What The Federal Reserve Can Learn From Toilet Paper and This Year’s #1 Performing Asset Class

When the pandemic first struck in the United States what many people will remember is how hoarding of toilet paper created massive shortages. For several weeks you could not find toilet paper on the grocery store shelves and memes circulated the internet wondering what life would be like without it. The Great Toilet Paper Panic of 2020 unfolded as everyone braced for the headwinds of the economic lockdown and pandemic. This trend accelerated worldwide as scared individuals purchased ten times their normal amount of toilet paper.  Eventually the supply chains rose to the challenge and today months after the pandemic began there is no real shortage of toilet paper in the United States.

What does this have to do with the world financial markets?

Everything!

Can you imagine a world where toilet paper shortages persisted? What would cause such an occurrence?  What would the casualties be if that occurred? How much time would you spend looking for toilet paper?  How much more would you be willing to pay for a roll?  What toilet paper substitutes would develop? What new laws would exist around toilet paper consumption and manufacturing?

The very foundation of all markets is rooted in the theory of supply and demand.  This theory explains the interaction between the sellers of a resource and the buyers. The theory defines what effect the relationship between the availability of a particular product and the desire for that product has on its price.

While a temporary shortage existed in toilet paper, the market quickly returned to normal because suppliers increased the supply of toilet paper based upon the massive increase in demand. The end result was normalcy. But… what would your world look like today if suppliers were unable to bring new supplies to the market?

While my question is theoretical in nature, all you need to do is look at the Gold market and you will quickly understand that all of these exact questions and issues, for real, are being addressed at the present moment.

Gold is a global store of value and medium of exchange that has persisted for over 5,000 years.  One of the problems with gold is that, unlike other commodities such as oil or wheat, it does not get used up or consumed. Once gold is mined, it stays in the world. A barrel of crude oil, on the other hand, is converted into gas and other products that are utilized in your car’s gas tank or an airplane’s jet engines. Commodities like grains are consumed in the food we eat. Gold, on the other hand, is turned into jewelry, used in art, stored in coins and ingots and locked away in vaults, with the idea that it is prosperity preserved for the future. Because of its chemical composition is such that the precious metal cannot be used up – it is permanent.

Since the United States came off the Gold Standard on August 15, 1971 investors in Gold have been considered doom and gloomers because they disagreed with a fiat currency system which promoted inflation and a debasement of the currency.  Traditional economists to this day refer to gold as a barbarous relic with little or no utility.  Furthermore, if you look on most major investment websites, Gold and precious metals are often not considered to be a legitimate asset class since you cannot earn interest on GOLD.

All of these inferences have labeled Gold investors as “deviants” who are outside of the mainstream norms. But unlike any other commodity, gold has mesmerized of human societies since the beginning of recorded time.  Historically, Gold is universally accepted as a satisfactory form of payment. In short, history has given gold a power unlike that of any other commodity on the planet, and that power has only grown over the last 50 years. The U.S. monetary system was based on a gold standard until August 15, 1971. Proponents of this ancient standard argue that such a monetary system effectively controls the expansion of credit and enforces discipline on lending standards, since the amount of credit created is linked to a physical supply of gold. It’s difficult to argue with this line of thinking after nearly three plus decades of a credit explosion in the U.S. led to the financial meltdown in the fall of 2008 and the current economic lockdown.

I am going to pose a few scenarios to you so you can understand the current tone of the gold market and decide for yourself what might happen moving forward.

When the pandemic and economic lockdown began, the April Gold futures contract came upon its expiration date on March 31st, also known as delivery. What this means is that as you approach the final day of trading a very small percentage of buyers remain in the contract and choose to accept delivery of the underlying metal. These traders are usually very well capitalized.  Some are bullion dealers, banks, international financial advisors who purchased the underlying futures contract with the intention of taking delivery of the actual metal at contract expiration. To do this, the buyers pay the full settlement price for 100 ounces of Gold and they receive a warehouse receipt for the underlying metal.

The main reason that futures markets work so well is they allow for the smooth convergence of derivative prices with the prices in the physical markets. The convergence of the two prices occurs by the delivery mechanism that exists in the futures market.  Although buyers of futures pay only a small, good-faith deposit in the form of initial margin deposit, they are always liable for the total contract value. That is why there are two types of margin, initial and maintenance margin. As the nearby future moves into the delivery period, a buyer of a futures contract who maintains their position must be ready to accept the actual commodity’s delivery and pay full value for the raw material product.

Commodity Futures exchanges work with industry to develop standardized quantities, qualities, sizes, grades, and locations for a physical commodity to be delivered. The exchange designates delivery locations as well as terms for commodity delivery. The exchange also sets the rules and regulations for the delivery period, which can vary depending upon the particular product.

At the time of the April Gold Settlement contract the COMEX exchange opted to not deliver any warehouse receipts to any of the traders who chose to accept delivery of the underlying metal.  “Force majeure” is a common clause in commodity contracts that essentially frees both parties from liability or obligation when an extraordinary event or circumstance beyond the control of the parties, such as a war, strike, riot, crime, epidemic or an event described by the legal term act of God, prevents one or both parties from fulfilling their obligations under the contract. In practice, most force majeure clauses do not excuse a party’s non-performance entirely, but only suspend it for the duration of the force majeure.

In April the COMEX and London Bullion Metals Association (LBMA) initiated its first Force Majeure.

As you might imagine, this story created all types of fear in the marketplace. Usually less than 1% of all futures contracts are delivered at expiration. However, at the April delivery roughly 5% of the Open Interest chose to accept delivery. It is very unusual and considered to be highly disruptive for a commodity not to be delivered. At its very least, this is considered to be a massive imbalance in the marketplace.

