Gold Outlook - gloomy?

The gold market has been disappointing a few people of late. In the midst of a meltdown of equities - a 10% fall - the gold price was pretty subdued, in fact it fell on several occasions, but recovered. Clearly those seeing gold as a 'safe haven' were matched by those needing to sell 'safe gold' to cover margin calls on their equity and other commodity exposures.

Well thats all well and fine, but what is the outlook for gold now?

Gold Fundamental Analysis
What we know about gold is that its:

1. Relatively cheap: Attractive when other asset classes are over-priced and central banks feel compelled to support those asset prices with easy money

2. Negative real yields: Gold is attractive when nominal yields on treasuries are low because inflation they are likely to be negative. So if gold lease rates are low and gold prices are considered low, then the metal is likely to be supported.

3. Uncertainty: Gold is attractive if there is a threat of war, whether on the battlefield or trade tensions. The rationale is that asset prices are supported by consumption and during wars capacity is directed from productive to destruction capacity, so paper money or higher taxation is required. Gold is taxed only at the point of production or sale (if profit), and even then there is the potential for unrecorded production or sale.

There are numerous misconceptions about gold that are supported by 'gold cynics', 'gold bugs' and gold producers alike. Really these arguments are often rationalisations by 'purists' that carry weight with the uninformed by virtue because their arguments are supported by alot of information. Some of these arguments are:

1. Gold is no longer relevant: Since gold's role as a unit of money was partially replaced by fiat paper money in 1933 (under Roosevelt), and then totally in 1971 (under Nixon) it never really lost its relevance. This point should be highlighted by the current price of the gold - around $655/oz.
2. Paper is not backed by gold: Well this is true, but it would be wrong to suggest that paper has no tangible assets backing , since under the modern banking system paper is created through the origination of credit, and that credit is backed by very tangible property. Home loans at the point of origination are backed by tangible collateral valued at 80-90% of the loan amount. Ever wondered why banks are reluctant lenders to business without tangible assets or regular income. The gold standard 'purists' would have us believe that they believe in a 'free market' but they were advocates of fixed price of gold, as when gold was fixed at $35/oz (pre-1971). But clearly that system didnt work since it required governments to subsidise its value. It actually makes more sense for the gold price to be free floating so gold is valued on the basis of supply and demand. Rest assured that there will not be too much volatility because the value of new gold output (2500tonnes) per annum is just 1.7% of the total above-ground supplies (150,000 tonnes). The implication is that gold would fall in value as mine costs fall but this would increase the purchasing power of all the existing gold in existence. This would be the productivity dividend. No other metal offers this benefit because other metals have a much larger proportion of their utility tied to industrial use.

3. Speculation is attributed to an excess of fiat paper: Whilst its true that fiat money does spark speculation, so does rampant wealth creation. When the global economy is growing at a pace that causes a rapid increase in incomes and falling interest rates, its understandable that people will be bidding up property prices. There is an expectation that they will miss out since people realise that the bull market will be sustained over a long period of time. The speculation arises merely because there is an expectation of a protracted increase in property prices, or equities. For this reason, weakness in equity prices are perceived as an opportunity to buy more rather than sell so long as the market supports credit creation. In western markets there is however another factor. The regulation of property markets through zoning regulations artificially raises the value of property.

Given these factors I would contend that gold is rising not because of fears of a financial crisis but because wealthy is growing whilst gold production is lagging in a number of countries. That means there are more buyers chasing less gold.

Gold Technical Analysis

In the chart below we can see that gold prices have been range-bound since Feb'07 between $640-690/oz. Currently gold is in a downtrend, and I expect it to fall back to $640/oz support. This view is supported by recent candles that show gold's failure to break the downtrend. Each rally is sold into. The good news is that gold was supported in the recent sell-down (10% equity market correction), but it remains in question whether the uptrend is supported. If this uptrend is broken, gold could move into a consolidation pattern or fall back to a lower support. Gold investors should sell gold if it fails to hold that uptrend line. Commonly when a trend is broken, it might recover to the trend, but then fall off thereafter..so the next week will be very important for gold.

Looking at the long term trend in gold in the chart below we can see that the current trend has been in place since July 2005. We can also see the historical importance of the $640 level. If that fails to hold, I think we are looking at a gold price of $US540/oz - upon which I expect support at gold's base line trend.

