Gold Is Not in a Bull Market

| About: SPDR Gold (GLD)

Recently, gold appears to have entered The Mother of All Bull Markets. Even though gold has backed off of its $1,072/oz record from two weeks ago, as of Thursday's close, the market was still up 18 percent for the year and climbing. Interest in the yellow metalfrom both individual and institutional investorshas never been higher.

But don't be fooled, says Jon Nadler, metals market analyst and PR head for Kitco Metals, Inc. The precious metals expert says the current bull market in gold is all an illusionone that the fundamentals can't support for long.

With over 30 years' experience in precious metals markets and investment, Mr. Nadler is a well-respected authority on gold. He writes a popular daily gold market commentary for Kitco, and his metals expertise is frequently sought out by the Wall Street Journal, Bloomberg, Reuters, the Associated Press, Financial Times, CNBC and more.

Recently, HAI associate editor Lara Crigger discussed gold fundamentals with Mr. Nadler, including what investors should look for in a gold bull market, why gold supply and demand are so out of whack with prices, and what two events should kick off a price correction.

Lara Crigger, associate editor, (Crigger): You've written before, "Gold is not in a bull market. The dollar is in a bear market." How do you know? What telltale signs indicate a gold bull market?

Jon Nadler, metals market analyst, Kitco Metals (Nadler): This phenomenon here has largely been a dollar-driven, dollar-based story, but the requirements for a bull market in gold extend beyond a simple anti-dollar relationship. There are four factors that truly make a gold bull market.

First and foremost, you have to have demand that far outstrips supply. Like any commodity in higher demand than supply makes available, you'd obviously see a price reflection.

Secondly, you'd have to have a falling stock market. The old adage is that gold is an inverse asset to currencies, stocks and other assets—so where's the bear market in stocks? Stocks have been up 50 percent-plus this year.

Third, you'd have to have an actual, tangible inflation level, and the threat of much higher inflation on the horizon as well. We don't see that either, which we'll talk about later.

And fourth, you'd need an increase in the price of gold across all major currencies—no exceptions. You can't have Aussie dollars and the South African rand going one way, while the euro and U.S. dollar is going the other.

Those four factors are not satisfied by the current picture in gold—not even remotely. What we really see is a momentum- and index-fund-driven speculative move that started almost on cue on Sept. 1. They've been piling in, hand over fist, with margin positions and futures positions that have now mushroomed to a level that's unreal—historic highs, on the order of 750 tons of long positions. They outnumbered the shorts 9:1 as of the week before last; it has since narrowed to 7:1 [as of Tuesday, Oct. 27]. Still, that's way distorted.

But I have to say from the get-go, I'm not a gold bear. I know that anybody who doesn't say "$2,000 gold!" is automatically a bear, but I'm just a realist who looks at supply and demand.

Crigger: But isn't gold supposed to be this ideal anti-dollar play?

Nadler: It's not that simple. In fact, statistically speaking, if you look at the correlation between gold and the dollar since 1971-72, it's -0.27. In plain English, that means if you are betting gold as an anti-dollar play, you're likely to lose money 73 percent of the time.

Then other people will say, "Well, it's a perfect inflation hedge." But gold's correlation to inflation is about 10 percent. So, perfect inflation hedge? Far from it. In fact, it's rather ineffectual against the mundane, everyday 5 percent (or sub-5 percent) inflation that we had for 25 to 30 years. It is very effective against Zimbabwe- or Weimar Republic-style inflation—and if that's what you see the U.S. coming to, then be my guest: Overload on gold.

Crigger: Why do you think these misconceptions still persist?

Nadler: Most of the hyper-bullish analysts are trying to apply 19th- and 20th-century thinking to modern-day central bank policy. They ignore many of these statistical realities that are borne out.

Look at 1980. There, you had all the conditions being met: falling stocks, actual rampant inflation, major catastrophes like Russia in Afghanistan, oil embargoes, Iranian hostages, you name it. What happened? The most aggressive Swiss money managers recommended that their well-to-do clients who felt really scared should put maybe 15-20 percent in gold. That's it. Nobody said then, or today, that you should have 30 percent, 40 percent, 50 percent in gold—except the perma-bullish gold bugs.

