Gold

Absurd attempts by the Indian government to curb gold demand

Gold in India has recently traded at unusually high premiums to the international "spot" price. This is mainly due to attempts by India's government and central bank to restrict the supply of gold and to make gold less attractive by artificially raising its price. For example, as noted in an article posted at Mineweb.com last Friday: "...the Reserve Bank of India has advised banks not to sell gold coins to retail customers. This is the third day in quick succession this week that both the apex bank and the Indian government have initiated curbs on gold. While the import duty was hiked to 8% just yesterday*, the apex bank has also imposed restrictions on banks and non banking financial institutions for providing loans against gold coins as well as units of gold ETFs and gold sales by private agencies."

Leaving little doubt regarding the increasingly anti-gold stance of Indian officialdom, India's Finance Minister P Chidambaram recently said: "I hope a day will come when we regard gold as any other metal, it just shines a little more than copper or bronze."

India's government and central bank haven't decided to wage a war against gold ownership for philosophical reasons or to bring about real improvement in the economy. What we have here is just another in a very long line of examples of government trying to manipulate prices to conceal a problem. In this case, the government of India perceives the current account deficit as a problem. The current account deficit is largely an effect of rapid monetary inflation (India's money supply expanded by 16.4% in 2010, 17% in 2011 and 13.8% in 2012), but rather than tackle the inflation problem in the only way that counts (by stopping or substantially slowing the growth in the money supply) the government is trying to stop people from buying gold. The thinking is that most of the gold bought each year by the residents of India is imported and thus adds to the current account deficit.

The Indian government's attempts to curtail gold demand in order to address an inflation problem make almost as much sense and have the same chance of working as the plan hatched by the US government during the 1970s to tackle the inflation problem of the time by handing out "Whip Inflation Now" buttons. India's inflation problem WILL (no ifs, buts or maybes) worsen if the money supply continues to grow rapidly, thus boosting the Indian public's desire to own gold. If India's government makes it too costly or difficult to obtain gold via legal methods, then more people will obtain gold via the black (that is, free) market.

    *Last week's hike in the gold import duty was from 6% to 8%, but at the beginning of last year the duty was only 2%. India's gold import duty has therefore quadrupled within the space of 18 months.

Current Market Situation

The gold market continues to consolidate. As shown on the following daily chart, there is some trend-line support near this week's intra-day lows. Note, though, that trend-line support/resistance is always somewhat arbitrary and less reliable than lateral support/resistance defined by previous turning points. As also shown on the following chart, lateral support lies at $1350.



Our view remains that the gold market bottomed in April and successfully tested its low in May, but the recent price action hasn't done anything to substantiate this view. As a minimum, for substantiation we would now need to see a daily close above the early-June high ($1423.30).

The most bullish short-term factor is the upside potential created by the extreme negativity in the market. It seems that even the long-term gold bulls are now resigned to additional short-term weakness. The most bearish short-term factor is gold's inability to rally in response to the recent weakness in both the US$ and the stock market.

In the coming Weekly Update we plan to discuss "tapering" (as related to "QE") and explain why the eventual/inevitable QE tapering is not something that gold bulls should be concerned about.

The Stock Market

Brazil

When an economy is a major producer/exporter of commodities, a commodity bull market combined with rapid monetary inflation can make the economy look strong even if it is structurally unsound. In this case the underlying weaknesses will usually be revealed after the commodity bull market ends or there is a substantial slowdown in the rate of monetary inflation.
 
Brazil's economic weaknesses started to become apparent after the commodity world entered a cyclical decline in early-2011. These weaknesses include grossly inadequate transportation infrastructure, government regulations that make it difficult to start and operate a business, restrictions and high taxes on imports, and an obvious "price inflation" problem. From the perspective of most international stock-market investors, the "price inflation" problem is likely the most important issue.

Brazil's increasingly obvious economic problems and the cyclical decline in commodity prices have turned the country's stock market from a relative-strength leader to a relative-strength laggard. Of particular note, while the S&P500 Index and the Dow Jones World Index are close to 3-year highs, the following chart shows that Brazil iShares (EWZ) is close to a 3-year low.