Conclusion

My rationale for thinking gold might fall to this level is:
1. Strong global growth: The global economy is no lower US-centric since China and India are growing 3times the pace of the US. Whilst US GDP per capita might be 20x more than these countries, these 2 countries combined have 10x the population and increasingly they are contributing to global output.
2. Growth displaces yield: If global growth stays strong you can expect equities to be the focus and for weakness in bonds. There is the prospect that the Fed might provide the stimulus of lower interest rates to keep equities in play. I think the stimulus is likely to be a token 0.25% cut, and I think they will take it back when the market can hold it. I dont believe the Fed wants asset prices going any higher. I think they will be trying to keep then flat. The Fed will still be worried about inflation.

Anyway we will know very soon...

Base Metals - due for a shake out?

The base metals like Copper, Aluminium, Zinc and Lead seem to be holding up very well considering the uncertainties in the market. In contrast nickel is faring far worse, but it has likely bottomed. Paradoxically nickel miners are recording strong prices. There are I guess a number of reasons for this:

1. Strong demand from China

2. A market view that the Fed will support the market with a rate cut

3. Tight supplies for some metals

Having said that, the fundamentals dont look so good for some metals, and some charts might give reason for concern. The chart above shows that copper prices have retreated from a strong resistance level. My belief is that copper is headed down to $US2.50/lb, but it will then find support. Long term I think the outlook is positive, and we are likely to see an ascending triangle develop in coming years....a protracted period of high prices. I think things will be ok in the short term because it takes time for bad loans to be liquidated, and in the meantime there are strikes and the prospect of a Fed stimulus. But I really dont see higher copper prices in the medium term.

1.Copper prices have been held up by strikes in Chile and Mexico

2. We have yet to see any flow through of softer demand from China

3. There is a shortage of lead and aluminium because of a lack of discoveries. Stocks are thus short and prices bouyant.

But there has been alot of nickel capacity added so nickel prices have collapsed. But we might expect a turnaround there, so for the next 2-3weeks I expect stronger metal prices, but then massive selling.

Precious Metal Outlook

The market has been abuzz with conflicting advice on the direction of precious metals. Some argue that the precious metals have already gone up, inflated by the same credit bubble that pushed up other commodities, whilst others argue gold and silver have been a laggard until now because of strong global strong, and that gold and silver will rally because the Fed will lower short term interest rates to stabilise asset (property & equity) values.
There are a number of issues here that make me reflect:
1. The Fed has for a long time cared little about asset prices - that was on the upside, not the downside. And its long held mantra was that it would do what it takes to preserve growth. It seems unlikely that the Fed will engage in any monetary stimulus, but rather it is more likely to engage in short term stimulus to stabilise the markets. I think the Fed is aiming for an orderly unwinding of bad credit. The problem is, I think markets, looking for performance will not be impressed by the 'low growth' scenario, so I think they will sell off equities, and I think property will follow it.

2. Gold prices: Based on the chart below, gold does not look too bad. It seems to be following its upward course, but what's got my attention is the selling off, evidenced by a string of 'engulfing candles'. Short term profit taking? Perhaps. What has me worried is that if there is a correction in stock & commodity prices, funds will be selling precious metals to cover their positions. This would lead to alot more 'panic selling', the result of which I think would see gold fall to $US550/oz. Talk about life being a 'tight rope'.

3. Silver prices: I would have thought silver prices would exhibit a close correlation to the gold price, though perhaps silver has lost some of its monetary charm, and is weak because of the weaker outlook for silver industrial consumption, given that a much higher proportion of silver than gold is used by industry. The silver chart looks seriously bad, so I suspect its about to fall back to $8/oz and consolidate around $9/oz.

