It is well-known that gold prices are fairly stationary.  Over long time, they represent a form of insurance, whose price is the non-existing yield (if we forget for the moment the return that could in theory be earned by lending bullion at rock-bottom lease rates).  Gold mining companies are not like that.  They do not “hold” gold – they sell it.  They currently dig out gold at an average cash cost of $490/oz and, depending on the total cost, pocket the difference with the spot price or some combination of spot and forward sales.

A self-respecting gold investor should hold a portfolio combining the insurance value of gold or gold-backed instrument, a position in companies that sell gold for a good profit and a sub-portfolio for derivative trades enabling her/him to benefit from changes to the volatility of the metal.  The problem is that the three subportfolios require very different skills and time horizons.  Physical gold requires a long-term macro vision (and wealth to preserve in the first place).  Investment in gold mining equities – long or short – requires a level of knowledge of the complex industry which can only be gained by actually working there; a privilege few of us mortals will have.  Finally, dynamic option trading requires both experience and a fairly good orientation in what other large derivative desks are doing.

We shall focus here on the second element of such an ideal portfolio – investment in gold mining companies.  Four years ago, during the height of private equity activity, someone made an interesting observation that unlike oil and gas industry, mining attracted very little in way of leveraged long-term investment.  In many scarce commodities – from lithium to uranium – it is theoretically possible to take a controlling position in an early stage company against the future offtake of the product (assuming that the private equity firm is appropriately positioned further down the value chain).  But in gold, the intermediary bullion banks have been in the business for decades and the product is never “scarce” by any conventional measure.  In addition, the complex knowledge necessary to analyze a mining investment is a hurdle that few non-operating companies undertake.  Those who can do this, are successful royalty businesses.

Why is it so difficult to switch from analyzing, say, retail or machinery sectors to analyzing mining?  There is one underlying conceptual difference.  Your clothing stores and your factories will be differentiated by the product they churn out.  But the process of a factory based in Mexico or in China may be exactly the same.  In mining, the opposite is true.  The product is essentially an undifferentiated commodity, with specific qualities and standards determined by decade-long interaction between producers and users.  But it is the process of obtaining this commodity that differs in every single operation.  The combination of geology, metallurgy and engineering makes each and every one mine a unique operation.  In order to understand the process fully, nothing replaces the actual visit to the site.  And the sites tend to be off-the-beaten track.  As my former boss would quip – “God had a sense of humor when he decided where to put gold”.  From the Arctic Circle to breath-taking heights of 12000 ft and equally suffocating depths underground, from deep jungles to parched deserts, gold just does not happen to be easily accessible.

The 19^th and early 20^th century gold rushes in California, Alaska, Australia, Brazil and South Africa show that God’s sense of humor was somewhat less acerbic at that time.  But much of the easily accessible land has now been scoured for prospectivity, a process that accelerated in the 1980s.  Parts of Australia and Nevada are now drilled out like Swiss cheese.  No wonder that the most prospective gold and copper porphyry-rich Tethyan belt snakes through Burma, Tibet, parts of Afghanistan and Iran, and into Pakistan, where Barrick & Antofagasta’s Reko Diq project is located.  In addition to the challenges posed by the difficult terrain, it is the above-ground factors in these countries that have considerably raised the operating risk.  Such an adverse environment requires the deposit be highly prospective – either rich in grades (which is preferable), or very large.  In the latter case, the operation may incur high development cost or extend way into the future, making the value of the project highly vulnerable to discount rates used to value the cash flows.  The question how to reflect the risk of low-frequency but high-impact events is a huge topic with bankers insisting on somewhat arbitrary adjustments to the discount rate, and operators seeking to reflect the hazards directly in the cash flow profile.  Either way, the shareholders purchase the associated risk, most often with little knowledge of the applicable probability distribution for the potentially damaging events.

This is just one example of the complexity involved in the decision to invest in a mining venture.  Even though the rewards can be considerably higher than in the case of defensive holding of physical gold, the homework concerning the intangible notions of risk takes a bullion-hoarding investor way out of his comfort zone in the Swiss vault.

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The stock market apathy is now being countered by feverish M&A activity. The last two weeks have seen an unprecedented onslaught of announcements targeting a variety of companies: Potash, McAfee, NedBank, 3Par Inc, International Power, Cairn India, Dana Petroleum, New Alliance and Sphere Minerals (which controls attractive iron ore assets in Mauretania). With the exception of Kinross’s advances in West Africa (and the earlier Newcrest-Lihir tie-up), the gold mining industry has been remarkably quiet on this front. This relative inertia continues despite the much higher level of fragmentation than in the case of more M&A-prone potash or iron ore industry. Why has the gold industry been so quiet? The answer is threefold.

The first part of the answer lies in the structure of the gold mining industry. Three out of top 10 gold mining companies are domiciled in South Africa. After Pretoria’s initial green light to Anglo American, Billiton and several others to establish Plc structures in the UK, the process of internationalization of South African resource companies stalled. The last significant acquisitions made overseas by SA gold mining firms were executed in 2001. The liquidity and fungibility of their shares made it extremely difficult to compete for Australian assets and practically impossible to enter a contest for North American assets. The legislation favoring ownership by historically disadvantaged South Africans, first leaked in 2002, further depressed any interest in South African producers as potential targets of corporate activity. Several years later, the botched approach by Harmony to take out Gold Fields offered the final nail in the coffin. Short of resuscitating the idea of intra-South African consolidation (or rather asset rationalization), there is little chance of the three giants to play a decisive role in the global consolidation of the industry.

