Unallocated vs Allocated

On this Kitco forum thread, a question was asked about whether one should be converting from unallocated to allocated. Many years ago I wrote up the following text on this page of the Perth Mint website:

The Perth Mint maintains finished goods inventory of its coins and bars at all times to meet normal demand from its distributors and Depository clients. Accordingly, unallocated clients will usually be able to convert their metal within a few days of giving notice.

However, it is important to note that if you request a physical product that is not in stock, or a very large quantity, the Mint may need to manufacture it. The lead times for manufacture will depend upon the size of the order, current demand and production capacity. It is because of this uncertainty that some clients choose allocated storage - as their metal has already been fabricated it is ready for collection at short notice.

Clients worried about potential delays in collecting metal in extreme circumstances, but with concerns about the cost of allocated storage, usually take a staged approach:

1. While the world environment is benign, they hold unallocated. They do not incur ongoing storage costs and fabrication charges.
2. When the environment becomes uncertain and risky, they convert to allocated.
3. When the world is at a crisis point, they take delivery of their physical metal.

This approach can save clients significant amounts of money as it may be some time between stage 1 and 2. Clients who do not feel they can judge the shift from stage 1 to 2, or feel it may be sudden and unpredictable, opt for allocated as they are using precious metals as "insurance" and see the storage fees as the cost of that insurance.

Each person will have a different assessment of what stage we are at. One thing to note is that the Perth Mint has a legal obligation to do conversions/collections, so those orders will always take priority over any other orders in the system, which gives some people comfort.

There were a few other questions raised that may be of interest.

"If the demand continues to be high then production capacity will rise and premiums will fall in the end. But will this coin/bar demand ever be big enough to influence the spot more than marginally?"

I have speculated in this blog that the industry will eventually respond, but it won't be quick as two things need to happen: 1 bosses in refineries and mints "get it" that the demand is staying high; 2 takes months to buy and commission equipment. High premiums are here to stay for at least 6 months if demand continues.

I think if the current demand was able to be filled then it would have an impact on the spot price because it would take physical off the market. Coin and bar demand is somewhat sticky. The fact that demand has not be able to be met has resulted in buying power being "wasted" on high premiums instead of on buying more ounces.

There is also no doubt in my mind that the US ETF has also impacted on the price by providing an easy way for the average person to buy gold. That was the whole reason the World Gold Council (run by miners) paid to get it set up - they wanted a easy way for physical to get taken off the market. Problem is that it is also easy to sell, and i think that is what is causing the volatility in the gold price. Compared to coin and bar buyers, ETF investors are more fickle in my opinion. The World Gold Council would have been better off ensuring the industry was ready to meet retail demand for coins and bars, because that also takes physical off the market, but for a much longer time.

"when do you think the paper spot price may be reconciled with the physical spot price + premium? Do you think there is an intentional cornering of retail market by big players, or is it just a priority of serving wholesale customers first. If there is a real shortage, why not charge wholesale customers more?"

In my experience, and this may just reflect the type of clients I've dealt with, but new highs in the gold price drive new account openings so the price drop will cool things a bit, but just a bit as the key driver now is still uncertainty about the financial markets and banks.

There isn't any cornering of the retail market by big players - all "wholesale" deals for coins and bars are to dealer who resell to the public. If a mint is at capacity selling product to a wholesaler or retail customer doesn't actually change anything really, because it all ends up with retail customers in the end. The big private clients I know who go allocated may well buy some smaller coins and bars, but the bulk of their metal is in 400oz and 1000oz bars as they are the cheapest.

Misinterpretation of Gold Lease Rates

Brian Kelly (founder and CEO of Kanundrum Inc, a private investment firm and research boutique) recently posted an article on Seeking Alpha called Misinterpretation of Gold Lease Rates and Why Gold Could Rise. In the article he says that “lease rates reported in the press are a derived rate and actually represent the amount that can be earned from the gold carry trade” and goes on to posit a relationship between lease rates and gold prices. Unfortunately it is Brian who has misinterpreted lease rates, and has done so quite badly.

The gold carry trade involves borrowing gold at, say 1%, selling the gold, and then investing the cash at, say 3%. If the gold price doesn’t change, you earn a net 2%. The bigger the net difference the more carry trade return you can earn (assuming a stable price) and therefore more attractive short selling of gold should be – as long as there is an expectation that the gold price won’t rise too far to wipe out the profit from the interest rate differential.