In conclusion I dont think the Fed would mind a fall off in asset prices just as it has not been too concerned about a rise in asset markets. I just think it wants to ensure a smooth fall so that people can sell out or go broke 'silently', so that consumer demand is not hindered. I think the Fed will fail on this point. I dont think the Fed will lower short term rates in Sept'07, or if they do, they lower it by 0.25% instead of 0.5%. I think they of course want the market to believe they will support the market with an interest rate cut, but I think instead their intent will just be to allow the uncertainty to wash out of the market. I think the other reason for weaker precious metal prices will be a shake out in base metal markets. I can see volatility on the LME and Comex exchange, where funds will be liquidating gold to pay margin calls on other metals, and otherwise just liquidating.
The good news is that gold and silver will recover, but it will present a good buying opportunity. Months ago there was alot of talk about a shake out in the commodity markets, but that fear seems to have been overshadowed by the 'sub-prime scandal'. I think commodity price collapse might be about to occur. So you'd thus have to expct some volatility in the $AUD, $CAN, RSA particularly, but it will be short term price action for gold and silver.

Gold & silver performance

Alot of people seem to hold gold and silver in total disdain. I was just reading an article on Yahoo (http://finance.yahoo.com/expert/article/richricher/42433) by Robert Kiyosaki. There are several aspects to these complaints...but I was actually surprised to see that alot of people hate Kiyosaki...you would think they were blaming him for the property collapse, or not warning them. Just shows how much people are living in a totally rationalised dream world. I can't imagine more press on any issue but overheated US property markets for the last 2 years.
Well Kiyosaki's latest posting is his recommendation to buy silver. Critics argued that gold & silver had under-performed against other metals, that precious metals were no longer relevant, that silver was no longer used in film...so his a total idiot. Well first of all, gold has doubled and silver done even better over the last few year despite the popularity of digital cameras.

But more important I think for performance junkies is that you dont buy physical metal - you buy stocks. But consider some of the other benefits of metals over other industries...and tell me that it shouldn't be in your portfolio.

1. How many companies allow you to effectively choose which 'factories' (mines) you invest in?
2. How many industries can you get supply cost curves for each producer?
3. How many industries have terminal markets so they can sell everything they produce?

4. How many industries offer producers the opportunity to lock in (hedge) future prices?

5. How many other commodities give you 100%+ price rises?

6. How many other producers give you a total breakdown of mine costs and revenues?

None, except other metals. Not all miners mind you, but those for whom its a selling point, and just as a matter of routine for any company that has to produce a mine feasibility study. It might not be in stock exchange disclosures, so look in the presentations to analysts on their websites.

Its true that precious metals have not performed as well as other metals, but consider why:
1. Mining costs have doubled in the last few years - not because of gold & silver mining but because the big iron ore, coal, base metal projects around the world hogged all the geological services and mine consumables, pushing prices up considerably. Well those metals will have softer prices in future because they are demand-based.

2. Strong currencies have undermined the performance of precious metals more than other metals because their prices have not risen so high. Commodity currencies like Australia, South Africa, Brazil, etc have mostly doubled, so thats had a huge impact.

But thats all history. Any softening in the global economy will undermine demand based commodity prices and the currencies along with them, but precious metals will out-perform. I expect gold and silver will fall too if financial institutions are forced to sell hard assets to cover loosing financial positions, but precious metals have yet to have the final play. They will at least double over coming years, and I think even better. And you will also benefit from weaker commodity currencies, and investing in the growth earnings of miners...just another reason to invest in stocks...not physical metal.

Whilst I like Kiyosaki's recommendation I think the timing is a little wrong. Why? Because I think that precious metals will be sold off along with everything else if their is a rapid collapse in asset markets, so its best to sit on cash until precious metals take some direction - that is they break a previous high or low.

The chart above shows silver holding the $11/oz support, but I think if thre is a sell off of assets then silver will be sold off, so better to wait for support in more certain markets because they fell faster than they climb. I can see silver falling as low as $8/oz. But it will eventually go as high as $50/oz.

Yeh I know ...people have been saying it for 50 years....well its happened already in the 1970s and its been on an uptrend since I researched (with WHI Securities) and recommended all metals in 2001. Since then it has been strong...but it will go for another rally.

Relationship between gold, oil & Dow Jones Index

Its interesting to ponder the historical relationships between certain commodities. By looking at such relationships we can often see patterns that we might not otherwise have seen. A great many scientific discoveries were made on the basis of pattern recognition, and all knowledge is based on patterns. In a sense logic comes down to similarities and differences between objects (foundation of perception) and ideas (foundation of conception, clarified by context).