The second part of the answer has to be sought in the relative valuation of gold mining stocks. The CEO of Yamana has recently complained that the undervaluation of large mining stocks vis-à-vis their smaller competitors lies behind the slow pace of consolidation. It is true that when a tier I company does venture out, the allegations of ‘overpayment’ abound. Kinross’s CEO is still facing a tough battle with many reluctant shareholders over the purchase of Red Back. Both gentlemen have investment banking background and Yamana’s boss seems to be correct in his assessment. Currently North America’s large gold stocks trade at around 13x next year’s cash flow, 21x forward earnings, 7x EV/Ebitda and around 1.4x NAV. By comparison, the 2nd tier producers, where most growth is expected, trade at 16x cash flow, 23x PE, 9x EV/Ebitda and around 1.7x NAV. And that despite the largest companies having the free cash flow yield twice the size of the second group’s. Essentially, that would mean that large companies – many of which were built on successful acquisitions in the past – are bound to destroy value if they embark on costly acquisitions among the 2nd tier producers. But that does not rule out some activity on the part of 2nd tier producers targeting small and emerging gold miners.

Here lies the third reason behind the slow progress in consolidation. Even if we put aside the Chinese and Russian producers, the universe of potential takeout targets runs close to three digits. Monitoring this universe requires dedicated teams for both desktop overview and on-site due diligence. Many of the 2nd tier producers lack the adequate corporate structure to focus on any targets that are not known already – through geography, personal contact or other privileged leads. Investment bankers will not find a $150m-$300m deal attractive enough to dish out a detailed proposal. Essentially, the industry lacks vehicles facilitating the deal flow beyond the most obvious targets (Lihir was one of them). Canadian banks may have the best information about their actual and prospective clients, but it is the prospective acquirer which will eventually have to do all the time-consuming homework. The signature of confidentiality and standstill agreements with the target will invariably divert resources from the key development work that 2nd tier miners depend on. Those which may potentially have such resources at their disposal (ElDorado? Agnico-Eagle?) possess plenty of in-house growth projects in the near term, or are busy integrating recently acquired assets. In addition, while tier 1 companies may more easily deploy resources from other operations to increase efficiency gains from the target’s assets, smaller acquirers usually find the post-merger acquisition just as challenging as the ongoing process of monitoring the available universe of potentially attractive targets.

The occasionally optimistic pronouncements about the overdue nature of gold mining consolidation are destined to remain just that – optimistic. The fragmentation of gold’s primary supply is a combination of historical legacy and the comparatively high-value, yet low tonnage nature of the majority of the relatively isolated deposits with few operational synergies. This does not mean that interesting targets are not there – in West Africa, in the Andes, in North America’s northeast or in Southwestern Pacific. But the process will be as slow as it has been in the past – regardless of the bouts of M&A fever in other sectors.

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Let us step back to the onset of the first yen-carry trade, in 1996. After a record year for gold investment in Japan (1995 was punctuated by the Kobe earthquake and 18-year low prices in JPY terms) the investment demand nearly halved to 57t. The following two years saw a combination of profit taking and bursts of demand towards the end of each calendar year. In 1999, the Yen strengthened and deflation began, but overseas gold also hit a low of $275/oz. Investment demand in Japan picked up 16%, but this was a short-lived phenomenon, despite deepening deflation and further strength in the Yen.

Carry trades resumed in 2001. Between terrorism, Argentina’s default, Enron and a collapse of Daiei supermarket chain, Japanese investors increased somewhat the purchase of gold for investment purposes (this was the time when yellow jewelry barely sold in Japan). In early 2002 – against the background of weakening Yen and stronger gold prices, Mrs Watanabe rushed to purchase gold to protect the household against reduced government insurance for time deposits. Investment in gold hit 95t – an amount never registered again. At that time, bullion would change hands at around Y1400/g.

The subsequent three years of deflation saw a recovering economy, buoyed by exports and aggressive (and ultimately futile) attempts to weaken the Yen. Interest in gold depended on a variety of factors, ranging from the health of the banking sector, the performance of the local stock market and the JPY exchange rates.

The shock came in 2006, after the deflationary period was over. The carry-trade driven depreciation of the Yen sent the prices fast above Y1500/g and Mrs Watanabe began to take profits. That year, the Japanese disinvested a net amount of nearly 43t. With equally weak Yen the year later – and gold continuing to gain strength (crossing Y2600/g), 2007 saw a further 32% growth in net disinvestment. This process continued until JPY reversed the course in the wake of Lehman’s collapse towards the end of 2008. The return of deflation and a stronger Yen (a veritable ‘Hauch des Lebens’ for the otherwise embattled uncovered interest rate parity) coincided in 2009 with further dishoarding, albeit at a much slower pace.