The point of a carry trade is, therefore to “capture the difference between the rates” (see Currency Carry Trade for a further explanation). The question then is what are the two “rates” and what represents the net difference. The formula Brian mentions in his article is Lease Rate = LIBOR – GOFO. He therefore assumes that the net difference is the lease rate. However, that same formula can be restated as GOFO = LIBOR – Lease Rate. Which is the net difference?

Regrettably for Brian, it is GOFO, not the Lease Rate. How can I be so sure? Well when I worked in the Perth Mint’s Treasury and we borrowed gold, we were charged the Lease Rate, not GOFO. But don’t take my word for it. I quote from a booklet titled “A Guide to the London Bullion Market” issued by the London Bullion Market Association (who you would think would know what they are talking about): “Forward rate = Dollar interest rate – metal lease rate”

Therefore the fact is that it is GOFO which represents the “amount that can be earned from the gold carry trade”. GOFO is the measure of the net difference, “the amount that can be earned from the gold carry trade”, not the Lease Rate.

As a result not much store should be put to Brian’s subsequent analysis about the relationship lease rates and the gold price. The chart below shows the relationship between the real “carry trade” indicator (I’ve chosen the 6 month GOFO rate) and the spot price. I take a more longer-term strategic view and looking at the chart there is no clear relationship or correlation that I can work with. For example, in 2002-2003 GOFO was low and the gold price rising. But 2004-2006 GOFO was rising but the price also went up. I don’t see any tradable signals one can rely on.



Brian has also developed what he calls the Kanundrum Model of Markets, which explains the way people and markets behave. Below is a summary of his key “stages”:

Discovery – Stage 1

Stage 1 of any emerging trend is first characterized by a change in direction. It is usually preceded by a surge in volume as the asset makes a new low. This is the stage where major investors are establishing new positions.

Disbelief/Confusion – Stage 2

Price retreats after the initial surge and often the retreat is significant. Investors who did not buy when they heard that Stage 1 investors were buying believe that this is the time the Stage 1 investors are going to be wrong.

Belief and Proof – Stage 3

In this stage the asset makes its largest price move. It is by far the most important part of the trend for an investor to be a part of. Volume is huge and price moves are beyond what anyone expects. This part of the trend usually lasts much longer than anyone expects. This is also where almost every type of investor has a reason to be involved in the trade.

Complacency – Stage 4

Price begins to retreat from the unbelievable prices achieved during Stage 3. However few participants are concerned. Market participants are accustomed to the asset price and many investors use the pullback to add to or establish new positions.

Mom and Pop – Stage 5

The price begins to move back up and individual investors invest. The price moves may be less than during Stage 3 primarily because individuals do not have the buying power that larger professional investors have. As well, Stage 1 and Stage 3 investors are taking profits.

In this blog post dated 13 October, Brian believes that gold is currently in Stage 2: Disbelief/Confusion. Now I’m not so sure about his model and the stages one has to choose from but it is an interesting and fun way to view the market. Using his model, I would suggest we are in the middle of Stage 4 (see chart below). What stage do you think we are at?

James Turk says there is no shortage ...

... of wholesale precious metals, that is. In this GATA dispatch, James Turk says "So far the London and Zurich markets continue to operate without problems, but I sense some strains are developing" and "we are giving retail investors the opportunity to buy alongside big institutional firms operating in these markets and to gain the advantages of these markets -- deep liquidity and transparent pricing"

This is what I have been trying to say all along - physical metal in the wholesale markets is not in shortage, it is the conversion of that metal into retail coins and bars that is causing a shortage of retail product, pushing up their prices.

He goes on to note that his clients "are purchasing metal based on the spot price in London and Zurich for both gold and silver. Thus they are able to buy metal without the huge premiums now being charged on eBay, for example, for fabricated product like coins and small bars"

The unfortunate thing for precious metals is that because people don't trust Mr Turk's system or ones like it, they are "wasting", in a way, their purchasing power on premiums instead of on the metal itself. If the spot price for bulk silver is $10 p/oz but is $14 p/oz for retail silver, then those who spend their $14 on a GoldMoney type system create demand for 1.4 oz whereas those buying retail forms only create demand for 1.0 oz.

Could it be that the reason the silver price (or gold) is not as high as some would like is because all this demand to spend fiat dollars is not being fully channelled into silver but partly spent on premiums instead?

I am a strong advocate of holding physical metal, but once you have a reasonable stash if you want to make an impact on the price maybe continuing to pay incredible premiums may not be the way to go. Of course it does come down to trust in these systems, so I understand why people may not want to buy stored metal. However I can't help but think that a lot of dollar buying power is ending up as profit in the hands of coin dealers instead of into silver and gold itself.

