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Gold Reaching for the Sky

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The metal could peak at $1000, or bubble higher.

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All that glitters is not gold. Or is it? In the 21st century, "the barbaric relic" has been one of the best investments that you could have made. Since 2000 the price of an ounce of gold has risen from $271 to a high of $941 - for a not so shabby 347% gain. The DJIA in the meantime has only managed to eke out a 30% gain over the past decade rising from 10,900 to a high of 14,200 before the recent retrace to 12,300.

Gold has produced ten times the return of stocks over the past 7 years. It's been the Arnold Schwarzenegger of the investment universe while stocks have been the Woody Allen. Don't misunderstand us, we like the Wood-man well enough, but when it comes to our portfolios we want nothing but muscle to pad our returns.

Nevertheless while past performance is nice, it means nothing. As the immortal Raul Julia once stated in the movie The Gumball Rally, "What's behind me does not matter", as he ripped out his rear view mirror before commencing a cross country car race. The only question that does matter is what lies ahead for the yellow metal. We take up the argument here.

$1500? No problem.

Notice I didn't even bother to set the argument at the more conventional $1000/oz level because $1000.00/oz is a gimme. We'll probably break that barrier sometime in 1Q of 2008 and then the party will really get started. It will be on the cover of Time Magazine, updated every 5 minutes on financial television, Grandma will go rummaging through her long forgotten jewelry drawers trying to find any trinket that she can sell for scrap and so on. Bottom line: gold is going up as fear and loathing spreads through the global economy and investors trust the value of the dollar less and less.

Not So Fast

$1000 is exactly the problem. Everyone is targeting $1000 and I bet there is a mountain of take profit orders at that price level. I agree that when we crack $1000, the gold story will be plastered on the covers of the Economist, Time Magazine and Business Week. But that's exactly when gold will top out. It's in a bubble. Everyone "knows" that its supposed to go higher and that alone may be reason enough for it not to get there. Markets rarely go where the majority thinks they will and we all know how those stories end. The Magazine Indicator has correctly forecasted the major recoveries in the US dollar and the top in technology boom. The same will be true for gold. Furthermore, even if we look beyond sentiment, gold prices could top out if inflation eases. The Baltic Dry index which is a measure of the shipping cost for commodities is well off its November highs. Central banks from the US to the UK expect inflation to ease as growth slows. Just this week, in their Quarterly Inflation report, the Bank of England said that a "sharper slowing in activity would threaten to pull inflation below the target." One of the main reasons why gold has been doing so well is because it is typically seen as an inflation hedge. Therefore, if you believe that global growth will slow even further then consumer prices will come fall as well, bringing gold down with it. When we have a correction in gold, the moves can be anywhere between $50-100/oz.

Yeah the inflation part usually true. But gold can also serve as store of value in times of turmoil and that's what I think is happening now. The global financial system is teetering on the edge. The Fed is priming the pump trying desperately to reflate the system. Helicopter Ben is lowering rates every month while Federal government deficits are going to balloon, especially as tax revenues dry up. Hey I am no gold bug, I hate the stuff actually – and I certainly don't think you can run a modern post-industrial society on the gold standard. But as someone once said, gold is not an investment it's an insurance policy. If times get tough – and I think they will – people will flock to gold for safety, especially if the dollar continues to decline. In fact that's been the best correlation bet in financial markets this whole decade – the lower the dollar goes the higher the gold rises. Basically it's serving a function as "hard money".

You're right, but if the dollar rallies your whole case falls apart. In fact, the dollar HAS already been rallying since the beginning of February. The main reason is because the Street believes that the Fed's aggressive rate cuts will lead to shallow downturn and a swift recovery. All the other countries that have not cut interest rates or have cut by only very little will be left behind the curve and rushing to catch up with the Fed and when this happens, we will see a more meaningful rally in the US dollar and a turn in gold.

Ok I'll give you that. If the greenback strengthens the argument for stronger gold diminishes but doesn't go away. In 2005 the dollar appreciated considerably and gold still rose. This is a secular bull market in gold. As we pile on more and more debt, investors become less secure and confident in holding paper assets and flock to gold.