The trick of course is to ensure the relationships we observe describe something in reality and are not some arbitrary construct. The best way to determine that is:

1. Identifying similar relationships in related variables

2. Identifying patterns over a longer period of time

3. Establishing a hypothesis that describes the events you describe

4. Testing your hypothesis in a different context.

The focus of this topic is the price of gold in terms of $US, oil and the Dow Jones Industrial Average. The benefit of these materials is that they have been traded for a long period of time, so offer a good historical data base. Gold and oil prices are internationally-traded commodities with a high value so we dont need to be concerned by local disparities because of cultural bias or disparities in transportation costs.

Looking at the oil price, we can see that in the last 20 years prices have varied between $10 to $78 per barrel. Thats a fair spread. This is in nominal dollars. If we adjusted for inflation we can expect this spread to be around half. Looking at the chart below, we can see that the oil price reached a peak of $78/barrel in Mar'06, and has just retraced from a 2nd peak in the last 2 weeks. The implication of this is that we are facing 2 outcomes:

1. The oil boom has ended - the chart pattern suggesting a 'double top'. We should be looking to reduce exposure to oil until we get confirmation at the $55/barrel level.

2. The oil boom is continuing - the chart pattern suggests an 'ascending wedge', in which case the oil price could fall back to $55/barrel and find support before recovering.

Clearly we dont need to know anymore until we get to that level since oil prices are going their under either scenario. This is supported by the current tightening in interest rates and possible recession outlook. So when $55/bbl is reached, we should be looking for a new direction. Of course its possible that oil prices could still go higher, in which case we should see oil prices holding the $70/bbl support.

The gold price is at an historically high level in nominal terms but consider that copper prices have rallied from $0.80/lb to $3.50/lb (450%), but gold has only risen from $290 to $720/oz (350%). Considering this and the fact that gold prices are much lower in real terms, perhaps there is more upside to gold. For a number of reasons I think we are looking at a 'super-cycle', where the expansions have been lengthened by market liberalisation and technological innovation. When you consider that Vietnam (75mil), Bangladesh (150mil), Indonesia (230mil) have yet to really open up their economies, there is still alot of cheap labour offering ever-lower unit labour costs. Thus I maintain that there is still alot of market potential, both for opening up new consumer, savings and debt markets. At the end of the day, that's of significance to gold because it results in greater consumption, which erodes the stockpiles retained by central banks. Can we expect gold to break $700/oz again, or are we looking at a fall back to the $500/oz support?

The following chart is an interesting way to look at gold and oil prices. By looking at the price of oil in terms of gold we are stripping out inflation and productivity issues which impact on both. Oil and gold prices have historically had a close relationship. Yet oil is an industrial material, whilst gold has a quasi-monetary value besides. I would suggest that gold follows the industrial supply-demand paradigm in the good times, but functions as a monetary unit when paper (fiat) money is in question, where the threat is inflation. Of course credit expansion can be unwound by cost of living inflation or asset deflation (debt liquidation).

Reading from the chart we can see (in blue) that the gold-oil ratio trades within a certain band. Lookng at the next chart we can see that the gold-oil ratio has changed over time, so there is a cyclical element to the trade, and as it stands we are at the start of a new downtrend in the ratio, which augers for much higher prices in future. It would be interesting to tie these departures from trend to specific times or events.

Yet another ratio we can look at is the Dow-Gold Ratio. This ratio is simply the Dow Jones Industrial Average (DJIA) divided by the gold price in nominal terms. The DJIA represents just 26 stocks on the NYSE, however they embody some of the largest companies in the world, so it is still seen as a good proxy for the US market. The rationale for using it is that it has been measured since 1897.

The chart suggests that the value of equities is growing at a much faster rate than the price of gold, and that there is a linear relationship between these variables. I think the rationale for this relationship is the growing use of credit or more importantly the greater leverage offered by financial institutions. The implication is that a certain amount of that money floods into equities, pushing up prices (equity indices) to an unsustainable level, and then they fall off. As we can see, when the Dow reaches a peak (as it did in Sept'00), gold prices are bottoming.

Investing in precious metals

Interested in gold bullion - see the London Bullion Market Association listings of gold & silver bullion dealers whom buy and sell gold. Website: www.lbma.org.uk/good_delivery_gold.html. Better still, consider buying stocks in gold or silver producers. See my various equity market blogs.