In EWZ's favour, it is 'oversold' and within 3% of intermediate-term support. This could mean that a rebound will soon begin. However, as is the case with the Australian Dollar (A$) it is beginning to look like EWZ is in the process of completing a major topping pattern and that a short-term rebound could be followed by a decline to much lower levels. Here's a chart that shows the similar longer-term chart patterns being traced out by Brazil's stock market and the A$.



Japan

We took advantage of additional weakness in DXJ (the Wisdom Tree Japan Hedged Equity Fund) last Thursday to take profits on the balance of our DXJ put options. This means that for now we don't have any direct bets against the Japanese stock market, although we effectively have an indirect bet via a small long position in the Yen. The overall decline probably isn't over, but enough is enough. A 22% peak-to-trough decline over the space of about 2 weeks is enough.



As mentioned in a previous TSI commentary, an interesting aspect of the recent action in Japan's financial markets is that it indicates a possible change in the long-time relationship between stocks and government bonds. First, the primary catalyst for the stock market's sharp decline appears to have been a sharp rise in Japanese Government Bond (JGB) yields. Second, unlike what has usually happened during previous sharp stock market declines, the recent stock market decline didn't lead to significantly lower JGB yields. As evidence we present the following chart of the 10-year JGB yield. This chart makes the point that while Japan's stock market was tanking the JGB yield consolidated near its 12-month high.



The interplay between Japanese stocks and government bonds bears watching closely. Confirmation that rising interest rates are now a cause of stock market weakness rather than an effect of stock market strength will signify that Japan's latest inflation experiment has already failed.

Gold stocks that are breaking out to the upside

In the 27th May Weekly Update we highlighted some gold stocks that had shown relative strength by holding above their April lows during May. Today we are going to highlight some gold stocks that are breaking out to the upside from basing patterns. Not surprisingly, some of the stocks that were showing relative strength by not breaking below their April lows have been among the first stocks to break out to the upside.

Here are the relevant charts:

a) Almaden Minerals (AAU). By achieving consecutive daily closes above its 50-day MA and resistance at US$1.80, our favourite "prospect generator" has done enough to confirm that an important bottom is in place.



b) Kinross Gold (KGC). By achieving consecutive daily closes above its 50-day MA and resistance at US$6.00, KGC has done enough to confirm that an important bottom is in place. As noted last week, the break above US$6.00 creates a short-term chart-based target of $7.50.



c) Midway Gold (MDW). By achieving consecutive daily closes above its 50-day MA and resistance at US$1.03, MDW has done enough to confirm that an important bottom is in place. We have indirect exposure to MDW via AMB.TO, but direct exposure could be appropriate.



d) Pretium Resources (PVG). The break above US$8.00 completed a multi-month bottoming pattern. There is some resistance at US$9.00, but the next resistance of significance lies at US$11.00. PVG's Brucejack project is possibly the best undeveloped gold project in North America.



e) Sulliden Exploration (SUE.TO). Impressively, this exploration-stage gold miner with a project in Peru is now trading above its 200-day MA and near its high for the year, although it is still trading more than 50% below its high of the past two years. The relatively strong performance has undoubtedly been partly due to Agnico Eagle's April-2013 investment in the company.

We successfully traded SUE a few years ago, but currently have no interest. The company is well-financed and its gold project appears to be economically robust, but the valuation is comparatively high.

Gold demand and "paper" versus physical

When you read breathless commentary to the effect that the demand for physical gold is rocketing upward even as the gold price declines, remember:

1. Physical demand cannot be satisfied by paper supply.

2. Everyone making the claim that the demand for physical gold is surging relative to the supply of physical gold is fixating on one small part of the physical gold market.

3. At any given time, the total demand for physical gold equals the total aboveground supply of gold. This is basic economics. It has always been the case and will always be the case.

4. The gold demand numbers and charts that are often contained in articles and analyses, including the numbers/charts published by Gold Fields Mineral Services (GFMS) and the World Gold Council (WGC), represent flows of gold from one part of the market to another. These numbers/charts say nothing about overall demand and nothing about price. For example, the Zero Hedge article posted HERE includes a "gold demand" chart that actually provides no useful information about gold demand, as well as some hopelessly flawed "gold demand" analysis from the WGC.

5. If there really were widespread difficulty obtaining sufficient physical gold to satisfy demand it would be evident in the term structure of the gold futures market (there would be substantial and sustained "backwardation" in the futures market).

