Thursday, April 06, 2006

Recent gold action

Gold traded over $600 during Thursday's session, closing at $599.70 in New York. Since $600 gold has been getting a fair amount of news coverage, let's examine the reasons being trotted out to explain the rising gold price.

A Bloomberg article points to investment fund buying as a main factor driving recent price strength. Also discussed was the "inflation risk" that makes holding gold more attractive for investors, especially in an environment of low real rates. A surprisingly credible argument for gold's strength managed to make its way into the article: ``The market perceives an inflation risk, although it hasn't shown up in some of the government statistics,'' said Michael Cuggino, portfolio manager of Permanent Portfolio Fund in San Francisco. ``Low to negative real interest rates after inflation are generally bullish for gold.''

Unfortunately, Bloomberg's report did not end on such a sensible note. Another source weighed in with the following remarks, ``We're entering bubble territory,'' said Christoph Eibl, head of commodities trading at Zug, Switzerland-based Tiberius Asset Management AG., which has holdings in energy, metals and agricultural commodities. ``Prices have moved away from reality, and are no longer linked to fundamentals.''

I find that last comment to be a bit absurd if it was made in specific reference to gold. Certainly, one could say that commodities in general have undergone an astounding advance, and it is possible that certain commodities now carry a speculative premium in their price (as discussed by Dr. Marc Faber in a recent interview). However, I think it is odd to declare, in a discussion centered specifically on gold, that prices are "no longer linked to fundamentals" when the recent chain of events (and the metal's current strength against most major currencies) clearly suggests the opposite.

As mentioned in the Bloomberg article, investment demand has come on strongly, and investment purchases of gold have outstripped jeweler purchases so far this year. This in itself is huge. Where was investment demand for gold just a few short years ago? Not long ago, most people looked at you cross-eyed or at least gave you the third degree questioning when an investment in gold was suggested. Since gold crossed $500, a new attitude has begun to replace the former stance of suspicion. The small cadre of dedicated goldbugs hoarding bullion and gold coins has been enlarged to include an investor class that gets its exposure to gold through ETFs and precious metals-focused funds. A change in sentiment is clearly underway as the investing public and investment professionals increasingly warm to gold.

Not only is investment demand up in North America, it is profoundly evident in Asia and the Middle East. The people of India and China have traditionally been buyers of gold, in the form of jewelry and as a store of savings. Their purchases will only increase over time, as their economies continue to develop and prosperity levels rise among the masses. Middle Eastern demand is pronounced as ever, with the Gulf economies prospering from a recent oil boom and the resulting flood of new money. An ongoing repatriation of funds previously held abroad, and the establishment of the Dubai Gold Exchange, have no doubt also encouraged gold purchases. Meanwhile, a sizeable increase in Gulf central bank holdings of US dollar reserves have led some to consider diversifying out of the dollar and increasing the region's central bank gold reserves as Russia, Argentina and China have done.

There will not be an easily mineable influx of supply to meet this demand. Gold mining companies face a dwindling resource base and rising costs in extracting gold from the ground. Consider the environmental hurdles and permitting difficulties associated with bringing on new mines in many jurisdictions, along with the increasing push for nationalization of "strategic resources" in Latin American countries, and it becomes a little unclear as to where all this gold will be found.

These facts are not being expressed in the mainstream US business press. Rather than give due weight to the big picture trends driving the gold price, most coverage derides the advance as being speculative in nature. But is that a surprise? A current CNN Money article reads, "$600 gold: Want in? Think twice". While the article dutifully describes several options for prospective gold investors and the risks associated, it ends in a dissuading tone. "Not everybody could handle losing 40 percent in one year...Most people probably don't need an investment in precious metal funds."

I guess it's just one more brick in a wall of worry.