Failure to Launch

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Although confidence still shows hardly any signs of making a return, other components of the financial world indicate that some work is in progress, and that we can eventually expect some visible results. For example, Citi is trying to work things out with half a million of its mortgage holders who owe it some $20 billion, and who may be fretting about being able to celebrate the coming holidays at their address of record. However, the economic roster is looking more like a hit list drawn up the Bada Bing, over in Jersey.

American Express became a bank overnight, and that transformation was likely not because of a burning desire to offer more products and services to its customers. GM inched closer to Circuit City's fate, as the sand clock runs out of grains and its dealers cannot seem to push any iron off the lots. Toll Bros. revenue slumped as luxury home buyers pulled a vanishing act. Starbucks offered only decaf profits on the quarter, as its legions of java junkies opted to skip the latte a bit more often. The Sands suspended casino building operations in Macau. AIG's process of zombification took another step forward with additional taxpayer cash, making one wonder how many firms will end up as the walking dead down the road. One Bloomberg commentator wondered if major retailers are next. Could a bailout of Santa be far behind?

And, if the above were not enough to send you reaching for some Xanax this morning, consider the ultimate outcome of the hyper-cycle in commodity prices: profit-hungry rogue suppliers of materials who could give a hoot about something that could kill you. Radioactive stuff. The world has enough trouble without having to contend with beer kegs and elevator buttons that send a Geiger-counter crackling. This is true, folks. Beware that Stella - you might acquire a star-like glow yourself...

Precious metals opened lower, after yesterday's Beijing spending plan proved to be no more than hot and sour soup. Hot at first, as commodity speculators saw redemption in the package. Sour after a while, when the same crowd decided that the program may be insufficient to halt the global slide. First-hand evidence came none too early, as oil prices fell under $60 and the greenback rose to 86.20 on the index. The Nikkei did not fare very well overnight, losing 272 points and indications were that US stocks might not enjoy a better session either.

Commodities weighed on European stocks this morning as economic concerns outweighed yesterday's China boost. Gold lost $8 on the open, quoted at $736.50 and raising questions of retests of the $730 area support (beyond which $690 looms once more). Silver fell back under double-digits, losing 25 cents on the open, at $9.90 per ounce. Platinum basically returned yesterday's gains an dropped $35 to $818, while palladium slid $4 to $215 per ounce as GM struggles to see another day.

And now, we bring you the focus topic from the latest VM Fortis report on gold. As briefly mentioned yesterday, it concerns the much-vaunted gold ETFs. Let's dig in:

"Gold ETFs saw considerable inflows in September as the financial crisis raged globally. In total (see p.12) 113t was added to their holdings, which are now well over 1,100t. Investors were clearly attracted by gold's reputation as a safe haven in times of trouble, and perhaps one that stands in contrast to a banking sector on its knees. However despite this "perfect storm" and large inflows the gold price failed to regain its highs of March 2008, and subsequently as some of the fever subsided the price fell back (along with other commodities) to its lowest level in more than a year. It's too early to speculate on whether gold's failure to perform has caused long-term damage to its reputation as a safe asset in difficult times, however we can examine the motivation of gold ETF investors, and ask whether gold has been a successful investment for this group of investors.

One way to do this is to look at what price investors in the ETF bought their holdings. There have been gold ETFs since 2003, but the sector really took off with the launch of the US StreetTRACKs ETF in November 2004 and since then most months have seen net inflows of gold. Over that period the gold price has gone from less than $400/oz to over $1,000/oz, so clearly investors have been buying in at different gold prices.

Charts may be found at: http://www.kitco.com/reports/fortis_nov2008.pdf

The first chart on the vertical axis shows monthly inflows into gold ETFs (the blue bars) and months when there were outflows (grey bars), and at what gold price these were made (the horizontal axis). So for example most inflows, just over 300t, came at a gold price of between $400/oz and $450/oz. This was the price when the US SPDR ETF was first launched, and includes the large inflows seen at launch. These investors are clearly sitting on large profits if they still retain their holdings.

However there have also been inflows at much higher prices, including prices well above today's price . these investors are facing potential losses. Of course we cannot be sure of the actual price investors who still own precious metal ETFs actually paid in the first place. This is for two reasons. First there have been outflows of metal from time to time, and we do not know at what price the investors who sold their holdings originally bought into the ETF. They might be the investors who bought in early and at a price of $400/oz, or they might be investors who bought at a much higher price. Furthermore as there is turnover of ETF shares in the secondary market we cannot be certain that the investors who originally bought at various price points still own their holdings . the net figures on ETF holdings might be masking movements in the gross figures.

There is no perfect way to deal with the first problem. However given outflows in gold have always been small as a percentage of inflows, the inaccuracy it can cause should be limited. We have used two methods to adjust for outflows. First we assumed that when there is an outflow it has come equally from investors across all price brackets. For example if there were 500t in gold ETFs but a monthly outflow of 50t, we assume that 10% of all holdings purchased at every price point have been sold. This method means that we assume much of the holdings that were bought early on, and at lower prices, have been sold.

The other method is to assume that it is the most recent 50t of investment that gets sold when there are outflows. As will be seen the two methodologies give similar, but not exactly the same results. The second potential pitfall, that of secondary market sales, is probably not too critical . most ETF providers have repeatedly said that investors in ETFs are of the .buy and hold. type: on this reasoning; it would seem safe to assume that most investors who bought into the ETFs still hold their shares.

The second chart then is the first chart put on a cumulative basis and with the corrections for outflows - it shows our best estimates of the price at which gold ETF investors who still hold their investments originally bought their holdings. The chart can be read as follows: the vertical axis is cumulative tonnes held by the ETFs; the horizontal axis is the price at which we estimate those holdings were bought. The blue or grey line shows the cumulative metal held by each ETF at various price points according to our two methodologies. So in gold, for example, we believe very little was bought at $300/oz to $400/oz, but more than 200t was bought at prices below $450/oz, and 400t-450t at prices below 600/oz.

The current gold price is about $750/oz, which we have shown by the vertical line; we estimate that 750t-800t currently held in the gold ETFs was bought at prices below this level, with just 300t or so above. So even at today's relatively low gold price it seems that many investors in the gold ETF are still sitting on large profits. This is in stark contrast to the silver or PGM ETFs, which were launched at a much later stage in the commodities bull market and might explain why gold investors have stayed the course more than those in the PGM ETFs. But note, however, that if the gold price were to fall to $600/oz, then a lot of investors in the ETF would then suffering losses, which could make them more likely to sell up and see large outflows of gold."

Liquidations and risk-aversion are back on the radar. The recessionary/deflationary trend is keeping players parked on piles of cash for the moment.

Happy Veteran's Day to our USA readers. Remember them ALL.