Gold: All that Glitters?
New York: October 05, 2003
By John R. Stephenson

It never fails. In every group of investors there is one - a gold bug, someone who thinks that gold is going to hit $800 an ounce. But what casual observers might not realize is that gold has been on a fairly steady climb northward over the last several years. Gold finished the week at $385.40 (U.S.). Is this strength warranted and can the glimmering metal continue its ascent in the face of strengthening stock markets? Is the run in the price of gold over with? Should you continue to sit on the sidelines or is there still some further room to go on the upside?

Figure 1: The Price of Gold

Gold has historically been a store of value and a haven for investors during uncertain times. This is because gold, as opposed to monetary instruments, is a hard asset. For centuries, gold has been used first as a currency and then later until the 1970’s as a reference value for currencies. Today, gold floats on the open market and is subject to the forces of supply and demand. Historical evidence indicates that gold tends to do well in times when the major world economies are reflating (trying to boost demand). In order to boost demand (reflate), central banks and policy makers create conditions likely to stimulate demand. These conditions include: low or negative real rates of interest, rapid money supply expansion and fiscal stimulus, budget deficits and currency devaluation. These conditions are extremely favorable for stronger gold prices. Clearly, the situation in the U.S. and Western Europe is just that - relationary.

Figure 2: The U.S. Dollar and Gold

Figure 3: Money Supply and Gold

With the world’s major economies facing a chronic oversupply of goods and services, enormous debt burdens (both at the corporate and individual level) and looming pension and health care liabilities, it seems unlikely that in the short-term there will be a reversal of the reflationary path that western governments are currently following.

In addition to these fundamental factors which are favorable to gold prices, there is the development of strong investment forces, which could also support the long-term price of gold. Recently, a gold bullion certificate has been introduced for trading on the U.S. commodities markets. India is opening a gold futures market and Chinese officials are considering lifting the ban on individual trading on the Shanghai Gold Exchange. Additionally, there has been a lot of talk about the creation of an exchange-traded fund for gold. All of these changes have the net effect of making it easier to buy gold? something that has to be good for the price of the commodity.

The sentiment towards gold is clearly bullish with both investors and speculators viewing gold as a store of value, particularly given the decline of the U.S. dollar. At the present time, there is a high level of speculative interest in gold relative to historic norms. This speculative interest could, in the short-run, put some downward pressure on gold prices if speculators decide to take their bets off the table and cash out at a tidy profit.

With a weak U.S. dollar, renewed speculative interest in gold, elevated debt levels and loose monetary policies (and no end in sight to these conditions), the fundamentals are extremely strong for gold prices remaining above $370 U.S. for some time.

Investors can either participate in the gold market by buying the commodity directly or buying shares in companies that produce gold. Historically, the equities of gold producers move 4% for every 1% move in the price of gold. One stock to consider is Barrick Gold Corp. (ABX) which, while it has faced declining production and rising cash costs, is currently developing four projects with high growth potential. Barrick is the second largest gold miner in North America, producing 5.7 million ounces annually at an average production cost of $175 per ounce. The company also has $1 billion in cash on the balance sheet and no debt. These factors coupled with the fact that the shares of Barrick are currently trading at a significant discount to its peers, makes it an attractive stock to consider.