Gold Reconsidered

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A couple of weeks ago, with gold knocked as low as $416.10, resource investors were wondering just how low gold could go. Now, with gold rebounding over $420, such musings might turn to questions such as, "Can gold hold at these levels?" and "Does it still have what it takes to hit $500 by year-end?"

While I’ll share my views on the topic, I tend not to be overly concerned about short-term price action, but rather concern myself with finding great companies, with good financial structures, using proven exploration techniques on multiple, highly prospective targets. In other words, companies that will make you rich on process under any reasonable gold price scenario. Price volatility, other than a dramatic meltdown the likes of which I don’t expect, is, therefore, not unwelcome as such volatility allows me to (a) buy great companies on the cheap when prices dip and, (b) sell for a profit when prices move strongly to the positive. Simple but effective. Right now, I am very much an active buyer.

But back to the topic at hand. When gold briefly touched $416.10 on the heels of the euro’s train wreck, a lot of people began to fret that it was on the way to its recent low of $379 gold, reached in May of last year. Yet, it is worth noting that gold has been over $400/oz., on average, for over a year now. And the 200-day average is over $426.72. So gold over $400 is not some short-term spike, but a trend in motion.

It is also important to consider the historical context for current prices. Adjusting for inflation, $400 today is only about $175 in 1980 dollars, when gold hit its $850 peak. So, rather than being historically expensive, gold is still actually quite cheap and has a lot of room to move up before threatening previous highs.

But the most intriguing thing I’m keeping an eye on is the relationship between the U.S. dollar and gold.

As everyone who invests in this sector is already aware, over the last couple of years, gold has largely traded in a converse pattern to the U.S. dollar, appreciating most when the dollar falls, and depreciating when it rebounds.

Over the long run, that works in gold’s favor because the dollar’s problems are legion and almost nothing will keep it from heading lower. Much lower. Of course, the government could stem the erosion by returning to the gold standard, thereby underpinning the currency with something more tangible than the operating speed of a printing press. But returning to the gold standard, which would require $5,000 an ounce gold, has almost no chance of happening in the foreseeable future. That pretty much clears the way for the dollar to depreciate more or less steadily to its intrinsic value…just shy of completely worthless.

Of course, in order for the dollar to slide, it must slide relative to something else. Until the recent setback to the euro, that currency was the "it’s not the dollar" alternative of choice for FX traders around the world. Now that the EU constitution has correctly been relegated to the trash bin of history, uncertainty stalks those lands and the gilt has worn off that particular lily. The Italians are even considering abandoning the euro.

But I see a glimmer of hope for gold in all the European hand-wringing: after predictably taking it in the neck on the U.S. dollar’s rebound against the euro, gold unpredictably staged a quite impressive rebound of its own. From the abyss of the technically important $417 level, gold moved quite briskly up to where it sits today, around $425. While we need to see a lot more of the same before getting overly excited, it is encouraging that gold has moved up even on days when the U.S. dollar moved little, or even moved up… signaling what may be the baby steps for a decoupling of gold from the U.S. dollar.

One plausible explanation for the decoupling is that, since 9/11, global investors in general, and those from the Middle East in particular, have been moving money out of U.S. dollars and into the euro — both as a way of diversifying away from the weakening dollar, but also to reduce the odds of outright confiscation by a U.S. government striking out like a mad ape at real and imaginary terrorists everywhere. Put another way, if you were a wealthy Syrian or Jordanian — or a citizen of just about any Middle-Eastern potentate — how much of your money would you have in U.S. dollars? Especially considering that the U.S. Treasury claims to exercise control over all financial instruments denominated in U.S. dollars, regardless of which bank, or which country, they are deposited in?

When the euro began to look shaky — and what’s next for it is still anyone’s guess — I suspect a lot of holders decided to cash out and move on down the road. But to where? Some percentage of that money has found, and will continue to find its way into gold… a trickle that will turn into a stream and then a river once the U.S. dollar starts again on its inevitable descent.

In support of that contention, it’s worth noting that Saudi Arabian gold consumption grew by 10 percent to 37.3 tons in the first three months of 2005 when compared with the same period a year earlier.

All of which is to say that I see nothing standing in the way of gold finding a wider audience — both individually and institutionally — over the coming year. And I can name a lot more reasons for the U.S. dollar to continue its slide, in earnest, before year-end, than I can for it to continue defying gravity. So I would rate the likelihood of gold holding above $400 as extremely good, and of it crossing the $500 mark by year-end as eminently doable.

But what about central bank interference? If you believe the people at the Gold Anti-Trust Action Committee, desperate governments and their central bankers will do whatever it takes to keep gold out of contention as a viable currency alternative… which is to say, to keep gold prices low. Whether that amounts to a conspiracy, or central banks simply selling when prices are high, as would any other investor who bought low, the question boils down to: how much gold can the central banks actually dump on the market?

Many bullion banks report large gold holdings, but many also extend credit based on those holdings, and few admit outside auditors. With all the shell games, it’s hard to say how much unencumbered gold they actually own. But even if they do own market-disrupting quantities, many are restricted in various ways as to what they can do with that gold. Jim Turk’s recent comments on the prospect of IMF gold sales suggest it is easier said than done. The IMF is reported to have a hoard equivalent to 15 months of gold production for the entire world. Selling that much gold in a short — or even not so short — period of time would obviously have a profound impact on the price of gold. But the IMF needs approval from 85% of its subscription base, of which the U.S. represents about 17%, and Congress balked the last time this came up. And central banks and government repositories are subject to innumerable legalities regarding disposition of their gold; outside of totalitarian regimes, any major changes there are likely to be seen well in advance by the public.

That being said, central bank action — even apart from bullion sales — can certainly impact the price of gold. Take for instance the late February, 2005 announcement by the Bank of Korea that it was diversifying its reserve holding (i.e., dumping dollars), sending the dollar (temporarily) plunging and gold rising. That these institutions have the weight to move global markets is a double-edged sword, but in time, even they will not be able to push back against the tide. And, given a persistent enough weakening in the U.S. dollar will almost certainly trigger other central banks — notably others in Asia — to add to gold reserves, not sell them off.

I remain convinced that a continuation of the bull market in commodities in general, but specifically precious metals, is a near certainty. For any number of reasons: supply and demand fundamentals… underinvestment in finding and developing new resource deposits during the long bear market that ended in 2002 … the current phase in the exploration cycle… the unstoppable rise of Chinese and Indian consumerism… state-driven competition to secure long-term global resources … and more. And all against a backdrop of the Forever War against Islam that threatens to keep energy prices high, drive up inflation and ultimately cause the collapse of the house of cards built on U.S. debt in all its many shades.

But most of all, I see gold at $500 by year-end coming about because gold holds up so well by comparison to its paper competitors — the U.S. dollar and the euro most notably. Sooner rather than later, as people start looking in earnest for financial safe havens, they’ll begin turning away in droves from U.S. Treasuries and overpriced real estate… and turning to gold and silver, assets which are both tangible and portable.

There will, of course, be bumps along the way of the sort that cause some resource investors to question their premises, and perhaps even to abandon the sector altogether. But for those with the conviction to take advantage of the current weak spot in the market by buying high-quality junior gold and silver resource stocks that are now selling for bargain basement prices — the upside can be extraordinary. When prices do go to $500, and the masses begin piling in, these stocks will be trading for multiples of where they are today.

Doug Casey (send him mail) is the author of the best-selling Crisis Investing and The International Man. This first appeared on Bill Bonner’s Daily Reckoning.

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