Premiums & GLD

I found this comment to this SilverAxis blog of interest:

Is CEF’s “sizable” premium (9% at the moment), really all that high for a verifiable vaulted proxy for real metal (assuming it is), when there is a 45% premium on Silver Eagles and a 14% premium on a 100 oz bars deliverable from Tulving?

The premium on the Central Fund of Canada is interesting compared to GLD, which consistently seems to get questions about whether it really has the gold behind each share. GLD does not trade with such a premium, and sure its open ended nature ensures it closely matches the spot wholesale price, but are not the premiums on CEF and retail physical indicators of the market's assessment of the "safety" of such ways of holding gold relative to other methods like GLD? Of course the market is a voting machine, not a weighing machine so the premium may just indicate mood rather than real risk.

While not having anything more to rely on but GLD's assurances that it has the gold, personally, I consider that since it was created and sponsored by the World Gold Council, which is owned by gold miners (who want the price to go up), that they would not be involved in an ETF that wasn't talking physical off the market (which is ultimately the best way to make the price go up).

Precious Metal ETF Holdings

I found this short but interesting comment by Tim Iacono on Seeking Alpha about whether changes in GLD's holding have anything to do with the price of gold: http://seekingalpha.com/article/82626-does-gld-inventory-affect-the-price-of-gold

This was a topic I was planning to cover in a future blog because I have seen other commentators analysing GLD creations and redemptions. I feel some caution needs to be exercised with such interpretations. I'll expand upon this in the future, but in the meantime here is my reply to Tim that briefly explains my caution:

I'm a bit wary of reading too much into changes in GLD holdings over the short term because of the inherent lack of transparency in the gold market. As most gold trading is over the counter (OTC) and not all done on a nice visible stock exchange, you can't be sure that positions in GLD are not offset in other markets.

The GLD (or any ETF) redemption/creation process involves costs, so it is more profitable for market makers in GLD to avoid this where possible. For example, where retail investors are selling GLD, the normal (ideal) process is for the market maker to buy GLD from them and sell gold on the OTC spot market. They redeem GLD for physical gold and use this physical to settle their OTC spot sale.

However, if the market maker feels that the sell off in GLD is temporary and that retail investors will come back in the future, then they can make more profit by holding GLD and avoiding redemption/creation cost. They still have to buy GLD and still sell gold OTC so that they do not have a trading position and any exposure to the gold price, but instead of redeeming GLD, they lease gold in the OTC market and use that leased gold to settle their OTC spot sale. Their long GLD position (asset) is offset by a lease (liability). Considering that gold lease rates are 0.2% there isn't much holding cost with this strategy.

The only time a market maker would then redeem GLD for physical gold is if there is sustained selling over a period of time. In this situation the market maker's holding of GLD would continue to grow. They then redeem and use the gold to repay the lease.

As a result, I feel that analysis of GLD's (or any other gold or silver ETF) redemption/creation flows against the gold price is only realiable if done in time period blocks of a month or more.

Investment timeframes - Part II

Short Term

Following on from last week, why do I say that the nature of the gold market itself makes profitable day trading difficult? It is all about information, or lack thereof. Apart from pockets of relative transparency like COMEX or ETFs, the vast majority of the market is opaque. The “retail” or “average Joe” trader simply does not have access to the same amount of information about the status of the market and its flows that a “wholesale” trader does (and even they can’t see the entire market). Without understanding what is really driving short term changes in the price, I doubt it is possible even for the most astute and disciplined trader to make consistent profits.

Let me contrast it to stock markets. There are a few key features that help the day trader. Firstly, you know exactly how many shares have been issued and if there are different classes, how many of each and what the differences/rights each has. Secondly, all trading is done through (usually) one regulated market. Thirdly, you can see daily trading volumes. Fourth, at any point in time you can see the depth of the market – how many shares are being offered to buy or sell at each price level. This mass of data, combined with analysis of price charts, gives the trader room to apply skill and a bit of gut instinct to the task of making a profit.

How does the gold market stack up on these features? Firstly, no one knows for sure at any point in time how much gold there is out there to be traded, nor in what form or in what locations. The wholesale market may have a bit of an idea, but no such information is published to retail traders on a daily basis. Even if one did know the size of the gold out there at that point in time, due to its refinability, scrap gold can flow back into the market quickly (a factor if you are planning on holding a position for a few weeks), so the total “shares on issue” in not fixed and changes in response to the price.

