The Fundamentals Driving the Gold Price have not Changed

By David Levenstein   Aug 9 2010 10:00AM

Since 2001 the price of gold has been in a very strong bull market and has increased in value almost five times in US dollar terms. And, no matter where you live in the world, had you owned gold, the value of your investment has increased anywhere from two to four times.

Gold is a monetary metal whose price is determined by inflation, by fluctuations in the dollar and global equities, by currency-related crises, interest rate volatility and international tensions, and by increases or decreases in the prices of other commodities. The price of gold reacts to supply and demand changes and can be influenced by consumer spending and overall levels of affluence.

We are experiencing one of the worst recessions ever, caused by a financial disaster a scale of which has been unprecedented, and which effected practically every economy in the world. In order to avoid a total monetary collapse which began this time three years ago, central banks around the world were compelled to provide monetary assistance. They provided bail out packages to some of the largest financial institutions as well as various stimulus packages in order to kick start their economies. However, it appears that the economic stimulus has been a dismal failure, only stimulating government interference in the economy, while piling up massive debt. Most western countries still suffer from low GDP growth as well as high unemployment.

One of the major driving forces behind this bull market has been the declining value of the US dollar. Gold is bought and sold in U.S. dollars, so any decline in the value of the dollar causes the price of gold to rise. The U.S. dollar is the world's reserve currency - the primary medium for international transactions, the currency in which the worth of commodities are calculated, and the currency primarily held as reserves by the world's central banks. However, now that it has been stripped of its gold backing, the dollar is nothing more than a fancy piece of paper. The dollar has been in an overall downtrend since 2001, and this longer-term down trending pattern seems well established and likely to continue. The Dollar Index which is a widely used index that measures the US dollar relative to a basket of foreign currencies has already dropped more than 30% since 2001 while gold has risen more than 400%.. (The currencies in the Index include the Euro, Yen, Sterling, Canadian Dollar, Swedish Kroner and Swiss Franc).

Gold has maintained its value in terms of real purchasing power in the long run and is thus particularly suited to form part of central banks' reserves. In contrast, paper currencies always lose value in the long run and often in the short term as well.

Although gold is renowned as a hedge against inflation, at the moment levels of inflation are extremely low. However, when all else fails, and as governments rescue themselves with the printing press, making their currency worth less and gold worth more, the ultimate consequence of all this  “quantitative easy,” will be inflation, and possibly hyperinflation.

Historically, it has been proven that gold is a very effective preserver of wealth, so prudent investors diversify part of their assets into gold. The key to diversification is finding investments that are not closely correlated to one another. Because most stocks are relatively closely correlated and most bonds are relatively closely correlated with each other and with stocks, many investors combine tangible assets such as gold with their stock and bond portfolios in order to reduce risk. Gold and other tangible assets have historically had a very low correlation to stocks and bonds.

As more investors turn to gold, the demand for the yellow metal increases, but in the case of gold, production is declining. And, it is very difficult to open new mines when the whole process takes about seven years on average, making it hard to address the supply issue quickly. Of course there was a time when central banks couldn’t wait to get rid of their gold and switch into US dollars and US Treasuries. But, last year there was a change in sentiment and for the first time in twenty-two years, they became net buyers of gold instead of net sellers.  And, in the first half of this year, sales of gold from the IMF and the major central banks of the world are a fraction of what they have been in previous years.

Although, the demand for gold for use in jewellery decreased last year, there are signs of increasing demand. Overall during the second quarter of this year, global jewelry demand volumes rose by 43% on the year to 470.7 tons, according to the World Gold Council (WGC). The demand was mainly driven by non-Western markets, where consumers appeared to have adjusted their price expectations, the WGC report said. Among the strongest performers were the UAE which saw volumes climb 29% during the second quarter of 2010, on the year and Saudi Arabia where volumes rose 29%, the report said.

Gold demand in China, the world’s largest producer, gained in the first half as government measures to cool the property market and falling equities spurred investment, the Shanghai Gold Exchange said July 7. Gold climbed to a record in June as investors sought to protect their wealth amid concerns about the global economic recovery. The total volume of gold traded on the Shanghai Gold Exchange jumped 59 percent from a year earlier in the first half to the equivalent of 3,174.5 metric tons (102.1 million troy ounces), Song Yuqin, vice general manager at the exchange, said last month.

As gold enters its tenth year of its current bull run, there are still many market analysts who continue to refuse to see gold as a good investment. Yet, the fundamentals driving the gold market remain unchanged, and it is my opinion that we are going to see much higher prices in the future.

TECHNICAL ANALYSIS

During the last few sessions gold has managed to hold above $1160 which represents a 50% Fibonacci retracement of the move that began in February this year and that peaked in June. The price of gold is now set to test the 50 day moving average $1211. However, the price needs to hold above this level and break above $1220 in order to resume the up trend. I maintain that we will see this shortly.

David Levenstein

****

David Levenstein is a leading expert on investing in precious metals, with more than 30 years experience.

For more information go to: www.lakeshoretrading.co.za