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Published: September 22, 2010
Gold is on the march. The yellow metal is spiking to a new
all time (non inflation-adjusted) highs of nearly $1,300 per
ounce on renewed speculation that the Federal Reserve's next
moves will only strengthen the case for higher gold prices down
the road.
Let's take a closer look at some key questions to see if gold is
set to shine even brighter or eventually lose its luster.
Q: What is the Fed concerned about?
A: In its most recent statement after
Federal Reserve Open Market Committee (FOMC) meetings,
the Fed noted that potential
deflation is of increasing concern. (Core annual inflation
has been running at 0.9% for five months in a row, its lowest
pace since 1966.) Any drop in prices could spell real trouble
for the economy and would imperil borrowers that are seeing
lower income but constant debt levels.
Q: What might the Fed do?
A: To help support prices, the Fed can inject money into the
economy by buying back bonds. (The bondholders that sell their
debt back to the government would presumably put that cash to
use elsewhere in the economy.)
Q: Why should that impact gold?
A: Many fear that the Fed is simply inviting the prospect of
troubles down the road. Early in the last decade, the Fed also
sought to boost the economy's prospects by keeping interest
rates low. That set the stage for rampant low-cost borrowing and
an eventual housing boom, which turned out to be disastrous for
the economy when the music stopped.
This time around, the concern instead focuses on what might
happen if the economy hums back to life but the Fed has a hard
time keeping growth (and inflation) from surging. In the recent
economic bubble, inflation never emerged. Yet gold bulls insist
that we won't be so lucky next time. That's because budget
deficits are now far higher, and if the United States can't meet
its obligations, then inflation will rise as the Fed raises
interest rates to keep attracting buyers for its debt. That
would cause the dollar to weaken and gold would provide shelter
in the storm. (But if rising inflation fails to materialize,
then many that had bought gold on inflation fears may look to
sell their positions.)
In addition, gold isn't as closely tied to economic cycles as
are many commodities and equities, and it is frequently bought
to diversify portfolios and guard against losses elsewhere.
Conversely, as economies improve and stock markets rise, the
argument for owning gold weakens. The fact that gold is hitting
new highs even as the S&P 500 has had a strong two-week run is
fairly unusual.
Q: What's the upside for gold?
A: Ah, the crystal ball question. Bulls think it can move
toward the $2,000 per ounce. mark, which is actually the
all-time high when adjusted for inflation. Why that price? There
seems to be no real way to peg an actual projected value on
gold. The price is driven by sentiment and not any sort of
underlying asset value. We can figure out global demand for
gold, and also how much is being produced each year. But we
don't have a clear read of how much actual gold is sitting in
central banks and especially in safe deposit boxes. Contrary to
popular belief, central banks tend to offer contradictory
statements on their gold holdings to keep
currency speculators from knowing the state of their
finances.
Gold producers generally spend around $450 per ounce to produce
gold ($900 on a fully-expensed basis), so with gold above
$1,000, there is ample incentive to hike output. And rising
output of anything tends to have a dampening effect on prices.
It hasn't happened yet, but some suspect we may be reaching the
point of a gold glut -- at least in terms of industrial and
jewelry demand. Financial hedging demand is fairly immune to
supply, and could continue to power gold higher. Gold contracts
that expire in 2016 place a $1,447 price on an ounce of gold.
Rising prices have a way of feeding on themselves. JP Morgan's
asset management arm continues to load up on gold on
expectations that it will attract even more interest in coming
years. (This is also known as the Greater Fool theory or the
Keynesian beauty contest.)
Q: What's the downside?
A: The short answer is that gold could fall below $500 if
all of these concerns fail to materialize. That's where gold
traded back in 2005. And that's likely the area where supply and
demand are truly affected, financial hedging considerations
notwithstanding. As long as massive budget deficits remain as a
concern, however, gold is very unlikely to fall back to that
level.
Q: If I think gold has more to climb, should I buy gold or
gold stocks?
A: The benefit of buying gold (or a gold
ETF like the SPDR Gold Shares (NYSE: GLD)) is that
you aren't paying for the operating expenses of gold companies
and you are eliminating company-specific risk. And since gold
producers may seek to lock in (or hedge) the price at which they
can sell gold, they may not be able to fully profit from the
sharp upward move in gold prices. (Currently, most gold
producers are unhedged and willing to accept market risk, but
that may change if prices rise higher.)
Then again, profits at gold-mining firms can grow even faster
than the underlying
commodity's price if they didn't lock in prices. That's due
to the fixed-cost nature of gold mining. As noted earlier, it
costs roughly $450 per ounce to mine, store and transport gold.
So with gold selling at $1,000 an ounce, that's a $550 gross
profit. But if gold prices rose +50% to $1,500, then per ounce
gross profits would nearly double to $1,050. (Actual profits are
well lower when non-mining costs are included.)
During the past 25 years, gold stocks have historically traded
for between 12 and 24 times projected profits. Now they trade
for just 11 times next year's profits. But that's because
profits have risen so sharply and could well re-trench. If gold
stayed above $1,200 per ounce for a number of years to come,
then these stocks would look appealing. But if gold fell below
$1,000 per ounce, then these companies' P/E ratios would appear
astronomically high.
Investors can also look at where the gold miners trade in
relation to their
net asset value (NAV). They have historically traded between
1.4 times and 2.4 times NAV (except in early 2009 when they
traded below NAV) and currently trade at 1.8. That NAV would
rise and fall in step with any move in gold prices.
Q: What about "peak gold?"
A: While the question of peak oil dominates energy
markets, it's really not important in gold mining. Most
publicly-traded gold producers estimate that they have proven
reserves that are equivalent to 10 to 20 years of annual
production (and a similar amount that they have yet to verify as
recoverable). And unlike oil that disappears when it is used,
actual industrial demand for gold is so small relative to the
amount held in bank vaults and jewelry chests, that any shortage
could be met fairly easily.
Yet it is getting more expensive to mine gold as the easiest
plays have been mined out and new mines are in increasingly
remote or hard-to-mine locations. In 2000, it cost roughly $175
to mine and transport an ounce of gold. That figure moved above
$250 in 2006, above $400 in 2008, and appears headed toward the
$500 mark in the next year or so. Despite that rise, gross
profit margins have surged. Gold miners made roughly $50 for
every mined ounce from 1990 through 2005. Per ounce profits are
up nine-fold since then.
But as noted above, miners have plenty of overhead costs, and it
actually costs more than $900 to produce an ounce of gold when
they are accounted for. That's why gold miners would hate to see
a sharp pullback below $1,000 an ounce.
Action to Take --> All of
this highlights a real conundrum for investors. Gold prices are
being supported by economic concerns that have yet to (and may
never) materialize. Gold can easily power higher (and
technicians note that it just passed an important resistance
level). But on a fundamental basis, gold appears quite
overvalued. If gold prices fell to a point that truly
reflects the fundamentals, then gold miners would see profits
evaporate. Gold makes sense as a defensive
hedge and as a means of
diversification. But it's not a clear value as a pure
investment.
-- David Sterman
Staff Writer
StreetAuthority
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