Alan Greenspan said, “gold will always remain the ultimate form of payment in the world” which is part of the reason gold prices are climbing during a period of financial uncertainty. China has been stockpiling gold to diversify their reserves, a trend that could continue to stimulate the market. The following article from Money Morning discusses the reasons that gold prices are likely to increase in the future.
As gold once again breaks the psychologically important barrier of $1,000 an ounce, all the pundits are wondering if it will last.
I have to confess that – deep down – this makes me smile. The reason: I know that the real question to ask is “When will gold go on to set new highs?”
So let me cut right to the chase. This breakout run in gold prices will last.
The “Golden Staircase” tells us so.
After bottoming out about $250 an ounce about nine years ago, such key fundamental catalysts as increasing demand, lower supply, inflationary fears and a flight to safety have been driving the price of gold northward.
But gold is like any other financial asset in that prices don’t rise in a straight line – especially if they’re rising a long way. But they follow a clear and discernable pattern.
As asset prices rise, they often initially overshoot. Then they “correct” – fall back a bit. Then they “consolidate,” or trade sideways, usually for a period of six to 18 months, but sometimes for even longer.
It’s this period of sideways trading that creates the horizontal “step” in the “Golden Staircase” – a technical-analysis tool that lets us “see” the foundation for the next step up in the long-term uptrend in the price of gold.
The formation of the newest “step” in the staircase was started in mid-2007. That’s when the $1,000 price level was first breached. On Tuesday, Sept. 8, when gold prices eclipsed that key barrier on Tuesday, Sept. 8, it was the fifth time they’d attempted to do so.
Each of these attempts has helped define $1,000 as a ceiling. But in a “Golden Staircase,” the ceiling eventually becomes a new floor. So once the $1,000 price point is eclipsed in a decisive manner, it will become a key “support level” for gold prices.
You can also think of it as the top surface of a new step.
And that’s precisely the juncture where gold finds itself right now. [Editor’s Note: Please see accompanying graphic: “Gold ‘Steps’ Toward New Highs”].
From a technical standpoint, the outlook for gold is bright, indeed. But the fundamental picture is even more bullish.
Barrick’s Bullish ‘Bought Deal’
Now, I realize it was probably pure coincidence that the world’s largest gold miner, Barrick Gold Corp. (NYSE: ABX), announced it would raise $4 billion on the same day gold flirted with $1,000. But the conspiracy theorist in me likes to believe otherwise.
For Barrick Chief Executive Officer Aaron W. Regent, this so-called “bought deal” was a conscious strategic move. Barrick has a reputation for wisely using hedges to its own advantage. The strategy served the company well in its copper-production business. And when gold prices fell in the late 1990s, Barrick turned to this strategy again – and again benefited nicely.
Recently, however, Barrick’s bankers have been coaxing the company’s leaders to ditch the hedges in order. The reason: In an environment of rising gold prices, hedged bets dampen profits. Removing those hedges, by contrast, elevates profits. But it also elevates the company’s risk.
So when a company such as Barrick makes a strategic decision to raise equity capital in order to close a large portion of its infamous hedge-book, that’s a highly bullish sign for gold prices.
When Central Bankers Become Gold Buyers
A third Central Bank gold agreement has recently been ratified. And, interestingly, it’s a weaker version of its two predecessors.
New limits will allow for only 400 metric tons to be sold annually, down from 500 metric tons in the previous deal. The deal is bullish on its face. And, even better, there’s more to it than meets the eye.
You see, the last 10 years of these agreements have seen some 4,000 metric tons unloaded into the market. And even in the face of the $80-billion-selling headwind these divestitures created, gold has managed to stage a rise from $250 an ounce to the current $1,000.
And the story gets better, still: According to the World Gold Council, the world’s central banks became overall net buyers of gold as of this year’s second quarter – the first time that’s happened since 2000.
China Goes For the Gold
In the post-financial crisis global economy, China is quickly becoming the proverbial “800-pound gorilla” – the player that has to be courted, but that can’t be tamed.
And now, in a signature move, China has decided to take a remarkable step, choosing to take control of its own gold.