At no time over the past month has there been any market-wide inability of physical gold sellers to meet the demand of physical gold buyers; there has only been a temporary inability of sellers in one part of the market to meet the demand for certain items manufactured from gold (the coins and small bars favoured by the retail investor). Moreover, it's very unlikely that there will ever be a bona fide shortage of physical gold. This is because the mining industry's contribution to total supply is so small as to be almost irrelevant (gold mines shutting down wouldn't have a big effect on overall supply) and because most of the world's gold is held as a store of value. It should therefore always be possible for a change in price to bring the total demand for physical gold into line with the aboveground supply of gold.

Now, we admit that at some point in the distant future the US dollar could become so devalued and disliked that the existing holders of physical gold won't sell for any amount of dollars. But in that situation it wouldn't be possible to use dollars to buy anything of value. In other words, in that case the problem would be an inability to use dollars to buy any useful resource, asset, good or service, not just gold. However, it will always be possible to use something of value to buy physical gold.

We are effectively saying that the real price of gold is what gold can be exchanged for. The gold price could eventually become infinite in US$ terms due to the US$ becoming worthless, but the real price of gold will never become infinite. If it did then someone with a single ounce of gold could buy everything in the world.

The real price of gold is likely to remain in a long-term upward trend while the current monetary system remains in place, but it will probably never be more than about three-times its present level. The reason is that the real price of gold must bear some relationship to the real prices of everything else that people want to own/consume.

In the US, the "Goldilocks" economy has apparently returned. The economy is not too hot and not too cold. It is just right! According to the currently popular line of thinking, the Fed is pumping enough new money into the system to enable investors in equities and high-yield bonds to have a good time, but not enough to cause an inflation problem. This creates a bearish backdrop for gold, although at this stage it looks more like gold is about to complete a test of its April low than make a sustained break to new lows.



It is often the case that a successful test of an important price low will be accompanied by greater negativity than occurred at the price low. This is the case right now in the gold market, although we obviously don't yet know that gold's test of its April low will be successful.

Evidence that there is greater negativity in the gold market now than there was when the price was bottoming in mid-April is contained in the COT data (there has been substantial shrinkage in the speculative net-long position since mid-April) and the GLD holdings data (the amount of gold held by GLD has fallen by 3.6M ounces since mid-April). It is also contained in the CEF/gold ratio, which was discussed in last week's Interim Update and is mentioned again below.

The following chart shows that there has been a sizeable decline in CEF/gold since mid-April, indicating that precious metals sentiment is now more pessimistic than it was at the April price low. The only time over the past 20 years that CEF/gold was lower than it is today was during 2000-2001 -- near the beginning of gold's long-term bull market.

More details on the US money creation process

Here is the next -- and hopefully final, for a while -- instalment in our on-going effort to clarify how the Fed's QE boosts the money supply.

One of the most important points to understand is that for every dollar of asset monetisation carried out by the Fed, one dollar gets added to bank reserves (NOT counted in the money supply) AND one dollar gets added to commercial bank deposits (part of the money supply). Another way of saying this is that the Fed's QE increases the economy's money supply dollar for dollar, with each new dollar being 100% backed by reserves.

Delving deeper into the mechanics of the process, what happens is that the Fed conducts its asset purchases via Primary Dealers, the current list of which is found at http://www.newyorkfed.org/markets/pridealers_current.html. Details of how the Fed interacts with Primary Dealers to expand the money supply are contained under the heading "Bank Deposits - How They Expand or Contract" on page 6 of the Federal Reserve document archived HERE*. For ease of reference, here is a relevant excerpt from this document:

"One way the central bank can initiate...an expansion [of the money supply] is through purchases of securities in the open market. Payment for the securities adds to bank reserves. Such purchases (and sales) are called "open market operations." How do open market purchases add to bank reserves and deposits? Suppose the Federal Reserve System, through its trading desk at the Federal Reserve Bank of New York, buys $10,000 of Treasury bills from a dealer in U. S. government securities. In today's world of computerized financial transactions, the Federal Reserve Bank pays for the securities with an "electronic" check drawn on itself. Via its "Fedwire" transfer network, the Federal Reserve notifies the dealer's designated bank (Bank A) that payment for the securities should be credited to (deposited in) the dealer's account at Bank A. At the same time, Bank A's reserve account at the Federal Reserve is credited for the amount of the securities purchase. The Federal Reserve System has added $10,000 of securities to its assets, which it has paid for, in effect, by creating a liability on itself in the form of bank reserve balances. These reserves on Bank A's books are matched by $10,000 of the dealer's deposits that did not exist before."

