Gold bugs have been vindicated as geniuses in 2020’s bull run. The precious metals are shining, and the commodity bulls are raking in the African Krugerrand and the Canadian Maple Leaf coins. Ain’t life grand? Like every explosive market, investors are wondering if they are witnessing a bubble in real-time. That is seemingly the $2,000 question, but is it the wrong one? Perhaps the real question is: Are we starting to see a bubble form in the paper gold markets? If so, hang on to your Chinese Pandas and Australian Kangaroos because it might be a bumpy ride.
Physical vs. Paper
Paper gold is an asset that reflects the price of gold futures, but the real metal does not back it. The paper acts as a substitute for the real thing, whether it is an exchange-traded fund (ETF) or a COMEX futures contract. In the end, you have the promise to receive gold. Physical gold is self-defining: a bullion of fine gold in the form of a bar or a coin. The yellow metal is in your possession, and you are not beholden to bubbles or chaos in the financial markets.
There is a divergence in price. Paper gold typically does not include buying and selling physical metals. Gold futures determine the changes in gold spot prices in the U.S. dollar, the euro, the yen, and other fiat currencies. Physical gold is priced based on both demand and refiners purifying gold ore into .999 fine bullion, which is then sold to mints, governments, and wholesale dealers.
Novice investors might be wondering why you should choose one over the other. For the most part, if you own gold to protect your wealth throughout your life, physical ownership is preferable. However, if you are speculating that the price of gold will go up or down based on market conditions, trading ETFs or contracts could be reasonable options, based on your strategy.
A Bubble Brewing?
In recent weeks, interest in gold has skyrocketed, perhaps even more than during the financial crisis more than a decade ago. Since it is harder to acquire physical bullion, either due to declining supplies or tremendous premiums, many traders are turning to paper for access to the five-millennium-old metal. The potential problem with this is that if there is a rush to take delivery of gold, paper will crater since these funds are mostly a promise to buy the yellow metal when it is necessary.
Is there enough gold to cover demand from those standing for delivery in futures contracts? Many of the banks or brokers do not buy gold and store bars and coins in safekeeping. A lot of these outfits depend on the fractional reserve system, selling gold without ever acquiring it. According to metals maven Doug Casey, you can usually find out if this is the case by reading the fine print of paperwork or investments:
“Sometimes the fine print will state that all that is being sold is a promise. In other cases, it will say that the seller makes use of an outside facility for storage, and the buyer is, therefore, subject to the conditions of that storage facility. If the buyer were to request a copy of that agreement, he might find that the terms of the ‘storage facility’ amount to only a promise to purchase.”
Since the Coronavirus pandemic, it has been common knowledge that the expectations of gold buyers have been difficult to satisfy. From refineries suspending operations amid the public health crisis to not arranging air transport for gold, it is hard to believe that there is enough deliverable gold in the United States, COMEX vaults, and bullion banks.
The London Metal Exchange (LME) is in the beginning stages of extending gold contracts that are closer to physical delivery than competing contracts. This could dismantle the present paper gold system. There have also been recommendations to incorporate blockchain technology into gold markets to ensure accountability, transparency, and integrity in every transaction, from the mine to the consumer. What better way to blend a conventional asset with the technology of tomorrow?
A 5,000-Year-Old Bubble
Gold bugs aver with a smirk that the yellow metal is in a 5,000-year-old bubble. Critics, mainly the Fed bugs, will always dispel every run as nothing more than speculation and unfounded fears – until now. Everyone seems to be grabbing a pan, a pick hammer, and a copy of The Treasure of Sierra Madre. Even the investment titans who ring the old doomsday inflation alarm are urging investors to scoop up some bullion. Are you trying to make a quick and dirty overleveraged profit on an overexposed ETF? Or are you going long by picking up a ten-ounce bar and placing it in your safe? Either way, it is critical to know the fundamentals. The “gold is money” phrase yelled by libertarians everywhere is correct, but gold can also make you money in today’s chaotic world.
Read more from Andrew Moran.