This short summary of the recent history in Japanese gold investment reveals Mrs Watanabe’s uncanny sensitivity to the fluctuations of real values (rather than nominal prices). It is all the more surprising because it is, a priori, impossible to gauge the exchange rate reaction to changes in monetary aggregates. For example, a reduction in money supply should, ceteris paribus, lead to an increase in nominal exchange rates – and (depending on interest rates) a possible increase in real exchange rates. However, as the velocity of money is reduced, deflation sets in, and deflation means a decrease in real exchange rates.

Despite the multifactor complexity of these phenomena, the wisdom of (ageing) Japanese crowds got it right. Naturally, the gold investment demand exhibited a very high (negative) correlation to gold prices expressed in Japanese Yen (based on annual average prices). No surprises here. However, given gold’s relentless gains during the last decade, the nominal exchange rate (JPY/USD as a proxy) offers little guidance (barely 34% correlation to gold prices in Japanese Yen). The value of the Japanese Yen vs USD does not correlate with the gold investment demand in Japan at all.

It is by looking at JP Morgan’s broad Yen index (real effective exchange rate), that an astonishing picture unfolds. First, gold confirms its role as a “reality” check on the actual value of the currency (an argument made on these pages previously). JP Morgan’s JPY index and gold in JPY correlate at 55%. And Mrs Watanabe beats even that. Her gold purchases since 1996 correlated at 63% with the real effective value of the Japanese currency!

More granular data (e.g. on a quarterly basis) would be necessary to refute alternative hypotheses. Yet even at this high-level, the short review illustrates how attuned Japanese investors are to the real purchasing power of their currency. Rather than offloading gold at the first sight of positive real interest rates, they continued to hoard the metal and then sold a third of these holdings once the economy crept out of deflation. Remarkably, latent inflation fears never dented their resolve.

Watanabe-san! Atama ga sagarimasu!

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With no apologies to 19th century’s dialectical materialism, I have chosen the quote to describe the increasingly uneasy feeling US monetary authorities express regarding the mid-term prospects of America’s economy. With the vocally dissenting exception of Kansas City’s Thomas Hoenig, the Fed has once again expressed this week its relative malaise vis-à-vis the slowing growth. Bernanke & Co also showed how limited the DIY toolbox is to counter the Japanese scenario. The markets reacted accordingly.

Yet the oft-quoted “Japanese scenario”, or “defure jidai” (era of deflation) is poorly understood. There is now considerable interest in the mechanism of Japan’s recurrent deflation and gold investors should heed some of these lessons as well.

First, it is important to stress that Japan has not been mired in deflation without interruption for two decades since the collapse of the property bubble. Rather, there have been two distinct periods of deflation – the first one during 1999-2005 (following the banking crisis of 1997-98) and the second one in 2009-10 (triggered by the global recession).

Secondly, deflation alters investors’ behavior. Deflation is particularly damaging to debtors, who, in the context of falling real incomes and prices, must make interest and amortization payments in nominal amounts. No wonder that Japan’s corporations focused on debt minimization rather than profit maximization. Private investment stalled and marginal efficiency of capital collapsed. But the debt repayment obsession continued even at near 0% rates during the periods of positive CPI, as in the mid-1990s. Japanese investment behavior durably changed because investors believed that the pre-1989 asset prices were “wrong”.

It is impossible to understand what role gold has played in such an environment without tracking the performance of the Japanese Yen. The Japanese love story with gold was a short but boisterous affair. Despite the country’s efforts to diversify energy imports after 1973, the second oil shock triggered a major panic in Japan. In January of 1980, gold hit JPY6495/g. By the time deflation set in nineteen years later, the combination of a strong Yen and uncoordinated sales from central banks brought the prices to JPY917/g. For a deflation-gripped Japanese household, whose cash tomorrow was worth more than cash today, gold offered just another route from riches back to rags.

It’s from this low point that a more interesting story unfolds. Between 1996-98, during the first spell of carry trades (when the Yen lost 25% of its value), gold remained flat at around JPY1400/g. The second period of carry trades – between 2001-08 – saw the reversal of fortunes. Now the Yen barely diverged from the mean of 114 to the dollar, while gold gained 230% in Yen terms. Despite spells of interest registered by Tanaka Kikinzoku, most gold buying during this period occurred overseas. The most recent period of a stronger Yen has seen much more modest gains of about 4.6%. Remarkably, Japan – with little domestic gold mining – has now become a gold exporter! In other words, the first bout of deflation in Japan was accompanied by gold’s gains, while the second one has so far sent mixed messages – in line with gold’s significant volatility in JPY terms.

In fact, the fluctuations of the Yen exchange rates matter more for a deflation-bruised Japanese investor than the relative value of assets and liabilities exacerbated by the recurrent liquidity trap. The reason behind the limits of the Japanese experience lies in the asymmetry of the global exchange rates. The Yen is a structurally strong currency. The Hondas and Toyotas sell for dollars and euros (ah, yes, and the renminbi), which then have to exchanged into the Yen – boosting the demand for the Japanese currency. US and European corporations do not have the equivalent need to sell Yen proceeds from the current account (i.e. trade account and proceeds from overseas investments). Instead, the solutions to weaken the Yen were periodically sought in the capital account. Although Mr “Yen” Sakakibara’s efforts to weaken the currency were first spurned by Larry Summers, Japan’s ultra-low interest rates offered the global markets a cheap way to finance investments elsewhere. These carry trades were there to stay until all hell broke loose in 2008. But as 2009 showed us, the low US Libor reduced the attractiveness of the Yen as a funding currency. At the same time, the demographically challenged Japanese corporations have now moved to build and control vast swathes of Chinese industrial capacity, thus reducing the dependence on the weak Yen. All this will limit Japanese appetite for gold, even if the current rebound in industrial production does not immediately warrant a durable escape from deflation.

