Permanent Gold Backwardation

Synopsis:
David Galland checks in on his Happiness Meter, and Keith Weiner discusses gold backwardation and the future of fiat currencies.




Dear Reader,

David Galland here. In a moment, we'll get to the main investing topic indicated in the title of today's edition, Permanent Gold Backwardation, but first a little bit of musing. If you are the serious type, with things to do and people to see, feel free to skip right on down the page until you strike that article – you won't hurt my feelings.

That's because, coming off a particularly busy week – one that included putting out the February edition of The Casey Report (read it now, we'll take all the risk), I'm in the mood to muse about things more philosophical.


The Happiness Meter

By David Galland

It was best-selling author Robert Ringer who first brought the concept of a "Happiness Meter" to my attention. (A bit of trivia: Ringer was involved in publishing Doug Casey's first book, The International Man).

According to Ringer, every one of us humans comes right off the showroom floor equipped with a Happiness Meter that allows us to check in on how satisfied we are with our lot in life at any given point in time. You can try it yourself right now by asking yourself how happy you are at this very moment, on a scale from 1 to 10 – with 1 being thinking dark thoughts about stepping off high places and 10 being whirling about like a Sufi dervish in the throes of ecstasy.

In Ringer's view, if your Happiness Meter is pointing somewhere to the south of the number six, you might want to consider taking corrective action.

Fortunately, with a bit of reflection, it is usually relatively easy to identify the factor in your life causing your level of happiness to wane.

As an example, over the last 45 minutes my usually reliable Dragon Speaking software went extraordinarily buggy and started calling up blank emails every time I spoke… the music in my headset stopped playing and refuses to start up again… and my primary online brokerage account refused to let me in, instead notifying me that I must make a phone call should I wish to transact further business.

Meanwhile, in the background of my basement office/pool room/video room/workout space – usually my fortress of solitude at this hour of the day – a member of the immediate family whose name will go unmentioned has decided that Friday morning is a good time to listen to a lecture on the history of ancient Asian trade routes while exercising. And, as would be expected, they were listening to said lecture loudly enough to be heard over the spinning noises of the stationary bike – the result of which is that, while trying to pull together the necessary concentration to write these musings, I was a victim of collateral knowledge.

Normally, one expects, and therefore easily adapts, to the occasional glitch in the smooth flow of one's daily routine, but when the glitches avalanche as they did this morning, adapting requires actions more tangible than unleashing a stream of colorful language, most of which was fortuitously masked by the professorial observations emanating from the far side of the room.

In this particular instance, mitigating the circumstances causing my Happiness Meter to veer sharply to the left involved taking a deep breath… hitting the reboot button on my computer… doing 10 push-ups… and plugging in a new headset (the malfunctioning one is temporarily resting where it landed somewhere over my right shoulder). The exercise and history lesson now complete, I have been returned to my solitude.

And so it is that, with my music again blasting in my headset – ensuring my declining years will include regularly asking, "Eh? What did you say?" in an altogether too-loud voice – my Happiness Meter has rebounded to a near-normal level much closer to 10 than to 1.

Of course, there is a big difference between passing bouts of unhappiness such as what I am now well on the path to recovery from, and those more systematic. While, now starting late, I don't plan on going into any depth on the subject, I do have enough steam left to make a few observations that you may find useful, especially if you like to make your own investment decisions.

What Moves Your Meter?

Every society is permeated with informational and philosophical threads that, together, form what is commonly referred to as "conventional wisdom." For instance, conventional wisdom in much of the developed world informs us that hard work and diligence result in material rewards. And that those material rewards translate into ever-increasing levels of happiness.

In fact, I suspect that most people, if asked to do so, would reflexively plot happiness and material wealth in a lockstep progression: the more wealth, the greater the level of happiness.

There have been a number of studies on the subject, though most of them are highly suspect – including one conducted by Princeton University, which stated that over the "scientifically derived" level of $75,000 in annual income, happiness fails to progress further.

Naturally, no sooner had the study hit the desk than certain progressive elements of society piped up with the conclusion that government policy should effectively limit everyone's income to that magic number. According to these altruistic folks (albeit altruistic with your money, not necessarily theirs), it's only logical that taxes should be highly punitive once the high-water mark on happiness is reached – after all, once you've reached the $75,000 mark, what's the point of having more?

While, of course, I disagree with the notion of limiting anyone's income for any reason, I actually don't disagree with the notion that money not only can't buy you love (loving, perhaps, but not the real thing), it can't buy you happiness, either.

