December 10, 2007
Despite the age of the advance, the fundamentals remain stubbornly bullish for gold prices.
In other words, gold is still undervalued.
I wish I could feel the same about the other commodities.
Unfortunately, I think valuations for the industrial commodities include a premium for economic growth, which means that investors may be overestimating demand. What I mean is: analysts tend to tie their projections for oil or copper demand to forecasts for economic growth, rather than the fundamentals of money. Ergo, they can be vulnerable to an economic downturn if the global economy is not as lean as most think. Meanwhile, gold is typically a countercyclical commodity, and it hasn't gone up as much.
Not every situation is the same of course.
I didn't feel the same in 2001 - I was bullish on most commodities despite the oncoming recession.
But given the valuations in most of the commodities now, I feel differently.
We've come a long way from $12 oil and 60 cent copper.
And unlike the tech boom, the current (post 2003) boom is commodity focused.
That is, the malinvestments are just as likely to exist in the commodity business as they do in the real estate industry today... or the technology industry in 2001. Moreover, the global boom is not healthy.
The economic booms in China and Europe, and most anywhere else today, are as much a product of money and credit creation as they have ever been in the United States. The Chinese central bank has been inflating its currency at rates that exceed 20 percent for years. Regardless of how much growth potential there is in China such inflation is going to produce problems, just as it did in America's youth.
And it isn't confined to China. With the Euro up more than 70% against the dollar in the last five years, it is amazing that the ECB president should worry about inflation at all.
But a closer look will reveal that the central bank has been anything but the stodgy old gold bug that many investors believe it is. Since 2000 the ECB has grown M3 by 81%; the Federal Reserve has grown MZM 85 percent in the same period. Other central banks have been even more aggressive.
The Bank of England has grown M3 by 112% while the Australian central bank has grown it by 139%. There are times when the Federal Reserve outpaces the other central banks, like in the period, 1997- 2003, which paved the way for a massive decline in its foreign exchange value.
But there are three main points I'd like to emphasize here.
The first is that the global boom is not as healthy as many believe. Second, the demand for many of the industrial commodities is tied to expectations that global growth can continue without US impetus.
And third, the US dollar may finally be undervalued relative to most other fiat currencies.
Too many investors have come to believe that the dollar alone is troubled, and that currencies like the Euro and Canadian dollar have become "superior" monetary standards.
If I'm right, there are serious headwinds for gold bulls to overcome in the short run.
A downturn in the global economy would be fundamentally bullish for gold, but would produce huge declines in the industrial commodities, along with a break in the foreign currency bubble.
Rising Production Costs Keep Market Tight
We have seen gold brush off a 35-40% correction in oil and copper prices during 2006, and a small bear market rally in the US dollar during 2005. It even brushed off a so-called tightening campaign by the Fed between 2004 and 2006, not to mention the uptrend in bond yields in that time period.
This is a testament to the tightness in gold valuations, as I hope to demonstrate.
I believe that the gold market will continue to weather such things with no more than a 20- 25 percent correction until we see the kind of bullish momentum in gold prices that leaves the market vulnerable to greater downside.
I mean, with valuation targets in the $2000- 3000 per ounce neighborhood floating around, how far can gold really fall? One way to approach this question is through an analysis of production costs for the gold miners.
Since the 1999 bottom in gold prices, production costs have doubled. Those costs are likely to rise more in coming years, thanks to the regulatory and monetary climates.
But if companies like Barrick were shutting down mines at a $300 gold price back in 2000 - when cash operating costs averaged something like $175 per ounce of gold (sold) - the price of gold at which this might happen today is more like $550, or higher taking other expenses into account. For instance, my estimate of Barrick's total operating expenses is roughly $600 per ounce of gold sold today.
So you could say that the valuation floor for gold has risen from about $255 back in 1999 to the $500-$600 range today - or if you will, approximately where the 200-week moving average is currently hovering in the chart.
All else being equal, the price of gold cannot fall below these levels for long because as it did, mines would be shut down, and the consequent production declines would underpin the market. Indeed, in some sense, a 30% decline to $550 could be considered a worst case hypothesis, as this level would characterize the kind of pessimism that predominated back in 1999.
The weakness in this floor is the possibility of deflation - either monetary or cost deflation, both of which I consider to be really low probability events.
So far we've seen the biggest bull market move in gold in more than two decades.
Yet, except for a few bursts, it has largely been denied the momentum reminiscent of the moves in oil and some of the base metals, and even wheat lately.
It has not yet reached the magnitude of the gains of the seventies - which bore witness to two general advances that saw gold prices multiply 5 to 6 fold in less than five years in each case. However, in its seventh year, the current advance is the longest ever WITHOUT A CORRECTION EXCEEDING 25%.
I have shown that for most of the advance thus far, gold has barely kept its proverbial head above water (the cost of production). That's one reason the bears haven't been able to get a trend shattering correction out of the market yet, despite the age of the move. The bears probably need the market to blow off even higher than it did last year before the market is susceptible to the kind of correction that interrupted the 1970-1980 bull market in gold during 1975 when it fell from the $185-199 level to $110 (40-45%) in 1976 before surging to the $800 level in 1980. It takes some froth to get big corrections.
But now, as financial crisis and recession looms, and investors seek to understand the causes, the spotlight can't seem to avoid the monetary policies of the Fed, and other central banks.
The time for gold to build up a head of steam of its own and tackle $1000 has never been better.