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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 gold’s 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 today’s 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
During economic booms. 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. lead.600 1. . Thus. Many gold mines had already sold their output forward. structural supply glut. only a few gold mines could operate profitably. Back in 2000.“Gold: The End of a Megatrend” by Markus Mezger the market. In fact. which in 2011 should total roughly 4. active-management perspective.200 1. nickel and platinum – have such low inventories that their forward curves shift into backwardation. investors in commodity futures are usually able to reap positive roll yields. The gold mines have also reversed their forward sales and now enjoy above-average margins. In the case of gold. Today. Yet from a purely scarcityoriented. 2. many of the commodities with industrial uses – including crude oil.400 1. industrial demand for gold is around 1. moreover. this has almost never occurred in recent decades. copper. The gold market is characterized by a huge. A cost-induced reduction in supply is not on the horizon.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. one that cannot be cushioned by existing inventories.000 1. the picture looks altogether different. tin and palladium – but not to gold. This lack of positive roll yields is attributable to the far above-average level of above-ground inventories. and the unwinding of these transactions promised to generate a hefty.100 tons. This scenario is currently applicable to copper. During such periods. In addition.500 tons lower than the physical supply. the most attractive commodities would be those likely to exhibit a market deficit. the current gold market is essentially living off the willingness of investors to absorb this excess supply. however. zinc.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 . one-time boost in excess demand.800 1. which can be effectively transmitted to the market via a highly liquid gold-lending system. crude-oil products.
Notwithstanding the above. Gold as a hedge against inflation Gold has a long history as a monetary metal. During the era of the so-called Gold Standard (1880-1913 and 19241932). gold should therefore yield a real interest rate of zero percent. but has overshot the target by a wide margin. the precious metal was able to fully preserve its purchasing power. compensates for the inflationary devaluation of paper currencies. Thus. gold was still undervalued. gold has not only closed this gap. 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. Over the longterm horizon. Over the past 10 years. gold is the archetypal form of real money which. it is also true that an ounce of gold will not buy you two good suits. over the long haul. Thus. even as some paper currencies (notably Germany’s paper Mark) became practically worthless in the wake of hyperinflation during the interwar period. By the end of the 19th century. while gold is now almost 37 times more expensive than 40 years ago. gold was able to retain its purchasing power in terms of US dollars. leaving other commodity prices far behind. gold has by now become relatively expensive as a hedge against inflation. As recently as the late 1990s.“Gold: The End of a Megatrend” by Markus Mezger 275% 225% GSCI Petroleum Roll Returns GSCI Copper Roll Returns GSCI Gold Roll Returns 175% 125% 75% 25% -25% -75% 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 3. however. This was due to the gold selling and lending activity of central banks. the money supply in the major currency zones was limited to the level of national gold reserves. gold had developed into the sole monetary benchmark. which opened up a gap between the rate of inflation and the price of gold. There is an important caveat here: Although the old maxim that an ounce of gold always buys you one good suit still holds true. Also after the Second World War. Thus. the Goldman Sachs Commodity Index Spot Return has increased sevenfold since 1970. .
since 1970) 2nd Oil Shock 1. the model suggests that the gold price now has only a few months of appreciation left before a multi-year bear market sets in.5. Tiberius has come up with a simple model based on the ratio of the gold price to the US Consumer Price Index (US CPI). As of September 2010. one would have achieved a rate of return comparable to that of gold. .“Gold: The End of a Megatrend” by Markus Mezger 10. such as in the 1980s and ‘90s. Our model generates a buy signal when the ratio falls below 0. indexed to Gold. indexed to 110) S&P Goldman Sachs Commodity Index (spot prices.000 Gold as inflation protection already overvalued US consumer goods prices (indexed to 110) Gold price (in USD per ounce. and a sell signal when the ratio rises above 2.000 Hedging 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 100 Allowing for all these factors. Both of these time series begin in the year 1860. but without any of the nerve-racking drawdown phases. and the ratio’s baseline value has been set at 1. In contrast to the over-exuberant early eighties. Using just this simple model. our model has again switched into short mode.