Viewed from a slightly different angle, social convention has evolved to the point where chasing after money is as subconsciously normal as hunting small animals was to our primitive ancestors. To those ancestors, success in the hunt made the difference between eating or not eating, and maybe starving or not starving. In the modern context, the money chasing – especially for those who have already taken care of fundamental needs – has little to do with providing the essentials of life and, it seems to me, is only tangentially connected to happiness.

Of course, that is not to say there is no value in money chasing. For some people, having more money than the next guy provides a satisfying ego boost or enables them to attract a better-looking mate (much the situation with the ancients, as well), but I suspect in the case of many, the money chasing is merely reflexive at this point. It's just what we do.

But if more money doesn't correlate to more happiness, then what does?

In my opinion, based on much observation, the answer requires turning inwards. That's because while there are commonalities in what makes people happy, in the final analysis, the factors that move the meter are highly personal.

To the extent that it helps frame the topic, following are just a few of the elements in my life – in addition to properly functioning electronics – that push my Happiness Meter into positive territory.

• Exercise. Not too much, not too little – but regular bouts of sweat-inducing, heart-pounding physical exertion to keep fit and reduce the odds of being visited by the specter of poor health. Of course, everyone knows this to be true, yet millions of people still fail to take even 30 minutes every other day to do something physical.

• Study. It's odd that I – whom every single classmate from my school years would confirm as an indifferent student – should place such a high value on study, but I do. If I have learned anything over the years, it is the confidence-building power of knowledge. Each time I study something I am intensely interested in – which is all I ever study – I feel as if I have tuned up my brain. As I tell the kids to the point where they roll their eyes, "If you aren’t learning something every day, you are standing in place."
  
  (For self-directed investors, there is a wealth of great information out there to sharpen your skills. Start with the fundamentals – I always recommend Benjamin Graham's classic The Intelligent Investor – as that will steer you away from the many reefs associated with chasing after unrealistic returns. Then expand from there. So, not only can studying make you feel happier, it can make you a more successful investor as well.)

• Humor. Given the number of ugly, threatening and real and potentially dangerous elements present in the world, one should take every opportunity to enjoy a good laugh. Look at it this way, the world is always going to be the way it is, so if you want it to be a happier, more fun place – that's got to come from inside.

• Everything in moderation, including your excesses. I have never gone along with the modern meme in Western nations, the United States in particular, that one should live like a Puritan. You know, that a glass of wine every now and again is acceptable, but stringing two – or heavens forbid, three! – glasses together categorizes you as a wastrel in the eyes of polite society. Personally, I like to hang out with people who like to have a good time. Even so, giving in to excess on a regular basis triggers consequences that are likely to decrease, not increase, happiness and so should be kept in check. Too much of a good thing can very much be a bad thing.

• Challenges/new experiences. There may be nothing I dislike more, which is to say nothing that dampens my Happiness Meter more, than remaining on the same path until the point that it wears a rut in the ground. Perhaps that's because I don't believe there is a second and more wondrous life waiting just on the other side of my last heartbeat.
  
  As a consequence, my view of time is rather limited in scope. The simplest of mathematical equations results in the irrevocable fact that ten years from now, I will be 68 years old. Add another 10, and I'll be 78. While I hope good genetics, exercise and maybe medical breakthroughs will help make the years ahead happy and productive ones, at this point in time it is safe to assume that my biological age will become a limiting factor in some of my decisions.
  
  The conventional wisdom about such things is that the older you get, the more you should hunker down (and don't forget to double lock your doors!). Which, in my view, is the same as sitting for a coffin fitting.
  
  Instead, I am a huge believer that if you don't constantly find new ways to challenge yourself, whether by climbing a mountain, starting a new business, taking up a new sport, moving to a foreign country… something!... you will slowly degrade into a shadow of your former energized self. And how can anyone be happy about that?
• Compromise reluctantly. This is a hard one, because we are all asked to compromise every day. Only a truly selfish person never compromises, but when it comes to the big stuff, only a fool – or someone willing to live an unhappy existence – gives in. While I understand the dynamics and in many cases sympathize, I have a hard time understanding how a person remains in a bad marriage, no matter what the reason. Likewise, how anyone stays in a bad job, or remains in a bad neighborhood, or sends their kids to bad schools. That is not to say that breaking the bonds of the norm, no matter how bad the norm may be, is easy – it usually isn't – but failing to break those bonds means accepting life as a slave.
• Meditation. Most people who know me probably wouldn't categorize me as the "New Age" type, and I'm not. But when I was in my early 20s, I pretty much accidentally stumbled into a transcendental meditation class during which I instantly connected with the benefits of being able to calm and clear the mind at will. As with all things, I don't take it to excess (like the guy I know who spent 10 years getting smacked in the back for bad posture by his Zen teacher in a Japanese monastery), but I do try to find 15 or 20 minutes of quiet time each week – usually after a workout – where I zone out while listening to music punctuated with tinkling bells, softly falling water and the likes.
  
