The gold market has been one of the best investments for the last 12 years, with the precious metal rising from less than $300 per ounce in 2000 to a record high above $1,900 in August 2011. The rising risks on the global economy, an accommodative monetary policy, the expanding FED’s balance sheet, and an exploding national debt, all contributed to the debasement of the US dollar, which couldn’t sustain its value relative to a commodity, which is produced and available in very limited quantities.
After 1971, when Richard Nixon put an end to the Bretton Woods agreement and to the gold standard, many investors started looking at gold as the best hedge against expected inflation. The quantitative easing program initiated in 2009 in order to ignite an economic recovery raised inflation expectations and pushed gold higher to a record level attained in August 2011. After that month the metal entered a quiet period of sideways movement until the bears come in at the start of this year. Gold declined from its peak at $1,909 to $1,205 – a non-negligible decline of 36%, with most of the decline occurring this year alone as gold is down 25% YTD. The market turned volatile and even experienced a two-day mini crash of 13.5% in April. Is this the start of a bear market or is gold expected to bounce back?
With Ben Bernanke orchestrating the US economy with the help of unconventional measures of monetary policy, throwing $85 billion a month to keep treasury yields and mortgage rates at the lowest possible, one would think there’s no reason for gold to decline. Quantitative easing could only result in higher inflation in the long-term thus one should expect gold to rise too. But inflation hasn’t been rising and it is holding much below the 2% threshold that would put investors on the defensive. While the FED has been “printing money”, expecting banks to pick it up and lend it to households and companies, banks end depositing it back at the central bank instead. Banks aren’t lending. By one side, this reduces monetary policy effectiveness, but by other side, it is the main reason why inflation hasn’t been picking up. The money multiplier is failing, as there is a missing link between monetary base and money supply.
With inflation under control and with Ben Bernanke threatening with tapering on its bond-buying program over the last FOMC meeting a few weeks ago, investors dumped their gold holdings, in special ETFs. In just one week, the Market Vectors Junior Gold Miners ETF (GDXJ) hit an all-time low and investors shredded $800 million from it. Scared investors just want to get out.
If the reasoning behind all this makes sense, there’s something that doesn’t: the gold price itself. Gold spot price closed at $1,255 yesterday and has been moving inside the low $1,200s for several days now. It has been estimated that the marginal cost to explore/produce gold in 2012 was around $1,290 per ounce. At current spot prices, gold miners are losing money and will certainly react. The financial market where gold derivatives are traded, or paper-gold, is out-of-sync with the real market where physical gold is exchanged and this is an unsustainable situation. With rising production costs and decreasing availability of high-grade gold, miners will decrease supply to let prices rise.
Even though monetary policy may seem out-of-favor for the gold market, at this point we feel comfortable with the fundamentals. Gold miners face hard times ahead. Many juniors will have difficulty to get the funds they need to deploy into their projects as market caps depressed but as a whole the sector looks good. The Market Vectors Junior Gold Miners ETF (GDXJ) declined almost 75% during the last two years and many companies are now trading at their book values. As a long term bet, this is an excellent opportunity to enter the market. Remember, the investment is a game between fear and greed. It pays to be a little greedy when all others have fear.
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