Just this month, in fact, Hong Kong announced that it would bring all its gold bullion back home, recalling the reserves from depositories in London. Hong Kong has just completed construction of a high-security depository at the city’s Chek Lap Kok Airport (Hong Kong International Airport), and plans to market the facility as a safe storage option to other Asian central banks, commodity exchanges, precious metals refiners, commercial banks, and exchange-traded funds (ETFs).
This development can (and will) be spun in all sorts of ways, but what it really means is that China has lost confidence in the West. After last fall’s near-meltdown of the global financial system – a financial cataclysm due almost entirely to major missteps by Western economic powers – China’s Beijing-based leaders want much greater control over its own assets.
And who can blame them?
China’s Ravenous Gold Appetite
At more than $2.3 trillion and counting, China’s foreign currency reserves have become the stuff of legend in recent years. But here’s the rest of that story, with apologies to the late Paul Harvey: According to a late August Financial Times report, “Beijing recently revealed that it had been secretly buying gold for years in order to diversify its foreign reserves, and has almost doubled its bullion holdings.”
China’s official gold reserves now run 1,054 metric tons. That means its holdings have doubled in just six years.
And when you consider the risk China faces on its $2.3 trillion in paper (foreign currency) reserves – much of them U.S. dollar denominated – it’s understandable that China has been ardently seeking shelter. In a late-July special report for Money Morning called “The Three Triggers of the Global Gold Bubble,” I told readers:
“All it would take is a loss of faith in the greenback. It’s important to understand that dollars are nothing more than paper and ink, backed by the full faith and credit of the U.S. government. In a year in which the budget deficit could easily top $2 trillion, this does not reassure me.
The dollar holds its value only as long as the greenback’s holders maintain their faith in the currency. The moment people decide they don’t want your dollars, they become worthless, or at least worth much less. In that case, it will take a lot more dollars today to buy the same thing you bought with many fewer dollars only yesterday.”
For China, this is a very real concern. Especially when it comes to Beijing’s concerns about the loose-credit stance of the U.S. Federal Reserve. China’s Cheng Siwei, former vice chairman of the Standing Committee of the Chinese Communist Party, recently told Great Britain’s Telegraph newspaper that “If [the Fed] keep[s] printing money to buy bonds, it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our [Chinese] foreign reserves are in U.S. bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies.”
In an exciting addendum, Siwei noted that while gold is a solid alternative, “when we buy, the price goes up. We have to do it carefully so as not to stimulate the markets.”
This statement tells us a lot. For instance, there’s definitely an upward price bias contained within gold’s recent price consolidation. And don’t expect gold’s price “floor” to fall too far below the $1,000-an-ounce level: China will almost certainly step in to scoop up all it can.
Meanwhile, it seems that China’s populace is catching on to the ideas of its central government. In the just-mentioned FT article, the newspaper said “the rising tide of wealth among middle-class Chinese has made China the second-largest gold jewelery market in the world since 2007, behind only India.” The article goes on to say “Total gold demand in China last year was nearly 400 [metric tons], up by 21% from 2007.”
The lesson here is clear: China’s growing appetite for gold is a powerful trend that will benefit gold investors for years – even decades – to come.
Warning: The IMF Is Now The World’s Central Bank
This fundamental bullish sign for gold is perhaps also the most ominous for the world’s financial well-being.
In an August maneuver that somehow stayed off the radar screens of most global investors, the International Monetary Fund (IMF) Board of Governors “voted” to create new “money” in the form of Special Drawing Rights, or SDRs.
As Money Morning told readers back in April, SDRs have been a unit of account used by the IMF since 1967, and denominated in a basket of currencies, including the dollar, pound, yen, and euro.
But now they’ve become a convertible asset. China, Russia, and Brazil will begin purchasing SDR bonds later this year, with China’s share starting at a whopping $50 billion.
As Bloomberg News reported, “the allocation … will not increase the fund’s pool of money available for lending [but] will provide members with an additional method to obtain hard currencies.”
And that’s scary, because the implications are enormous.
The IMF has become the world’s central bank.
The IMF can create SDR debt instruments out of thin air, without having hard assets to back them. The IMF’s own Web site explains the basic process, noting that “SDR allocations provide each member with a costless asset.”