On the third and fourth points, there is no published information on daily trading volumes or market depth; indeed, no volume data is published at all. I’m talking here about the whole market. Sure, some gold is traded on regulated markets but that information is only part of the picture and certainly little of it is live. If you only have part of the story, you don’t have the story at all in my opinion.

Network Nature of the Market

The key killer for me is the second point – gold is simply not a publicly, regulated traded thing. And COMEX and ETFs and the like don’t go anyway towards solving that because they are not closed systems. It is easy to run a position in those markets that are offset or hedged with an opposite position in the spot/forward market. Detailing how that is done is for another blog. The gold market operates much like the internet – it is a network of wholesale dealers, independently trading with each other, and it is the sum of those individual trades that makes up the “spot market”.

It was always amusing to me when clients would ring up to buy and we would quote a price and then, naturally, they would say “Well, where can I get what the spot price is?” so they could work out if our price was “fair”. The answer was, “It doesn’t exist. You could spend a few thousand getting a live Reuters data feed, but even that is just indicative.” Being used to the comforts of a stock market, many didn’t like that answer and thought we were pulling a shifty on them. In the end, all we could say was that they had to do what we did, which was ring around to see who was offering the best price at that time. It made some uncomfortable, but as I pointed out in my first blog, this is the “pointy end” of investing, it’s real trading, it is about bargaining, haggling, being in the know.

The funny thing is that this network nature also gives the market strength. Transparency is nice, but not at the expense of robustness. Just like the internet, where if a part goes down then data can be rerouted, if London was nuked for example, then trading in gold could still continue. Sure, liquidity would be reduced, but as deals in the end are done over the phone, it is just a case of dealing with other counterparties in other countries. Because it is not locked in to one “exchange”, gold can be resilient in the face of a failure in part of the network. And this is how the medium and long term investors want gold to trade if it is to be the asset of last resort. The market needs that flexibility to if it is to continue trading.

But the network nature of the market and the corresponding lack of transparency is a problem for the day trader. To understand what the retail trader is up against, it may be better to explain what happens when they call up to buy some gold from a dealer. There are many small variations to how this can work; this is but one way, probably the simplest where a dealer just lays off a trade with someone else immediately instead of holding a position.

Spot Trading

Any trading desk needs an indicator of where the market is, and most use Reuters. However the price displayed on Reuters under code XAU is just an indicator. It is updated by the bullion desks of the big banks and is in effect, a bulletin board or forum where banks can publish their prices in the hope other dealers will call them up to do a trade. Sort of like an advertisement. Unlike a stock market, it is not a commitment to deal at those prices, but most times you can. However there are many times, especially when the market is moving quickly, when the dealers don’t have time to update their quotes on Reuters and so when you ring them up, they say “Sorry, Reuters off the market, my current price is $5 below the screen”.

As a result, when you call a dealer for a price, they themselves cannot really know exactly where the market is. They see $900 on the Reuters screen, but this is what they will be charged, so they have to add something on to it as they have to make a profit (you expect something for nothing, it costs to run a trading desk, to talk to you, to do the other side of the trade with the bank, to settle the funds, bank fees etc). The dealer also has to consider that by the time they get off the phone with you and then call another wholesale dealer the market may have moved, so they might need to add a buffer on top of their margin. Sometimes if your deal is big enough and the market volatile, they’ll get another trader on their desk to call a bank and get a firm price before they quote to you (and they’ll want an answer quick because the bank ain’t gonna want to sit on his quote for too long because he/she has got to trade it as well).

Dealers have a network of other dealers they trade with. Each dealer has a different bit of the gold market pie, they can see what is driving their deals (be they a refiner selling a miner’s gold, a bullion dealer selling coins and so on), but not necessarily what is driving other flows. They are in constant contact with each other, doing deals, talking and exchanging information on what they are seeing in the market, watching the Reuter’s price movements. They use all this information to set their prices and to ensure they don’t lose money. Over time they build up a gut instinct, a feel for market movements and where it might go that day.

If you call up the Perth Mint to trade, you are likely to speak to Deniece, the Mint's senior bullion dealer. She has what I would consider probably the best background training for a bullion dealer - croupier at Sun City. When the market is moving you can do any number of deals before you have time to enter them into the system to confirm your position and profit, so you have to be able to run them in your head, to know where all your 'gold chips' are on the 'table'. She has been there since 1994 and every working day she has been sitting in front of a computer screen watching the Reuter’s gold price tick up and tick down, talking to people like you wanting to buy or sell gold – that’s coming up to 4,000 days of trading. And you think you can day trade against dealers like her, with zero information about what’s going on in the market? Get real.

