2 More Big Reasons To Buy Gold

 |  Includes: GDX, GDXJ, GLD
by: Disruptive Investor

In my last article, I discussed the relation between gold prices and the monetary base to conclude on a long-term bullish stance for the precious metal. This article discusses two more critical reasons to be bullish on gold for the long-term.

The demand from central banks and its positive impact on prices is the first big reason to be bullish on gold for the long-term. According to the February 14, 2013 report on gold demand trends by the World Gold Council -

The fourth quarter saw 145.0t of buying by central banks across the globe, the second highest since the sector became a source of demand in Q2 2009. The annual total of 534.6t represented the greatest level of demand since 1964 as the net of central banks adding to their gold reserves was cast wider, reaching Brazil, Paraguay, Iraq and Venezuela.

The biggest annual demand for gold by central banks in nearly 50 years is just the beginning of the demand coming from central banks. Going forward, this demand will increase further resulting in strong support for gold prices at higher levels. In the year 2012, nearly 12% of the global demand for gold came from central banks. This is significantly higher than the five year (2008-12) average of 4% gold demand coming from central bankers. Clearly, central banks are increasingly seeking refuge in gold in an environment where countries are competing hard to devalue their respective currencies.

I mentioned earlier that the record demand in 2012 is just the beginning of the demand coming from central bankers. The chart below underscores my point.

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For most of the emerging economies and relatively robust economies, gold as a percentage of total reserves is very low. China stands out in this data as it has $3.3 trillion of reserves with only 1.8% of the total reserves in gold. The point I am trying to make through this chart is that the room for diversification to an honest currency is significant for all holders of large reserves. As the race to devalue currencies continues, central banks will increase their holding of gold in order to preserve the purchasing power of their savings. The gradual accumulation of gold will result in steady and an increasing demand from central bankers going forward. I have highlighted just a few countries in the chart. The proportion of gold holdings is low for nearly all high growth economies with significant reserves.

The second big reason for being bullish on gold closely relates to the first. As of third quarter of 2012, the total reserve held by all central banks in the world was $11.2 trillion. For the same period, the total value of gold held by central banks was $1.8 trillion. In other words, if all the currency held by the central bank were supposed to be backed by gold, only 16% of the currency would be backed given the current gold reserves and gold prices. This is just to give investors an idea of the amount of money floating globally just backed by government trust. In the last five years, investors would have realized or gauged the amount of trust they can bestow on the governments. Clearly, this is a concerning scenario and continued high deficits in the advanced economies would mean that foreign reserves would swell further. In such a scenario, central banks and individuals would be seeking refuge in gold, which is more of an unofficial currency for many individuals.

The point I made on swelling deficits and rising reserves is evident from the chart below.

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Total currency based foreign reserve holding in the world was $5.6 trillion at the beginning of 2007. The currency reserve has exactly doubled to $11.2 trillion as of the third quarter of 2012. I must add here that this excess global liquidity will manifest itself in the future in the form of high inflation in different regions and different asset classes. Another important point to note in the chart is that the amount of currency backed by gold was 11.5% in 1Q07. This has steadily increased to 16.0% as of 3Q12. Clearly, central banks are buying more and more of gold along with their swelling currency reserves. This trend is bullish for gold in the long-term.

Another interesting way of looking at things would be to determine the price of gold if all the foreign exchange currency reserves were backed by gold held by central bankers. If the current reserves of $11.2 trillion were backed by 1,012 billion ounces of gold reserve held by central banks, gold prices would be $11904.4 per ounce. I am certainly not suggesting that gold should be at $11904.4 levels. The point I am trying to make here is that there is a lot of paper currency floating in the world and gold is certainly not overvalued. Rather, gold is undervalued considering the pace at which paper money is swelling globally.

Considering these two critical factors and the factor discussed yesterday, I can say with a lot of conviction that gold will trend higher in the long-term.

The best way to consider exposure to gold would be physical gold. Investors can also consider the following options:

SPDR Gold Shares (NYSEARCA:GLD) - The investment seeks to replicate the performance, net of expenses, of the price of gold bullion.

Investing in gold mining companies is also a good option at a time when gold prices are expected to trend higher, and gold mining companies are making significant operating level profits.

The Market Vectors Gold Miners ETF (NYSEARCA:GDX) is a good investment option for the long term. The ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The ETF holdings have an attractive P/E ratio of 10.2, and an equally attractive price to cash flow ratio of 5.3.

The Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) is another good long-term investment option. The ETF seeks to replicate, net of expenses, the Market Vectors Junior Gold Miners index. The index tracks the overall performance of foreign and domestic publicly traded companies of small- and medium-capitalization that are involved primarily in the mining of gold and/or silver. Therefore, the risk related to exposure to GDXJ would be relatively higher as compared to GDX. The ETF holdings have an average P/E ratio of 9.0, and an average price to cash flow ratio of 2.2.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.