Gold In Record Territory – Where will it go from here?
The announcement that the Indian central bank purchased 200 tonnes of gold (6.43 million ounces) from the International Monetary Fund ignited a rally in bullion. With the price now firmly above $1,100 for the first time, opinion is divided as to where it will go from here.
There are a couple of optimistic elements in the purchase of gold by the Reserve Bank of India. For one thing, the knowledge that the IMF was intending to sell more than 400 tonnes of its bullion reserves had put a damper on the gold market. Many gold analysts were concerned that the IMF would dribble gold onto the market and therefore depress the price as the Bank of England did a decade ago. Finding a ready buyer for half of the gold that the IMF planned to sell removed that overhang from the market.
The second reason for optimism is that India’s conversion of dollars for more gold in its official reserves may be a signal that other Central Banks could do the same. Analysts now see the potential for other central banks to step up and take the other half of the IMF gold, removing the balance of the overhang. China is at the top of the list, although their official position is that they will continue to buy domestically produced gold. With China now the world’s largest gold producing nation, they have ample supply.
The thinking that other central banks would exchange a larger portion of their US dollar reserves for hard assets was escalated by some commentators to a belief that central banks will make a wholesale switch out of dollars and into gold. Some are even suggesting that gold might become the leading reserve currency.
That thinking needs to be evaluated carefully. First, the 6.43 million ounces purchased by India boosted gold from 3.7% to 6% of their total reserves. India has a long history of having a strong affinity for gold.
China made headlines earlier in the year when it disclosed that its central bank has been buying gold. Again speculators began anticipating a massive gain in China's gold holdings. In fact, China had stated some years ago that it intended for gold to represent 2% of its total foreign exchange reserves. The purchases over the last year merely saw gold keep pace with their ballooning foreign currency reserves.
Central banks will play an increasingly important role in the gold market. Net sales by the Bank of England and the European central banks were a key factor in depressing the gold price in the late 1990s. An agreement among the largest official sector holders of gold, known as the Washington Accord, put a quota of 500 tonnes per year on sales from that group. The Washington Accord was an important turning point in the gold market.
Mine production falls short of meeting physical demand, so net sales by the central banks have balanced demand and supply for more than a decade. Over the past couple of years, the central banks in the Washington Accord sold less than their quotas, although their annual sales still represent more than two times the amount purchased by India.
A further 203 tonnes on offer by the IMF, together with the 400-plus tons from the Washington Accord countries should satisfy demand from other central banks, even as they ramp up their sales.
The growing interest in holding gold by central banks is being augmented by other purchasers, including sovereign wealth funds, hedge funds and a broad range of other professional investment managers, some of whom are buying gold for the first time. Individuals, in all parts of the world, are also buying gold in record amounts.
Some of those purchases are being made with a long term perspective, but there are also a great many players in the market with a very short timeframe. It is very important to realize that the traders can reverse sentiment and become sellers in as much time is it takes to click the sell button on their computer screens.
It is also worth remembering that the jewellery sector is extremely price-sensitive. That price sensitivity starts with the sophisticated buyers who operate at the wholesale level in the jewellery industry. When the price spikes, as it has recently, those professionals stand back from the market, waiting for the inevitable correction. In terms of the physical movement of gold on an annual basis, the jewellery industry is a much bigger factor than investors.
In the past, the speculators have become sellers as soon as the upward trajectory levelled off. The result has been a series of spikes followed by sharp pullbacks.
While history tends to repeat, there are reasons to believe that the present situation is unprecedented and may result in a different pattern. The financial crisis of the past year was the worst in eight decades. Trillions of dollars of shareholder wealth was wiped out. Companies that for decades were seen as the backbones of the economy – General Motors and major American banks, for example – were suddenly bankrupt.
The American dollar, the undisputed global currency of choice for decades, is now seen by many as being on a long slide. The bearish outlook for the dollar involves more than the massive government debt that continues to grow in trillion dollar increments as bailouts continue and more troops are readied to be sent to Afghanistan and Iraq.