Deflation happens when saved money is not (productively) invested. Low interest rates in a weak economy, lack of credit growth, excess corporate savings, overcapacity – all these themes echo from Marunouchi to Wall Street. Yet, it is impossible to gauge whether the usually optimistic American extroverts will ever consider the pre-2007 house prices “wrong”. In the meantime, what matters more is the relative performance of the currencies. The currencies benefiting from risk aversion (the Yen, the Swissie) and from Asian growth engine (again the Yen, the Taiwanese dollar, the Won, the Aussie) are not friends of local gold investors, especially in a deflationary setting. On the other hand, the US dollar and the Euro are structurally weak, even though the dollar’s vast fixed income market will periodically make it the destination of risk-fleeing capital. European and American investors have thus little choice but continue to add to their gold holdings to offset the competitive erosion of their currencies’ value. For as long as the continued pressure on the labor markets does not derail the global trade, this recurrent weakness of Euro and Dollar should help counter the deflationary pressure.

Finally, it is worth remembering that investment in economically inert gold is, ceteris paribus, deflationary. Luckily, with barely $350bn of equity gold available worldwide and about a $1 trillion in private vaults, the global deflationary risk of flight into gold is a doomsday scenario better shelved with the Mayan calendars.

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How should it be otherwise? When you already own eight apartments in Wenzhou, three ambitious mistresses and a gleaming black Buick with a chauffeur, what else is there to impress your peers than a solid gold toilet, in the aptly gaudy style known from Hong Kong exhibits or the recent Shanghai Expo. For the rest of us math majors, the equation goes: “more solid gold toilets – better for the gold market”. Then multiply it by 1.3bn and you attain nirvana.

The attractiveness of gold toilets has as much to do with the delicate tastes of the ‘xinfu’ (nouveaux riches), as it has with the paucity of gold investment products in China. Not surprisingly, this week’s announcement about the widening of gold trading in China has created quite a stir, helping gold test the elusive $1200/oz level again.

China’s reform of the internal gold market has been painstakingly slow. Although the government monopoly was broken in 2001 and Shanghai Gold Exchange opened a year later, for the first four years SGE served exclusively the jewelry market. Only in 2006 were individual investors put on a “trial method” to trade 100kg bars. It took two more years for CSRC to treat favorably the application to open up the futures market. Nearly 7m gold futures were traded on Shanghai Gold Exchange in 2009. This has been a helpful development for Chinese gold producers, who are not allowed to export gold mined in China. Yet some of the gold mined in China finds its way through bank swaps into Hong Kong market. The announced launch of Hong Kong Mercantile Exchange and its gold futures contract represents a (healthy) competitive threat to SGE. SGE could counter this partly by allowing in foreign participants on the exchange, but any such allusions are, for the time being, a matter of bureaucrats’ “opinion”, not policy.

Meanwhile, in the absence of ETF products, most individuals on the mainland rely on popular coins (golden pandas and Olympic coins) and bars. In fact, China is now the world’s fourth largest market in terms of coin and bar hoarding.

The PBOC’s announcement called for better financing services to facilitate Chinese banks’ hedging overseas. It is impossible to divorce such statements from the problem of the closed China’s capital account and the tortoise-like internationalization of the renminbi. PBOC faces an unsolvable dilemma. Further boost to renminbi’s global role would mean progressive loss of control over its value. On the other hand, readiness for such a move would require a comprehensive plan over how to grow the economy of a post-mercantilist China. There does not seem to be such a plan at the moment. As a result, only 1% of China’s international trade is settled in renminbi and only 4 (four !) renminbi bonds have been issued by non-residents. Open cross-border trading of gold is as distant a future for Chinese investors as is renminbi’s full convertibility.

For all this skepticism, the decision to modernize China’s gold investment market should be applauded. Investment demand represents 18% of overall gold offtake in China and the potential for growth remains significant. Neighboring countries such as Korea and Taiwan have a per capita consumption nearly four times the Chinese level. This contrast is comparable to the overall differences in terms of GDP per capita. Should China continue to grow faster than the rest of East Asia, its gold demand will grow accordingly.

But even if ETFs and other investment products outweigh the importance of golden toilets, China will, in foreseeable future, remain predominantly a gold jewelry market. Whereas the global jewelry consumption now accounts for roughly half of the total demand, Chinese appetite for jewelry ensures that as much as 78% of all gold sold appears in ornamental form.

This brings us back to one of the key considerations of a self-respecting gold investor. China’s jewelry market exhibits a strong seasonality of its own, with most purchases made in September, November and January. In the near term, the recognition of the impact of these flows holds much more importance than any exegesis of PBOC’s mutterings.

