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Nov 2008 - Understanding Gold

Understanding Gold

Quite a few comments have been written about gold and its expectations since October 2008. Particularly after the US$100/oz fall within two days to 23 October 2008, hovering above US$700/oz despite significant demand for physical gold, and subsequently rising US$100/oz to over US$800/oz similarly over about two days around the 23 November 2008.

Even more comments are likely to follow with its recent drop of over US$50/oz to US$766/oz on 1 December 2008.

We (ERA) have analysed gold and the gold price for over 30 years since 1977 when we were employed to review South African gold shares and try to predict the gold price in Union Corporation’s (which was taken over by Gencor, and later by Gold Fields) head office in Johannesburg.

There are probably three main points about gold and consequently the resulting gold price, namely :

Firstly, it vacillates between being a currency and a commodity. Its value can vary depending on what someone is prepared to either pay for or sell it. We recall once reading a Chinese fable/tale about a Mandarin who wanted the leaves cleared from the paths on his estate and offered to give 1 gold coin for every 500 leaves collected.

Most gold price models incorporate a currency parameter. Originally, it used to be the Dmk/US$ exchange rate which has subsequently probably become the Euro/US$ exchange rate, and which has a classic inverse correlation to the gold price. The weakness in the gold price has probably been due to the strength of the US$, which many have found difficult to understand as usually when a country prints its currency at such a rate, the result has usually been rising inflation and a weaker currency, not a stronger one as with the US$.

Many remarks have cited the strength as being due to Americans returning to their haven of safety in the financial turmoil and converting offshore currencies into US$, returning the US$ back to the US. Other comments have alluded to hedge fund borrowings having to repay in US$ - either way the US$ has managed to strengthen.

However, for gold, the commodity pressures began to have an impact, firstly when there was an absence of gold coins in North America, then an absence of gold bars in Dubai, followed by ~50t of gold sold in one festival day in India, and subsequently 140t of gold reputedly bought in Saudi Arabia in early November 2008. The Perth Mint has stated that it is struggling to meet demand and has deferred any new orders to January, as even on a 24/7 basis and working overtime it has too many back orders of physical gold to satisfy.

There are not many gold bars and coins on display these days, although we saw gold bars and coins on display in China at the China Mining Conference in Beijing for the coming Chinese New Year of the Ox as shown in Figure 1, and China is domestically consuming all that it produces (~300tpa and rising) of gold.

Secondly, gold is contrarian. When everyone and the media write that it is going to rise, it usually falls, and when the published majority thinks it is going to fall, it usually rises.

Consequently when two major brokers forecast the gold price to collapse and average (according to one of them) to an average of US$690/oz for DQ08 and US$630/oz for MQ09, the scene was set for a sudden rise, which occurred almost the next day with a $50/oz jump in the gold price on Friday 21 November.

It is a fact of life that most people who forecast the gold price, get it wrong.

Why...because it vacillates according to the first point; it is often contrarian, and it is impacted by the third point, namely it is a haven of safety...but :

While gold is a safe haven of last resort, that also means when investors have lost everything else, then their gold has to be sold to pay any outstanding debts. It also means that hedge funds may be forced sellers too, to meet anticipated redemptions. We remember the October 1987 crash. The gold price rose during the week of the crash and fell the week after, as it had to be sold to cover investors’ stock market losses.

Believe it or not there is a correlation with the oil price, but it is not simple. Increasing oil prices do lead to inflation, due to the knock-on pricing effect, but are not the main cause of inflation.

When we used to model the gold price (which we described in detail in our column in the January 2003 issue of Paydirt), the key parameters of one of the most successful forecasting models (of the South African Chamber of Mines) were : the real US long-term interest rate, the Brent oil price, the DMK/US$ exchange rate and the annual increase in USM1 money supply led by 4 quarters (or one year) to provide inflationary expectations, plus a “constant” (determined from linear regression of the parameters) to balance the equation deriving the US$/oz gold price.

The inclusion of the oil price in the model gave a significantly better statistical fit than its exclusion. And like it or not interest rates are falling with cpi (or inflation) rising, so real interest rates are falling - another factor in gold’s favour.

Models used to work reasonably well until the hedging dampened them like “pouring oil on troubled waters”. Julian Baring was 100% right when he said that gold hedging and forward selling was dampening and holding back the gold price and he and Mercury Asset Management (later taken over by Merrill’s) were strongly against it, discouraging it whenever and wherever possible.

Gradually the hedging dissipated and the gold price recovered to what it has become today. However, without the hedging comes the volatility, the gold price behaviour is back to what it was before the hedging occurred in the late 1970s to early 1980s, ie extreme movements of up to US$50/oz per day or more. The movements are even more accentuated than before due to 24-hour trading- back then it was a case of watching the Reuters’ print/ticker machine printing out one line at a time.

The market is still learning how to handle such movements, and that’s all they are – just volatility. The market has improved, at one stage a $2/oz move in the gold price resulted in a 2% move in gold share prices, but the collapse in share prices of up to 20% last night (1 December) on the US$50/oz fall in the gold price will be shown in most cases to have been overdone.

And so to demand for gold. Aside from the staggering demand from India this past year in the usual wedding festivals that follow the monsoonal rains and harvests, the Chinese public are becoming increasingly affluent and that has to be good for gold. Gold is relatively cheap in China, after all the Rmb is currently probably the world’s strongest currency having risen by ~20% against the US$ in the past 3 years (since 2005), and the US wants it to be allowed to strengthen ever further.

One of the clearest signs of the growing affluence (apart from clothing and boutique shopping bags and shops are cars. We saw Porsche’s being driven in Nanning in Guangxi in November 2008 and a Porsche showroom there.

Apparently, the largest dealership for Bentleys is now in China, and in 2007 the 9 Bentley dealerships spread throughout the country, sold 258 of them. Also in 2007, China contained 7 of the 10 Bentley Mulliner 728s which cost ~Rmb12m each (divide by about 7 to get 1US$, or 4 to get A$1). And Xian in Shaanxi Province is reputedly becoming one of the main centres for Rolls Royce’s (106 were sold throughout China in 2007). BMWs, Audi’s and Mercs have become commonplace now throughout China, amongst the various forms of 4WDs.

The coming Chinese New Year (4707) of the Ox starts on 26 January 2009, as symbolised in the Chinese gold bars in Figure 1 and they have those absolutely fantastic new year sayings (for gold bulls) such as “Gold should be seen everywhere in the house”, aside from giving gold gifts to each other.

While wary of forecasting a gold price, we (ERA) think that based on the above demand factors, there appears to be an increasing likelihood that the gold price is underpinned at US$700/oz and capable of rising much higher. Usually regarded as requiring hard work that results in more prosperous times, the year of the Ox will hopefully be a lot better for gold (and gold shares) than the outgoing year of the “Rat”.

Disclosure and Disclaimer: This article has been written by Keith Goode, the Managing Director of Eagle Research Advisory Pty Ltd, (an independent research company) who is an Authorised Representative with Taylor Collison Ltd, and with his associates, may hold interests in some of the stocks mentioned in this article. The opinions expressed in this article should not be taken as investment advice, but are based on observations by the author. The author does not warrant the accuracy or completeness of any information and is not liable for any loss or damage suffered through any reliance on its contents.

Figure 1. Four 9’s and Five 9’s Gold Bars (20g to 200g) for the 2009 Chinese New Year of the OxGDNnov08-1

  • Written by: Keith Goode
  • Saturday, 01 November 2008