Tuesday, February 8, 2011

Bullish On Gold All The Way To $1,600

by Agustino Fontevecchia

With gold prices falling since the beginning of 2011 and the prospects of an economic recovery gaining traction, many have doubted whether the incredible rally in gold prices is sustainable. The bullish argument can be made by looking at fundamentals underpinning the market, though, as gold investors will see the market tightening around stagnant production and higher demand through 2011.

Research by Standard & Poor’s MarketScope Advisor pinpointed a few of the organic trends that will prop up prices through the year. In the note, analysts estimate that gold prices will end 2011 around $1,600 an ounce, giving the precious metal an upside of about 20% from early February prices.

Stagnant or declining gold production will be one of the main market forces supporting higher gold prices this year. According to S&P’s research, production will remain stagnant for the next several years “as old mines are becoming depleted” and significant discoveries fail to be made. Global mine output in 2010 reached 2,652 tons, only 1.2% above 2000 levels, leading S&P’s research team to conclude that “production will remain stagnant for the next several years.” Among producers, they suggest Barrick Gold, Newmont Mining, and Randgold Resources. The research team expects “sizeable gain[s] in sales and earnings versus 2010 levels,” with EPS projected to grow 50% for the producers they follow. (Read Bob Lenzner’s piece, Gold Is Not The Ultimate Bubble Yet).

Demand-side fundamentals will be price-drivers for gold in 2011. Accommodative monetary policy in developed economies and an extended low-rate environment will both pump up demand for gold and reduce the opportunity cost of holding it as an investment, reads the note. Quantitative easing expands the money supply and possibly “leads to rising inflation and the debasement of the currency” in which it’s applied; this will send capital in dollars, pounds, yen, and many other currencies out in search for yield. As evidenced by Ben Bernanke’s last speech and the FOMC’s last statement, rates will remain at the almost 0 range for an extended amount of time, rendering treasuries unattractive and increasing the appeal of gold as “monetary reserve asset.” (Read Bernanke’s Victory? Chairman Speaks More of Deficit Than QE2).

This last trend, that of gold as an alternate monetary asset, will be furthered by nations seeking to diversify their reserves as a reaction to a falling dollar with an uncertain future ahead of it. China leads the way in terms of reserve accumulation, but Brazil, Russia, Japan, and various other East Asian nations have been amassing huge fortunes which are now at risk due to U.S. economic and monetary policy.

Demand for gold has come from everywhere. Added to the likes of billionaire investors George Soros and John Paulson, the central banks of emerging markets including China, India, and even the oil producers, are retail investors. Through the SPDR Gold Shares ETF (GLD), investing in physical gold has been democratized and opened up to almost anyone (S&P suggest GLD as a way to tap into rising gold prices).

Even retail investors in mainland China have been revving up their appetite for the yellow metal. According to a piece by Eric Sprott and David Franklin published in ZeroHedge.com, “Asian demand for physical gold and silver is akin to a tsunami.” The piece fleshes out how a new investment facility provided by the Industrial and Commercial Bank of China (ICBC) and the World Gold Council has opened the door to investors in mainland China to “accumulating gold through a daily dollar averaging program.”

“Chinese retail demand for gold increased by 70% from October 2009 to September 2010, representing a total of 153.2 tonnes of gold imports. Yet, over the same period, the demand for gold jewelry rose by only 8%. There is a clear trend developing for Chinese investment in gold as a monetary asset, and China is buying so much gold for investment purposes that it now threatens to supersede India as the world’s largest gold consumer,” reads the piece. Now, through the ICBC Gold Accumulation Plan (ICBC GAP), 1 million new accounts have been opened to invest in gold, and, as the ICBC is “the largest consumer bank on earth with approximately 212 million separate accounts,” the prospects for this program’s super-charged growth is huge, say Sprott and Franklin.

The authors estimate that if the limited program were opened up to all ICBC depositors and to the next four largest Chinese banks and the rate of gold purchases followed the same growth pattern exhibited in the “test period” mentioned above (i.e. 1 million accounts since April 1), then it would result in gold purchases of an extra 300 tons of gold per year, or over 10% of estimated 2010 global gold production. “The ICBC Gold Accumulation Plan and other alternate methods of investing in gold have the potential to overwhelm current supply in the gold market.”

While many consider gold to be overbought and due for a major correction, it seems like fundamental market forces are positioned to support the precious metal’s assent even further. S&P’s MarketScope research team suggests looking into the market vectors gold mining ETF (GDX) and the basic materials select sector SPDR (XLB) for investors looking for additional ways to express their bullish sentiments.

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