the other hand, industrial commodities would have to undergo huge price increases before actually generating the inflation currently priced in by gold. Now, there are quite a few market analysts who fear that the worldwide monetary expansion currently underway threatens to trigger precisely this sort of extreme price inflation for commodities and consumer goods. It would certainly be in the self-interest of Tiberius Asset Management AG to tailor its forecasts in this direction. That would be much too facile, however. To reach an educated conclusion, one must first clarify which monetary supplies we are talking about. After all, there are significant differences between the M0 monetary supply, which is directly affected by central bank intervention, and the M2 money supply, which is essentially driven by the credit creation of the commercial banking sector. Of course, it could well be true that the central banks, through their hefty expansion of M0, have intentionally set themselves an above-average inflationary target in relation to recent decades. Nevertheless, this monetary stimulus, will still have to be transmitted to the economy by the commercial banking in the form of additional loan origination. Unfortunately, you can lead the horse to water, but you cannot make him drink, as German Economics Minister Karl Schiller aptly put it in a similar context in the 1960s. Yet there are also good reasons why credit growth in the commercial-banking sector is at below-average levels, at least in industrialized countries. First and foremost, the credit excesses of the recent past were so great that many market participants are currently preoccupied with reducing their debt loads (i.e. by de-leveraging). This means that the basic prevailing trend is a deflationary one, even it is being masked by the highly




Long Neutral

Ratio Gold to US-CPI

Gold: The End of a Megatrend by Markus Mezger

inflationary policies of central banks. The central banks, for their part, will not succeed in stoking moderate inflation (2% -7%) as long as the commercial banking sector simply keeps hoarding money. The easiest solution would be for households to start anticipating inflation. However, this would require that they begin buying up finished goods or raw materials, which are still favorably priced, rather than gold and silver. But as long as households prefer precious metals as their top pick, we are unlikely to see an actual occurrence of the inflation everyone apparently wants to hedge against. 4. Gold as currency The current gold holdings of central banks were accumulated mainly during the eras of the Gold Standard and the Bretton Woods system, when the gold price was pegged to the US dollar. In the gold bear market of the eighties and nineties, however, central bankers began to adopt the notion that they could dispense with gold as a currency reserve, given that it bore no interest in contrast to bonds, for example. Thus, the proportion of gold in global international currency reserves declined further and further during this period. Typical for this long-term trend was the year 2000: At a time when the general US dollar euphoria was at its height and President Bill Clinton could still boast of a budget surplus, the sirens of the financial markets were able to hoodwink central bankers into believing that USD-denominated bonds were the asset category of the future, while gold was a barbarous relic to be despised. In hindsight, of course, the gold sell-offs by the Swiss National Bank or the Bank of England look pretty short-sighted now! Nor is it understandable, in retrospect, why Asian central banks (particularly in China and Japan) exhibited such a preference for USDdenominated bonds at the time. Inasmuch, our alarm bells go off when we now see how these same institutions feel compelled to purchase gold and dump US dollar bonds from their currency reserves. For we know full well that central bankers are generally civil servants whose investment behavior is even more pro-cyclical than that of the trend lemmings at major financial institutions. Thus, central banks would rather buy "past performance" than have to explain to their boards and to the public why they are overweighting an asset class that has had a negative track record in previous years. As a rule, central bankers tend to be the last to smell the coffee, long after the players in the private sector! Not surprisingly, it was not until 2009 and subsequent years that smaller central banks finally began ramping up their gold purchases; at the time, the European central banks were only gradually winding down their gold sales in the wake of the Washington Agreement on Gold. From my perspective, the market has now run out of greater fools who could step in as buyers. Thus, private institutions with large gold stocks would be well advised to exploit the gold-buying fever of central banks to head discretely for the exit. More likely than not, the central banks will once again find themselves holding the bag on the sell side once the bears start roaring on the gold market! At this point, many gold bugs are likely to express their vehement disagreement. After all, the financial markets are currently haunted by speculation over nothing less than the potential breakup of the Eurozone. Understandably, quite a few of these gold bugs are already dreaming of a return to gold-backed currencies. None of this will materialize, however, at least in my opinion. In a worst-case scenario, a currency reform may become necessary to shore up one of the paper currencies the Japanese yen being most at risk from a fundamental perspective, though this risk is ironically not on the financial markets radar screen. But even such a currency reform would only bring forth another fiat-money currency a perfectly viable solution, given the fiscal and monetary monopoly enjoyed by a countrys national treasury. In the end, the additional monetary policy options that such a fiat system offers are simply too tempting for policymakers to resist. In the event of a crisis, outstanding government debt can simply be inflated away, with plenty of lead time before most bondholders realize they are being fleeced!

