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The Gold Bull Market - Extended Edition

The seasonally strong period for the gold price is now upon us and, at the time of writing (26th Sept 2009), the price has sustained a move just above the psychological $1,000 an ounce level. After a record breaking eight-year bull market, which has seen the gold price quadruple from a 20-year bear market low of $255 in mid 2001, gold's financial attributes are now widely appreciated. The question many are asking is - can the gold price sustain this move above the $1,000 an ounce level and make further upward progress ?

Gold BarsGold Price Above the Long Term Inflation Trend
As the accompanying charts highlights, the dollar gold price is currently well ahead of the price that can be justified by the long term inflation trend in the US. The chart is a semi-log scale, which is effective at displaying the proportional rise in the gold price over time. Had the gold price simply tracked US inflation since 1935, it would currently be trading at just under $600 an ounce. Our calculations are based on a starting price of $35 an ounce for gold in 1934, when the dollar at that time was devalued from $21 to $35 an ounce as the US attempted to escape from depression in the mid 1930s. The $35 price level seems a logical starting point, although we have to acknowledge that different starting points produce different (and mostly lower) inflation-adjusted gold prices.

Real Gold Price Since 1935Premium Reflects Global Debt & Inflationary Concerns
The premium most likely reflects deep seated concerns by investors regarding the financial risks of the consistent global trade imbalances, the level of debt build up in the global economy and the possible inflationary consequences and perhaps dollar crisis if it all gets out of hand.

Is the Premium Justified ?
As we discuss in more detail later in the article, the near term demand and supply outlook appears to be overwhelmingly in favour of higher gold prices. But for the 'buy & hold' investor, the question must be - does the current gold price premium over the long term inflation trend already sufficiently factor in the inflationary risks or do these risks justify higher gold prices still?

Gold's Physical Attributes are Remarkable
First, however, it is worth examining gold's physical attributes as they are remarkable and are an integral part of the metal's monetary or financial attractions.

Gold is the heaviest metal (highest density), it is virtually indestructible and its melting point is 1064 degrees Celsius. It is the most stretchable pure metal known to man - a single gram can be crafted into a sheet one metre squared, which is so thin that the sun can shine through. It does not oxidise (rust) in air or water, it has no taste in its purest form and it is an excellent conductor of electricity. Its physical beauty has seen it used as jewellery for thousands of years. In addition, its robustness and dependability has seen it in increasing demand in many new complex industrial applications where price is less of a consideration.

In terms of its geological rarity, gold bearing rock is very rare and even when it is discovered an average tonne of gold ore yields only 6 grams of gold. That is six parts to a million. Its durability, rarity and divisibility make it valuable and tradable and allow significant wealth to be stored or transported with relative ease. Given all these physical attributes, it is easy to understand how gold has been an accepted form of money for thousands of years.

Three Gold Bull Markets in the Past century

The Depressionary 1930s
The first major bull market in gold in the past 100 years occurred during the deflationary depression of the 1930s. Then, in an attempt to solve the economic problems of the day, governments globally severed the existing gold-currency exchange rate allowing the money supply to be rapidly increased in several currencies (economies). These attempts largely worked to kick start economic activity and helped end the depression.

With a significant increase in the supply of other currencies in circulation in the mid 1930s against a relatively fixed supply of gold, the result was a higher gold price relative to those paper currencies. In US dollars, the gold price increased from circa $21 to $35 an ounce by the mid 1930s. It was officially fixed at that price until 1971 although the free market price started to edge up from 1967 onwards.

The Inflationary 1970s
The next major bull market in gold started in the late 1960s and extended to early 1980. In the mid 1960s, the US was spending heavily to fund the Vietnam War in particular. The financial resources required to fund the war led to a significant increase in supply of US dollars at that time. In this period, unlike the 1930s, rampant inflation was the result. The US government officially closed the gold window in 1971 which meant that dollars could no longer be converted into gold at the old ratio of $35 dollars to an ounce of gold. With so many new dollars in the system, you can understand why. Of course, this move was the official devaluation of the dollar against gold.