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Linearity derives from the common human experience of life which begins, continues and ends. This is the way we conceive of history, literature, art and indeed any form of human creation limited by the boundaries of space and time. To increase the comforting sense of familiarity, we seek dominating plots and tend to focus our attention on them. This is what gestalt psychologists dubbed “figure/ground” perception. It is simply too demanding to conjure up multiple indicators, factors, aspects and plots into a web of complexity. We leave such tasks to computers. It is true that Gabriel Garcia Marquez and Roger Altman proved that innovative, non-linear narratives can be hugely alluring, but we still look at the markets and the economy by singling out all-encompassing themes: recession or recovery, double dip, expansion, austerity, stimulus, etc, etc. Presenting such themes in terms of binary outcomes tempts our simplistic minds even further.

The second dominating narrative structure is the belief in cycles. As most humans evolve in a climate characterized by regular changes – four seasons in temperate climates, dry and wet seasons in the tropics, near permanent darkness and midnight sun in the Arctic – all of us expect some form of recurrent patterns. Some traditions even injected such hopes into religious thinking, thus avoiding the eschatological destiny of much Western heritage. Markets lend themselves frequently to seasonal thinking. There are some good reasons for this: the construction season in much of the northern hemispheres, the January lending bulge by calendar year-obsessed Chinese state banks, lengthy summer holidays in Europe and in South Africa, the return to activity (and to football) after the Labor Day in the US.

As discussed on these pages before, gold is not immune to inherently seasonal thinking. Gold investors are painfully aware of these rules these days. The massive liquidation of Comex positions over the last three weeks and the wave of redemptions on the most CTA-exposed gold ETF product in the US have conspired against the hopes of those who had expected the summer of 2010 to turn out differently. It was not to be. In USD terms, gold is down 7.5% since it peaked on June 21. In EUR terms, it has now collapsed by 14% since the peak on June 8. Such losses pale in comparison to equity losses among many of the mining and exploration companies. The likes of Jaguar, New Gold, Allied Nevada, Central Rand Gold have each lost a quarter of their market value over the last month and trade at levels last seen when gold itself was 20% below the current prices.

Euro’s strong rebound in the midst of this summer’s hekatombe adds insult to injury for European investors. Despite all the criticism surrounding the broadly un-stressful bank “tests”, Euro has shot up over the last several weeks against most currencies.

But moving away from the linear story of Euro’s hopeful happy ending – to the cyclical considerations of the northern summer, it is interesting to gauge the relevance of the previously discussed monsoon seasonality for Euro-denominated investors.

Over the last 10 years, we find that between July 1 and August 31, gold in dollar terms averaged 2.5% returns, with the exception of 2008, when it lost 16% during the period. By comparison, in Euro terms, the average summer returns have been negative (-1.6%). Is Euro strength also seasonal? But why? Through the summertime influx of the pound, dollar, yen, rouble, lira, zloty, won and renminbi-wielding tourists, maybe? Remarkably, the current pullback in Euro-denominated gold prices positions 2010 as potentially the worst year yet – worse even than 2008, when European gold lost 11% over the summer (courtesy massive inflows into USD).

The underlying theme of this seasonality is, of course, India’s physical demand and so the overview would be incomplete without any comparison to Rupee’s performance. In fact, we note that during this seasons the Indian currency usually remained fairly stable against the dollar (with minor losses in 2004, 2006 and 2009), but the range of outcomes for Euro – Rupee exchange rate has been much wider, with large losses in 2001, 2005 and again this year. This Rupee weakness is an unwelcome sign for gold investors globally. Although Indian buyers seem to be increasing purchased volumes after significant price pullbacks in Rupee terms (as they did on July 2nd and again this week), this support will remain fragile for as long as Rupee remains under pressure.

I leave it to sharper minds to figure out how to square the European tall tale of a continued economic bliss with Rupee’s eternal recurrence between strengths (2005, 2007 and until June 2010) and weaknesses (2006, 2008-09). Longer term market forecast is of not much use, whether our attention is directed to structural changes or to cyclical phenomena. But in short term, timing the market bottom will require much skill. Slovaks, now a Euro-land, have an apt adage for such circumstances “gold without wisdom is but clay”.

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Now that most of the reassured German savers are driving their distinctive, white caravan vehicles onto the beaches of the Mediterranean, some of the Euro-scare is gone. The recurrent, invariably negative debt news from Ireland, Spain or Hungary fall short of denting Euro’s progress, even against the currencies whose central banks are now on a firmly tightening cycle.

Yet the underlying interest in the physical gold has not disappeared. Rather, it has taken a breather – and every time this happens after a spell of buying panic, speculative gold demand falls off. Such conclusions are easily reached by comparing the Comex positions – good 5moz off the recent highs – and the global gold ETFs, at 67.2moz still notching all-time highs in volume (even though the biggest product of all – the GLD – has suffered redemptions of late). Should this process of bifurcation between long-term buy & hold behavior and speculative trading continue, some time later this year the total ounces under the ETFs may tower as high as three times over the Comex long positions.

German press is full of articles expounding on Euro-skeptical Teutons’ sudden urge to succumb to the yellow glitter. Some academics went as far as to seek evolutionary explanations to the phenomenon. The apparently irrational drive to place savings in non-yielding assets is, according to German psychologists, a response to the basic, atavistic survival fears. Whenever such fears surface, the simplest strategies are always considered first. The simplicity of physical investments would benefit gold, silver and other tangible assets. Such biases in favor of familiarity are well known in behaviorist literature under the term of “ambiguity aversion”. The illusion of competency is one of the aspects of ambiguity aversion and can be easily applied to the behavior of German investors, few of whom can be considered gold market experts (even though for many years there has existed in Germany an OTC gold equity business for retail investors, along with independent, yet highly specialized brokers and analysts).

