Gold has officially entered abear market with a 20% drop from
its peak in 2011. Exchanges recently halted trading to
The chorus of bears has grown just as loud as the holdout bulls,
who point to massive easy-money programs. The range of
possibilities is astounding.
The one certainty is that no one knows where gold's pricewill go.
So what can you do to establish an outlook and afair value for
something that can cause such a speculative craze?
When themarket panics and investors rush for the exits, you have
to have a calm assessment of value. Looking at long-term supply
and demand can help youput a floor on anyasset and develop a
Gold Still Glitters
First, we have to really look at the impetus behind the biggest
sell-off in gold prices in the past 30 years. The metal got
caught in a perfect storm of data and rumors -- some temporary,
others possibly longer-lasting.
Recent economic data out of the U.S. and China have been weaker
than expected, leading to subdued pricing pressure and less need
for aninflation hedge in the form of goldinvestment . The single
biggestfactor came from Cyprus, which may need to sell as much as
$525 million in gold reserves fordebt payments.
The massive loss in gold over a couple of days led many traders
to getmargin calls, when their portfolio values fall below set
limits for borrowing capacity. To satisfy the margin
requirements, traders needed to sell off more assets, sending
prices down further.
Despite the near-term pressure, the longer-termupside for gold is
still strong. The Federal Reserve has quintupled the size of
itsbalance sheet in just five years to almost $4 trillion. The
Bank of Japan just announced a two-year plan to double its own
balance sheet and set an explicit target to jump-start inflation
from -0.7% to 2% annually.
That may notmean much to most investors, but to economic geeks
like myself, it's huge. Rates and inflation are fairly benign
right now, but a pickup in theeconomy or a hit tocentral bank
confidence could cause both to surge. When this happens, the
assets held bythe Fed and the Bank of Japan -- which are not
regularly revalued to current rates -- will be worth less than
the value they hold on their books.
When this happens, the value of the dollar and yen will drop, and
the value of gold will jump.
What's more, odds are that Europe will have to join in on the
greatmoney print as well. Massive austerity isn't working, and
the region just saw its third consecutive quarter of negativeGDP
growth. It's only a matter of time beforecreditor countries like
Germany jump on the easing bandwagon or just let the whole
unified experiment go down the tubes.
Either way, gold wins big.
Constant Supply, Growing Demand
Unlike other commodities, gold is not consumed. Nearly 100% of
all the metal ever mined is part of the current supply, which
grows at about 1.7% annually. Supply is stable and easy to
Demand, on the other hand, is less easily estimated and can be
extremely volatile. Commercial demand is the more stable of
thefactors . Jewelry accounts for about 42% of annual demand;
another 10% is used in technology and dentistry. Investment
accounts for another 35% of demand, with the rest attributed to
centralbank reserves .
Despite the recent weakness and rumors of Cyprus selling, demand
from sovereign nations has been fairly stable as many countries
try to diversify their assets away from the constantly
The last piece of the puzzle is gold's value increase due to
changes in the value of the dollar in which it is priced. Despite
the massive amount of monetary easing around the world, the
inflation rate is still fairly benign. The 10-year average rate
of inflation is 2.3%; estimates for the next few years are around
3% on the high end, and possibly higher after that.
Information from the World Gold Council shows that growth in
demand during the past 10 years has been about 2.6%, with demand
for jewelry decreasing 3.5%, technology increasing 2.1% and
investment demand skyrocketing by 16% annually.
Even if investment demand drops on price weakness, the trade-off
between commercial and investment demand is pretty strong. As
prices come down, investment demand falls but commercial demand
increases, so we can assume that overall demand remains fairly
Applying an annual growth in demand of 2.6% on top of the
inflation rates to gold's price since 1989 yields anintrinsic
value of $1,269, or 9% lower than its current close.
Price of Gold since 1989 and Fair Value Estimate to
Applying the 2.5% inflation expectation and 2.58% demand
growth to 2015 estimates yields an intrinsic value of $1,400.
While gold's rise over the past decade has been meteoric, it
doesn't appear to be that far off of a fair-value estimate.
Another round of selling could bring prices down to a level I
would feel comfortable with for a long-term investment.
Physical Gold For Protection, Miners ForIncome
I don't think the sell-off is quite over in gold, so I would be
hesitant to buy into the physicalcommodity just yet. However, the
longer-term drivers are still intact. A good strategy for
investors may be to hold a small position in the
SPDR GoldShares (
for inflation protection combined with a position in the gold
miners for current income.
While the gold miners may not provide as much upside return
should gold shine again, their shares provide a good opportunity
through continualrevenues anddividend distributions.
StreetAuthority's Nathan Slaughter recently sold off some
positions in his
Scarcity & Real
portfolio but is holding on to
, which has the strongest balance sheet among the miners. The $22
billion miner trades for a premium against peers at 14 times
trailingearnings but pays a 2.2% dividend.
I also like
for itsdiversification in copper and gold, making it a play in
both metals. The shares trade relatively cheaply at 9.2 times
trailing earnings and pay a strong 4.4% dividend. The sell-off in
commodities has pushed the shares to a four-year low, which may
represent a good long-term entry point for investors.
I would look for another sell-off in gold prices before buying
into the commodity itself, maybe another 10% off the current
price. The recent weakness may already make for a good entry
point into some of the miners.
Risks to Consider:
There still exists potential upside in the price of gold on
speculative demand and global uncertainty. Europe is far from out
of the woods, and theemerging markets may not be able tosupport
global economic growth. Investors waiting for a better entry
point run the risk of missing out on some upside.
Action to Take -->
The long-term drivers to bebullish on hard assets like gold are
still intact, but the speculative fervor in the metal is just too
high right now. Look for the yellow metal to fall closer to its
intrinsic value before putting your money in for the long