From1967 to early 1980, the price of gold rose from $35 an ounce to over $800 an ounce at the peak. That peak in the gold price was not seen again for 28 years (2008). Undoubtedly, the markets had over-reacted and pushed the price of gold too far at that stage in anticipation of double-digit inflation for years to come. In fact, inflation peaked shortly thereafter and gold's correction became a severe one and over an extended period of time as disinflation through the 1980s and 1990s became the norm. As the accompanying table above highlights, by 1980 the price of gold had risen substantially ahead of the long term inflationary trend.

Then the 21-year Long Bear Market
But, as the chart also shows, just as the market over bought gold on the way up, so too it over sold it on the way down. The 21-year long bear market that lasted from 1980 to 2001 saw gold trading significantly below the long term inflationary trend by the mid 1990s. At that stage, gold was commonly referred to as a relic, no longer relevant as a hedge against currency swings as inflation appeared to be firmly under control. Sentiment was further dented when central banks globally started selling off some of their long held gold reserves. Of course, we now know that central banks acted unwisely in dumping a portion of their gold reserves at that time. The Bank of England in particular must take the distinction for having sold a significant portion of its gold reserves at the bottom of the market in 1999 when the gold price first hit the low of $255 an ounce.

But there is nothing like outstanding values to call the bottom of a bear market. Outstanding values eventually bring the buyers back in and the gold market was no different.

Enter the Global Trade Imbalances of the 2000s
The recent bull market, which officially started in May 2001, has seen the gold price rise from $255 to over $1,000 currently. This current gold bull market has been driven by global trade imbalances, which have led to competitive currency devaluations across the globe. This resulted in lower interest rates globally than would otherwise have been the case and which, in turn, led to excessive asset price inflation and excessive debt levels. The outturn, as we now know, was the destabilisation of the global financial system.

Gold Price Since 1998The response to the global credit crunch has seen governments inject significant liquidity into the financial system. If this liquidity is not withdrawn at some stage, then it will mean too much money chasing too few assets and eventually inflation will take off. This is what the market sees and gold, as usual, provides the ultimate hedge against this eventuality.

The Common Link in All Three Gold Bull Markets
Although all three gold bull markets of the last century appear to have different causes, the common theme was a substantial increase in the supply of money in circulation that was not justified by an equal increase in the amount of goods and services traded.

The Near Term Demand & Supply Outlook is Favourable

A Look at the Supply Side
On the supply side, the annual gold supply is declining and it is difficult to envisage what factors could lead to an increase in supplies in the near term. As the table opposite highlights, current annual supplies of gold comes from three principle sources - new and existing mine production, recycling of existing industrial and jewellery gold and the selling by central banks of a portion of their gold reserves.

Gold SupplyMine Production Biggest Source But Declining
Mine production provides the biggest source of annual gold supply. But existing production supplies obviously have a finite life and exploration activity for new mines has become an increasingly difficult task even with the advances in technology. Gold is a scarce resource and even when a new deposit is found, ever stricter environmental regulations both delay and increase the cost of the extraction process. It can take years from the time a gold deposit is found to commercially mining that gold. The consistent decline in the price of gold from 1980 to 2001 saw global gold exploration activities fall dramatically. The quadrupling in the gold price since 2001 has, understandably, reignited gold exploration activities. A further problem, however, is that gold production, which was traditionally dominated by more stable supply sources including Canada, South Africa, Australia, the US and Russia, has partially shifted to less politically stable regions including many of the smaller Latin American countries. The result is less certainty over the consistency of supplies.

A fall out of the global credit crisis of 2008 for the gold market has been the impact on project funding. The curtailing of the available funding for the industry has resulted in delays for even those projects where deposits are ready for commercial production.

The bottom line is that gold production from mines globally has fallen marginally from circa 2,600 tonnes in the year 2000 to nearer 2,500 tonnes in 2009.

Recycled Gold Has helped Plug the Gap
The higher gold price has increased the supply of recycled gold and there appears to be little reason why recycled gold should not continue to provide an increase in supplies for several years yet.

Central Banks Should Turn Net Buyers
But the supply from central bank selling is declining rapidly. Indeed, a fall out from the global credit crisis in 2007-08 is that central banks are now even more aware of gold's attractions as a financial reserve. It is the most liquid reserve which is important in times of crisis. The main alternative financial reserve that central banks have held has been government bonds. Due to the very liquid market globally in US government bonds, they in particular have dominated central bank reserves globally. But with the steep increases in US government debt and the on-going weakness in the US currency, even US government bonds are seen as less gilt edged than previously.

