Where gold goes from here

Where gold goes from here Throughout the last 25 years gold has had two distinctive moves, first a down move and then an up move.

Spot gold closed at $850 per ounce in January 1980, and shortly thereafter the market entered a steady decline that lasted nearly two full decades, finally bottoming at $252.80 on July 20, 1999. After nearly two years of forming a base, the present bull market began in April 2001, and the market has been vaulting higher ever since.

Those who were fortunate to get in at the bottom of the current trend deserve congratulations. For the rest of us, we are evaluating the gold market and contemplating opportunities now. So, let’s examine some of the reasons behind gold’s run-up and consider what may be in store for the yellow metal in the near future.

Putting gold’s current prices in context, consider the recent high of $592 per ounce represents a 25-year high. The last time price was above $500 was 1987. In 1999 gold traded at $252. As shown in “Gold got going,” much of the run-up has occurred throughout the past six months.

WHERE’S THE REASON?

At first glance the bull market seems to be primarily a speculative rally, as many of the traditional fundamental drivers for gold are absent. Gold most often is seen as a reliable hedge against inflation, but inflation was especially tame in most parts of the world last year. Inflation, or the fear of inflation, doesn’t seem to have played a role in the recent rally, especially when we consider that a big part of the demand for gold is coming from Japan, a country presently battling the opposite of inflation: deflation.

It’s also true that gold is often considered a safe haven in times of war. But while the continuing conflict in Iraq is indeed a war, it is generally thought of as being rather limited in scope; surely not capable of fueling a fear-based rush to gold. If it were, the more recent rapid rally should have started in early 2003, not late 2005. The idea that gold rallies during times of war is a part of the more general view that gold thrives in times of investor caution. Here again we are no closer to the underlying causes of this rally. The problem with this line of reasoning is that 2005 was not a troubling year in general. One widely held barometer of investor caution comes from the currency markets, specifically the Swiss franc, which lost roughly 15% relative to the U.S. dollar in 2005. The strength of the dollar against nearly all of the major currencies is a testament to voracious global risk appetites. Add to that roaring international equity markets, record investment banking profits, and brisk private equity activity, and the case becomes clear that the investors of 2005 were not particularly risk averse.

The next logical place to look for fundamental clues on this rally would be China. Indeed, 2005 was the year that factored China into nearly every economic and political story. Business writers are now programmed to look to China every time there is mention of market “imbalances.” In the case of gold, however, there seems to be only the slightest connection.

It’s true that China has demonstrated a seemingly insatiable appetite for industrial metals, which has greatly contributed to the general metal rally this past year, most notably in copper, zinc and nickel. The problem is that gold has no significant industrial use and dealers report very little buying from Chinese accounts. It may be true that Chinese buying in the wider metal markets has affected gold as well, using the theory that a rising tide lifts all boats, however this was not a significant factor. It seems the Chinese like silver, platinum and copper, but for gold we must look to the other emerging giant: India.

INDIA AND THE MIDDLE EAST

In India we find one piece to the puzzle. Traditionally, Gold has always been seen as a store of safe and secure wealth in India. It was, is and seems likely to remain so for the foreseeable future. As India continues to develop economically, and as a burgeoning middle class demands more consumer goods, gold likely will remain a trusted and in demand commodity. Cash jewelry sales were reported to have been brisk in 2005, although they have moderated at the current high prices. Even still, cash demand in India is one solid factor behind the recent rise.

Another factor can be found in the Middle East. With crude oil prices rising rapidly in 2005, money managers in this region were especially busy devising portfolios to suit the current investment climate. Thankfully for U.S. government officials given the ballooning U.S. current account deficit, the “recycling” of petrol-dollars was big business in 2005.

However, the investment equation did change slightly at the end of October when the dollar made its last big push against the euro, taking the EUR/USD down to 1.18. At this level, many investors began to feel that the dollar had reached a medium-term high. It may not be coincidence that the peak of the dollar coincides with the real drive in gold. Middle Eastern demand is thought to have played a large role in this part of the equation.

It also should be noted that aside from Middle Eastern investment flows, cash demand for gold in the Middle East is helping drive the market. The recent rally in oil prices has spurred a consumer demand for gold jewelry similar to that seen in India.

The dilemma faced by Arab investors in 2005 speaks to one of gold’s real strengths — its universality, or in other terms, its absence of country risk. Throughout 2005, every major currency battled its unique weaknesses. The dollar is perceived, rightly or wrongly, as vulnerable to its “twin deficits.” So when the dollar reaches an assumed peak, where does the savvy investor turn? To the euro, with its own deficits, anemic growth, political gridlock and structural concerns? To the British pound, with its slowing growth, slacking industrial sector and touchy consumer and housing sectors? Or, to the yen, which spent most of 2005 in a veritable free fall?