Gold: The End of a Megatrend by Markus Mezger

As for the Eurozone, it is quite surprising that those who claim that a default by Greece would spell the end of the monetary union have managed to remain virtually unchallenged. Recall that in 1998 we saw the insolvency of Russia, a country whose importance to the world economy was far greater than that of Greece today. Moreover, the default of a state does not automatically translate into the disappearance of its currency, as was demonstrated in the case of the ruble. Yet these two phenomena are being conflated by some politicians in a conscious attempt to transfer national decision-making powers from the national parliaments to the EU in Brussels. Thus, the unification of Europe is being pushed through under the pretext that the crisis is supposedly unsolvable any other way. The pressure currently being exerted on the Eurozone clearly originates from the bond markets. By demanding a more than 50% annual premium for Greek bonds, these markets have expressed their opinion about Greeces prospects loud and clear. In contrast to the surprising collapse of Lehman Brothers in 2008, however, the European banking sector has had a one-and-ahalf year grace period in which to prepare for a Greek default. During this time, it was also able to unload a part of its Greek exposure onto the shoulders of the European Central Bank. Finally, financial airbags have already been put in place for the banking system in response to the experiences of 2008. Thus, the long-overdue debt haircut for Greece is unlikely to trigger a chain reaction in the banking sector. The one potentially critical issue is a possible contamination of the Eurozones other peripheral markets. As we see it, however, declining interest rates in Italy, Spain and Portugal bear out the fact that financial markets have recently proven adept at making the appropriate distinctions among the various peripheral euro states. If the crisis were to grow worse, on the other hand, we could even see a temporary suspension of the affected bond markets. That policy makers can be quick to resort to compulsory measures on the bond markets in extreme situations is borne out by the historical example of the US in the 1930s, when the yield of 10-year US treasures was fixed by decree at 2.5% for years at a stretch.To sum up: The Euro system will almost certainly still be around five years from now, albeit in slightly modified form. The same applies to the US dollar zone. The current atmosphere of doom and gloom will ultimately prove overblown. 5. Gold and stocks Comparisons are often made between gold and stock cycles. Both asset classes serve as hedges against inflation. In the case of gold, this is due to its traditional role as real money. The long-term trend of stock prices, meanwhile, is driven by profits, which in turn depend on the price level. As a form of productive capital, stocks also benefit from real growth in the underlying sales markets. Gold, on the other hand, cannot offer any real return over the very long term, given that the hoarding of gold is not a productive use. Over the very long haul, we should therefore expect to see an upward trend in share prices in relation to gold. If we take dividend payments into account, we can identify just such an uptrend over the last decades. The classic method of comparing stocks and gold is via the Dow-gold ratio. However, the Dow Jones US Industrials stock index, which forms the ratios numerator, does not include dividend payments. Thus, the long-term upslope of the Dow-gold ratio appears to be flatter than would be the case if a total return index were used. The Dow-gold ratio is subject to very large cycles. The first major upcycle of stocks in relation to gold took place in the 1920s and culminated in a return to baseline levels during the Great Depression of the 1930s. The boom years of the 1960s were the driver of the second upcycle, whose highpoint, at around 27 points, was significantly higher than that of the previous cycle. Eventually, the stagflation of the 1970s pushed stocks back down and the ratio languished at the rock-bottom level of 2 points. The most recent upcycle for stocks driven by the bubble in tech, media and telecom (TMT) stocks, with the ratio once again marking an all-time high of nearly 45 points. Here, the top occurred in summer 1999, as gold traded at 255 dollars per ounce. Since then, we have seen the start of a cyclical correction in the Dow-gold ratio, and this is now nearing completion. Just as with the ratio between gold the consumer price index, it is quite possible that gold will continue to outperform for another few months. But the strategic call is clear: long shares and short gold! Investors who have