The underlying assumption of any such comments is that the German equity market with the median dividend payout ratio three times the Japanese levels should remain the adequate destination for “rational” behavior. But individual investors in Germany are also much more skeptical with regards to the merits of their local treasury market, even though the flagship 10 year Bund has actually outperformed JGB of the same maturity by some 30bp so far this year. A generalized aversion to debt has been again underlined by Angela Merkel this week, when she stated that her compatriots would only increase their consumption when the public deficits appear to be under control. Any stimulus would be instantly annihilated by a deeply ingrained beliefs akin to Ricardian equivalence. There is some truth to such claims. I vividly remember visiting German investors several years ago. At a time of low risk aversion in the markets and handy capital inflows into the most exotic frontier projects, Germans we met required that the gold companies run balance sheets with only assets and equity – and thus reflect more adequately the liability-less character of their underlying asset.

Delving deeper into the nature of those “fears”, reveals a deeply embedded Angst over a possible replay of the 1920s style hyperinflation. Equally relevant are lingering concerns regarding longer-term wealth erosion. Interestingly, this fear of loss of wealth is common even among Germans with stable jobs and earnings prospects. Psychologists point out here that German investors are generally more conservative and more risk averse than their American counterparts. One could add to it comparatively poor understanding and even an aversion to capital markets in general. Some of the experts even believe that should any signs of insolvency among Landesbanken return, German investors’ behavior could even jeopardize liquidity of those investment markets where large overseas players and large local public institutions are not overwhelmingly present.

By anchoring on the painful experiences of the 1920s, German investors too often exhibit overconfidence in the doomsday scenario of a debt-swept common currency. The range of probable outcomes for the Eurozone is certainly a lot wider than outright implosion. However, if Euro-skepticism is the main driver of diversification into gold, then it would mean that Germans do not really consider gold an alternative to equities and fixed income. Rather, gold appears as an alternative form of cash whose value responds inversely to deflation/inflation than any other form of cash. Ironically, should this be the underlying reason for stocking up gold bars and coins last May, then this allegedly irrational investment behavior re-emerges with distinctively rational tones.

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The article offers a perfect opportunity to reiterate our belief that gold has (“probably”) not peaked.

First and foremost, the fact that gold hit a recent high at $1263/oz tells us nothing about the potential of this asset to move in price up or down.  Nor does the all time high of the 1981 ($2185/oz in current dollars) tell us anything more.  Gold bugs would love us to believe that the price somehow has to “revisit” these levels.  Gold bears believe that the price may fall to long terms lows of 2001.  Both arguments are nonsensical.  There is nothing in the 30 year chart of gold prices that tells us what could happen in future for the simple fact that gold is not a mean-reverting commodity.  This is because it resides outside the simple supply and demand framework.  With 7000 days of inventory available for consumption it could just as well be lying worthless, but it is not.  And nor are there 30-year mean reversion “cycles”.

Once we have cleared this misconception of naïve chartism, let us focus on what we believe are 10 good reasons for gold to still surprise us, on the upside.

1.  Scarcity of safe haven assets in the global investment universe.  Currently, the Treasury debt of US, Germany, Japan, (sometimes) UK, and, by extension, US dollar, Japanese Yen and Swiss Franc offer the safety valves par excellence.  Gold does not offer a yield and trades more like a (small) currency.  But it is a currency that cannot be debased by the whim of central banks, many of which are slowly losing their orthodox monetarist armor.

2.  The debt overhang in the OECD economies has forced the authorities to begin the tightening cycle by imposing austerity measures.  Too much austerity cold dip the brittle global economy into recession.  A more plausible scenario is that fiscal austerity has to be offset by continued loose monetary policy.  By allowing the inflation rate to run ahead of the nominal interest rates, some of the debt is monetized, alleviating the burden, but also guaranteeing negative interest rates – tested friends of non-yielding assets, such as gold.

3.  Should the double dip become a reality, further monetary activism by central banks cannot be ruled out.  Whether this means a new wave of unsterilized QE or other forms of liquidity operations, any signal of further injections would benefit gold before other assets climb upon the bandwagon (as the lessons of late 2008-early 2009 showed us).

4.  Gold lease rates remain stubbornly low despite the fact that Libor has now rebounded from the record lows it enjoyed since late summer 2009.  Low lease rates are negatively correlated to gold prices due to the nature of the gold value chain and inventory financing.

5.  Emerging market growth continues.  In several large emerging markets, gold is a conspicuous consumption item.  Even if the jewelry demand slows down (as it has over the last 2 years), the very pace of growth in wealth accumulation portends well for the demand in the longer term.  For this to happen, the momentum in the appreciation of gold (in local currency terms) has to slow down, and, importantly, the gold industry has to ensure that attractive product appears on the market for the new generations of more affluent, urban consumers.