For many global investors, the safe answer was gold and this is likely the basic, though predominant, case for why gold has done so well of late — a lack of other alternatives at the end of a good year. But that’s not the whole story. Three other factors also are important to consider.

JAPANESE INVESTORS

Regarding speculative demand for gold, Japanese investors deserve special mention. Japanese investors are frequently seen as being large buyers in the recent gold rally, but they are not buying gold as an inflation hedge. Instead, they seem to have found gold in 2005 partly by accident.

As a county currently in a 0% interest rate environment, the Japanese have had to seek out higher-yielding investments overseas. A great amount of yen gets converted into dollars when the Japanese purchase U.S. Treasuries and other agency debt. Increasingly, though, throughout the last few years, large sums have been invested with Japan’s high-yielding trading partners, Australia and New Zealand.

In recent months, these so-called carry-trades had been working well. The Japanese would sell their yen and buy high-yielding New Zealand dollar deposits. The shock, however, came in early December, when Standard & Poors expressed concern about New Zealand’s current account deficit. The news sent cautious Japanese investors scrambling to close-out their New Zealand dollar positions.

With the dollar pricey, the yen not offering any yield and the Australian dollar perhaps too similar to the New Zealand kiwi, many turned to the booming gold rally. Those who bought into the rally on Dec. 7, 2005, when S&P made its announcement, would have received prices around $514.

BIG PLAYERS

There is little doubt that funds have recently played a big role in the gold market, as have speculators of all shapes and sizes, but detailed analysis is hard to find. Yes, it’s true that any time a financial market is hot you can bet that the smart money players are actively involved. Gold is in a trend, so trend followers own gold.

Here’s what we do know: The recent up-move has pitted managed futures programs and funds (aggressive speculators) against so-called commercials (mining companies). Funds are the quintessential momentum players. The old adage of buy low and sell high has been changed to buy high and sell higher. As long as the trend continues higher, these players will continue to accumulate long positions.

Mining companies have always been the traditional short hedgers, locking in prices against the cost of production. Under normal conditions, higher prices should cause producers to continue to hedge production. However, if prices continue to rise, these hedges start to get expensive, as losses on short hedges total in the billions of dollars. At that point, continued short hedges may be curtailed or even covered. It would be quite interesting to see how prices would react if one of the main sellers was out of the market.

Another murky element to this market is the role of central banks. Although current thinking seems to hold that modern central banks no longer need to hold large gold reserves, many still do, and in large quantities. Few analysts mention any over-arching reason for the world’s central banks to add more gold to their reserve portfolios. On the other hand, like funds, many central banks do not disclose their exact holdings to the public, and a hot market is a hot market regardless of who you are.

THE CORRECTION

The great rise did seem to come to an abrupt end on Dec. 12, 2005, after gold reached a high of $543. The following week prices dropped to a near-term low of $492.30 on Dec. 21. As would be expected, much of the blame was placed on funds deciding that enough was enough, precipitating a strong sell-off as tight sell-stops were triggered like falling dominos.

We might also mention it was shortly before this time when the gold rally started making front-page news in the world’s newspapers. As gold has always been the preferred asset of the ultra-conservative sky-is-falling set, the press attention was surely not a helpful wake-up call for last-minute investors. In fact, it can be said confidently that a piece of timeless investment wisdom held true in the case of gold’s recent rally: By the time a financial market makes the front page, the end is near.

The cooling of this hot market was helped along by the Tokyo Commodities Exchange (Tocom). After witnessing skyrocketing volumes and consecutive limit-up and limit-down markets, Tocom administrators decided to double the margin requirement for gold trading at their exchange on Dec. 14. During the last week of 2005, however, another bullish pattern developed, which propelled prices to new highs in the first part of 2006.

THE OUTLOOK

Now that gold has returned to the spotlight, we should expect increasing volatility as both bulls and bears jockey for position. Some of the themes that drove the gold market higher in 2005 remain valid in the early part of 2006. Political unrest, especially in the Middle East, remains a concern. Iran’s intention to continue its nuclear program, new leadership in Israel and the potential for civil war in Iraq should provide investors ample global stability concerns to justify a safe-haven investment such as gold to remain popular.

Keep in mind, too, that the 1980 high of $850 per ounce equates to roughly $2,200 in current dollars, so there may well be plenty of room for gold to move higher. On the other hand, if some of these issues cool down or are resolved smoothly, and if momentum begins to slow as new highs are made, gold may indeed reach a peak in the coming year.

Mark Smyth is a currency market analyst and Mike Zarembski is a futures market analyst and assistant manager with Xpresstrade in Chicago (www.xpresstrade.com).

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