Gold is on the march. The yellow metal is spiking to a new all
time (non inflation-adjusted) highs of nearly $1,300 per ounce on
renewed speculation that the Federal Reserve's next moves will only
strengthen the case for higher gold prices down the road.
Let's take a closer look at some key questions to see if gold is
set to shine even brighter or eventually lose its luster.
Q: What is the Fed concerned about?
In its most recent statement after
Federal Reserve Open Market Committee (FOMC)
noted that potential
is of increasing concern. (Core annual
has been running at 0.9% for five months in a row, its lowest pace
since 1966.) Any drop in prices could spell real trouble for the
and would imperil borrowers that are seeing lower income but
constant debt levels.
Q: What might the Fed do?
To help support prices, the Fed can inject money into the economy
by buying back bonds. (The bondholders that sell their debt back to
the government would presumably put that cash to use elsewhere in
Q: Why should that impact gold?
Many fear that the Fed is simply inviting the prospect of troubles
down the road. Early in the last decade, the Fed also sought to
boost the economy's prospects by keeping interest rates low. That
set the stage for rampant low-cost borrowing and an eventual
housing boom, which turned out to be disastrous for the economy
when the music stopped.
This time around, the concern instead focuses on what might happen
if the economy hums back to life but the Fed has a hard time
keeping growth (and inflation) from surging. In the recent economic
bubble, inflation never emerged. Yet gold bulls insist that we
won't be so lucky next time. That's because budget deficits are now
far higher, and if the United States can't meet its obligations,
then inflation will rise as the Fed raises interest rates to keep
attracting buyers for its debt. That would cause the dollar to
weaken and gold would provide shelter in the storm. (But if rising
inflation fails to materialize, then many that had bought gold on
inflation fears may look to sell their positions.)
In addition, gold isn't as closely tied to economic cycles as are
many commodities and equities, and it is frequently bought to
diversify portfolios and guard against losses elsewhere.
Conversely, as economies improve and stock markets rise, the
argument for owning gold weakens. The fact that gold is hitting new
highs even as the S&P 500 has had a strong two-week run is
Q: What's the upside for gold?
Ah, the crystal ball question. Bulls think it can move toward the
$2,000 per ounce. mark, which is actually the all-time high when
adjusted for inflation. [Read:
The Truth About Gold
Why that price? There seems to be no real way to peg an actual
projected value on gold. The price is driven by sentiment and not
any sort of underlying asset value. We can figure out global demand
for gold, and also how much is being produced each year. But we
don't have a clear read of how much actual gold is sitting in
central banks and especially in safe deposit boxes. Contrary to
popular belief, central banks tend to offer contradictory
statements on their gold holdings to keep
speculators from knowing the state of their finances.
Gold producers generally spend around $450 per ounce to produce
gold ($900 on a fully-expensed basis), so with gold above $1,000,
there is ample incentive to hike output. And rising output of
anything tends to have a dampening effect on prices. It hasn't
happened yet, but some suspect we may be reaching the point of a
gold glut -- at least in terms of industrial and jewelry demand.
Financial hedging demand is fairly immune to supply, and could
continue to power gold higher. Gold contracts that expire in 2016
place a $1,447 price on an ounce of gold.
Rising prices have a way of feeding on themselves. JP Morgan's
asset management arm continues to load up on gold on expectations
that it will attract even more interest in coming years. (This is
also known as the Greater Fool theory or the Keynesian beauty
Q: What's the downside?
The short answer is that gold could fall below $500 if all of these
concerns fail to materialize. That's where gold traded back in
2005. And that's likely the area where supply and demand are truly
affected, financial hedging considerations notwithstanding. As long
as massive budget deficits remain as a concern, however, gold is
very unlikely to fall back to that level.
Q: If I think gold has more to climb, should I buy gold or
The benefit of buying gold (or a gold
SPDR Gold Shares (
) is that you aren't paying for the operating expenses of gold
companies and you are eliminating company-specific risk. And since
gold producers may seek to lock in (or hedge) the price at which
they can sell gold, they may not be able to fully profit from the
sharp upward move in gold prices. (Currently, most gold producers
are unhedged and willing to accept market risk, but that may change
if prices rise higher.)
Then again, profits at gold-mining firms can grow even faster than
's price if they didn't lock in prices. That's due to the
fixed-cost nature of gold mining. As noted earlier, it costs
roughly $450 per ounce to mine, store and transport gold. So with
gold selling at $1,000 an ounce, that's a $550 gross profit. But if
gold prices rose +50% to $1,500, then per ounce gross profits would
nearly double to $1,050. (Actual profits are well lower when
non-mining costs are included.)
During the past 25 years, gold stocks have historically traded for
between 12 and 24 times projected profits. Now they trade for just
11 times next year's profits. But that's because profits have risen
so sharply and could well re-trench. If gold stayed above $1,200
per ounce for a number of years to come, then these stocks would
look appealing. But if gold fell below $1,000 per ounce, then these
ratios would appear astronomically high.
Investors can also look at where the gold miners trade in relation
net asset value
). They have historically traded between 1.4 times and 2.4 times
(except in early 2009 when they traded below NAV) and currently
trade at 1.8. That NAV would rise and fall in step with any move in
Q: What about "peak gold?"
While the question of peak oil dominates energy markets, it's
really not important in gold mining. Most publicly-traded gold
producers estimate that they have proven reserves that are
equivalent to 10 to 20 years of annual production (and a similar
amount that they have yet to verify as recoverable). And unlike oil
that disappears when it is used, actual industrial demand for gold
is so small relative to the amount held in bank vaults and jewelry
chests, that any shortage could be met fairly easily.
Yet it is getting more expensive to mine gold as the easiest plays
have been mined out and new mines are in increasingly remote or
hard-to-mine locations. In 2000, it cost roughly $175 to mine and
transport an ounce of gold. That figure moved above $250 in 2006,
above $400 in 2008, and appears headed toward the $500 mark in the
next year or so. Despite that rise, gross profit margins have
surged. Gold miners made roughly $50 for every mined ounce from
1990 through 2005. Per ounce profits are up nine-fold since then.
But as noted above, miners have plenty of
costs, and it actually costs more than $900 to produce an ounce of
gold when they are accounted for. That's why gold miners would hate
to see a sharp pullback below $1,000 an ounce.
Action to Take -->
All of this highlights a real conundrum for investors. Gold prices
are being supported by economic concerns that have yet to (and may
never) materialize. Gold can easily power higher (and technicians
note that it just passed an important resistance level). But on a
fundamental basis, gold appears quite
. If gold prices fell to a point that truly reflects the
fundamentals, then gold miners would see profits evaporate. Gold
makes sense as a defensive
and as a means of
. But it's not a clear value as a pure investment.
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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