Sorry, but I have to ask. What in the world is a “costless asset?” How can you “create” an asset that has no cost to either produce or acquire? And if it costs nothing to create, how can it have any real value?
It’s outrageous. And it would even be comical – laughable, even – if the implications weren’t so dangerous.
The IMF no longer has to depend on borrowing – much less on contributed assets – to increase the funds it has available to lend.
So a new international fiat currency has just been created and added to the long list of national fiat currencies already in use. Like most of its brethren, this currency too can be expanded at will by a handful of un-elected officials. And, as one writer recently stated, “hyper-inflation is the terminal stage of any fiat currency.”
Consider yourselves forewarned. Worldwide inflation is now a bigger threat than ever. Expect the IMF to embark on its own monetary printing spree. A tidal wave of inflation could be headed our way.
Folks, this is going to get ugly.
The Next Bubble?
I have said in the past, that gold could very well be the next bubble.
Now, it seems, that idea is gaining acceptance.
In a recent interview with Canada’s BNN (Business News Network), Canada’s serious business program, Sam Stovall, chief investment strategist at Standard & Poor’s Equity Research (NYSE: MHP), said that “if we end up with concerns about the U.S. dollar, we could probably end up with a bubble in gold prices.”
I rest my case.
How to Play Your ‘Golden’ Opportunity
So what can you do to protect yourself? Well, it seems that even former U.S. Federal Reserve Chairman Alan Greenspan knew the answer to that question. In May 1999, while testifying before the U.S. House Banking Committee, Greenspan actually said that “gold will always remain the ultimate form of payment in the world.”
That’s one piece of Greenspan-given advice that I believe investors should take.
As the price of gold advances, gold-miners will be the “go to” stocks to play. They will benefit from leverage as the yellow metal advances in price.
To measure the health of gold stocks, an often-used proxy is the Amex Gold Bugs Index (HUI), a weighted benchmark composed of 15 of the world’s largest gold-and-silver mining companies. However, the HUI only includes those companies who don’t hedge their gold production beyond 1.5 years. That was done on purpose. The index was designed to provide significant exposure to near-term movements in gold prices. In an environment of rising gold prices, these stocks tend to be much more profitable.
To then gauge whether gold stocks are a relative bargain, we look to the HUI-to-gold relationship. By dividing the HUI “price” by the price of gold (HUI/gold price), we get a ratio that’s a very useful value indicator.
From mid-2003 until mid-2008, this ratio held around the 0.50 range, meaning the HUI bought about 0.50 ounces of gold.
In last fall’s stock panic, we saw this relationship insanely stretched to 0.20. In late October 2008, the HUI only bought 0.20 ounces of gold. That was totally irrational and unsustainable.
Gold stocks were trading at levels not seen in nearly two decades. Extremes like this simply cannot last.
Today, we’ve seen that gap close as I had predicted in January. To see how the HUI-to-gold relationship looks now, check out the graphic below.
This chart provides a ratio that tells us the “buying power” that gold stocks have to buy gold. The ratio had improved from the 0.20 ratio of last fall and was recently as 0.42. Expect that to continue to shift toward the 0.50 level. In fact, it will most likely overshoot, running up to 0.65, before settling back to the historical norm in the 0.50 neighborhood.
The message here is that spectacular gains are still in store for gold and silver stocks.
The biggest bang-for-buck still lies with the junior gold sector. The best proxy for this is the S&P/TSX Venture Composite Index (CDNX), otherwise known as the Toronto Venture Exchange. It consists of about 75% resource stocks.
The CDNX has been steadily carving new highs almost uninterrupted since March, now posting a whopping 80% gain since its December 2008 low. That’s an impressive performance. Remember, this is an index.
The players in this sector promising the best returns are the junior gold-and-silver companies either already producing, or with near-term production.
In the next 12 months, some will likely throw off returns of in the multiple hundreds of a percent, or even multiple thousands of a percent. Major miners really need them to replace depleted production and to grow their reserves. So many will be takeover candidates.
And with gold breaking and sustaining the $1,000 barrier, junior gold and silver miners are the place to be for explosive returns. Just hold onto your hat.
This article has been republished from Money Morning. You can also view this article at Money Morning, an investment news and analysis site.