Commodities - what and how to invest?

Based on my analysis presented in my Market Commentary blog we are looking at 5 or more years of subdued growth and stable asset prices, or a precipitous shakeout of asset market and credit liquidation culminating in a rapid transition to economic growth, though a calamitous shift in wealth from those with asset or liability exposure to those with cash. The question is:
1. Does the Fed have the skills to maintain a flat market for 5 years?
2. Will global markets be exposed to exogenous factors that might impose instability, eg. bird flu?

Does it not strike people that the safe option is to avoid assets. But under this scenario, where do you put your cash?
1. Cash - the problem with cash is that it makes you no money
2. Gold bullion and other precious metals
3. Gold 'derivatives' that offer exposure to the gold market. The problem with financial instruments like these is that you might not be safe from a failure by the counterparty or market maker. Best to avoid these products.
4. Gold stocks offer the best exposure since you dont just have a fixed exposure to the physical metal, but exposure to a growing inventory of metal, as long as the stock is producing or close to production. The benefit of this is that you have the opportunity for the market to price in long term high gold prices and such an extrapolation can blow out your capital gain. There are several things you should look for - unhedged production and the ability to scale up production.
5. Gold exchange traded funds (Gold ETFs) offer 2 types of exposure. Some buy physical metal, others buy stocks. Equity funds can target emerging producers or blue-chip exposure.

How to invest in precious metals

I often give alot of lip-service to metals, so I will discuss here what is the best approach to investing in commodities. My experience relates to metals only, so excuse my narrow focus on this commodity group.
There are several ways to invest in commodities:
1. Futures: This is where we take a leveraged position in a commodity contract at a current forward price for delivery of physical commodity at some future date.
2. Exchange Traded Options (ETOs): These are rights to buy (call options) or sell (put options) in an underlying financially traded commodity at a certain price, with an OPTION to exercise that contract at a future date. You can hold the contract to maturity, or you can trade it in the secondary options market. Either way, you will be looking to retain a premium over the upfront price you paid for the option + the strike price (paid on maturity), so that you can retain a capital gain. The reference price is of course the underlying security - in this case the commodity price.
3. Contracts for difference: There are a number of financial intermediaries offering contracts for difference (CFDs). These market makers are effectively creating a market that mirrors the a primary market where 'physically traded' positions are taken. There are a range of vendors, eg. CMC Plc, Saxobank, HSBC, etc. Many of these companies dont just trade commodities, but forex, equities and indices as well, all on generous leverage.
4. Stocks: There is the opportunity of course to buy stocks in companies that produce metal, or companies with projects that intend to produce metals. Stocks are considered harder because you have to understand the merits of individual stocks, and thats a more laborious proposition. But the implication is that because the 'devil is in the detail', so are the opportunities. Its common to find stocks which are underpriced, particularly at the speculative (small stock) end of the market. Researching on these companies tends to be less well-supported by brokers with the advent of discount, online brokers. The rise of independent research houses however might change that.
5. Company options: In some markets there are listed, often long-dated options in mining companies that present a very attractive exposure to the underlying security. Maturities might be as little as a few months, or as long as 5 years.
6. Exchange Traded Funds: There are exchange-listed funds that invest in commodities, blue chip or more speculative emerging producers. Resource funds tend to invest in stocks with no leverage, however its prudent to determine if your commodity investment fund is using leverage to take positions, and also just how actively they trade positions. Are they passive or active managers? Some combination might be best. A pure trading fund will be more risky. A passive fund would be risky if your timing is wrong and leverage is high.

When you consider investing in these options, you should consider the following:
1. What is your risk-reward ratio? How much are you prepared to risk loosing in order to gain X%.
2. What is your market knowledge?
3. How much leverage exposure is prudent? What is the downside given the highly leveraged economy, quite apart from your own finances.

Other facts to consider:
1. Commodity choices: There are relatively few metals that can actually be traded. Gold, silver, palladium, platinum on the Comex exchange and lead, copper, zinc, aluminium, nickel on the London Metals Exchange (LME). Other metals are not traded in such terminal markets, so you would need to buy stocks to gain exposure to these markets.
2. Trading platforms: Commodities trading has only become popular in recent years, so the market for trading platforms is not well developed.
3. Volatility: Commodity prices can be very volatile markets when they are in-play because the size of these markets is very small compared to the equity & bond markets, particularly since derivative contracts in these markets often carry larger positions than the physical markets that underpin them.