Investment timeframes Part I

When I moved to Perth from Sydney to take up the job of Depository Administrator I thought the best way to get up to speed quickly would be to go through each client file (we are talking good old paper here). This way I could see first hand how transactions were done, how I should word correspondence, etc. As I worked my way through the files, I started to see a pattern – the client would open the account, purchase a large amount of gold and then, nothing. No further contact, no further purchases or sales, no enquiries as to the price of gold, nothing.

Initially this puzzled me, I mean if you had a substantial investment, wouldn’t you be constantly reviewing your portfolio allocation and making adjustment accordingly? The behaviour seemed very odd, very un-investment like, especially for such obviously wealth persons. In a lot of a cases we were talking about periods of 5-10 years without any trading or contact.

As I got to trading and talking to a wide variety of the Depository clients, I came to understand that there were a lot of different reasons for buying gold. Associated with each reason was usually a timeframe, and by that I mean how long they expected to be invested in gold before selling out - hopefully at a profit. I ended up classifying them into three groups: short, medium and long term timeframes. The “no further contact” clients were in the long-term group, and specifically what I call insurers.

Now my definition of what those timeframes were may not accord with their definition as used in other markets or yours, but it does fit what I saw when analysing the transaction behaviour of the Perth Mint's Depository clients (and I did a fair bit of analysis, partly because I am a numbers person and partly because I was always looking to understand gold buyers).

Long Term

By long term I mean timeframes that are measured in years, indeed in some cases we are talking decades. This group can also be broken down into two sub groups - strategists and insurers. Common to both is the fact that they have a very strong, if not emotional, attitude towards gold. These are your classic buy-and-hold investor. Their view is historic and economic, broad brush. Their investment is more about wealth preservation than wealth generation.

The main difference between the strategic sub-group and the insurance is that the strategic do have an end game where they will get out of gold at a profit once the economic cycle has shifted back towards conventional investment classes like stocks. They are in for the long haul, but only because they see an extended period of poor returns but do generally prefer wealth creating assets. They may also hold a small permanent position in gold (say less than 1-2% of wealth) and are just upping the allocation to precious metals as a defensive measure for a period of time and then back down to a relatively low level.

The insurance sub-group on the other hand have no end game in sight, they hold a core position in gold that, once established, is rarely added to. They don’t care about the price and profit is not the focus. They are using gold as insurance, insurance against events that you cannot get insurance for – major depression, civil war, world war, societal breakdown, currency collapse. There are invariably very large amounts involved. These are people who have enough money that they can park some “lazy” capital into gold, enough that they can reestablish themselves with should the unthinkable occur.

Why I was initially puzzled by these clients was because I assumed that you bought gold as an investment, but the motivations of insurance are different. The way I like to think about this reason for buying gold is if you buy car insurance and then at the end of the year you have not had an accident, you don’t say to yourself “well that was a waste of money, I paid the premium and never got to claim on the insurance policy”. Instead you say “great, I didn’t have an accident, how lucky” and you write-off the premium. This is the same attitude these clients have towards gold – if the price goes down, they don’t moan about the money lost, they consider themselves lucky that there was no economic breakdown. They don’t want to make a lot of money out of gold, because in their view this means that they have lost all their other investments.

Medium Term

Medium termers, or tacticians, talk in timeframes of months, usually 6 months to less than 2 years. A lot of times they end up in gold for longer than that, usually because their assessment was out or they want to ride a trend a little bit longer, but in mindset they are generally not long termers. The motivation here is purely profit, the analysis behind their position is usually economic/currency valuation based.

Sometimes there is a blurring between medium and long temers, with some holding a strategic view on gold and so they plan on being invested in gold but cannot resist the opportunity to sell out at peaks and buy back in on corrections as they ride the bull market. They are definitely not buy-and-hold type investors.

I would also put into this category non-goldbugs who are just hitching on the “commodities story” and think the bull market in gold will run for a few years at most and that they will get out at the top (or near to it) in time, ready to deploy their profits into the next investment fad.

Short Term

Short termers have timeframes counted in days or weeks. Speculation is another word for it. My definition of 6 months or less is probably debateable and could be shorter. In any case, quick profit is the goal and there is no philosophical belief in gold.

Unlike the medium and long termers, this approach is one that I do not recommend, because I have seen few, if any, who have been able to do it. Why that is the case has little to do with the investor’s competency (although I have seen some who did lack any trading acumen) and more to do with the nature of the gold market itself.

Anyway, that for next week’s blog …