Whereto For Gold?

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By Greg Peel

Why did gold stall above US$1000/oz and fall to under US$900/oz? Because it ran too quickly from US$900 to US$1000. The following graph shows the period of acceleration away from the trend line – a period dominated by a surge in investor interest at the time the US financial system’s problems appeared to be at their most grave. This became a blow-off when the Fed made its second 75 basis point rate cut and saved Bear Stearns. The market decided that must be the end of the troubles, and gold positions were very quickly liquidated.

The metal found precious little buying support. The jewellery buyers had already given up when gold raced away from the previous US$725/oz high in the last quarter of 2007. In that quarter, jewellery demand fell 9% while investment demand rose by a whopping 66%. When the investors decided it was time to sell there were no jewellery buyers to meet the demand. Investors could only sell to investors, and there were few now looking to buy. Once again we had found the jewellery gap (as explained in “Gold at 1100 Says GFMS”; Commodities; 10/04/08).

Gold’s recent movement closely reflects that of May-June 2006. In that period a lot of new money flooded into recently created investment vehicles such as exchange traded funds, which in itself fuelled the rally to US$725/oz. The US dollar at the time was actually undergoing a brief period of relative strength. When everyone who wanted to buy gold had, the market collapsed very quickly back to just above US$550/oz before buyers re-emerged. Jewellery buyers had long been left behind at US$500.

By 2007 India and China in particular had enjoyed another year of surging economic growth and rising incomes, and US$700 became the new US$500 for jewellery buyers. This is clearly evident in the mid-year period where central banks sold and sold but the price remained supported above US$650. In August the financial world imploded and the credit crisis began in earnest. Gold shot straight up to US$800 but stalled when December brought a belief from some that the credit crisis was easing. It wasn’t of course, and Phase II took gold straight over US$1000/oz.

And now we’re back at US$900. From an investor point of view, one would have to say the odds are stacked in favour of gold testing further downside. Why? Because (1) US bank CEOs have begun to suggest the worst is over (again); (2) the US stock market is currently strong, attracting funds out of the safe haven and back into the casino; (3) the Fed has begun to hint that rising inflation will prevent any further drastic rate cuts; (4) the US dollar is very well supported when the euro approaches US$1.60; (5) the G7 has hinted at intervention if the US dollar falls much lower. All this adds up to gold having more downside than upside from here.

But the real question is: What’s the new jewellery buying level? Is it closer to US$800 or US$900? We’re doing some work here at US$900 at present, but we also did some work at US$800 on the way up. However, it may not be a question to which we will get an answer in the short term. For we are now entering the jewellery desert.

Annual jewellery demand is not smooth – it is very dependent on specific Asian gift-giving seasons. And we’re currently not in one. In fact, we won’t be in one again until about October. Have another look at the second chart. In 2006 gold collapsed in May and bounced in June when the market decided it was oversold, but it found no support and drifted straight back to the low once more. It wasn’t until October that the price began to rise again – just as Asia began gearing up for weddings and other seasonal ceremonies.

On that basis it would be reasonable to assume that gold might do something similar this time, in which case jewellery buyers may need only be paying in the eight hundreds and not the nine hundreds by October.

So the next question is: What might now stop gold falling back towards US$800? The very simple answer to that is the euro rising through US$1.60. At present the gold price is almost perfectly correlated to the euro. For the euro to rise through US$1.60, we would probably need any or all of (1) the Fed to cut on April 30 by more than 25 basis points; (2) the G7 to do nothing; (3) the credit crunch to remain very crunched (and Libor is rising, not falling); (4) some big loss/write-down announcements out of non-US banks; (5) another Bear Stearns; (6) the current US stock market strength to prove fleeting; (6) oil to just keep going up and up and up; (7) the US to invade Iran.

The technicians at Barclays Capital see the euro rising to US$1.63 in three months time, before trending back to US$1.50 over twelve months. On this basis they see gold going from here straight back to US$1000. Fundamentally they cite apparent stability of ETF volumes at current levels, despite the liquidation of long futures positions at Comex.

GFMS is calling gold at US$1100 some time this year, based on US dollar weakness and the potential for more “skeletons in bank closets”.

Goldman Sachs JB Were similarly sees positive drivers for gold being “very much intact” on a still weakening US dollar.

Citi, on the other hand, cites the jewellery desert in the next few months as a reason why gold may not be able to stage a rally back in the short term. Longer term the analysts remain bullish, based on ongoing central bank liquidity injections and the strength of jewellery demand out of the Middle East, China and India at the appropriate time.

They also make particular note that the market for gold is actually a very small one. While global equity and bond markets represent trillions upon trillions of dollars of investment, the total value of investment in gold in 2007 (bar, coin, futures and ETFs) was US$13.5 billion. That’s less than what Citigroup wrote-down in asset-backed security valuations just in the last quarter.

So we are on a cusp at present, and the near term fortunes of the gold price depend entirely on the US dollar.

One consistent factor is that the price movement in shares in gold mining companies always amplify that of gold itself. When gold falls, mining shares fall proportionally more, and when gold rises, gold shares outperform the metal. GSJB Were, being among the short term gold bulls, thus suggests there are good opportunities to be had in Australian goldminers.

In the large caps Were prefers Newcrest ((NCM)) over Lihir ((LGL)). In the small caps the analysts like Avoca ((AVO)). While they have a Buy on both these suggestions, they also like Apex Minerals ((AXM)) and Sino Gold ((SGX)), but have only set Hold ratings at this stage. In Sino’s case they would like more clarity on the recent Jinfeng downgrade.

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