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Early Warning Signs
by Professor von Braun
December 3rd, 1999
The rapid rise in the gold price to $340 was exactly that, a rapid rise, followed by a decline and another decline. The pricing of gold stocks has mirrored both the rapid rise and the decline as well. No surprise there. What is surprising is that people are still bullish on the outlook for gold and gold stocks. Which is fine. But until the participants in the paper gold market get a serious kick in the seat of their respective pants, the pricing of gold will not reflect fundamentals.
This is unfortunate. But we live in the age of derivatives and derivatives are nothing other than paper contracts that are derived from the existence of something else, in this case the trading of physical metal.
This paper market will implode at some time and in a sense, already is out of control. The main players have not yet realized that. But eventually they will. Until that happens most bullish gold supporters will continue to get squeezed. Regardless of whether the price goes up or down that pricing is dictated by writers of paper, not supply and demand.
Mining company's income used to be derived from the sale of gold. Nowadays a large portion is derived from the sale of derivatives, of paper contracts written on gold produced, gold reserves and in some cases, on contracts already written up.
This too will end at some stage in the not too distant future. But it has not ended yet. Which is why we stated some time ago that not all gold stocks are created equal. In another article (written as gold started to retreat from $340) we said that it was way too early to get bullish on gold, that the rally would be short lived (which it was) and that the market was still under the control of the writers of paper contracts (which it is).
The Y2K build up, touted as the answer to gold's "problem" may have caused a shortage in gold coins, (wait till January and lets see how many come back on the market), but it did not impact the price. One newsletter writer that I spoke to still insists that gold will be at $400 by the end of this month. Wouldn't that be nice? Just don't bank on it.
There is no doubt that a long-term strategy of purchasing physical metal at $280 or under is a sensible thing to do. It is widely (within a narrow field) believed that a squeeze will happen (a long lasting one) and we have no argument with this. The question is when.
The answer is not until somebody collects the pens that are being used to write the contracts. When the bottom line is seriously impacted, as opposed to impaired, somebody will come looking for the writers of these paper contracts and will remove their ability to write contracts.
This will be caused by the realization that the contracts cannot be honored, which will most likely be preceded by a delivery problem or perhaps margin calls. Or both.
We have seen some evidence of this recently, but so far the band-aids appear to be working and it is entirely possible that they will last through to early January. It is unlikely that the powers that be would allow upsets in the gold market to occur during the run up to January 1, 2000.
When an upset does occur it will affect most, if not all of the players, including mining companies that are participants in the paper gold game. Shareholders need to be aware of this and stay alert to the potential impact on their investments. Perhaps the question should be "is this an acceptable risk?" Certainly there are some shareholders that are more than happy to sell in to any rally.
The often referenced connection between the gold price and gold stocks also needs to be reevaluated as the paper gold market participants include many of the mining company's as well. The term muddied-waters comes to mind.
The Prof can be contacted by email at email@example.com
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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