By Sean Goldsmith in the S&A Digest:
In 1973, the Hunt family of Texas (one of the country's wealthiest families) started buying precious metals to hedge themselves against inflation. Private citizens couldn't own gold at the time, so the Hunts bought silver. Six years later, Nelson Bunker Hunt and William Herbert Hunt, sons of the patriarch oil billionaire H.L. Hunt, started a silver pool with several wealthy Arabs. In a short period of time, the Hunt brothers amassed more than 200 million ounces of silver (half the world's deliverable supply).
Once the brothers had cornered the silver market, panicked investors chased the market higher. The price of silver rose nearly tenfold to $50 an ounce. But a rule change on the Comex and Federal Reserve intervention popped the bubble, and silver prices fell to $10 in March 1980. The Hunt brothers and their Arab partners lost more than $1 billion. The Hunt brothers eventually declared bankruptcy. And in August 1988, they were fined $10 million for market manipulation.
While the story of the Hunt brothers may seem like a warning to some, San Francisco-based hedge fund Passport Capital is citing it as proof a short squeeze is possible in the precious metals market... and as a reason to hoard physical gold (in lieu of gold proxies like GLD).
Passport believes 2009 will mark a shift in central banks' behavior in the gold market, as they become a net source of demand, not supply, for the first time in 20 years. And as central banks start buying, Passport thinks holders of paper gold won't earn as much as bullion holders.
A situation potentially unfolding in the gold market is similar to a short squeeze on a stock. As short sellers depress the price of the stock by shorting the stock naked, buyers may take advantage of the mispricing and start accumulating the stock. Eventually, enough stock will have gravitated to a few hands so that the remaining free float is not sufficient to cover the borrowing needs of short sellers setting the stage for a price spike.
We believe that gold is susceptible to a similar squeeze as the metal gravitates to investors who have little intention of lending or selling it at current prices, and central banks step back from the market as a provider of liquidity... The Hunt brothers' squeeze on the silver market three decades ago is an interesting parallel in history that suggests a physical squeeze on a precious metals market is possible, and that exchanges may change rules to protect the stability of markets in ways that do not necessarily benefit those holding futures positions.
David Einhorn of Greenlight Capital was probably the first hedge-fund manager to hold physical bullion. He said the carrying costs of storage were less than those of holding the gold ETF (GLD). Also, John Paulson, who has earned countless billions on his subprime and inflation bets, holds bullion (in addition to being the largest shareholder in GLD). He's also got a fund denominated in gold – and a new gold fund to protect against the dollar's demise. Just like the Hunt brothers, these hedge-fund managers are buying up tons of physical gold. They'll likely buy more gold on the dips. And they don't plan on selling. When central banks start buying and investors are clamoring for gold, will you have physical metal for delivery?
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