What we're saying at Kitco is that gold has a place in the portfolio, and it absolutely deserves respect—but don't get carried away. Don't bet on the wrong scenario at possibly the wrong time with too much gold, which will then skew your portfolio into volatility, unexpected corrections and actual disappointment.

Crigger: So let's talk a little about gold's supply/demand picture, which seems a little out of whack with the prices we're seeing.

Nadler: The gold market is made up of five pillars. On the supply side, you have mine supply, scrap gold supply and occasionally central bank sales or purchases (that's kind of a swing factor). On the demand side, you have fabrication demand for jewelry and so on, and investment demand, which is a cyclical, emotional phenomenon—people go into stages of panic, fear, greed, and bubbles are formed, and so on.

On the supply side, lately you've started to hear people say supply is running into oblivion, that it's "peak gold." Well, the reality is that GFMS' latest computations (which run through midyear) show an actual 7 percent increase in mine output, of 1,212 tons. Miners went on hiatus only because the credit crunch prevented those who had found all this gold from actually coming to market with it.

Crigger: Sounds like we won't be hitting "peak gold" anytime soon.

Nadler: No. Maybe we're not finding huge discoveries like we used to, but some $40 billion has been sunk into the ground to find new gold, and nobody goes out and spends $40 billion figuring it's wasted money and nothing else will be found. And miners are eager to find new gold, because the average cost of production is in the low-$400s. So at $1,000/oz, it's a party.

So now that some of that gold is starting to show in the pipeline, we better have eager takers for it all, because when you look at incremental mine additions over the next five to six years, we could have as much as 400 tons' worth of additional mined supply coming into the market year-on-year. That's significant—that's almost 25 percent higher yearly output in mining than people thought was coming.

And then there's the scrap supply, which has been a huge story this year. The combination of record prices and a dire need for cash during the economic crunch had a lot of holders of gold looking at the price and saying, "Oh, I'll take that!" With the proliferation of "cash for gold" operations, furnaces have been basically running 24-7 in every refinery that we know of, including our own in Montreal. Again, GFMS computed that we had 880 tons of gold coming into the market in scrap form. That's an all-time high-and it's twice the amount of scrap the market sees in a full year!

Crigger: Wow, those are pretty impressive numbers. Where is all this scrap gold coming from?

Nadler: It's coming from Turkey and India, which have led this parade of secondary supply. Europe and the U.S. are also drawing out a lot of new scrap through these new "cash for gold" firms.

Crigger: How has mine de-hedging played into the supply/demand picture?

Nadler: For the past several years, mine de-hedging has been a major contributor to the rising gold price, since obviously, that's taking gold back from the market. De-hedging has slowed immensely—90 percent in the first half of 2009.

So as we move forward, if miners start hedging again, then we'd expect a decent amount of gold to be coming onto the market in the form of forward sales. At $1,000/oz, if a miner isn't hedging, shareholders might start questioning, "Hey, no price risk hedging? What are you doing here?" And you have to wonder, where is the price support going to come from, if not de-hedging?

Crigger: So let's look at demand. Is it strong enough to support current prices? After all, we've seen much lower demand from India this festival season, jewelry demand worldwide, and so on.

Nadler: It's been a total disaster, effectively. World gold fabrication through midyear has fallen to a 21-year low; it's down 20 percent year-on-year. Jewelry fabrication, which is usually 60-70 percent of the gold market demand, fell to its lowest level in 20 years. Industrial fabrication was down 26 percent.

Then we add the remarkable story of India, which did something unheard of: In the first quarter, they turned into a net gold exporter. That's like Saudi Arabia taking in sand! This is the first time since 1980 that this has happened.

We normally count on India to take somewhere between 500-900 tons per year into their country, in good times and bad. But 2009 is shaping up to be probably the lowest level of imports in 12 years; that is, since it actually became legit to import gold.

Crigger: Will the increased demand from China offset that lower demand worldwide?