The trillions of dollars pumped into the economic system to keep it afloat are in demand in this moment, but that situation is already beginning to reverse. At the height of the crisis, investors around the world bought dollars in the form of T-bills and other short term instruments as a safe haven. With stock markets around the world losing half their values, that was a smart move.
Now, with economic activity in Asia and other emerging economies outpacing the developed world, those dollar instruments are being sold back to invest in more vibrant economies. It will be at least a year or two before the U.S. gets back to the kind of growth that would again draw international investment money back into the country in a big way.
There is another, sometimes overlooked, reason to expect further declines in the dollar. The financial crisis that engulfed the world over the past year originated on Wall Street. Top American ratings firms had given the highest ratings possible to mortgages that mere months later were labelled as toxic waste. There is a degree of bitterness and distrust around the world toward the ratings agencies and the banks that peddled that toxic waste.
Following soon after the dot.com bust, it may take some time for international investors to regain confidence in the American business system. A series of other embarrassments, including Enron and the Madoff mega-fraud, have deepened the distrust of American investments. Investors can deal with a business failure. But a $50 billion Ponzi-scheme that operated undetected for more than a decade brings the entire system into question.
At this moment, all of the negative news about the dollar is in the forefront of investor minds. That sentiment continues to push gold higher. Gold is measured in dollar terms, so a fall in the value of the dollar is automatically reflected in the price of bullion. In addition, the perception that the dollar will continue to fall has led investors around the world to buy gold, increasing demand for the metal and thereby boosting its value in real terms.
Gold entering record territory has attracted a frenzy of commentary. In the last few days, I have seen near term price targets for gold ranging from $450 an ounce to $8,000 an ounce. There are far too many variables impacting the gold market for any mortal to make a meaningful prediction of the future.
I am certain that gold is not going to $450 in the near term, or ever for that matter. I am equally certain that gold is not going to reach $8,000 any time soon. However, there is a large range around the current price that is within the realm of possibility.
Longer term, I am certain that gold is going higher. In the near term, a correction is a very real possibility, but not a certainty. The pattern of a sharp upward spike followed by a sudden reversal and a period of consolidation has been repeated numerous times over the past several years. The financial world is different at this time than it has been at any time in the past. Nevertheless, one must recognize the likelihood of history repeating itself.
Even though the gold price is in record territory, the gold equities have not kept pace, especially among the smaller companies. Those investors who see the gold price sustained at this level or moving higher should see the gold equities as irresistible bargains.
For those who see a correction in the gold price before the next leg up, take heart that since the gold companies have not participated in the recent price action, there is not a great deal of downside risk.
Rather than betting on the near-term direction in the gold price, investors may be better served by looking at things that are more readily quantifiable. I have often written about the progression in value of a gold deposit and the share price of the company that holds it as a deposit progresses from discovery through to production. An important part of that analysis is the vastly different prices attributed to a gold deposit in the hands of a small producer compared to the values per ounce that are attributed to the larger gold mining companies. The same deposit can have a value several times greater when it is owned by Barrick or Newmont or another major as opposed to a small company operating a single small mine.
Several sophisticated investment groups are now working to profit from that disparity in values. We recently wrote about Endeavour Mining Finance. That company has set about to amass a substantial holding of gold resources. Their strategy is to buy the small producers, which they can acquire less expensively than the larger companies. Ultimately, they plan to consolidate a number of small producers to create a million-ounce-a-year gold mining company. That consolidation would result in a valuation much higher than the sum of the values of the small companies.
That strategy of investing in the smaller gold companies also gives investors exposure to a great many more ounces of gold in the ground for the same invested dollars.
That is, investing in the smaller gold producers and development stage companies gives investors a triple winning combination:
- Exposure to more ounces of gold for the same investment;
- Gains in value as gold deposits move toward development;
- Upside potential in values as smaller companies are rolled into larger companies.
In Resource Opportunities, we seek to identify the companies most likely to be acquisition targets. In this way, subscribers will get access to producing gold companies and also the opportunity to realize the gains in value of particular companies.
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