What's Next for the Gold Market?

September 26, 2011 07:00 PM
The headlines were unequivocal:

o "Gold futures sustain steepest one-day decline in five years"
"Gold plunges more than $100"
"High-flying gold crashes in record $100 freefall"

As the media would have you believe it, gold is on an unstoppable downward spiral and no one is ever going to buy gold again. That's utter nonsense. Gold has been one of the best-performing assets over the last year. In fact it's been one of the top-performers in the last five years.

Let's just use the popular ETF Gold Trust (GLD) as a benchmark. As of 09/24/2011 it's up 28.31% versus the S&P 500's rise of 0.96%. Over the last five years, GLD is up 174% while the S&P 500 is down -13.57%. If you've owned gold over the last five years (I recommended gold in 2006 at $500/ounce) you've outperformed the broader market by a wide margin-even considering this week's carnage, which saw gold drop by 10%.

That said, I do expect precious metals prices in general and gold prices in particular to remain volatile this week.

Caught in the Crossfires

One of the most popular trades for the year has been long equities and long gold as a hedge against equities. However, as equities dropped a further 7% last week, many investors were forced to liquidate their gold positions to meet margin calls: net-long gold positions dropped 11% last week alone.

In addition, the CME increased gold margin requirements by 21% on Friday. This year's total margin increase for gold: 55%. This is adding further to the deleveraging process.

What About the Fundamentals?

The long-term demand dynamic for gold remains intact. In fact, if anything, demand for physical bullion has increased; but the deleveraging process in the financial markets is having a monstrous effect on prices. Let's not forget that the biggest demand for gold is for jewelry purposes and that the Asian countries account for 60% of total demand:

Source: The World Gold Council

Also, let's not forget the role of central banks in providing direct support for the physical markets. (Next week I will be sending out a note on how central banks influence gold prices.) For the first time in decades, central banks are now net-buyers of bullion:

Source: The World Gold Council

The fundamentals remain strong, especially in the fourth quarter, which is usually the strongest for gold sales. However, the fundamentals seem to have taken a back seat to fear and deleveraging.

While I wouldn't recommend initiating a net-long gold position right now, since things can get pretty violent in the short term, this downside does present a unique entry point for the long-term.

What's Next?

A lot depends on the sovereign debt situation in Europe. Dennis Gartman believes that a cascading default is imminent, and the market should expect a repeat of 2008. If that's the case, then the only safe asset out there is the US Dollar. The greenback is still the world's currency and everyone flocks back to dollars in times of crisis.

The Brazilian Real (BRL) is a good indicator of dollar strength. Look at how the dollar moved against the BRL in 2008.

Its sudden spike this month is reminiscent of 2008, notwithstanding the Brazilian Central Bank's unexpected decision to cut rates this month. What's the implication for gold? Now is not the time to be long gold in USD; much more advisable to initiate long bullion in EUR.

I still think the precious metals equities offer terrific rewards down the line. My favorite names are New Gold (NGD) and Silver Wheaton (SLW).

I mentioned that SLW was not a terrific buy at $40 but looked good at $35. After last week's carnage, it's now at $32. While we may see further downside, I think it's a great buy anywhere between $25-$30. Remember, SLW has no capex beyond initial premiums it pays to operators, revenues close to half a billion dollars, and 75% operating margins.

NGD announced a large discovery of more than 1 million ounces of gold last week but still got caught up in the selling frenzy. This pullback is a good entry point in my opinion.

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Amine Bouchentouf is the author of the best-selling book "Commodities For Dummies", published by Wiley. He is a partner at Parador Capital LLC an investment firm focused on commodities and emerging markets. He is also a founder and partner of Commodities Investors LLC, an advisory firm dedicated to providing insightful information and analysis on all things commodities.

About the Author
Amine Bouchentouf is the author of the best-selling book "Commodities For Dummies", published by Wiley. He is a partner at Parador Capital LLC an investment firm focused on commodities and emerging markets.