In contrast, gold comes with no liability against it. Its value is not dependent on the solvency of any government and unlike paper currencies, the supply of gold cannot be increased at will. Following the global credit crisis of 2007-09, there is most likely a renewed appreciation among the world's central banks of gold's uniqueness among financial assets - a precious metal with timeless and universal intrinsic value in which there is a global tradable market which does not shut down in times of crisis.

According to the GFMS, the metals consultancy group, central banks have been net sellers of gold in only seven years since the break down of the Bretton Woods exchange rate system in 1971. It is logical, therefore, to assume that net selling by central banks will soon turn into net buying depressing annual supplies even further.

A Look at the Demand SideGold Demand
On the demand side, the annual demand for gold has been rising and the trend looks sustainable. As the table opposite highlights, the largest source of annual gold demand is from jewellery and industrial usage. With the global economic downturn, demand from this area is estimated to have fallen by nearly a third from 3,200 tonnes annually in 2000 to under 2,200 tonnes by end 2009.

Global Economic Recovery Gold for Jewellery & Industrial Usage
But a recovery in the global economy should lead to a recovery in industrial and jewellery demand. On the industrial usage side, gold is becoming an ever more essential component - its unique physical characteristics make it highly stable and dependable and, where component failure is not an option, gold will remain the component of choice. Its newer applications have seen it used in satellite and computer parts, as a component in wind and solar power applications and in laser technology.

Gold JewelleryCentral Banks Likely to Return as Net Buyers
As we discussed on the supply side of the argument, while central banks has been net suppliers of gold in several years since the mid 1990s, it is highly likely that they will swing back into being net buyers of gold as they have been over the decades.

The last significant source of gold demand is from the investment community. And, in the past several years, investment demand has more than plugged the gap left by the central banks and the downturn in industrial and jewellery usage.

Investment Demand is the Major Swing Factor
As outlined at the start of the article, investment demand is being driven by the on-going risks of the global trade imbalances which reflect competitive currency devaluations globally.

Global Economic Problems Remain Acute
Let us take a look at one part of these global trade imbalances to see how they can cause instability and lead to inflation. China, in particular, has been a huge net exporter for the past decade at least. Exports to the US, for example, bring in dollars for the Chinese exporters. China has chosen to hold the dollars it has received in this export trade in its reserves rather than converting those dollars into its own currency, the Remnimbi. With these dollars, China has bought mainly US treasurues (bonds) which, in effect, returns these dollars back into the US economy. This practice helps keep the Chinese Remnimbi weaker and the dollar stronger than they would otherwise be. But the practice also increases the amount of US dollars (or liquidity) in the US economy and because the dollar is the globally traded currency, it also directly leads to excessive dollar creation in the global financial system.

The attraction of this arrangement for China, of course, is that it allows it to remain competitive in exporting to the US and elsewhere. In effect, to correct the US trade deficit, the dollar needs to fall against other currencies, which to some extent itb has beed but clearly not by enough. But if other currencies are also in effect devaluing themselves (like China) to maintain competitiveness in export markets, the net result is competitive devaluations of all currencies. It may not be visible from one day to the next but the competitive devaluation process that has existed in the global economy for many years has created an excessive increase in the money supply (borrowed money in this case). Against this backdrop, is it any wonder gold has been rising against all currencies ?

Excessively Low Interest Rates Fuels Bubbles
This trend resulted in interest rates globally being lower than they should have been during the late 1990s and early to mid 2000s. The resultant cheap money globally undoubtedly assisted in causing asset price inflation (in property in particular) and excessive borrowing in the chase to participate in rising asset prices.

On the banking side of things, artificially low interest rates (and government bond yields) encouraged banks globally to try and improve the income they could earn from assets on their balance sheets by buying higher yielding but riskier assets and to take on and give out more debt than they should have. The subsequent realisation that system wide leverage had become excessive against a backdrop of falling asset values caused a stampede for liquidity and an aversion of risk - in essence, everyone wanted their money back at the same time due to a sudden loss of confidence. When asset prices started to drop, the result was the global credit crisis.

