Monday, February 20, 2012

Gold Fever - still on

My first blog post was titled "Gold Fever!" (posted on February 12th, 2010). I wanted to go back to that article to look if anything has changed in two years.

The price of gold is now significantly higher than in early 2010. My feeling is that we might have a gold bubble forming, but we have not yet seen the mania phase of the bubble. Two main facts supporting this are:

1) Inflation adjusted gold price in U.S. dollars is far above the levels where it has traded in the last 110 years. However, it needs to be kept in mind that the gold hasn't traded freely during that time period. Gold ownership in USA was illegal between 1933 and 1975. The gold price in U.S. dollars was fixed until 1971. The first bubble in gold was formed during 1971-1980. This followed the liberation of gold and also was a period of high inflation. At the moment, inflation is low.

2) Gold prices have risen for 11 consecutive years and the record high gold price (over $1900) in September 2011 was not that far away from the peak of the previous bubble. The monthly average for January 1980 was $678 ($1919 in 2011 dollars) and all time high was $850 ($2406 in 2011 dollars).

There are many people looking out for exit. This has already led to volatility (wild price changes) and this likely will continue as greed and fear alternate in the minds of the speculators and investors. The last bubble resulted in much faster appreciation (you may call that "the mania phase") and much higher price in real terms than what we saw in September 2011. Therefore, gold still might have long way to go (upwards). How high it goes and whether it bursts in the same way as before remains to be seen.

It all comes down to supply and demand of gold. The demand side looks strong. World Gold Council recently reported that in 2011 investment demand for gold hit record of 1640,7 tons. India, China and Europe were the main drivers of investment demand, which comprises the purchase of gold bars and coins as well as exchanged-traded funds.

Inflation and especially expectations for future inflation will have a big impact on the price of gold in any given currency. For example, purchasing power of the U.S. Dollar has been declining steadily for the last 110 years, except for a few deflationary periods (most notably after 1929).

[You might want to check my old article written for Seeking Alpha titled "Riding the Second Gold Bubble" which review the last 110 years of gold price history as well as supply and demand]

In fall of 2011 we sold part of our gold position. We remain exposed to both the gold itself and to two of the biggest gold miners out there (Newmont Mining and Barrick Gold). Overall, our exposure to gold price continues to be much bigger than what is typically recommended for diversification purposes (2-5%). My investment thesis into gold remains unchanged from what I wrote in my first blog post: "There are many reasons to own gold or any tangible things right now. In my mind, two of the biggest are fear of inflation and fear of another, a far more serious financial meltdown than experienced so far."

Two years ago all eyes were on Greece and they still are. However, now it seems to be much more widely accepted that the problem isn't just Greece or any of the so called "PIIGS" countries. Most of the Western Europe along with USA and Japan has big problems. Huge piles of debt, chronic budget deficits, chronic trade deficits, unemployment and so forth. Politicians go for the we-have-to-grow-our-way-out-of-this -story as they always do. Secretly, they probably hope central bank bails them out because most of the factories have gone East and the prospects of growth are quite limited in the manufacturing sector at least.

Therefore, like so many times in history, countries will resort to money printing in one form or another. Any other way to cover the liabilities and pay back debt is just too painful. I believe this will take place eventually in Europe also. The only reason we have "PIIGS" crisis is that they can't resort to money printing ("quantitative easing" as they call it in U.S.). They no longer have that option after they joined eurozone. They don't have own central bank that can do the trick and Germans don't let them off the hook via European Central Bank (ECB)- for now. Eventually ECB is the only one that can bail out the banks and the countries in Europe.

This is where the yellow metal comes into play. Even though gold is not used broadly as currency right now, it has been used as such in history and may be used once more. It continues to be the ultimate benchmark for currencies. That is why central banks hold it. In the West, central banks have always kept a significant part of their reserves in gold whereas in the East emerging countries have very little gold. Thus, there may be plenty of central bank purchases in the years to come as emerging countries continue to diversify into gold. According to World Gold Council, central banks continued to be net buyers in 2011 (439,7 tons up from 77 tons the year earlier).

The problem with gold is that it does not yield anything. Central banks don't seem to care because it is the ultimate reserve for them. In fact, when interest rates are low, gold is an attractive alternative to traditional bank savings (cash) for anybody. Jeffrey Currie, the head of Goldman Sachs commodity research, reportedly said in Goldman Sachs Global Strategy Conference in London in January 2012: "We will continue to be long on gold until we can see an absolute turn in the rate cycle, which we don't see happening any time soon." [source: Dow Jones Newswires]

The author was long gold and gold mining companies at the time of writing.