this monetary stimulus. the clear short signal derived from our model is qualified somewhat by recent developments on the Asian emerging markets. as German Economics Minister Karl Schiller aptly put it in a similar context in the 1960s. In the oversaturated industrialized economies. On the other hand. 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. it could well be true that the central banks. Even if gold still appears attractive in Indian rupees or Chinese renminbi. and the M2 money supply. through their hefty expansion of M0. Recall that India and China are among the largest retail markets for gold jewelry. To reach an educated conclusion.5 2 1. Now. these trends do not invalidate the basic logic of our model. at least in industrialized countries. the credit excesses of the recent past were so great that many market participants are currently preoccupied with reducing their debt loads (i. industrial commodities would have to undergo huge price increases before actually generating the inflation currently priced in by gold. will still have to be transmitted to the economy by the commercial banking in the form of additional loan origination. you can lead the horse to water. however. have intentionally set themselves an above-average inflationary target in relation to recent decades. which is directly affected by central bank intervention. First and foremost.“Gold: The End of a Megatrend” by Markus Mezger Neutral Short Neutral 3 2. but you cannot make him drink. even it is being masked by the highly Short 3. Of course. Nevertheless. 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. there are significant differences between the M0 monetary supply.5 Long FIAT MONEY 0 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. This means that the basic prevailing trend is a deflationary one.5 GOLD STANDARDS 1 0. on the other hand. by de-leveraging). this holds all the more true for oil and copper.e. That would be much too facile.5 Neutral Long Neutral Ratio Gold to US-CPI . After all. Yet there are also good reasons why credit growth in the commercial-banking sector is at below-average levels. Unfortunately. It would certainly be in the self-interest of Tiberius Asset Management AG to tailor its forecasts in this direction. which is essentially driven by the credit creation of the commercial banking sector. 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. When measured against local inflation and currency trends. gold is actually still inexpensive in these countries. one must first clarify which monetary supplies we are talking about.
at the time. this would require that they begin buying up finished goods or raw materials. As a rule. From my perspective. The central banks. with plenty of lead time before most bondholders realize they are being fleeced! . In the gold bear market of the eighties and nineties. of course. None of this will materialize. it was not until 2009 and subsequent years that smaller central banks finally began ramping up their gold purchases. 4. Inasmuch. in retrospect. central bankers began to adopt the notion that they could dispense with gold as a currency reserve. 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. In the end. In the event of a crisis. when the gold price was pegged to the US dollar. the proportion of gold in global international currency reserves declined further and further during this period. 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. the financial markets are currently haunted by speculation over nothing less than the potential breakup of the Eurozone. Thus. quite a few of these gold bugs are already dreaming of a return to gold-backed currencies. though this risk is ironically not on the financial markets’ radar screen. 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. But even such a currency reform would only bring forth another fiat-money currency – a perfectly viable solution. at least in my opinion. 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. 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. while gold was a “barbarous relic” to be despised. given that it bore no interest – in contrast to bonds. 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. But as long as households prefer precious metals as their top pick. rather than gold and silver. In hindsight. central bankers tend to be the last to “smell the coffee. however. for example. After all. More likely than not. Thus. why Asian central banks (particularly in China and Japan) exhibited such a preference for USDdenominated bonds at the time. 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. the additional monetary policy options that such a fiat system offers are simply too tempting for policymakers to resist. the market has now run out of “greater fools” who could step in as buyers. 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 gold sell-offs by the Swiss National Bank or the Bank of England look pretty short-sighted now! Nor is it understandable. In a worst-case scenario. Thus. given the fiscal and monetary monopoly enjoyed by a country’s national treasury.“Gold: The End of a Megatrend” by Markus Mezger inflationary policies of central banks. many “gold bugs” are likely to express their vehement disagreement. Understandably. which are still favorably priced. the European central banks were only gradually winding down their gold sales in the wake of the Washington Agreement on Gold.” long after the players in the private sector! Not surprisingly. outstanding government debt can simply be inflated away. will not succeed in stoking moderate inflation (2% -7%) as long as the commercial banking sector simply keeps hoarding money. However. we are unlikely to see an actual occurrence of the inflation everyone apparently wants to hedge against. 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. The easiest solution would be for households to start anticipating inflation. for their part. however.
however. The most recent upcycle for stocks driven by the bubble in tech. The long-term trend of stock prices. The same applies to the US dollar zone. declining interest rates in Italy. with the ratio once again marking an all-time high of nearly 45 points. we could even see a temporary suspension of the affected bond markets. the European banking sector has had a one-and-ahalf year grace period in which to prepare for a Greek default. whose highpoint. Here. Over the very long haul. The boom years of the 1960s were the driver of the second upcycle. If the crisis were to grow worse. however. we can identify just such an uptrend over the last decades. As a form of productive capital. is driven by profits. Gold. the long-overdue “debt haircut” for Greece is unlikely to trigger a chain reaction in the banking sector. it is quite possible that gold will continue to outperform for another few months. this is due to its traditional role as “real” money. at around 27 points. However. Moreover. 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. financial “airbags” have already been put in place for the banking system in response to the experiences of 2008. 