What's Driving Gold and Gold Stocks (Part One)

What’s Driving Gold and Gold Stocks (Part One)

Justice Litle, Editorial Director, Taipan Publishing Group

Gold and gold stocks have been hit hard in recent days. In part one we examine the reasons as to why, and in part two cover why gold stocks could be one of the biggest trades of 2009.

Gold and gold stocks have been hammered as of late. The yellow metal took a header on Monday, with the futures closing right on the 200-day exponential moving average. If that support doesn’t hold today (Tuesday), gold may even be trading lower by the time you read this.

So what’s going on exactly?

There are a few factors at work at here. To skip ahead a bit, there is still strong reason to believe gold stocks could be one of the best trades of the year – but in the short run, the environment for gold looks challenging.

The IMF Bogey

One old bogey that has come out of the woodwork is the prospect of IMF gold sales. At the recent meeting of the G20 in London, there was general agreement that the IMF (International Monetary Fund) should sell just over 403 tons of gold to free up cash for loans to poor countries.

Yawn.... the “IMF to Sell Gold” headline makes for much better press than the actual details.

For one thing, 403 tons of gold is just not that much. We’re talking roughly $11 billion worth at today’s prices. That’s a drop in the bucket, especially compared to China’s roughly $2 trillion pile of reserves... less than one percent of which are held in gold.

(For more detail on the relatively tiny gold holdings of many of the world’s central banks, see the Feb. 24 Taipan Daily piece “Why the IMF and Fort Knox Won’t Put the Hurt on Gold.”)

For another thing, the prospect of IMF sales is not new. The IMF has actually been trying to sell gold for more than two years. Part of why it hasn’t been able to do so is because authorizing the sales requires an 85% majority vote from the IMF’s 185 member countries.

On top of that 85% hurdle, the United States basically holds veto power over any IMF gold sales measure (because America’s proportional voting rights are so large). In that regard, the U.S. government has informed the IMF that, by order of law, authorization from Congress is required for any gold sale to go ahead. (Can you imagine Turbo Timmy making that request, to this Congress, in this climate? Ron Paul would have a field day.)

So any approved IMF gold sale would be small, in quantities easily absorbed by countries like Russia or China (who have openly stated a distaste for their overlarge dollar holdings). Any sale would further require 85% approval, plus approval from the United States Congress... and last but not least such sales, if they happened, would probably be disbursed over many years. The remaining 3,200 tons of gold the IMF holds represent quota requirements from member countries and cannot legally be sold.

But, still, gold has been sinking like a stone. What else could be the problem?

Ready to Scrap

Another factor hurting gold in the short term is “gold scrap,” or scrap sales. Private holders of jewelry and trinkets, particularly in Turkey, the Middle East and Asia, have been stepping up and selling their scrap gold.

India, the “world’s largest gold buyer by a wide margin,” has even stopped importing “for the first time in 10 years,” the Financial Times reports. In February and March India saw zero gold imports, while January imports came in light. Vietnam and Thailand, normally reliable buyers of gold, have also been selling. Stepped-up scrap sales have even put Asia scrap sales at a discount to the standard London quote.

It’s important to point out that many of these scrap sales are driven by distress more than any sense of market timing. Unemployment woes and rising food costs have forced hard-up Asian families to dip into their emergency stashes. Traders have further noted that these scrap sales seem sensitive to price. As the gold price per ounce fell towards $900 and below, scrap sales volume saw a clear decline.

Mark-to-Whatever

Yet another factor weighing on gold has been the suspension of “mark-to-market” accounting rules.

Last week America’s FASB (Financial Accounting Standards Board) bowed to pressure from Wall Street and loosened up mark-to-market accounting rules, causing a huge sigh of relief from the banks. Here is how I explained it to Macro Trader members on Friday:

Part of the reason stocks rallied big on Thursday was a suspension of “mark-to-market” accounting rules.

In plain English, this means the banks will no longer have to use real-time pricing for the stinky stuff on their balance sheets. They’ll be able to “estimate” what the toxic assets should be worth instead.

This is sort of like a homeowner saying “well, my house might not be saleable in this tough real estate market, but in a better market I’m sure it would be worth, oh, $300,000... so that’s what I’ll say it’s worth for now...”

Some people think the suspension of mark-to-market rules for bank assets is a smart idea. Others think it’s a terrible idea. Either way, it’s pretty bullish for the financials, at least in the short term.

Stocks also rallied [recently] on news of a potential trillion dollar injection into the IMF (International Monetary Fund), and the general perception that the G20 meeting in London was a success.

The mark-to-market change is basically a cheap magic trick. The banks may benefit from the opportunity to abandon real-world accounting in favor of fantasy-world accounting, but toxic assets are still toxic assets. Smoke and mirrors won’t change that.

Hot Money Rotation

In sum, the current weakness in gold and gold stocks is all about short-term perceptions (with the exception of increased pressure from scrap sales, which remain sensitive to distress and price). The IMF news is more hype than substance, and the abandoning of mark-to-market accounting rules is more a tacit admission of how ugly the picture still looks for banks, rather than a concrete step towards fixing the problem.

Meanwhile, rally-happy traders saw the chance to buy up risky assets on the back of mark-to-market suspension and good G20 news. As a result of the major move we just saw – the biggest 4-week rally in the S&P since 1933 – areas of the market that had previously suffered from lack of liquidity, like high-yield debt, commercial real estate assets and so forth, caught a huge bid. There was a fast-and-furious hot money rotation out of “crisis insurance” type assets (like gold and gold stocks) and into “woohoo let’s party!” type assets (like bank stocks and high-yield debt).

That wraps up the near-term end of things as to why gold (and thus gold stocks) are out of favor right now.

Tomorrow I’ll share my reasoning as to why gold and gold stocks could still be setting up for one of the biggest trades of the year.