Huge Government Budget Deficits Fuel Borrowing Surge
In response, governments have been running huge budget deficits in an attempt to substitute the significant cut back in private consumption in many economies. In addition, interest rates are at previously unthinkably low levels and central banks are adding significant liquidity to the system by engaging in quantitative easing (printing money).

Inflation ChartThreat of Currency Debasement is Ever Present
While it is most likely that the right action has been taken, the fact remains that excessive government spending and central bank money printing could be highly inflationary in years to come.

Equally, from an investor's viewpoint, the massive increase in government budget deficits globally has lead to questions regarding government solvency. The Icelandic economy imploded and many eastern european countries are on life support from the IMF. Ireland, at one stage, was not too far behind but has started taking the corrective action required to both get its house back in order and to retain overseas investor confidence. If US government debt (i.e. the US dollar) ever lost the confidence of international investors because of balloning budget deficits, social security funding issues and excessive money printing, then a dollar crisis could result. What price then for Gold, as the only alternative store of wealth ?

The threat can be better understood by looking at the same scenario in the corporate world. A company runs its business in a conservatively financed manner for years only to suddenly increase it borrowings for new projects or an acquisition. If management misjudges things badly and the debt becomes unmanageable the only real way out of the debt trap may be a rights issue .i.e. to issue new shares to raise fresh capital. This significantly dilutes the value of the business for existing investors.

Similarly, if a government over borrows to a level where its economy cannot afford the level of borrowings then the temptation to monetise its debt (i.e. print new money) to spend or repaid existing debt would be irresistible. This, like a rights issue in a company, increases the amount of money in circulation and devalues the existing money or government bonds in circulation for existing investors.

This is precisely what the markets fear and are pricing in when investors buy gold. With the obvious risks attached to government debt in many countries gold is the legitimate alternative currency to hold, as it has no debt against it and its supply can not be artificially manipulated.

Hence, the cyclical backdrop remains very positive for gold. The annual supply of gold is declining and demand appears sustainable at current levels at least. The huge increase in US government debt and its on-going trade deficits suggest a deteriorating outlook for the US dollar and US dollar debt (i.e. US government bonds). Lingering deflationary threats serve to make the argument more compelling. And that is the nub of the current gold bull market. A bonus is that the current cost of holding gold after inflation is extremely low.

The Gold Price Outlook
In summary, the demand/supply outlook appears overwhelmingly in favour of higher gold prices in the short term and the decisive break above the $1,000 level in September 2009 is likely, in my view, to be sustained. And the move above the $1,000 level has occurred without any signs of bubble-like activity by investors. There has been no parabolic rise which typically signals the end of an irrational bull market in any asset class.

Opportunity for the Trader
Bull markets - like the gold price itself in the mid 1970s, global stock markets in the mid 1990s and global property prices in the mid 2000s - are not halted by over-valuation. Hence, the rosy near term demand/supply imbalance in the gold market suggests that a further up-leg in the gold bull market may well be underway and, at the very least, a trading opportunity is surely beckoning.

Not So Clear Cut For the Investor
For the 'buy & hold' investor, however, the case for gold is, of course, less clear cut. As the earlier chart highlights clearly, the gold price is already well ahead of the long term inflationary trend. If global trade balances continue to correct, if government debt is seen to become more manageable and if central banks are successful in withdrawing the excess liquidity out of the financial system then the financial threat from excessive debt levels and the likely inflationary consequences will recede. In that scenario, the gold price may well revert back to its long term inflationary trend. But what odds would you put on this goldilocks scenario? If you deem the odds of a successful outcome to the global economic problem to be low, then gold provides the ultimate hedge.

Gold CoinsDetractors argue that gold produces no income. But such arguments fail to point out, or to understand, that gold does not need to pay any income as it has no liability (debt) against it. Said another way, gold does not produce wealth. Rather, it protects wealth. Hence, it should not be compared to assets such as shares or property. It is the ultimate alternative currency to paper money. It is a core holding in the asset allocation process as an alternative to cash deposits normally held in paper currencies (dollars, Euros etc) . 



Rory Gillen
25th September 2009