And:

"If the dealer immediately writes checks for $10,000 and all of them are deposited in other banks, Bank A loses both deposits and reserves and shows no net change as a result of the System's open market purchase. However, other banks have received them. Most likely, a part of the initial deposit will remain with Bank A, and a part will be shifted to other banks as the dealer's checks clear. It does not really matter where this money is at any given time. The important fact is that these deposits do not disappear. They are in some deposit accounts at all times. All banks together have $10,000 of deposits and reserves that they did not have before." [Emphasis added]

The above-referenced Fed document appears to have been prepared in 1992 and in some respects is out of date. In particular, it doesn't incorporate the regulatory changes of the early-1990s that, via a process called "sweeping", effectively make the traditional "money multiplier" irrelevant by enabling any amount of reserves to support any amount of deposits. However, the description of how the Fed's asset monetisation expands the amount of money within the economy (not just the amount of money held in reserve) is still accurate.

Now, the effect on the economy of the Fed's asset monetisation will depend on what the Primary Dealers do with the new money credited to their bank deposits. They aren't going to leave the money in uninsured deposits earning roughly 0% interest. They are going to invest the money somehow. Some of the new money will likely be directed towards the purchase of bills, notes and bonds from the US Treasury, thus making the federal government one of the first receivers of the new money. The government will then spend the money on whatever the government spends money on (defense contractors, salaries of government workers, welfare payments, etc.). Some of the new money could also be invested in equities and corporate bonds, in which case the sellers of these equities and corporate bonds will end up being among the first receivers of the new money. They will then use the money to buy something else, and so on.

Some of the effects on the US economy of the large money-supply increase brought about by the Fed** are readily apparent. For example, the new nominal all-time high for the stock market is an obvious effect. In general terms, however, the most obvious effect has been to maintain the long-term downward trend in the US dollar's purchasing power. Following the bursting of the real estate and mortgage-financing bubbles in 2006-2007, the US economy should have experienced a great deflation. That the great inflation has continued with only a 1-year interruption is due to the Fed-engineered increase in the money supply.

    *Thanks to Mike Pollaro for the link to the Fed document.
    **The US money supply increased by about $3.7T from the start of the Fed's first QE program in September of 2008 through to March of 2013. About two-thirds of this money-supply increase was directly due to QE.

Gold and the Real Interest Rate

A real interest rate of less than zero indicates that the central bank is punishing anyone who attempts to save in terms of the official money. This is bullish for gold, because savers faced with inevitable purchasing-power losses on their cash holdings will be encouraged to seek an alternative means of saving, and gold is often considered to be a good alternative. As far as we can tell, the real interest rate remains well below zero in the US.

In the above sentence we say "as far as we can tell", because the real interest rate can't be accurately quantified. Even if it were technically possible to determine a single number that reflected the change in the purchasing power of money (it isn't) and even if the CPI were this number, it wouldn't make sense to calculate the real interest rate by subtracting the preceding period's change in the CPI from the current nominal interest rate (which is how most people mistakenly do the calculation). The reason is that what matters to investors and savers today is how the purchasing power of money will change in the future, not how it changed in the past. Therefore, the real interest rate is correctly defined as the nominal interest rate minus the EXPECTED rate of purchasing power loss. There are ways to roughly assess the markets' expectations, but anyone who thinks they know the average amount of currency depreciation expected by millions of market participants is kidding themselves.

The yield difference between the 10-year T-Note and the 10-year TIPS is a simple and reasonable way to roughly assess the expected rate of US$ depreciation. It is appropriate to view this yield difference as the MINIMUM amount of US$ depreciation expected by market participants over the next few years, because almost everyone knows that the official "inflation" statistics understate the true rate of "price inflation" (the official "inflation" stats determine the TIPS payout).

The following chart shows that the aforementioned yield difference dropped from about 2.6% to about 2.3% over the past few weeks, pointing to a small -- although not insignificant -- decline in "inflation expectations".


