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Gold Bears Prematurely Come Out of Hibernation


With dollar's recent 3-day rally, a predictable call for gold's collapse.

With the dollar's recent 3-day rally off its low for the year, the gold bears have once again predictably come out of the woodwork to call for gold's imminent collapse. And in the interest of "education," I thought we might review the basic fundamentals of the shiny yellow metal once again.

For example, gold bears like to say that gold is going to $500, $600, $700 (pick a number that's a lot lower). My standard response is "Only if there's aggressive investment selling."

I don't think most people understand that the gold market is much more complicated than eyeballing a chart and saying "I think we're going here." Not only does gold have monetary properties (i.e., there's a reason that the Fed and other central banks hold it as a reserve asset), but it's basic supply-and-demand fundamentals must be looked at as well.

As far as new supply goes, the marginal cost of production in 2008 was roughly $800 an ounce (although it's probably more around $750 this year, given the drop in crude oil last year). This means even after the price has roughly tripled since its secular bear market low in 1999, it's still not all that profitable to even mine gold at $950 where we are today. That's also why there's been so little exploration over the past decade, which is why mine supply continues to fall every year.

Looking at the demand side's fundamentals, jewelry demand normally accounts for most gold demand, but obviously, times aren't exactly "normal."

Jewelry demand has been at virtually zero all year thus far in 2009. Meanwhile, scrap supply has surged in 2009 (think as mostly Americans have dumped their gold jewelery to eager investors that want to trade in their "Bernanke bucks" for the yellow metal.

Given all these headwinds, you might be saying, "Wow, it sounds like gold has a lot of bearish things going against it right now." And you'd be correct. But then you might also wonder why gold is roughly the same price that it was over a year ago when every other asset price collapsed last year and has yet to recover. The answer: rising investment demand.

Click to enlarge

It's this investment demand that's soaked up all of this supply and virtually replaced jewelry demand. Meanwhile, central banks have now turned from chronic net sellers of gold throughout the 1990s and early 2000s to net buyers of gold.

You may be saying, "That all sounds nice, but what is your point?" The point is that unless investors suddenly change their behavior and aggressively sell gold, it simply can't go a whole lot lower than probably 850ish given these supply and demand fundamentals (no matter what a chart guy might see in the fish guts and entrails on his ouija board).

And if investors haven't sold gold aggressively to date, why would they do so now, after all the money printing that has occurred since last fall's global margin call and the squeeze that resulted in the dollar's meltup (all of which failed to do anything more than keep the gold price rangebound)?

The more likely outcome is that these investment buyers will aggressively increase their gold purchases, especially once gold trades above its March 2008 high and makes new all-time highs since investors tend to perversely chase higher prices. Now factor in what happens when most scrap supply is absorbed by these investors and it begins to wane. Then factor in when jewelry demand from India returns, as it could this fall (as is the normal seasonal tendency), thanks to the stronger rupee vs. the dollar.

I get accused all the time by fellow Minyans of being bullish on gold no matter what over the past couple years, but surely you can see why I have been so bullish given these bullish fundamentals alongside a housing bust that was inevitably going to lead to massive money printing on a scale that the world has never seen? That's not to mention the fact that "being bullish" on gold has been right and one of the only things that withstood both last year's financial collapse and has continued to hold up this year as other asset prices have recovered to some degree.

In the near term, gold may go up or it may go down within its rough trading range between $900 and $1000 that it has been in for most of 2009, but those looking for a big selloff in gold based on their charts will have to wait for much higher prices before they will get that big selloff. And I continue to believe the odds are high that we're going to get those much higher prices over the next several months.
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