Best market to trade
The best market to trade depends on personal circumstances. If you are accustomed to options or futures trading, you might prefer that, since stocks might exposure you to a range of technical (mining) parameters that you dont understand. Alternatively, you might decide to buy a range of stocks to reduce this risk exposure. Regardless of the market you trade, everything in life carries a risk. If you opt out of life's challenges, you present yourself with a equally daunting financial risk. In conclusion, risk is not avoided, its managed. There is no fixed 'risk exposure'. Risk is a personal factor. You can't say options are risky or not, it depends on your level of preparedness. There is the perception that you are 100% exposed with options, but you retain at least some tangible asset with stocks....but there are always exceptionsd. Big companies are promoted as safer than small companies, but its not always the case. Test those market assumptions that you accept. I've invested in small companies sitting on $5mil in cash but the market places a value of $2-3mil on their listing....which in itself could be worth $3-5mil for a company in a hurry to get listed.

GOLD!!! Why 2007-09 is going to be good.

At a time when most metal prices are falling, you might wonder why I would be advocating gold stocks. Well there are a number of reasons:
1. Gold prices have been bouyant after a long period of consolidation. I suggest its poised for a major move to $1100-1500. Much is made of the relationship betwen the gold price and USD, but the reality is that gold has tangible value in and of itself. It has a relationship with all currencies, not just the USD. The only reason that is not apparent is because gold is quoted in terms of USD. Of course, we have to consider the extect to which gold prices are growing of their own accord, and the extent to which they are growing because of USD weakness/strength. We can see from the following chart that gold is on an upward trend, and we should expect a price surge when the price breaks $US695/oz in coming weeks. The $720-730 price level widll be another resistance level. Once broken we should see alot of upward movement in gold prices.

2. Gold fundamentals look good: Gold prices have not risen as much as other metals since 2001. Jewellery demand has recovered as buyers have adjusted to higher prices (costs). Higher interest rates in alot of countries will be politically unpalatable in alot of countries, so expect our 'independent' central banks to go easy on monetary policy...thats to say they will be lagging so real interest rates should remain low.
3. Inflation is getting worse: Consider the world's 2nd largest miner - Rio Tinto - it just reported that cost increases grew as much as revenues at these times of high commodity prices. The government chooses to focus on wages and the 'manipulated' core CPI as a basis for determining inflation, but they are conspicuously flawed when you consider that they fail to consider the costs of 'actual' living. eg. They exclude rent or property values, they exclude food, energy, because these items are considered too volatile...of course that is true over the short term.

You might be aware that 'gold bugs' have been advocating gold for a great deal of time. Well its not that they have been wrong, as since 2001 gold has risen from $290 t0 $730/oz before consolidating around $630-680/oz. So they have been wrong of late. The reason for this lies in the role played by gold. Gold fills two functions:

1. Industrial demand: There is a supply and demand for gold in industrial and consumer applications like dentistry, electronics

2. Investment demand: There is a demand by consumers and investment funds which is fairly long term, and recognises both the industrial and speculative demand for gold.

3. Speculative demand: There is a transient demand for gold that that recognises its role as money. When the monetary system comes into question, people want to hold gold because its tangible, unlike the paper offered by governments.

When economies are growing strongly there is a portfolio-weighted investment demand for gold that tends to support the gold market. Gold has also been supported by tight supplies as most central banks have agreed not to sell more than 500 tonnes per annum over 5 year periods. When you have strong economic growth other investment options will out-perform gold. It is not until gold is recognised as a safe-haven that we see gold markets really getting their rightful attention. For that to happen, we are going to see:

1. Tightening of interest rates to the extent that other asset classes (property, equities, bonds) offer a poor investment alternative.

2. Higher inflation: Dont expect inflation to readily show up in wage demands, its more likely to show up in higher commodity prices.

3. Technical signal: Gold prices break their previous resistance and move up to higher levels. This is a conservative strategy to wait for price evidence. We need to look at gold in a number of currencies to look at the real change ib gold prices.

I will update this file with more content in coming weeks!