6.  Central banks are net buyers.  The history of the last 20 years is one of central banks selling gold.  Not anymore.  Western central banks have used only 10% of the 400t annual selling quota.  Meanwhile, there is no purchase quota for central banks which continue to accumulate $640bn in foreign reserves annually.  Thanks to the purchases by South East Asian, South Asian, Central American, Middle Eastern and Russian central banks, for the first time in decades, central banks are now net buyers of the metal.  The combined forces of the current account surpluses and the injection of western private surpluses into the emerging markets ensure that the continuation of this trend is highly probable.

7.  The recent liquidity shock means that most global economies are now engaged in competitive currency depreciation.  The market frontruns some of that activity.  While it is often lost on casual FX observers focused on specific currency pairs, long term trend in most currencies is one of progressive debasement – captured well if the currency is denominated in gold price, or – among the western economies – on a trade-weighted basis.  This is the world of competing weakness – dollar vs euro.  Gold aligns its destiny with the one which is periodically stronger, flipping the correlations in the process, and showcasing long-term asymmetry to these two dominant currencies.

8.  There is a broad consensus that a recovery, should it occur, would be highly inflationary, given the $3 trillion of stale liquidity now hoarded in private (corporate and household) surpluses in the western world.  This remains one of the main reason why the recent purchase of gold by European investors focused mostly on allocated physical holdings, rather than “gold-backed” products.

9.  Inflation is, however, clear and present danger in many emerging markets.  India is a prime example, with reserve requirements AND interest rate increases introduced to slow down the runaway prices.  India could be the future of many other emerging markets, as they continue to shift away from their overdependence on exports.  The development of domestic consumption, in absence of strong currency, would be inherently inflationary, but could be necessary if the US consumer does not recover its $11 trillion dollar purchasing power anytime soon.

10. Finally, gold as investment continues to be a tiny market.  Only 2.5% of the overall gold stock is traded annually.  A little over twice that much is available to equity investors worldwide (both in ETF form and as gold mining stocks).  This is the the equivalent of the value of 300moz – roughly three and half years of the global gold production.  There is little chance that this production accelerates in the near term.  Consequently, the gold market is dependent upon continued sales of secondary product.  Only this flow – from the used jewelry in Asia and the Middle East saves the gold market from dangerous bubbles.  And let us hope that it continues.

The Economist was right in the article, underlining the importance of the jewelry market.  There is no robust gold market without successful jewelry sales.  But the jewelry does not drive the gold price, it provides a floor under the gold price, responding to the prices determined in the global markets.  Ten years ago, the jewelry volumes were twice the current level.  The gold price was too low even the Economist’s most vocal bears.

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Since last October, the gold market has experienced five significant pullbacks, the strongest of which occurred after the record highs of early December. Within two weeks, the profit taking and liquidation of spec longs sent the prices down 11%. Since then, a paradigmatic shift has occurred in the gold market. While the December highs were achieved with the then predictable 89% correlation to Euro, six months later, gold hit an all time high while correlating positively 90% to the dollar. Last week’s strengthening of the Euro in response to reduced perception of banking risks in EU is the mirror image of how dollar’s strength would have affected the bullion throughout most of the noughties. We humans like investing such turnarounds with meaning. And the meaning of this correlation flip can be reduced to a simple quip – gold aligns its destiny with what, at that point in time, is perceived as a “stronger” currency. There was nothing secular and eschatological about its long-term correlation to Euro. There is nothing unavoidable about its current relationship with the dollar either.

As is usually the case, gold equities have suffered during gold’s recurrent retracements, but the worst pullback in GDX index occurred in January. December was more damaging for large Canadian stocks, as if the specialist fund liquidation had waited for a confirmation of a trend-breaking pullback. At the time of writing it, it is the Canadian mid-sized stocks (between C$1m and C$5m market cap) that suffer mostly in the market, but this group has already notched an impressive 59% return year-on-year, performing twice as well as gold itself or as generic gold stock indexes. Such divergence is not necessarily surprising in light of the recent survey by FundQuest, which has found that only four types of active portfolio managers consistently outperform passive indices: experts on currencies, small-cap growth, Asia-Pacific diversified equities and… precious metals companies.

How much deeper should the current pullback dig? Over the last week, GDX is down nearly 8% and mid-sized Canadian stocks over 10%. If the experience of the last 10 months can serve as a guide, then another 4% to 10% drop would not be surprising. Yet if that happens, and the upward trend does not resume immediately, it could yet be one of the worst summers for gold equity investors.

In fact, with the exception of the memorable August of 2008, the July-to-mid-August losses on gold stocks have been less than dramatic and on average the 10-year seasonal negative performance is only 4.5% in North America and 6% in South Africa. Gold itself is known to have recoiled by little more than 1%, on average, during this period.

There are three factors that could pull the gold equity performance either way this year. On the one hand, the broader equity market is in shambles, scared of global deflation, stoked by fiscal retrenchment in Europe and increasingly aggressive interest rate activity in price-volatile emerging markets. Regardless of how resilient the gold prices stay throughout the summer, the gold stock holders’ fortunes are not immune to broader sell-out in the equity market. The analysts’ cry of “deeper NAV discount” could be comforting, but the reality is that such deep discount could itself prefigure poor future returns on the underlying asset.

