Gold prices set for another rally - Feb 2011

The start of a mighty rally is about to unfold. The following charts show on a short term scale that gold has broken a recent short term high to achieve a new high, and that it has in fact changed trend. The 2nd chart shows the long term trend, with the prospects for a rally up to around $1,800/oz expected over the next 12 months.

We will be looking for gold to rally to the previous highs around $1425/oz.

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Author Andrew Sheldon

Applied Critical Thinking

www.SheldonThinks.com

Is the gold price a bubble?

Some of you might be worried about the gold price being a bubble, so I would like to place your minds at easy. There are a number of reasons why the gold price is not a bubble:

1. Gold is appealing when there is no returns on other asset classes. In fact gold is appealing if only bonds are low-yielding because only a little bit of that money need to 'slosh around' into gold equities and derivatives.

2. Derivatives are less alluring when financial markets are panicky, so fund managers prefer ETFs, physical gold, mining stocks with long life production capacity, to avoid financial risk exposure.

3. Risk of further currency debasement - the equity markets are going to fall at some point because of low returns will eventually see stocks sold off...US unemployment is around 10%.

4. Risk of slower global growth

5. Gold has very small industrial demand, and very large investment holdings. During times like these 'speculative demand' can greatly add to the price

6. Gold after adjusting for inflation since 1980 ($760/oz) is not very high. Thirty years of inflation means gold is cheap. We looked some time ago at the historic dow jones/gold ratio and concluded that gold can go to $2400/oz without much trouble. The more debasement of the USA, the higher the Dow will go, so rest assured $2400/oz is based on a 10,000 pt Dow. It might be 20,000 in 5 years time. Anyway, you don't need to speculate about that. This ratio has worked well for 113 years.

I personally like emerging gold producers. Africa has particular appeal because of the cheap cost of developing resources and the excellent exposure provided in Australia, Canada and the United States, as well as the London-based AIM (Alternative Investment Market). These markets also provide exposure to gold in Mongolia/China, Russia, Latin America and Indonesia/PNG.

I tend to forget the appeal of silver because there are few stocks in Australia chasing silver. The reason is that they mostly focus on Africa, Asia, whereas most silver mines are in Latin America and the USA.

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Andrew Sheldon www.sheldonthinks.com

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!