Looking for a Snap Back

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"Dichotomy between buyers and sellers means gold is moving into very strong hands."

January has been a difficult month for gold, so much so that many market mavens—analysts and investors alike—are abandoning their bullish expectations.

From its year-end 2010 price near $1,420 an ounce to its recent low just over $1,320 gold has so far shed some $100—about 7%. Measured from its all-time high just over $1,432 in early December, the recent decline is less than 8%. Either way, in percentage terms, this doesn't amount to much of a correction in the metal's 10-year old bull market.

Bright Fortunes

In contrast to gold's naysayers and born-again bears, I believe gold's fortunes remain very bright.

What's more, recent market activity, rather than signaling an end to gold's decade-long advance, strengthens the case for a sharp snapback in the metal's price and new all-time highs later this year.

Indeed, with gold's fundamental price drivers all remaining supportive, I expect another strong advance over months ahead—with the yellow metal rising to $1,700 an ounce by year-end 2011. While this seems like a lofty target, it amounts to "only" 19% above the recent market lows and is dwarfed by last year's 29% annual gain and the even bigger 32% advance registered in 2007.

Euro Trigger

Much of gold's price action in recent months has been triggered by the ebb and flow of "safe-haven" funds into and out of the euro.

Whenever Europe's sovereign debt problems worsened or the life span of the European currency seemed more uncertain, a flight of capital and speculative funds out of the euro into both the dollar and gold—perceived as "safe havens"—gave both the greenback and the yellow metal a boost. And, whenever sovereign debt fears subsided, safe-haven demand for the dollar and gold diminished.

Historically, gold and the dollar have typically moved in opposite directions: Think weaker dollar, stronger gold; stronger dollar, weaker gold.

But lately, the two have moved up and down together like Siamese twins—rather than in opposition as history suggests. We can now see why: Both gold and the dollar are being driven up and down together as confidence in the euro waxes and wanes.

To the detriment of both gold and the dollar, a number of developments have come together in recent weeks to boost euro confidence and push the currency to a two-month high. The list includes:
  • A spate of better-than-expected economic indicators;
  • The successful refunding of sovereign debt by Portugal and Spain;
  • Strong demand for the euro-zone rescue fund's first-ever bond issue; and
  • Tough anti-inflation talk from European Central Bank President Jean-Claude Trichet.
This good news won't last forever. Instead, significant economic and social disparities between the stronger "core" economies (led by Germany and the Netherlands) and the weaker "peripheral" economies (such as Iceland, Ireland, Portugal, Spain and Greece) will continue to threaten the viability of Europe's common currency. Sooner or later another funding crisis will trigger a new wave of capital flight seeking a safe haven in the dollar. . .and gold.

Who's Selling...

To understand where gold prices are headed this year, it's important to recognize that most of the selling in recent weeks has come from U.S. and European short-term institutional traders and speculators—banks, trading firms, commodity funds and hedge funds—operating mostly in derivative markets, some simply taking profits, others betting on the downward momentum of the market and many reacting to the reversal of "safe-haven" funds that late last year sought security in U.S. dollar assets and gold.

These players have no long-term view of gold and certainly no allegiance to the metal as an inflation hedge, store of value, portfolio diversifier, insurance policy and traditional savings medium. They simply sense a profitable trading opportunity. Today gold is in their sights. Tomorrow, it may be petroleum, cocoa, rice, steel or long-term U.S. Treasuries. And, one day they will be buying gold again.

. . .And Who's Buying

In contrast, strong physical demand not only continues but also may well have picked up as lower price levels attracted bargain hunters. Much of the buying has come from Asian markets—China, India and other countries where gold has great cultural appeal as a store of value, savings medium and harbinger of good luck and prosperity to those who hold it.

Big premiums (over New York and London prices) on gold bars in Hong Kong, Mumbai and other gold-trading centers across the region indicate a shortage of physical metal as refiners struggle to meet strong demand for the various bar sizes popular in the Asian markets.

It is also likely that some central banks are taking advantage of the current price decline, quietly adding to their gold reserves or accelerating their purchases. Likely buyers include the People's Bank of China, the Bank of Russia and possibly one or more of the reserve-rich oil-exporting countries.

In fact, all of the central banks that have bought gold in recent years today remain significantly underweighted in gold. All still hold the lion's share of their official reserves in U.S. dollar securities. . .and all have an incentive to buy gold on major price declines.

Strong Hands

Significantly, this dichotomy between buyers and sellers means that gold is moving into very strong hands and much of this metal is unlikely to come back to the market anytime soon.

Buyers in Asia are mostly long-term holders, often for a lifetime. Similarly, many of the retail and wealthy buyers of bullion coins and small bars in America and Europe are motivated more by fear than by greed and are likely to retain their physical gold holdings for years to come.

As a result, when the current wave of selling abates, gold will have the potential for a swift and sizable recovery—all the more so if these same players view the metal as an attractive vehicle for trading and speculation on the long side of the market.

Jeffrey Nichols
NicholsOnGold

Looking for a Snap Back

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