Is there a Gold Flush?

The gold market has recently been declared by several banks, including Goldman Sachs and Credit Suisse, to be at the end of its decade-long bull run. However I contend that it is a time to buy gold. With gold prices currently at US$1574 an ounce, this is near the low point in 2012.

There are several reasons that the aforementioned banks feel gold’s decade-long bull run has come to an end. Gold’s bull run coincided with the introduction of gold exchange traded funds (ETFs) that were launched in 2003. These gold ETFs offered investors a relatively low cost and easily tradable method of holding physical gold. The way they work is that the ETF buys physical gold and then issues shares that investors can buy and trade on an exchange. Collective ETF gold holdings globally are 2,491 tonnes – larger than all but two central banks, the USA and Germany. However since January of this year, ETFs have sold 140 tonnes of gold. The sell-off is partly due to broader negative sentiment towards gold as investors become more confident in the global economy and put their money into riskier assets such as equities. As investors grow more confident in the US and Chinese economies, they are shifting their allocations to equities. The Dow Jones Industrial Average surpassed its previous record high set in October 2007 by closing at 14,253 last week. Furthermore, regulatory filings reveal that George Soros and Louis Bacon have sold portions of their gold ETF holdings in February. As ETFs have become a major force in the physical gold markets, their recent sell-off could accelerate a dip in gold prices.

How can it be worth-less?

The ETF gold sell-off is also a surprise, when compared to previous periods of gold price weakness when ETF holdings showed investors stuck with the metal. The simultaneous fall of gold ETF holdings and the price could reflect the activity of a few hedge funds selling their gold investments. Yet it is also worrying that despite the US’s failure to avert signing budget cuts into law, gold has remained at its low price. Perhaps it is because there is less fear of unbridled inflation or a collapse in the USD’s value. Even on the Comex futures bets on falling gold prices is at the highest level since 2000. Moreover, the latest 5% drop in gold prices in the past two weeks due to uncertainty of the duration of the US Federal Reserve’s asset purchase programme has made the 50-day moving average price of gold fall below its 200-day moving average, intimating little support for the metal. Furthermore, with the US and Asia showing stronger economic activity, investors are opting for assets that benefit from GDP growth, pay interest or dividends. The gold sell-off may also have longer term roots. Gold soared from a low of US$253 in 2001 to a high of US$1920 in 2011. Many suggest that from a long-term perspective, the decade-long bull ran has rendered gold substantially overvalued both in absolute and relative terms.

In the last few years, the metal has failed to show any strong signs of a directional trend, typically trading within a range of $1570 to $1850. There are several explanations for the ETF sell-off that may be positive for gold. Perhaps there is a shift in the type of investors that allocate a proportion of their assets to gold in ETFs. The investors were generally individual investors and institutions such as pension funds or insurance companies that were more inclined to hold their gold during times of trouble as they were driven by longer-term considerations such as the need to hedge against currency debasements and unexpected inflation. However, it could be that gold ETFs, like many other asset classes, are becoming popular with shorter-term traders as well as long-term investors. Therefore, the recent sell-off of gold could be a short-term trend rather than an inflection point in the gold price trajectory. China’s launch of its first gold ETFs this year should also help increase demand for gold in 2013. As China, along with India, are the two largest physical markets for gold worldwide, the demand from these two players can have a major influence on the gold price. As China’s economy propels more of their citizens into the middle-class, their consumption of luxury items made of gold will likely increase. The Indian Rupee has also strengthened since the beginning of 2013, which should make gold more affordable for price-sensitive Indians. The patterns of demand for physical gold is also shifting with many other emerging markets in the Middle-East and South-East Asia now accounting for a higher proportion of gold demand. It is also emerging market central banks that are increasing their gold reserves as a hedge against inflation eroding the value of their substantial USD reserves.

The ranging of gold prices in the past few years between $1570 and $1850 suggests that perhaps gold has finished its bull-run. Yet it does not mean that the gold price will suddenly spiral downwards. On the contrary, if gold is trading within a range, we are near the bottom of the range signalling a good time to buy gold. The combination of strong physical demand growth for gold in emerging markets as well as the scarcity of gold should ensure that prices are supported within this range in the coming years. Therefore, I recommend taking a long position on gold and buying into an ETF, such as SPDR Gold Shares, and wait to sell at around $1800-1850.