  I know it may seem a bit foolish, but if you've never tried it, you should. I know a guy whose father and grandfather had both died of heart attacks before the age of 45; he meditates every day and is still going strong in his late sixties.
• Family and friends. Reasonably well-behaved kids and interesting friends can add a lot of depth and context to a life. Conversely, just because someone is genetically related or is a friend of long standing doesn't give them license to ignore certain standards of civility.
  
  Yet, many people cling to negative relationships no matter how low they pull them down. Personally, I refuse to maintain dysfunctional relationships. As a consequence, I have several relatives whom I now have next to no contact with and don’t worry about it at all. Likewise, I have my share of former friends, including one well-known but consistently misguided financial guru who was positively shocked when I told him, “Listen, there are better than six billion people in the world, so I have a wide choice of people whom I can associate with – and you aren't one of them.”
• Music. I was never particularly musical growing up and don't have a very sophisticated taste in music even now – but I know what I like, dramatic music that almost never fails to lift the spirit and triggers vigorous foot tapping. (As I write, Sympathy for the Devil by the Rolling Stones is blaring through my now working headset.) For some people, this role is filled by art, flowers or whatever lifts the spirits.
• Create. A very important factor in my life, and in the lives of most happy people I know, is to constantly be creating things. It doesn't matter if it's a polished block of wood with slots for the kitchen knives to slide into or a full-blown orchestra piece or silly YouTube video – I can't imagine how a person can be fundamentally happy if they aren't creating… something! Speaking of which, if I haven't thanked you lately for allowing me to share my weekly musings with you, and for your many nice letters, thanks – you've made me very happy!

I could go on but will stop there. If there is a point to these ramblings, it is that, in my view, each of us is innately aware of almost mechanical steps we can take to positively impact our Happiness Meter.

In my case, if I am not feeling particularly happy – and nobody can be perfectly happy all the time – by returning to my personal fundamentals, I know that without question pep will soon return to my step.

Does this really have any relevance to those of us who like to manage our own investments? I think it does.

For example, if you find yourself staying up at night worrying about your investments, it's a clear sign you are doing something wrong. You can choose to continue being worried, a clear sign of unhappiness if there ever was one, or decide to do something about it.

You might start by making sure that your worries aren't simply an outbreak of over-emotionality caused by other factors in your life: exercising too little, problems on the home front, concern over a job, etc. We humans are complex creatures, given to all sorts of unwarranted worries – so make sure your basics are covered before doing anything rash. Panic almost never does anyone any good.

Next, you might want to study your portfolio, specifically the reasons why you own each of your holdings and what you expect of them. As I have commented upon previously, tangible investment risk is largely a function of the likelihood that you'll be forced to sell at an inopportune time. If your investment logic is solid – and that logic should always be based on being positioned on the right side of powerful trends, then not overpaying for the investments that you choose to play those trends – the daily gyrations, no matter how severe, should be of almost no concern.

If on checking your premises, you discover that nothing fundamental has changed that would have altered your original premise for making a specific investment in the first place, then your worries should drop away and your Happiness Meter rise. Alternatively, if you find you still have your doubts, then you are almost certainly overinvested in whatever is worrying you, and you should look to reduce your allocation to the point of unconcern.

Then you might want to get together with some friends, crank up the music, tell a few jokes and maybe do a little whirling about.

Whatever you do, don't let the persistent problems of the economy define your life or cause your Happiness Meter to get stuck in a bad place.

Moving along, it's my pleasure to introduce you to an up-and-coming entrepreneur and economist, Keith Weiner, a very serious student of the markets and gold in particular. When I first saw his work, I thought those of you interested in gold would find it useful and so reached out to him to provide the following article.


Permanent Gold Backwardation

By Keith Weiner

The Root of the Problem Is Debt

Worldwide, an incredible tower of debt has been under construction since President Nixon's 1971 default on the gold obligations of the US government. His decree severed the redeemability of the dollar for gold and thus eliminated the extinguisher of debt. Debt has been growing exponentially everywhere since then. Debt is backed with debt, based on debt, dependent on debt and leveraged with yet more debt. For example, today it is possible to buy a bond (i.e., lend money) on margin (i.e., with borrowed money).

