Gold rallies as subprime King Paulson folds

Well, the news that many gold bugs were waiting for has been confirmed in the last 24 hrs. Yes, “Mr Subprime” John Paulson has partially folded his cards on his long gold bet. Of course, this coincided almost exactly with the explosive rally we have seen in the gold price – such is the way of the markets..!

“JP” has he is known, made $10 million a day during 2007, accumulating a total profit of a cool $4 billion. He is not a man used to (in recent times) making mistakes of the magnitude he has on gold in the last 2 years and, like many traders on the wrong side of a trade for a prolonged period of time, seemingly succumbed to the pressure in the end that gnaws away at you daily and so wound up reducing at the bottom.

Paolo Pellegrini

The masterstroke bet on CDS mortgage instruments in the US that Paulson & Paolo Pellegrini set in motion in 2006, yielded a 500% profit in 2007 alone and inflated the company’s assets to more than $30 billion over the subsequent years. In 2010 Pellegrini left the company (we will be profiling him in the magazine next month by the way as an “under the radar” hedge fund manager that doesn’t get the plaudits he deserves) and, it seems, this coincided with the “invincible” Mr Paulson accumulating a plethora of wrongly timed bets as neither the Euro collapsed nor inflation rose significantly – 2 themes his fund was set up to benefit from.

During the last few years Paulson has been betting that gold would rise significantly as the Federal Reserve continues to print money out of thin air. With trillions of dollars already spent and no hard assets to back it he, understandably, reasoned that the paper money expansion could only ultimately drive prices higher. And, he is likely to be right if “Helicopter” Ben Bernanke persists in monetising the us budget deficit (which is what he is doing) in the face of a growing economy. However, in the recent past, “official” inflation hasn’t risen materially in the U.S. and gold had retreated as much as 22.7% during the second quarter of the year alone. Paulson had no chance against this stat.

Paulson’s bet did and still does make sense hoever, probably more than ever now, as expansionary monetary policy usually leads to inflation. His thesis has fallen apart though due to what we would term “improper money creation” and something we have covered in previous blogs. So called “velocity of money” has in fact decreased substantially and, roughly speaking, banks aren’t actually creating money out of base money, that is they are not lending on in the usual magnitude their reserves. They prefer to hold this extra money as excess reserves deposited at the central bank rather than lend it to households and businesses. This means that the FED has so far failed at creating real money, and which explains the low inflation numbers. At the same time, with tapering in sight, consensus wisdom  is that inflation will remain subdued for a long time. Consequently, hedge funds have been now selling gold as the “premium” reason for holding it vanished. George Soros was, per usual, ahead of the pack and he closed his entire position in Q1 2013.

We took a look at the latest 13F fillings, and which report fund management activity amongst the major funds in the US, and we were actually surprised with Paulson’s movements. If any man had the pocket depth, hubris and self belief to ride this through, we thought it would be him, but it is clear that he gave up at the high stakes table and has actually reduced his gold holdings by 53% from 21.8 billion shares Gold SPDR shares. Paulson’s holdings now sits at $10.2 billion. For the first time in many months, the Gold SPDR is no longer Paulson’s largest holding with Sprint Nextel Corp taking the slot at the end at the end of Q2.

Paulson’s gold sale makes sense in terms of risk management, if a little late, as the position was too large relative to his capital base. Having the firm’s destiny depend upon a 20% single position was just madness.

Ironically, as we have been banging on about on this blog extensively for nearly 2 months now, now is, in our opinion, most certainly not the time to reduce gold positions. The latest World Gold Council report revealed a 53% increase in physical gold demand as consumers in China and India took the opportunity presented by a 22.7% drop in gold prices to fill their pockets with gold jewellery, bar and coins. Not only was this surge unusual for the time of the year, but it was actually also an all-time demand high measure in the case of China. As ever, the money has been transferred from the weak hands to the strong ones in this recent gold route. The only surprise is that Paulson was the “weak” one.

Meanwhile, in this precious metals rally in recent days, we have taken the opportunity to profit take on positions that are up 50, 60 and 70% in just 2-3 weeks in our Precious Metals fund and move into structured and less risky option plays to benefit from further upside. For more details on our funds, click the image below.

R Jennings, CFA. Titan Investment Partners