                                          Chart Source: www.fullermoney.com

Given that the Fed Funds Rate (FFR) has been pegged at around zero for the past several years, putting a minus sign in front of the yield difference charted above effectively gives you the real FFR. The chart therefore tells us that the maximum* real FFR has ranged from -1.5% to -2.7% over the past four years and is presently about -2.3%, having risen from about -2.6% a few weeks ago.

It isn't realistic to claim that a small rise in the real interest rate from one number that's well below zero to another number that's still well below zero will create a bearish environment for gold. The relationship between the gold price and the real interest rate just doesn't operate that way. The upshot, then, is that the recent sharp decline in the US$ gold price has nothing to do with a change in the real interest rate.

The real interest rate remains unequivocally gold-bullish. This is one good reason to believe that the gold bull market has a long way to go.

    *Since we are calculating the real interest rate using a quantity that reflects the minimum amount of expected currency depreciation, the result of our calculation is essentially the maximum real interest rate. In other words, the actual real interest rate is probably lower than our calculated value.

Gold Stocks

The small up-moves in the gold-stock indices on Thursday and Friday of last week unfortunately did nothing to indicate that a bottom is in place. With the HUI's weekly RSI having dropped to an extraordinary 16 (refer to the following weekly chart for details), a momentum low is almost certainly in place. However, until there is a large weekly rise there will be significant risk of a decline to new lows. As noted above and also in last week's Interim Update, it looks like we are going to get another May turning point in the gold sector.



The note on the above weekly chart points out that the HUI's peak-to-trough decline has reached 60%, which is shocking but not unprecedented. To show that it is not unprecedented and to put the recent price action into perspective, we present, below, a long-term weekly chart of the Barrons Gold Mining Index (BGMI).

The green numbers on the BGMI chart indicate previous >60% declines that occurred during long-term gold-stock bull markets. There was a 61% decline from the 1968 peak to the 1970 trough, a 68% decline from the 1974 peak to the 1976 trough, and a 70% decline during 2008.



We are not making light of the recent price collapse; we are simply showing that this type of price action happens within long-term gold-stock bull markets. The price action is not proof that the bull market is over.

The Bank of Japan (BOJ) ups the ante

There was a lot of action in the world's two largest and most important government bond markets last week. First and foremost, there was extreme volatility in the Japanese Government Bond (JGB) market in reaction to the BOJ's new plan to rescue the economy.

The BOJ's 'brilliant' new plan to boost the economy is the same as the old plan, only much bigger. It's the standard Keynesian modus operandi: If the patient refuses to recover in response to a dose of medicine, increase the dose. Never consider the possibility that the wrong medicine is being used. Whereas the BOJ's old plan involved monetising assets (mostly JGBs) at the rate of 4 trillion Yen per month, the new plan ramps the monthly rate of asset monetisation up to about 7T Yen (the equivalent of about $74B). A goal of the new plan is a massive increase in the monetary base -- from 138T Yen at the end of last year to 200T Yen by the end of this year and 270T Yen by the end of 2014.

Although it was widely expected that the BOJ would step-up the pace of its JGB monetisation in an attempt to depreciate the Yen, Japan's central bank still managed to exceed expectations. This is evidenced by the market reaction to the news. For example, after the new plan was announced last Thursday the yield on the 10-year JGB immediately plunged from its already ultra-depressed level of 0.56%. It hit a new all-time low of 0.32% on Friday and then suddenly reversed course and rose to 0.65%, as the market first tried to discount the BOJ's additional JGB demand and later tried to discount the inflationary effects of the BOJ's monetisation. The 10-year yield then settled back to end the week at 0.53%. All of these yield changes are tiny in absolute terms, but are huge in relative percentage terms (Friday's intra-day rise from a low of 0.32% to a high of 0.65% constitutes a swing of more than 100%).

Almost anything could happen to the JGB market over the days/weeks immediately ahead. One possibility is that the BOJ's 'cunning plan' will quickly backfire in a big way, with the JGB market crashing due to bond investors rapidly coming to the conclusion that the Yen depreciation strategy will be a resounding success. If the market crashes and bond yields rocket upward, how will the BOJ respond? Will the BOJ chief come out and say that it was all a big joke?

