Just what is behind the continuing disjoint between paper and physical gold prices?

The price of gold has been subject to a rapid and seemingly never ending decline in recent weeks, falling from a high of $1360.9 back on the 29th of October (Comex Feb 2014 futures) to print as low as $1210.80 by the 4th of December (see chart below). Given that there has been no significant change to the underlying fundamental case for gold, and that demand for the physical form from Asian markets continues unabated (in fact increasing materially as chart 2 below shows), we need to look elsewhere for sources of causation…

Daily gold chart from 28 Oct to current day

Chinese gold imports over last 2 years 2 months

Official “inflation” has not reared its head meaningfully in developed world economies (although here at Titan we believe the real inflation rates are much higher) and so this, at face value, seems to be a hindrance for gold bulls, who saw this as the most likely effect of the ultra-loose monetary policies that have been adopted by the world’s major central banks. Cheap money has, it would seem, somehow been segregated from the real economy and contained in the financial system/economy/banks’ debt reparations. At some point however this will spill over into the wider economy and in fact the signs are already legion – property price increases in major cities in the US and the South East of the UK, the shenanigans with Bitcoin, high end art, certain food prices etc. We are in the nascent stages of significant inflation re-emerging in our opinion, and on a global basis.

Thinking laterally about other causes of the depression in the price of gold, we are reminded of what has happened to the VIX index (once seen as the definitive barometer of greed and fear) and in particular its crushing over the last 3 years, since the Flash Crash. Our assertion is that the sensitivity of the VIX has been masked, or if you prefer, obscured by the number of instruments/ETFS/ETC that have sprung up to track, replicate or even replace the Volatility Index. The question we ask ourselves is are we seeing a similar thing happening in gold?

According to the “Market Oracle” blog, the total annual value of gold traded on the COMEX and the London Bullion Market is some $20 trillion (that’s right, trillion!) or put another way, $33 billion per day on the LBMA and $29 billion on COMEX for the last full year stats of 2012. Market Oracle also provides statistics for the physical production of Gold in 2012, which they calculate to be some 2659 tonnes, which they estimate to have been worth, in contrast, $107.041 billion using a price of $1252.10 per ounce. We can see thus that the total value of gold traded is almost 200 times that which is actually produced out of the ground.

But that is not all, these figures for gold also do not explicitly take into account the effect of OTC traded gold certificates or promissory notes, nor that of ETFs that track the yellow metal – a good proportion of which may themselves be leveraged. In effect, the price of gold, which was meant to be among the purest of inflation hedges, has itself been debased by an orgy of paper & leveraged speculative trading.

As with any form of leveraged trading, as prices move sharply in either direction, loose holders (be they long or short) are forced out, stops are triggered and so create more directional flow, which in turn drives the price lower in a potential self-reinforcing spiral. It appeared that we had seen some short covering on Tuesday and Wednesday this week with a move back to $1250, but Thursday’s trade has seen a retreat once more back towards $1220.

There is, for the bulls, the potential for a hammer formation to be confirmed on the one year weekly chart under which the market is said to be beating out a base. But, that will not be confirmed until the close of play today, and, of course, we have the market moving November non-farm payrolls due shortly. Watch the $1255/60 level closely. With the all-pervading negative sentiment and despondency among gold bulls, now is a classic time for a rally to be set in motion, particularly considering that this time of year is seasonally a strong one and, as we can see from the long weekly chart, we are now actually sat right on the trend line from the bull market inception in 2005

Weekly chart from 2005

Conversely, a close below $1217 on the week implies a move back towards the old lows seen in July of this year of around $1180/oz. Given that these levels are below a round number ($1200) where human nature often places stops, given the above observations it seem inevitable that they will be tested if we breach $1200.

Take a look at the two charts below. The first displays the most recent full reported (end Nov) Managed Money short position. We can see that we are touching 5 year extremes again and are back to the level that sparked the near 20% rally during July and August.

The second chart is extremely interesting. It shows producers (ie miners), for the first time in many, many years, actually going net long futures (remember they are almost all the time net sellers in heding their actual production). Something is up that’s for sure and it will not take much to put a squeeze on the actual physical product. Inevitable the paper will have to follow and as it is being stretched to the downside, the stretch to the upside could be eye popping!