Gold: The End of a Megatrend by Markus Mezger

parked their money in gold over the last 10 years to ride out the over-valuation of stocks should gradually make their way back into the productive investment category of equities. In a world facing major economic and environmental challenges, investors will not be rewarded for hoarding gold, but rather for taking entrepreneurial risks. Now, some may argue that stocks, as measured by the long-term Shiller Price-to-Earnings Ratio (PER), are still expensive. However, the PER of shares should be considered in relative, not absolute terms. In the early 1980s, the average PER for the US stock market was barely above 5, translating into an annual profit of about 20% of the share price. Today, the average PER stands at about 12. Also consider that fixed-income investments featured double-digit yields in the early eighties. (Recall that the US prime rate surged as high as 20%.) Today, by contrast, 10-year US treasuries yield a meager 2% or so. Thus, when measured against bonds, stocks appear attractively valued at present.
64 Dow-Gold-Ratio












6. Gold and fixed-income investments The low returns currently available from fixed-income securities are one of the last remaining arguments for buying gold. The US inflation rate was last measured at 3.8%. While the core rate was reported at the lower rate of 2.0%, it shows not signs of decreasing. Thus, short-term money market instruments currently offer a negative real return of -3.8%, while 10-year US Treasuries feature a negative real return of -1.8%. We have created a simple model for the period since 1976 that generates a long signal when the real US money-market interest rate is below 2% and a short signal when it hovers above this level. By following the model, one could have achieved a return of 6.7% per annum with a volatility of 13.0%, whereas an investment in gold alone would have generated an annual return of 6.5% with a volatility of 19.4%. Over the next few years, the central banks are likely to keep key interest rates relatively low while allowing inflation to creep above target values around 2%. A new Paul Volcker, the Fed Chairman who vowed to "break the neck" of inflation with tight money, is nowhere in sight. Such a policy would be misguided in any case, since it would likely exacerbate current debt problems and lead to










Gold: The End of a Megatrend by Markus Mezger

political turmoil. At the same time, we are likely to see long-term interest rates kept low through central bank manipulation or fiscal intervention. Thus, an erosion of real value will be foisted on the holders of government bonds large institutional investors, for the most part. In this environment, it is difficult to imagine a sharp drop in gold.
10% 8% 6% 4% 2% 0% 40% -2% -4% -6% -8% Real interest level (2-year US Treasury Note minus inflation rates) (lhs) -10% -60%

Log returns of the Gold price - 3-month MAV - inverted (YoY) (rhs)
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2006 2008 2010


7. Sentiment Stroll through any German city and you will have no trouble finding at least two storefronts emblazoned with the words "Buy gold here!" in large letters. Even in small villages, these small shops are springing up like mushrooms. In the summer of 2011, we saw the Bild Zeitung, a leading tabloid, cover nearly its entire front page with an image of gold bullion; at the same time, lotteries were touting gold bars as prizes. The long-term gold bull market has obviously arrived among the general public! Admittedly, it is true that the average gold holdings of private investors are still very low. But even yours truly has had the memorable experience, back in 2010, of hearing his taxi driver expound upon the virtues of gold while ordering gold-mining stocks on his Blackberry! Equally overexuberant is the attitude of asset managers. The same people who were dead set against gold in 2000 and 2001 as a supposedly unsound investment are today even more obstinate in their refusal to short the precious metal. 8. Overall conclusion Gold is overpriced compared to other commodities and equities. The gold market is saddled with a structural oversupply, and is being kept alive only by investors eagerness to buy. Yet the trend lines on the long-range relative charts are poised on the verge of their long-term reversal points. At the same time, sentiment is completely lopsided on the bullish side. Thus, all the key preconditions for a price bubble are in place! This does not necessarily mean that we will see a sharp price decline in the coming months, however. A more likely scenario is that inflation rates in the industrialized countries will rise to between 5% and 10%, while a tight lid is kept on bond interest rates. In such an environment, gold would fall only slightly. From our vantage point at Tiberius, we expect to see

Gold: The End of a Megatrend by Markus Mezger

1,300 USD per ounce by the end of 2012. However, this does not change the fact that, relative to commodities and stocks, gold will likely prove to be a significant underperformer.

Stuttgart, October 10, 2011

Author: Mark Mezger