— There has been much discussion lately about whether or not gold is in a bubble. Yesterday, our mate Kris Sayce, over at sister publication Money Morning, discussed a few potential gold bubble signs to look out for in the years ahead.
— We have one to add to the list. And it’s an important one, because this ‘sign’ will lead to a major upward move in the price of gold equities. More on that below…
— In the meantime, let’s have a quick look at the Karate Kid market. After a few weeks of Europe- and Greece-induced ‘risk-off’ based trades, we now look to be beginning a period of ‘risk-on’ trades. Risk on, risk off. Risk on, risk off.
— Not surprisingly, you can thank the central banking fraternity for triggering this latest risk-on trade. Overnight, the European Central Bank (ECB) announced (in conjunction with the Fed, the Bank of England, the Bank of Japan and the Swiss National Bank) the provision of unlimited dollar based liquidity to European banks until at least year-end.
— This move came in response to stresses in the inter-bank funding market over the past few weeks.
–What does that mean?
— Well, there is a market between banks for overnight cash. At the end of each day banks tally up their deposits and withdrawals. Some have a surplus of cash and some have a deficit. The surplus banks have a choice of leaving it at (in this case) the ECB or giving it to another bank to satisfy their short-term liquidity requirements. They charge a fee on the loan.
— But lately, banks have been choosing to forego the fee and deposit at the ECB instead. As a result, interbank lending rates have increased. This signals there is a liquidity issue in the banking system. But really it’s a solvency issue.
— For example, everyone knows the French banks are in a spot of bother over their exposure to Greek debt. If the Greeks default, the French (and many other banks) would go close to collapsing.
— It’s not just the Greek debt that is the problem though. When the market senses a bank is on the ropes, it goes in for the kill. Not deliberately. It’s just the market mechanism at work. Customers large and small don’t want their cash kept in a suspect institution. So they ask for it back.
— But as you know, banks don’t have all the cash in ‘liquid’ form. That’s because they have taken your cash and lent it to, say, the Greek government. In order to satisfy a surge in demand for cash, banks must liquidate investments or call in loans.
— Doing this in a nervous market is a tough ask though. And if there are many banks in the same position (as is the case in Europe) the next step is a credit crunch where banks actually withdraw credit (via selling of assets and winding up of loans) instead of supplying it.
— This makes the banks’ guardians – the central banks – very nervous. So like the ECB did last night, they offer to supply unlimited ‘liquidity’ (cash) for eligible collateral.
— In a true liquidity crisis, where the assets are sound but there is a panic going on, this is the correct course of action. Central banks should lend against sound collateral at a penalty rate. Doing so in size will quickly stem the panic.
— But we are not in a liquidity crisis. It’s a solvency crisis. There are billions – probably trillions – of dollars of bad debt in the system. The banks know it, which is why they don’t want to lend to each other.
— But they won’t write down the value of the debt and clean up their balance sheets because a) they don’t have to and b) they expect the public, via austerity measures, to help repay the bad loans they have made. And writing down the value of debt to a realistic level would force them to raise a huge amount of additional equity and dilute management and shareholders.
— Interbank lending stress is just the market’s way of trying to force a restructuring of bad debts. The ECB’s overnight liquidity gift simply pushes the restructuring out a few more months. But it won’t go away. Central banks have flooded the world with liquidity in the past few years. What good has it done?
— Like we said yesterday, this is how a bear market works. Short-term rallies based on hope will suck investors back in…only to maul them later.
— Enough of bear markets. Let’s discuss the bull. The aim of a bull market is to keep you out of it. Corrections are seen as an excuse to take profits and move on.
— And so it looks in the great gold bull market. Gold is correcting after a stellar few months. That shouldn’t be surprising. But all the talk of a gold bubble will have some of you worried.
— Don’t be. We’ve come up with a sign to watch out for. When it arrives, you’ll know the bull market is probably within a year or two of topping out. That’s plenty of warning we reckon.
— There has been much angst about why the gold shares are not keeping up – or even outperforming – the price of bullion. Much of this has to do with the broking community that provides investors with information and valuations on the gold stock universe.
— For most other companies, analysts nearly always assume a steady rise in revenue and earnings. Not gold companies though. In all broker forecasts we have seen, the assumption is gold prices will fall. So in their ‘models’ they assume prices will peak this year (for the past five years it’s always been ‘this year’) only to decline sharply in subsequent years. Such assumptions have a big impact on companies’ estimated values.
— When brokers and investment bankers finally start putting rising gold prices into perpetuity into their models, you’ll know the gold bull market is reaching its final, manic phase. Such a change will have a massive impact on valuations and send gold stocks soaring.
— We think this is a good signal because it’s a manifestation of an emotional response to years of rising gold prices. Once brokers and investment banks really start to believe in the story – and tell their clients to as well (to justify paying ever higher prices for gold stocks) – the long-term gold bull should start planning his or her exit.
for The Daily Reckoning Australia