The time is now fast approaching when all debt will be defaulted on. In our perverse monetary system, one party's debt is another's "money." A debtor's default will impact the creditor (who is usually also a debtor to yet other creditors), causing him to default, and so on. When this begins in earnest, it will wipe out the banking system and thus everyone's "money." The paper currencies will not survive this. We are seeing the early edges of it now in the euro, and it's anyone's guess when it will happen in Japan, though it seems long overdue already. Last of all, it will come to the USA.

The purpose of this article is to present the early-warning signal and explain the actual mechanism to these events. Contrary to popular belief, it will not happen because the central banks increase the quantity of money to infinity. The money supply may even be contracting (which is what I expect).

To understand the terminal stages of the monetary system's fatal disease, we must understand gold.

Defining Backwardation

First, let me introduce a key concept. Most traders define "backwardation" for a commodity as when the price of a futures contract is lower than the price of the same good in the spot market.

In every market, there are always two prices for a good: the bid and the ask. To sell a good, one must take the bid. And likewise, to buy the good, one must pay the ask. In backwardation, one can sell a physical good for cash and simultaneously buy a futures contract, and make a profit on the arbitrage. Note that in doing this trade, one's position does not change in the end. One begins with a certain amount of the good and ends (upon maturity of the contract) with that same amount of the good.


Many commodities, like wheat, are produced seasonally. But consumption is much more evenly spread around the year. Immediately prior to the harvest, the spot price of wheat is normally at its highest in relation to wheat futures. This is because wheat inventories in the warehouses are very low. People will have to pay a higher price for immediate delivery. At the same time, everyone in the market knows that the harvest is coming in one month. So the price, if a buyer can wait one month for delivery, is lower. This is a case of backwardation.

Backwardation is typically a signal of a shortage in a commodity. Anyone holding the commodity could make a risk-free profit by delivering it and getting it back later. If others put on this trade, and others, and so on, this would push down the bid in the spot market and lift up the ask in the futures market until the backwardation disappeared. The process of profiting from arbitrage compresses the spread one is arbitraging.

Actionable backwardations typically do not last long enough for the small trader to even see on the screen, much less trade. This is another way of saying that markets do not normally offer risk-free profits. In the case of wheat backwardation, for example, the backwardation may persist for weeks or longer. But there is no opportunity to profit for anyone, because no one has any wheat to spare. There is a genuine shortage of wheat before the harvest.

Why Gold Backwardation Is Important

Could backwardation happen with gold? Gold is not in shortage. One just has to measure abundance using the right metric. If you look at the inventories divided by annual mine production, the World Gold Council estimates this number to be around 80 years.

In all other commodities (except silver), inventories represent a few months of production. Other commodities can even have "gluts," which usually lead to a price collapse. As an aside, this fact makes gold good for money. The price of gold does not decline, no matter how much of the stuff is produced. Production will certainly not lead to a "glut" in the gold market pulling prices downward.

So, what would a lower price on gold for future delivery mean compared to a higher price of gold in the spot market? By definition, it means that gold delivered to the market is in short supply.

The meaning of gold backwardation is that trust in future delivery is scarce.

In an ordinary commodity, scarcity of the physical good available for delivery today is resolved by higher prices. At a high enough price, demand for wheat falls until existing stocks are sufficient to meet the reduced demand.

But how is scarcity of trust resolved?

Thus far, the answer has been: via higher prices. Higher prices do coax some gold out of various hoards, jewelry, etc. Gold went into backwardation for the first time in December 2008. One could have earned a 2.5% (annualized) profit by selling physical gold and simultaneously buying a February 2009 future. Gold was $750 on December 5, but it rocketed to $920 – a gain of 23% – by the end of January.

But when backwardation becomes permanent, then trust in the gold futures market will have collapsed. Unlike with wheat, millions of people and many institutions have plenty of gold they can sell in the physical market and buy back via futures contracts. When they choose not to, that is the beginning of the end of the current financial system.

Why?

Think about the similarities between the following three statements:

• "My paper gold future contract will be honored by delivery of gold."
• "If I trade my gold for paper now, I will be able to get gold back in the future."
• "I will be able to exchange paper money for gold in the future."

The reason why there was a significant backwardation (smaller backwardations have occurred intermittently since then) is that people did not believe the first statement. They did not trust that the gold future would be honored in gold.

And if they don't believe that paper futures will be honored in gold, then they have no reason to believe that they can get gold in the future at all.

If some gold owners still trust the system at that point, then they can sell their gold (at much higher prices, probably). But sooner or later, there will not be any sellers of gold in the physical market.

Higher Prices Can't Cure Permanent Gold Backwardation

With an ordinary commodity, there is a limit to what buyers are willing to pay based on the need satisfied by that commodity, the availability of substitutes and the buyers' other needs that also must be satisfied within the same budget. The higher the price, the more holders and producers are motivated to sell, and the less consumers are motivated (or able) to buy. The cure for high prices is high prices.