Does the gold exist?

Since Gold producers have closed up their mines how much of a backlog in production actually exists?

When will the gold start being mined again?

Then at the settlement of the June Contract on May 31st, the exact same thing occurred.  Traders wanted to accept delivery of the underlying metal and the exchange chose to rather a cash settlement of the contract instead.  Force majeure was initiated again.

Bullion dealers unable to get their hands on Gold raised their prices far above the spot Gold price.

These two facts have not been widely reported in the financial media.

Look at them now through the eyes of someone who is trying to hedge their assets based upon the $5 trillion in new cash the Fed has added into the economy since the pandemic began. Gold, the ultimate store of value, was unobtainable.

Gold has rallied from $1,591 per ounce on April 1 to $1,835 per ounce as of today. That’s a 15% gain in less than three months.  But here is where this story becomes truly dramatic.

Gold has been the TOP performing asset class of 2020.

There is HUGE demand for the underlying metal and in spite of rising prices the demand increases since no supply is coming to the market.

Here is a breakdown of the top performing assets for 2020 so far:

Precious Metals 25.27%
Long Term Treasury 21.45%
Gold 17.12%
US Large Cap Growth 11.25%
10-year Treasury 11.21%
Long-Term Corporate Bonds 10.52%
Intermediate Term Treasury 8.00%
Corporate Bonds 6.46%
Total US Bond Market 6.30%
TIPS 6.01%
US Mid Cap Growth 4.34%
Short Term Treasury 3.48%
Short-Term Investment Grade 3.22%
Long-Term Tax-Exempt 2.24%
Intermediate-Term Tax-Exempt 2.13%
Global Bonds (USD Hedged) 2.07%
Short-Term Tax-Exempt 1.16%
US Small Cap Growth 0.67%
Cash 0.39%
Inflation 0.32%

All other asset classes are losing money!  But now look at the above list and exclude anything in the credit markets.

Why?

Well, since the 1990’s traders often would scoff at the Japanese credit markets because a 10 year Japanese Bond would yield .6%. The joke was that only the Japanese Fed will buy Japanese Bonds.

Guess what?

Today the U.S. 10 Year Treasury is yielding .6%.

Would you tie up your money for ten years for that meager return?

And what about the risk?

The Fed has been quite busy buying corporate bonds, municipal bonds, and other assets that it is technically NOT permitted to buy according to the Federal Reserve Act.  The Fed has created a loophole and is getting around the law by creating credit facilities with the US Treasury. The Fed prints new money and gives it to the Treasury which coordinates with a large broker (BlackRock) to buy the assets on the market.

Once you exclude all the low yielding credit markets from the above list you are left with Precious Metals, Gold and US Large Cap companies which have yielded far less than what Gold has returned.  Furthermore, look at the following chart of the S&P 500 Price to Earnings ratio.  We are far from the 2008 valuation levels on the S&P 500 but still in the very overvalued area historically. Many top investment managers foresee strong headwinds for the stock market based upon these norms.

                                           S&P 500 Price to Earnings Ratio

So we have a scenario in the Gold market where it is the #1 performing asset class and the last two settlements on Comex and LBMA traders wanting to accept and receive delivery of the metal have not been fulfilled.  Force Majeure!

Ian Fleming, the creator of the James Bond franchise wrote in his most famous novel Goldfinger that “Once is happenstance. Twice is coincidence. But three times is enemy action.”  Fleming meant that you can infer who is behind some adversity using the basic laws of probability.  Low probability events do not occur three times in a row.  When these events occur you could question the narrative at all costs to get the facts of what is really going on.

The current narrative on Wall Street is “Don’t fight the Fed.”  But the reality is that Gold is outperforming all other assets while the Fed tries to keep the economy afloat.

The August Gold contract comes up for delivery on July 31st.  This event is being watched more intently than any other report in the financial markets simply based upon the existing supply and demand imbalances that exist.  Should force majeure be enacted again I would venture that the very integrity of the Comex will come into question. The purpose of all markets is for buyers to be able to accept goods that sellers deliver. If those goods are unavailable for delivery the marketplace function is broken and participants should be aware of this.

There is a huge drive towards larger portfolio allocations to Gold (in some cases up to 10%) this is not coming only from the rich themselves but from their wealth managers and portfolio advisers.

This is a major change in the markets.

For decades, wealth managers have rejected Gold and pushed their clients into stocks, corporate credit and alternative investments including private equity. Recently all of those portfolio allocations have backfired.

The Federal Reserve has its hands full with all of the crises it is addressing.  But consider the following:  Demand is up from central banks seeking to diversify away from U.S. dollars. Low interest rates and poor yields in credit markets are adding great interest in the barbarous relic.  Supply is limited by the inability of the mining industry to locate significant new sources of gold ore. Also, foreign governments who mine gold are unwilling to sell in many cases because they can see the economic stress caused by the pandemic. Strong demand, flat supply, low interest rates and fear of credit losses are the best recipe for higher gold prices that the yellow metal has experienced since August 15, 1971 when Nixon took the United States off the Gold Standard.

Here is a price chart of Gold over the last 6 months.  Notice the support at lower prices that exists when “Force Majeure” was initiated by Comex and the LBMA.

                                                  Comex Gold With Delivery Dates

Visit with us and check out the a.i. at our Next Live Training.

Discover why artificial intelligence is the solution professional traders go-to for less risk, more rewards, and guaranteed peace of mind.

It’s not magic.  It’s machine learning.

Make it count.