Part of the reason why gold has been rallying is also the demand from Asian countries. Last year, China overtook the US as the world's largest consumer of gold. But even though demand for gold is rising in dollar terms (because of the high price of the commodity), in tonnage terms demand is actually slowing. According to the latest edition of Gold Demand Trends, identifiable demand fell 17 percent in tonnage terms compared to the fourth quarter of 2006. More specifically demand from India is expected to drop 25 percent this year because of high prices. It is already down 90 percent in the month of January compared to last year. Gold jewelry demand from China is expected to slow while Japanese investors will probably continue selling into strength. There is going to be a lot of supply out there and little demand, which will cap the rally in gold.

I agree. It's a bubble like any other. But the thing with bubbles is that they tend to go higher and further than anyone thinks. I remember when Nasdaq was trading 3500 and all the smart money was convinced that it was due to drop. Instead it went to 4000 and then 5000. At 5000 many long time bears caved in and covered while some even went long. Of course that's when the thing finally popped like a circus balloon. Gold may do the same thing. It can go to 1000, then 1500 and even 2000/oz before the mania wares off. So in my opinion the parabolic portion of the run is just starting.

I don't think that central banks will let this happen. There's a buzz in the gold market about how central banks could intervene to push prices lower, if they haven't already. I read an interesting interview with Chris Powell, a co-founder of the Gold Anti-Trust Action Committee. He said that there was a few interesting words uttered by Greenspan when he appeared before Congress in July of 1998. He waved off the necessity for the CFTC to regulate gold derivatives, telling Congress to fear not, that the "central banks stand ready to lease gold in increasing quantities should the price rise." Chris says that "the real purpose of gold leasing was to suppress the gold price." In 2005, William White, the head of the Monetary and Economic Department of the BIS confirmed that the Fed may be in on the gold market. When he talked about the "intermediate objectives of central bank cooperation, the fifth objective was "joint efforts to influence asset prices (especially gold and foreign exchange) in circumstances where this might be thought useful." There's even an official agreement signed in 1999 by the representatives of the ECB and the central banks of Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, Switzerland, and England-which spelled out how the banks would cooperate in the regulation of the gold market. It is believed that the official sector (aka central banks) is ready to step in on gold price rallies if it gets out of hand.

Where are the currency plays?

I think the Aussie will benefit handsomely if gold rises. Australia is after all the second largest producer of the metal in the world. Furthermore with 7% yield its one of the best paying currencies in the Industrialized world. But I am not so sure I would buy it against the dollar. I am afraid that if gold rises, it will be due to a big collapse in equities which will create massive carry trade unwinds and the Aussie could be a victim of those flows. Instead I think I'd rather buy it against other high yielders, especially the pound which will be more very vulnerable to a financial collapse.

I've long been an Australian dollar bull and I still like it. I think we'll get a move up to 92 or 93 cents if we gold hits $1000 but that may be the extent of the rally. If gold begins to top out, I'd sell Australian dollars against the Japanese Yen because the current market environment is incredibly difficult for carry trades.

What Does this Mean for My Stock Positions?

Long gold means being long resources economies of Canada and Australia. So, here is a macro idea to consider. If you are bullish gold into the next parabolic wave that basically implies a bearish view of global economy. Japan, as a major exporter is very vulnerable in such a scenario. Furthermore deceleration of global growth will generally suggest lower equity prices which will naturally push the yen higher and create a squeeze from both sides on Japanese multi-nationals (higher costs due to higher yen, lower revenue due to fewer sales) that deadly dynamic could drive the Nikkei back into the ground. Meanwhile if gold rallies, both the Australia and Canadian indices, which are chuck full of miners, could outperform. So a short Japan (EWJ) against a long (Australia (EWA) and long Canada (EWC) might be the play to make in 2008.

If you have a view in gold, I think you should just trade gold ETFs outright. No point in getting too fancy with the indexes of specific countries, although they may be good for diversification for the investors who want to get long or short gold but don't want to put all of their eggs in one basket.
No positions in stocks mentioned.
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