This would be a real worry if gold’s forward curve and lease rates exhibited behavior of growth-dependent, mean-reverting commodities, such as copper, iron ore or metallurgical coal. This is not the case and the binary deflation/inflation cloud which hangs over the markets may explain to some extent why this year’s seasonal weakness may be less pronounced.

The answer, as it often is the case, has to be sought in India. As the wholesale price index jumped to 10.2% in May, the price pressures began to seep from the visible food and energy items, feeding back into the manufacturing processes. This week, the Reserve Bank of India has acted decisively and off schedule, jacking up the rates by 25bp. The inflationary vise has now led to a general strike and an even more general feeling of overheating unease. Not surprisingly, as gold approached $1200 for the first time in two months, Indian buyers resurfaced with volume orders unseen since last January. Such strong demand points to a very robust floor under what could be a less depressing summer.

What could make the bottom fishing even more promising this year is the general nervousness injected into the market after the revelations of larger-than-life BIS gold swaps. While it is true that the liquidity-seeking central banks are ready to go beyond money market activity, the fact that cash strapped monetary authorities use gold as collateral, rather than sell it outright within the constraints of CBGA, is a positive signal.

Happy fishing.

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Yet lurking behind the gloss, there is a disturbing sign of global asset underperformance, increasingly shrouded in murky tales of impending deflation. It is a global picture of cash being hoarded by the private sector – companies and households alike. Most of these funds find their way back into the Treasury market of the perceived “safe” (read: sufficiently liquid) countries. Whenever the shift of capital into sovereign debt crosses a currency divide, the returns on gold holdings by local investors are heavily affected. And while gold notched up in the last quarter an impressive 22% in Euro, 16% in Canadian dollars (hitting an all-time high on the last day of June), and nearly 12% in USD, it only yielded pale 4% for Japanese investors.

European investors were the supposed winners in this global rush to capital preservation. Their 22% gain in gold largely reflected the loss of Euro’s purchasing power. A trade-weighted Euro lost 9% this quarter. And while it ceded 22% of its value to gold, it also fell against the Yen (11%), US dollar (9%), Swiss Franc (7%), and the pound – inexplicably buoyed by the market’s infatuation with UK’s new budget. Only the commodity currencies, spooked by the unexpectedly softer Chinese data have lost more ground than the common currency. In particular, the Aussie dollar has been penalized by the capital flight back to Japan.

In response to China’s sobering PMI numbers, the commodity rout has been widespread. Over the quarter, zinc has lost 25% of its value, iron ore 24%, lead 19%, copper 16%. Many of these metals are important buy-products of gold producing companies and can seriously affect the mines’ cost structure. As for oil, the correlation to gold has turned negative and the oft-watched gold/oil ratio hit record spreads twice during the quarter.

But while bullion and gold ETFs offer some solace to those who see debt monetization as an inevitable outcome of the current strains in developed world’s public finances, the mainstream investor is suffering from poor equity returns and scrams headlong into the Treasury market. Increasingly signaling serious deflation risks, the 10-year US Treasury yield dipped below 3%, bringing the returns to 4% over the quarter.

Not surprisingly, a crater has opened underneath the global equity market. In the flight from risk, global equities (MSCI world) returned negative 13.5% this quarter, while S&P500 has lost 10.9%. By comparison, the gold stocks’ performance has been stellar, yet in absolute terms it has been all but.

In fact, as the gold price continues to advance across all currencies and the commodity currencies are now suffering from China jitters, the returns on gold mining stocks have been trailing, yet again, the bullion’s gains. In a mean-reverting industrial commodity, such a yawning discount to NAV would presage a sudden collapse of the value of the underlying commodity (as was the case with many commodities two years ago). Are gold stocks now sending a warning shot?

In fact, the performance of global gold stocks varied widely. Asian equity markets are a depressing spectacle these days. Hong Kongers in particular are happy to swap their wealth into a bet on an IPO of one Chinese bank. Hong Kong market has lost 6.5% over the quarter and its gold stocks returned “only” 11.25%. Australian gold companies enjoyed somewhat of a late rally in June, leading to a 12.6% return. In North America, gold mining companies compare favorably to the broader market: GDX index returned 17%, HUI index 16%. The biggest winners were South African miners, with 17.9% return (most of which occurred in April – May) and London-listed gold stocks with an impressive 20.69% vs only 13% gains for bullion denominated in the British Pounds. London is one market which continues to favor gold equities over ETFs – a fact certainly not lost on the executives of the nascent Kazakhgold/Polyus giant.

All this means that the global equity sell-off has affected the performance of gold stocks even though the companies’ top line, cost of capital, inflation pressures and currency movements have all conspired towards higher margins. Indeed, since gold stabilized after hitting the most recent all-time high in USD terms (June 18), North American gold stocks have slipped around 3%. At the same time, exploration stocks, as measured by GDXJ index, have tumbled 9.2% and returned a relatively paltry 8% over the quarter. Not surprisingly, most exploration-focused gold funds registered a loss.

It is hard to imagine that the monetary and fiscal authorities would stand idle if the global economy began to slide into deep deflation, a scenario which may not bode well for the gold market. Yet many of the gold stocks are now attracting multiples more akin to industrial sectors dependent on the robustness of global demand. The outcome is binary. Either they are becoming a dangerous value trap, or should be treated as a tremendous opportunity should the current deflationary scare ease.

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