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. the Dow Jones US Industrials stock index. when the yield of 10-year US treasures was fixed by decree at 2. was significantly higher than that of the previous cycle. The pressure currently being exerted on the Eurozone clearly originates from the bond markets. As we see it. the default of a state does not automatically translate into the disappearance of its currency. does not include dividend payments. During this time. Since then. 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. on the other hand. In contrast to the surprising collapse of Lehman Brothers in 2008. Recall that in 1998 we saw the insolvency of Russia. the top occurred in summer 1999. as gold traded at 255 dollars per ounce. meanwhile. The classic method of comparing stocks and gold is via the Dow-gold ratio. cannot offer any real return over the very long term. on the other hand.To sum up: The Euro system will almost certainly still be around five years from now. a country whose importance to the world economy was far greater than that of Greece today. But the strategic call is clear: long shares and short gold! Investors who have . 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. 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. media and telecom (TMT) stocks. The current atmosphere of doom and gloom will ultimately prove overblown. Gold and stocks Comparisons are often made between gold and stock cycles. these markets have expressed their opinion about Greece’s prospects loud and clear. which forms the ratio’s numerator. Eventually. albeit in slightly modified form. The Dow-gold ratio is subject to very large cycles. Both asset classes serve as hedges against inflation.“Gold: The End of a Megatrend” by Markus Mezger As for the Eurozone. Thus. and this is now nearing completion. In the case of gold. 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. as was demonstrated in the case of the ruble. Just as with the ratio between gold the consumer price index. If we take dividend payments into account. we have seen the start of a cyclical correction in the Dow-gold ratio. given that the hoarding of gold is not a productive use. Thus. which in turn depend on the price level. Thus. it was also able to unload a part of its Greek exposure onto the shoulders of the European Central Bank. the stagflation of the 1970s pushed stocks back down and the ratio languished at the rock-bottom level of 2 points. Finally. The one potentially critical issue is a possible “contamination” of the Eurozone’s other peripheral markets. we should therefore expect to see an upward trend in share prices in relation to gold. stocks also benefit from real growth in the underlying sales markets. By demanding a more than 50% annual premium for Greek bonds.5% for years at a stretch. 5. the unification of Europe is being pushed through under the pretext that the crisis is supposedly “unsolvable” any other way.
The US inflation rate was last measured at 3.5% with a volatility of 19. Over the next few years. While the core rate was reported at the lower rate of 2. are still expensive. stocks appear attractively valued at present.“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. since it would likely exacerbate current debt problems and lead to 2010 1930 1935 1940 1945 1975 1980 1985 1990 .8%. 10-year US treasuries yield a meager 2% or so. the average PER for the US stock market was barely above 5. 64 Dow-Gold-Ratio 32 16 8 4 2 1 1925 1950 1955 1960 1965 1970 1995 2000 2005 6. Thus. one could have achieved a return of 6. it shows not signs of decreasing.4%. investors will not be rewarded for hoarding gold. (Recall that the US prime rate surged as high as 20%. whereas an investment in gold alone would have generated an annual return of 6. the central banks are likely to keep key interest rates relatively low while allowing inflation to creep above target values around 2%. Gold and fixed-income investments The low returns currently available from fixed-income securities are one of the last remaining arguments for buying gold. Today. but rather for taking entrepreneurial risks. by contrast.0%. Now. when measured against bonds. some may argue that stocks. However. A new Paul Volcker. is nowhere in sight.7% per annum with a volatility of 13. Thus. 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.) Today. Also consider that fixed-income investments featured double-digit yields in the early eighties. the average PER stands at about 12. the PER of shares should be considered in relative.8%. Such a policy would be misguided in any case.8%. as measured by the long-term Shiller Price-to-Earnings Ratio (PER). translating into an annual profit of about 20% of the share price. In a world facing major economic and environmental challenges. while 10-year US Treasuries feature a negative real return of -1. In the early 1980s. By following the model. the Fed Chairman who vowed to "break the neck" of inflation with tight money.0%. not absolute terms. short-term money market instruments currently offer a negative real return of -3.
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. an erosion of real value will be foisted on the holders of government bonds – large institutional investors. for the most part. cover nearly its entire front page with an image of gold bullion. these small shops are springing up like mushrooms.“Gold: The End of a Megatrend” by Markus Mezger political turmoil. In this environment. 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. however. Thus. 8. while a tight lid is kept on bond interest rates. At the same time. A more likely scenario is that inflation rates in the industrialized countries will rise to between 5% and 10%. sentiment is completely lopsided on the bullish side. and is being kept alive only by investors’ eagerness to buy. 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. 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. lotteries were touting gold bars as prizes. it is difficult to imagine a sharp drop in gold. Even in small villages. The gold market is saddled with a structural oversupply. In such an environment. Overall conclusion Gold is overpriced compared to other commodities and equities. we saw the Bild Zeitung. we expect to see . a leading tabloid. we are likely to see long-term interest rates kept low through central bank manipulation or fiscal intervention. From our vantage point at Tiberius. At the same time.inverted (YoY) (rhs) 2004 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2006 2008 2010 90% 7.3-month MAV . at the same time. But even “yours truly” has had the memorable experience. In the summer of 2011. Thus. Yet the trend lines on the long-range relative charts are poised on the verge of their long-term reversal points. 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. gold would fall only slightly. back in 2010. 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 .
300 USD per ounce by the end of 2012. October 10. However. this does not change the fact that. gold will likely prove to be a significant underperformer. 2011 Author: Mark Mezger .“Gold: The End of a Megatrend” by Markus Mezger 1. relative to commodities and stocks. Stuttgart.
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