Friday, April 19, 2013

Paulson Sticking with Gold

I may not be reading into this enough, but Paulson likely sticking with gold.

John Paulson, the hedge-fund manager who’s lost money this year after a 16 percent decline in gold, told clients that purchases by central banks and demand in Asia will support the metal in the near term.

“Although inflation and inflation expectations remain subdued, which appears to have dampened the appetite for gold so far this year, we believe that ongoing central bank purchases and strong gold demand from China and India will help support the gold price in the near-term,” Paulson & Co. said in a letter to clients that was obtained by Bloomberg News.

Gold plunged 13 percent in two sessions through April 15, the biggest slump since 1980. Futures touched $1,321.50 on April 16, the lowest since January 2011, partly on concern that central banks in Europe will sell holdings to pay debt. Paulson, who became a billionaire in 2007 by betting against the U.S. subprime mortgage market, had about $9.5 billion of his own money invested across his hedge funds at the start of this year, of which 85 percent was in gold share classes.

“With ongoing, open-ended bond purchases, the Federal Reserve’s balance sheets continues to expand, and the Fed has now also confirmed that there is not going to be an unwinding of the stimulus through bond sales,” the hedge fund said in the letter. “This, in our view, increases the probability that money printing will eventually lead to inflation.”

All That Glitters- Does It (Gold) Even Matter Anymore.

In my mind, it is emphatically yes. I mentioned earlier in the week that the price of gold was not reflecting changes in the inflation expectations- discussed here. In this post, I showed the below chart showing the price of gold versus inflation expectations embedded in the TIPS and the treasury bonds.

What I mentioned was that despite the continued decline in gold since September/October last year, inflation expectations have largely remained flat, trading within a range.

Over the last few days however, TIPS investors appeared to have taken queues from the shellacking in gold prices, and have reduced the expectational spread embedded in the TIPS/treasury markets. See the chart below.

It is interesting to see this dynamic in gold and inflation expectations play out while some commentators state the fall in the price of gold heralds in an improvement in the economy. I have a hard time accepting the idea that the economy can improve without inflation sustaining itself, if not rising, considering the money/excess reserve creation over the last few years. Additionally, declining inflation rates would not be of concern if not for a host of factors suggesting somewhat elevated risks for slower economic growth. We even have Fed governors out in speeches discussing a threat of lower inflation rates and the need for more or continued monetary stimulus.

I think the next few weeks or months will be a volatile time for gold and gold/precious metal equities. That said, I am not selling my positions nor would I suggest anyone else do the same. We may still see lower prices, but continued monetary stimulus- if not an increase if the economy and/or inflation rates slide further- should be supportive of gold. The talk of an exit from monetary stimulus is just that talk. Further stimulus should help provide a floor under both inflation expectations and gold prices.

Turning to the models, all three are at or near unprecedented levels, at least over the last decade of results that I show. The following are the charts for the three models updated for recent data.

3-month model, -2.1

1-year model. -3.3

6-month model, 2.6

The present results in the timing models just do not have any comparable (at least by degree) at any point in the last decade. That said, we have seen two periods when we saw comparable relative results. These periods include the May 2004 decline in gold and the free-fall seen in 2008. In both periods, the models precipitously declined and either approached or declined below the all important -2 demarcation. Following these periods, the price of the Phily Gold/Silver index gained 158% following the 2004 period and 248% after the 2008 decline. Although the volatility is likely to remain high, I am keeping my gold/gold equity exposure.