It's not really a disappointment that the new chief of the BOJ could believe that creating a huge amount of money out of nothing will help the Japanese economy. The unfortunate truth is that nowadays it isn't possible to get to the top of the central banking world unless you are a bad economist, because to get to the top of the central banking world you must be an advocate of economically-destructive policies. It is, however, disappointing that so few economists, financial journalists and other pundits call the central bankers out. Instead of general outrage, the reaction to the new BOJ plan to rescue the Japanese economy varied from "Excellent! Japan is finally on the right path!" to "It's a bold move, but there's a chance it won't work."

What we are dealing with here can be likened to a doctor who has a very sick patient. Instead of relying on modern medical knowledge to diagnose and treat the patient, the doctor scatters chicken bones and entrails around the patient's bed with the aim of driving away evil spirits. On hearing about what this doctor is doing, the typical reaction of other doctors and medical experts around the country is: "It's a bold move, but there's a chance it won't work".

The BOJ has come up with a completely harebrained scheme. There's zero chance it will work, provided that the goal of the scheme is a stronger Japanese economy. And even if the only goal is to reduce the purchasing power of the Yen, it might not work. This is due to the difference between the mechanics of the BOJ's QE and the mechanics of the Fed's QE. To be more specific, for every dollar of assets monetised by the Fed under its QE programs, one dollar gets added to bank reserves (not counted as part of the money supply) and one dollar gets added to demand deposits within the economy (counted in the money supply). Therefore, regardless of what the commercial banks do with their additional reserves, the Fed's QE boosts the supply of US dollars within the economy. (As an aside, this is why arguments along the lines of "the Fed can't depreciate the dollar if the private banks don't lend" are fallacious. The Fed can, and routinely does, inject money directly into the US economy.) However, when the BOJ monetises assets it generally boosts bank reserves to a far greater extent than it boosts the money supply. That is, the BOJ appears to rely heavily on increased lending by private Japanese banks to transmit its inflationary actions into the economy. This means that despite the massive scale of the BOJ's new asset monetisation program, the program won't depreciate the Yen unless it prompts Japanese commercial banks to make more loans.

Something worth considering is that the primary goal of the BOJ's new scheme might not be a stronger economy or a weaker Yen. The primary goal might, instead, be to provide the government with a politically feasible means of defaulting on a substantial chunk of its debt. The unstated strategy could be: transfer a lot of JGBs to the BOJ and then cancel the JGBs, thus inflicting a huge accounting loss on the BOJ. In this way the costs of a government debt default could be surreptitiously spread throughout the economy via a reduction in the Yen's purchasing power.

The BOJ makes the T-Bond look safe

The BOJ's antics and weaker-than-expected US economic data enabled US T-Bond futures to break above significant resistance late last week. The following daily chart illustrates the situation.



The T-Bond's intermediate-term downward correction might have ended early last month, but at this stage we don't expect it to do any better than test last year's high.

How bad could it get? And one simple way to deal with uncertainty.

Rick Rule, a very successful investor in natural resource companies, recently gave interviews in which he opined that the market for junior mining stocks will get much worse before it starts to get better. Click HERE to check out one of these interviews. The part about the market for junior mining stocks begins at around the 5-minute mark and continues to around the 9-minute mark.

Mr. Rule's view, in a nutshell, is that the large percentage losses suffered by most junior mining stocks to date have occurred via a fairly gradual whittling-down process, but in his experience this type of bear market doesn't usually end until there is a cataclysmic sell-off -- a spectacular market-clearing event that eliminates everyone who has been desperately holding on. He is talking about a situation where stocks that have been sold down from, say, $1.00 to 20c over a period of 1-2 years suddenly, in the space of a couple of days, collapse to around 7c. The stage is then, and only then, set for an epic bull market, not only because every last weak-handed and/or under-capitalised and/or inexperienced holder has been chased out of the market, but also because only the companies with the best assets and balance sheets are left standing.

We disagree that there needs to be a more spectacular sell-off to end the cyclical bear market. Some individual stocks will go on to make new lows over the months ahead, but we suspect that on a sector-wide basis, including the junior end of the sector, it just got as bad as it is going to get. Our reasoning is that by most measures the market is already as depressed as it was following the spectacular sell-off that occurred during August-November of 2008. However, the Rick Rule view of what's needed to bring about a sustainable turn for the better should not be dismissed out of hand. It should be accepted as one possible (and plausible) future.

