Tuesday 27 September 2011

Stay the Course

Lots of Physical Buying while Paper Sells Off

If you have wealth to protect this article could be worth reading.

Financial Sense

We are witnessing significant financial crises unfold around the globe as the culmination of decades of financial mismanagement, miss-allocation of capital, over-indebtedness and the ultimate demise of fiat currencies begins their final reckoning. As events rapidly transpire, markets suffer huge volatility caused by confusion and questions about what is now happening and what is likely to happen in the near future. 

While the road forward can take many turns, it should be clear that this final episode could spell the end of fiat currencies after a massive purging of global debt. Here we will try to distill a complex system of cause and effect and outline some potential paths. Ultimately, our quest is to understand the forces affecting both gold and silver, which we believe to be the ultimate currencies. To do that we need to look at what is happening with paper currencies around the world. This is our simplistic view, for what it's worth. More importantly, we believe it is critical to watch fervently as events shake out in the coming days, weeks and months to gain clues as to where we are actually headed.

Short-Term Liquidity vs. Balance Sheet Problems:

The short-term liquidity issues that caused problems with large U.S. financial institutions in 2008 are now plaguing banks and insurance companies across the Euro Zone. The U.S. Federal Reserve's response, as you may well know, was massive liquidity injections into the economy in the form of TARP, TALF, QE1, QE2, cash for clunkers, etc. and now "Operation Twist." Because we have a printing press the Fed was able to "accomplish" their mission of recapitalizing the banks in the U.S, although these banks still have to deal with their own balance sheet issues which include declining real estate values. The individual European countries gave up their respective own printing presses when they joined the Euro, so now, faced with the same short-term liquidity problems, they must turn to the EU to bail them out.

The EU did just that last week in a massive coordinated effort with our Federal Reserve, the Swiss National Bank, the Bank of England and the Bank of Japan. All pledged to supply unlimited U.S. dollars to European banks in need of short-term funding through the end of this year (see our piece on the details here). That effort helped calm short-term fears of bank illiquidity, but it did not solve the real problem of insolvency. Insolvency is a  balance sheet issue brought about by owning too much questionable sovereign debt (Greece, Portugal, Ireland, Italy) that cannot currently be repaid at anywhere near face value. Clearly, while there is a short-term liquidity issue (losing deposits through slow motion bank runs) in European banks, their balance sheet issues must also be addressed to restore health to the financial sector. Because valuable time was frittered away without a credible, cohesive "solution," the issue now is whether the markets will give the central banks and finance ministers enough time to recapitalize their banking systems and address their debt issues before equity markets revolt in a global meltdown.

One thing we want to be clear about it is that the solution to excessive debt is not more debt. It may provide time to work toward a solution, but in and of itself money printing is not a solution. A reckoning of the debt will happen. Eventually, a sound money system must be implemented. A healthy economy depends on a credible currency to grow and prosper. Ultimately the same holds true for the equity markets.

Effect on Gold & Silver:

This brings us to gold and silver. The run up in both metals, starting with silver in the spring and gold in the summer, hinted that fiat currencies were at risk and confidence in central bankers was declining rapidly (and with good reason). Silver's short-term overbought condition (late spring) and fear of a waning industrial demand due to slowing economic growth (recently) caused it to decline rapidly. Gold's descent this past week (and silver's too) was triggered by a fear of a less accommodative Fed and a potential meltdown in which everything is sold to raise cash. Both base commodities and equities have erased their gains for the calendar year to date, and anyone invested in them (individuals, pension funds, hedge funds etc.) is now experiencing losses. As deleveraging occurred in equities and commodities this past week, the need to raise cash to cover margin calls began. Gold, which is still positive for the year, became a source of funds while still booking a net gain for the calendar year.

While deleveraging in equity and commodity markets can continue and thus put more pressure on precious metals in the coming weeks and even months, the fundamental reason for owning them has actually become stronger, more pronounced and more critical. We believe a lot of the downside has already been experienced even though gold and silver could go lower in the wake of a worldwide equity meltdown (we are not predicting this, just pointing out the possibility).

What we want to be clear about is this: while the paper selling in gold and silver has been intense, so too has the physical buying. Lisa Sprott of Sprott Money announced Friday: "We have completely run out of physical silver, so we are temporarily out of stock." At KDPM, all of our premiums on silver coins were raised Friday because the market is so tight (in short supply). We have access to silver, but demand is once again overwhelming supply in the short-term. We expect premiums to go up again on silver and gold due to intense buying and lower supplies.

Where Do We Go From Here?

The most important thing we can do is stay alert to what is actually happening, that way we can revise our short term thinking to match reality. Our long-term belief, as we tried to portray above, has not changed and has even grown stronger: we are eventually headed to a gold and/or silver standard, and if not, these metals will be the best means of preserving one's wealth during chaotic times.

At this point here is what things looks like: the short-term deleveraging could continue, possibly precipitated by the recognition that Greece and possibly Portugal or Ireland have essentially defaulted. Or perhaps European banks lose deposits faster than they can effectively be re-liquified, causing a failure of one or more banks in Italy, France or elsewhere in Europe. That could cause gold to test its 200-day moving average (roughly $1525). Silver has already broken down below its 200 day moving average and could see one final swoon. At this point, it looks like this sharp decline in both metals could be short-lived due to the anticipated policy makers response of more money printing. Again, we are not predicting this to be the sequence of events, just trying to sort out some possibilities.

If the equity markets meltdown and thereby force their hand, the central bankers' response to this crisis will be as it was before - to print more and more paper currencies.  We have no reason to believe they will alter that path now, when faced with what is arguably the largest financial crisis in our history. Talk is cheap but behavior never lies. What central bankers have failed to realize is that they are the problem. Their interference in the free markets has caused unsustainable imbalances which must eventually be righted.

If a global central bank coordinated re-liquifying (money printing) effort materializes, the metals should eventually stabilize and continue their decade long bull run. While this decline may test your stomach, try not to let the volatility test your resolve. It is the health of the financial sector, not the stability of gold and silver, that is in question.

Please remember this:


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