Nadler: There is this wishful thinking out there that somehow China will become the end-all, be-all of the gold market; that they're ready to load up on thousands of tons for reserves, and they're telling everyone to buy an ounce of gold, all one billion of their citizens. It's nonsensical.

China has become first in production terms—they're now producing 300 tons of gold—but they're absorbing most of it internally. If they're going to buy reserves, they'll do it at the same pace they've done up to now, and they'll buy it domestically. They have no interest in dumping dollars for it, because obviously that would hurt their dollar holdings to a much greater degree. As far as the population being urged to buy gold, sure-the World Gold Council is telling every working-class person to buy gold. But look around at how many people can actually afford it, and it's a lot smaller than one billion.

Some people say it doesn't matter, that we should ignore it because investment demand will carry the day. Investment could carry the day, were it not coming from a specific species of investor: the hedge funds, replicator funds, whatever you want to call them. The latest gains beyond $845/oz, or certainly beyond $915/oz, to where we are today—it's pure froth from these types of funds. It basically amounts to hoarding by the futures market, by people with no loyalty to the metal or the market. They have a price objective, that's it. But when people start asking, "Where's the fundamentals to support all this?", the correction can be painful and very ugly.

Crigger: How long before we start seeing price corrections?

Nadler: It's based on two factors. First, when the dollar starts to recover in earnest. We saw that sort of recovery start to come in last July through October; when the dollar started to recover, gold went from $1,040/oz in March to $680/oz in October.

The other factor will be the clear indication by the Fed that it's done with low interest rates, and it starts to tighten. Some are saying that once it gets going, it might be as aggressive and consistent as was the rate-cutting campaign, so that every meeting of the Fed you'll have a quarter-point hike, hike, hike. The focus is on them so heavily now, due to the size of the injections, so they're not going to dither on the extraction of liquidity.

That said, can this push still have the inertia to take prices to $1,100 or $1,200? Of course it can. But if you distort the market in its essential components this far on what is essentially a fund play, I think you've got problems. When you get these fickle funds playing it for all it's worth, we don't know how long that lasts.

Crigger: How do you think gold ETFs have affected the supply/demand picture?

Nadler: You hear conflicting stories, right? First there's the people who say, "Look at all the tonnage GLD [SPDR Gold Trust] is amassing. It must be a sign that we're going to the moon." Others say, "The ETF is a fraud; it has no gold. It's a pure thing by the cartel." (Which, why would I want to touch gold at all if it's manipulated?)

I do see two things with the ETF that should be noted. First, undeniably, they've helped the gold price come to where it is today, by at least $150. That's a given. It's as if a new country came on the scene that owned no gold, and bought 1,100 tons over five years. Tell me that's not going to help the price upward! And at the same time, the ETF hasn't really added anything since June, even though prices have gone through the roof—futures are mushrooming, but the physical thing this represents is stagnating.

Second, the ETFs aren't under any central bank restrictions, so if they feel like selling 400 tons in December, they will, because their shareholders say "redeem." Tell me that doesn't make an equal-but-opposite effect. Significant tonnage can come onto the market under disposal not subject to any restrictions. It's the great gorilla in the room: Sometimes the gorilla's great to have around, but if it sits on you, you've got a problem.

People don't know yet how to treat it, because the ETF has been in an accumulation mode—a one-way street since its creation in 2004. We don't know how it will behave in a sideways or downward market. The jury's out.

Crigger: So based on fundamentals, where do you think gold should be?

Nadler: Ultimately, I think there's a lot less mystery in gold that adds up. If you dissect it all, you can come down with something more realistic. That realism compels me to say "reversion to the mean." We're trading some 30 percent above long-term averages. But if we take away the fear premium, take away the funds and the ETFs, and put in fundamentals, you're left with a range of $680-880—which isn't a bad level, by the way. It still gives producers double the return on their cost of production.

Crigger: But it's just so far from where we are right nowand the several-thousand-dollar level that some people are predicting.

Nadler: If they see that coming, well, I suggest freeze-dried food, a couple of Uzis and a cabin in Vermont—because if that's what they see, it would come to a point where even gold would not help. In fact, at that point, it would be a liability.