By the way, we get the impression that despite his guess that the environment for junior mining stocks will get worse before a new bull market begins, Mr. Rule has been adding to his junior mining exposure. In other words, he's not betting everything on a view that a better buying opportunity lies in the future. Sometimes an investment is cheap enough, so you do some buying even if you suspect that it will get cheaper.

Accepting, at all times, that there are numerous possible futures is an important part of being a successful speculator, but such acceptance tends to elude most people. Instead, the average speculator develops a view of how the future will unfold and is fine as long as events happen roughly in line with this view, but ends up being "all at sea" when the future unfolds in a very different way to what was envisaged. Frustration results when hopes or expectations collide with a reality that doesn't mesh with those hopes or expectations. If the frustration becomes sufficiently intense it will become anger and eventually despair.

Frustration can be minimised, in speculating and in other endeavours, firstly by accepting that you do not KNOW the future, secondly by embracing the reality that the future could be a lot different (in a bad way) from what you currently expect, and thirdly by considering what you can do now to account for the possibility that the future will be much worse than expected and what you will do in the future if worse comes to worst.

In speculating, one of the most effective ways of dealing with the possibility that the future will be significantly different from what you hope/expect is to always maintain a substantial cash reserve. That's why the minimum cash reserve that we advocate is higher than the maximum cash reserve advocated by most analysts/advisors. Our view is that an investment portfolio's cash percentage should vary from a minimum of 20% to a maximum of 50%, depending largely on the level of uncertainty. In our opinion, if you are supremely confident about the future and see terrific potential for profits, you should still maintain a cash reserve of at least 20%.

If gold-stock mutual funds had kept cash reserves of at least 20% then they would not have recently become forced sellers of whatever they could find a market for. From the perspective of the typical mutual fund manager the worst mistake is to not be fully invested during an upward trend, which is why they end up being fully invested, and therefore unable to meet redemptions without engaging in fire-sales, during downward trends. You don't have to be that stupid.

Why changes in production can be safely ignored when analysing the gold market

Last week we wrote that due to gold's existing aboveground supply being more than 75-times greater than annual mine production, if the entire gold mining industry shut down for a year it would not make a significant difference to total gold supply. Based on comments received from our readership this claim of ours regarding the gold-mining industry's effect -- or lack thereof -- on the gold price warrants some additional words of explanation.

This is a topic we've covered several times in previous TSI commentaries. For example, we covered it in moderate detail in the 2nd May 2012 Interim Update under the heading "Who/what determines the gold price?". Here's an excerpt from that piece:

"It is true that prices are set "at the margin", meaning that with supply and demand in balance a 20,000-ounce change in either supply or demand could affect the gold price. However, it is unrealistic to posit a scenario in which the global gold market is perfectly balanced and then a single investor or gold miner comes along and disrupts the balance via a small addition to supply or demand. The fact is that the gold market is large, very liquid and continuously adjusting in response to the decisions of millions of people throughout the world. These people (the owners of gold and the potential future owners of gold) exercise demand for the total aboveground gold stock, the size of which is estimated to be about 150,000 tonnes (4.6 BILLION ounces). Gold mining companies collectively add about 2,500 tonnes to this aboveground stock each year, which amounts to less than 2% of the total supply.

In the gold market, "the margin" is the net result at any point in time of the buy/sell decisions of all participants in the market, with any particular "margin" only existing for an instant. For example, there were innumerable changes in "the margin" in just the time it took us to type the preceding sentence. Furthermore, "the margin" can be influenced as much by decisions NOT to buy/sell as by decisions to buy/sell. If, for example, all the current holders of gold decided not to sell then the gold price would quickly move much higher."

We went on to conclude that with their decisions to buy, not to buy, sell and not to sell, gold investors determine the price at which the total demand for gold is temporarily in balance with the total aboveground gold supply.

The gold mining industry obviously has some effect on the gold price, but the effect is small in comparison with the effect of changes in investment demand. Gold miners are really just small sellers in a large market. Using some rough numbers to hammer home this point, we note that a few thousand tonnes of physical gold change ownership every week and that the global mining industry sells about 50 tonnes of gold during an average week. This means that gold miners account for less than 2% of the gold that is sold in an average week. The bulk of the remaining 98+% is investment related. To put it another way, a 100% change in annual gold production would be roughly equivalent to a 2% change in investment demand.

The investment demand for gold changes by at least 2% almost every time Ben Bernanke opens his mouth in public.