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Shocked That No One's Buying Gold?


...the gold complex reacts positively to the monetary "medicine", not the sickness.


Prof. Lewis,

What is your take on the recent trading in the metals versus the banks? I was somewhat taken aback on the recent selling off of the metals in lock-step with the sell-off in everything. I closed out my longs in Gold a couple of months ago because they were not acting right with the current scenario and instead just shorted the financials.

I'm frankly shocked that no one is buying Gold. Is this finally an opportunity of a lifetime to own the metals or will the fire sale from overleveraged hedge funds negate the reason to own gold? What am I missing?

Minyan Brian


First, keep in mind that many investors in the gold mining shares not only saw the housing bust coming but have been way out in front of anticipating not only its effects on the financial system and the economy, but more importantly, they've also anticipated how the Fed will respond to the housing bust and the credit crunch. Recall back on May 2, when "credit' wasn't even being talked about by most, I wrote here that:

The bottom line is that the Fed is trapped between the housing bust and rising inflation, and when put to the choice, the Fed will risk inflation, potentially accelerating (while hoping that it turns down) in order to try and save the economy from recession and the banking system from a further spread of credit rot emanating from the subprime (and now Alt-A) mortgage meltdown, which poses a very real systemic risk. Despite the Fed repeatedly talking a tough game about inflation, their actions have shown the exact opposite since this past summer, and when it comes to the Fed (like most things in life), actions speak louder than words. And those actions say quite clearly that the Fed doesn't give a hoot about the dollar or inflation, and anyone who thinks differently is likely in for a big surprise in my view.

And there have obviously been many more professors who have been much more prescient than myself in this department as well. I for one never imagined that it would take this long to get to this point, but here we finally are.

Fast forward to today, and the gold mining shares have been beat up even more than the S&Ps over the last few weeks (even though gold barely moved throughout the general liquidation that occurred). See the ratio of the SPX to GLD below. Note gold has outperformed the SPX since June.

Click here to enlarge.

Note gold has also outperformed the S&Ps since the peak in 2000 as well, as most of the S&P's gain since the 2002 low has merely been a function of inflation.

Click here to enlarge.

Even the HUI was resisting the decline in the S&Ps and diverging to the upside since late June up until the last couple weeks, which we can see in the HUI/SPX ratio below.

Click here to enlarge.

So, as you asked: Why the sudden panic in the miners of late? Basically, I think it's a combination of simple timing and the more bearish (towards equities) makeup of many gold mining investors.

First, gold stocks aren't "puts" on the stock market. They're options on future monetary inflation, which is the Fed's typical response to all financial and economic problems. In other words, the gold complex reacts positively to the monetary "medicine", not the sickness.

In the absence of monetary inflation, gold mining equities are just as vulnerable to margin calls and general illiquidity in the stock market (especially the small illiquid juniors) as other stocks. In fact, given gold mining's rather narrow following among investors, I'd argue that they can often be even more illiquid than the vast majority of the equity market during periods of panic.

One also has to remember that many gold mining investors understand the consequences of the housing and mortgage bubbles bursting and fear a collapse in equities, although on the other side of that, they know the Fed is going to be forced to inflate as a result of those consequences.

Thus, those investors want to be long gold equities. But one can't have it both ways when the margin calls and general "clearing of the sheets" begins. Gold bulls know gold stocks typically don't do well when the general equity tide goes out and everything is being tossed over the side. As a result, I think they simply panicked last week. In fact, it's rather ironic, but gold equity investors panicked even more than stock investors did last week.

Now, regarding timing, one never really knew for sure where gold mining equities would "be" when the Fed eventually stepped in and tossed aside its feigned "fight" against inflation (for example: the XAU could have been at a new high and merely pulled back as the equity market panicked, and then the Fed eased, and the golds would have made even higher highs, etc). In late 2000 for example, the gold shares began to rally over a month ahead of the Fed changing its risk assessment in late December of 2000 and then eventually cutting rates inter-meeting on Jan 3, 2001. I had been leaning more to the 2000-2001 scenario, but we obviously had a further wrinkle over the past three weeks.

It turned out that the Fed didn't say "Uncle" this time around until last Friday, when the Fed simultaneously changed its risk assessment for the economy and cut the discount rate (on an option expiration of all days), but it wasn't soon enough to prevent the gold shares from being tossed overboard with everything else, even though they had obviously resisted a decline up until the past few weeks. I think gold bulls just simply got nervous and couldn't take the pain anymore.

(Continued on Page 2)

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Positions in Gold shares, GLD

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