But gold is different. Unlike wheat, gold is not bought for consumption. While some people hold it to speculate on increases in its paper price, these speculators will be replaced by others who hold it because it is money.

Once the gold owners have lost confidence, no amount of price change will bring back trust in paper currencies. Gold will not have a "high enough" price that will discourage buying or encourage selling. Thus gold backwardation will not only recur, but at some point, it will stay in its backwardated state.

In looking at the bid and ask, one other observation is germane to this discussion. In times of crisis, it is always the bid that is withdrawn – there is never a lack of asks. Permanent gold backwardation can be seen as the withdrawal of bids denominated in gold for irredeemable government debt paper (e.g., dollar bills).

Backwardation should not be able to happen at all as gold is so abundant. However, the fact that it has happened and keeps happening means that it is inevitable and that, at some point, backwardation will become permanent. The erosion of faith in paper money is a one-way process (with some zigs and zags). But eventually, backwardation will become deeper and deeper (while the dollar price of gold is rising, probably exponentially).

The final step is when gold completely withdraws its bid on paper. At that point, paper's bid on gold will be unlimited, and this is why paper will inevitably collapse without gold.

Conclusion

Permanent gold backwardation leading to the withdrawal of the gold bid on the dollar is the inevitable result of the debt collapse. Governments and other borrowers have long since passed the point where they can amortize their debts. Now they merely "roll" the debt and the interest as they come due. This leaves them vulnerable to the market demand for their bonds. When they have an auction that fails to attract bids, the game will be over. Whether they formally default or whether they just print the currency to pay, it won't matter.

Gold owners, like everyone else, will watch this happen. If government bond holders sell their securities in response to this crisis, they will only receive paper backed by that same government and its bonds. But the gold owner has the power to withdraw his bid on paper altogether. When that happens, there will be an irreconcilable schism between gold and paper, with real goods and services taking the side of gold. And in a process that should play out within a few months once it gets started, paper money will no longer have any value.

Gold is not officially recognized as the foundation of the financial system. Yet it is still a necessary component. When it is withdrawn, the worldwide regime of irredeemable paper money will collapse.

Keith Weiner is a technology entrepreneur who founded DiamondWare, a VoIP software company, which he sold to Nortel in 2008. Keith is an adherent of Ayn Rand's philosophy of Objectivism and a student at the New Austrian School of economics, working on his Ph.D. under Professor Antal Fekete, with a focus on monetary science. Keith is now a trader and market analyst in precious metals and commodities. Now that central planning has failed, he would like the world to return to a proper gold standard and laissez-faire capitalism.


Friday Funnies

The following was sent to me by my friend John Mauldin during a break in a grueling trip he's on to South Africa. It's both funny and very apropos for those of us who understand the nature of intelligent speculation.

David,

I like a legal department that has a sense of humor. This is the standard disclaimer that Contango Oil & Gas Company (MCF) includes with their quarterly earnings reports:

Lawyer Stuff

The future is unknowable. We have good intentions, but all of our projections and estimates will be wrong, and could be materially wrong. Wildcat exploration is expensive, speculative and potentially dangerous. An offshore spill or explosion would be enormously expensive. We have insurance, but it may not be enough. You could lose your entire investment. Don't be lazy – read our 10-Q's, 10-K's and press releases, and if you lose money – please no tears.

"Don't forget about risk-free T-bills in your portfolio… After inflation and taxes, you'll likely only lose 5-10% of your investment."

—Contango V.P. Investor Relations

Speaking of my electronic breakdown today… this pretty well sums it up.


And since we're looking at how things have changed…


And thanks to Pete Kofod for sending this along… you really can't make this stuff up.


And finally, there's this… which I think is funny, but maybe it's more outrageous?


Here's the full article.


That's It for Today!

Thanks to the slow start this morning, I'm running late today so will sign off promptly.

Before I go, I'll mention that the registration opens next week for our Casey Research "Plan B" Summit in Weston, Florida, April 27-29.

So far, the confirmed faculty includes David Stockman, John Williams, James Rickards, Porter Stansberry, John Hathaway, Doug Casey, John Mauldin, Lacy Hunt, Gordon Chang, Andy Miller, Greg Weldon, Michael Lewitt, Adrian Day, Pete Kofod… plus, Bud Conrad, Louis James, Marin Katusa, Jeff Clark, Alex Daley and many more.

It's going to be a great event and will sell out quickly, so watch the mails for more.

Until next week!



David Galland
Managing Director
Casey Research