Should you dump gold now or buy it up? How high can Gold ultimately go? Oct. 14, 2013 Kitco reported the spot price of gold at $1,253.50 in USD. On Oct. 17, the spot price of gold was at $1,276.60 in USD. As of Friday Oct. 18th gold is near the $1,320 price level. These are nice short-term price movements in gold if you are on the right side of the fall and rise of gold prices. Volatility is good if you like riding the Steel Eel; just buckle up for the ride and be seated in the right place. The following are some notable hypotheses on the commodity of gold and the price of gold as you trade and invest through the last quarter of 2013 and beyond. A recommendation is provided at the conclusion of the article.
Gold, Oil, and the Dollar: Consider the gold price compared to the price of oil and the US dollar. The dollar's trend moves inversely to gold and oil prices on a macro-trend level. Does a drop in the price of a barrel of oil cause the dollar to move up? Does the price of gold moving higher cause the dollar to move lower and oil to move higher? Looking at recent and past events the correlation is a combination of external events like inflation or the threat of inflation, war or the threat of war, or gold backwardation or the threat of gold backwardation. The most recent example involves Dagong, a top Chinese rating agency downgrading US sovereign debt because of the US Congress's explicit act of delaying the eventual day of reckoning for America's debt. The Dollar Index Spot Exchange Rate (DXY) went from 80.47 on Wednesday to 79.65 on Thursday and Friday of this past week. Oil prices initially dropped on the 17th and slowly headed back up on the 18th of October. Gold prices jumped by $45~ in just two days of trading. All thanks to the US Congress and Dagong helping a bit. That is only one current surface event. The underlying factors are many.
It is current news events, rumors and actions that move these daily and weekly gold prices in volatile, oscillating movements in the short term. Wars and rumors of wars can move oil prices, default and the threat of default moves the dollar, and hoarding and dumping moves the prices of gold. When one of these variables moves, one or both of the others move. The long-term price movement of this trio is guided by underlying economic factors. The great depression, the great recession, and any future "great default" of the US Treasury with the help of quantitative easing, moves these markets. Dumping 40-50-60 tons of gold on the market in the early hours of the morning can do a lot for price movement to the downside for gold. This has the effect of stabilizing the dollar from dropping further. If the dollar has been falling below 80 and gold prices have made a nice rise in the past few days or weeks; look for a dump or an event, just saying. However, that tactic may soon be coming to an end when real market values appear and people lose confidence.
Energy and Gold: One hypothesis states that oil and gold prices trend together because the costs of rising energy needed to mine gold out of the earth causes gold prices to rise in order to recuperate mining costs. Miners will stop digging for gold if the costs are not worth mining the precious metal. When oil and energy prices increase but gold prices have not moved yet, it is not cost-effective to mine. This in turn causes gold prices to rise because the supply of gold has been limited due to a slow down in production. The oil-to-gold price charts show that before our "great recession" of 2008-09 on average, an ounce of gold could buy around 7-10 barrels of crude oil. After 2008, with wild swings in divergence, an ounce of gold could buy 13 to 20 barrels of oil. As the dollar falls, gold and oil trend up together over the same period. When the dollar loses value gold becomes a safe haven and prices rally. When energy and mining costs go up miners limit their production. This in turn causes a shortage in physical gold. Conventional wisdom states that when demand for gold increases, then gold prices increase because of a limited supply. However, there are days in the market when conventional wisdom just does not make any sense. Perhaps, unseen intervention is stepping-in to the market to push conventional wisdom to the side.
Debt Ceiling and Gold: Another hypothesis states the price of gold correlates to the total US debt, and more specifically the debt ceiling, for the long trend. You can find several charts from Bloomberg, World Gold Council, and GoldCore.com, which clearly show that in 1996, 2008, and 2013 gold prices have actually fallen as the debt ceiling was being raised but bounced back up to higher prices. The takeaway on this hypothesis is to buy on the rumor of a hiked debt ceiling and sell on the news and wait for a plunge. Then buy back into gold again at a lower price because the long-term trend will continue to follow the debt ceiling. (How many times have you figured out a trading strategy only for it to work once or twice and then become inefficient or dysfunctional?) We cannot have the dollar crashing during these debt ceiling hikes so a player may want to intervene by dumping 50-100 tons of gold on the market in one, giant pre-dawn plop, if they have those kinds of resources. One day, the powers that be may decide to stop supporting the dollar through gold intervention in order to introduce a global currency as advocated by China, Russia, Brazil, the EU, the UN, and most major economic forces on the planet. That may be nice for the short-term price of gold but bad for America.
Papering not Tapering. One current hypothesis states the Fed cannot start tapering now because they do not have data to back up their decision. The government shutdown in the first few weeks of October prevented the data from being produced. According to a Reuters report this past Friday Chicago Federal Reserve Bank President Charles Evans stated, "one of the most dovish policymakers at the U.S. central bank, on Friday said that while last month reducing the Fed's massive bond-buying stimulus might have been an option, such a move is no longer a possibility. My own personal view is, I don't think that we have enough positive additional information going into the next meeting to all of a sudden decide that it's appropriate to taper."
Whether there is truly a lack of information, or a lack of positive information, or it is a bogus excuse the tapering is probably not going to take place any time soon. QE purchases of $85 billion in Treasury and mortgage backed securities each month to push down long-term interest rates will hurt the US dollar and it supports gold. However, money managers are hypothesizing that QE will increase not decrease. Do I hear $100 billion anyone? The US government has passed the point where they can extinguish their debt. They can only roll-over the debt and interest and increase the debt ceiling. What is going to happen to US government treasury bonds when the market understands the roll-overs are increasing in size and never-ending? What happens when that discovery is made and no one wants to buy US debt? The dollar collapses and gold prices rally.
Gold Backwardation: Backwardation of a commodity happens when the price of its future contract is lower than the price of the commodity in the spot market. The future price is less than today's price. The difference between the future price and the current price is less than the cost of carry. It often happens when a delivery cannot take place because the commodity is not available. Backwardation most often signifies a shortage of a commodity. Gold, as a commodity is different from a consumable commodity like cocoa, orange juice and beef. Practically speaking no matter how much gold is mined it will not produce a glut in the market. If there are too many soy beans harvested then there can be a glut in the market and current prices fall because there is more supply than demand. When the opposite of a glut happens and there are no soybeans available for delivery then backwardation occurs. Gold as a commodity does not act like consumable commodities. Gold backwardation is rare. Backwardation in consumable commodities is not rare.
What causes a backwardation in gold? Is gold in short supply? All the gold that has ever been mined in world history has not disappeared or been consumed. It is lying around somewhere. Gold backwardation becomes a reality when delivery is scarce. But wait, did not my fund manager promise me I could convert my paper gold to real gold whenever I wanted it delivered to my front door? Could it be people do not believe they are going to receive delivery of the gold they purchased? People have lost trust in gold handlers. For example in 1968 the Fed sent the German Bundesbank 172 bad delivery gold bars. The "re-melting showed a loss in fine ounces terms four times greater than the gross weight loss." And also, "Germany requested an audit of their gold, which we refused, and $34 billion worth of their gold, which we said we would deliver in 7 years." In 7 years! Where's the gold?
With consumable commodities the inability to deliver the product today is resolved by a higher price. With high enough prices the demand falls and the existing supply is enough to meet the decreased demand. So, when conventional wisdom claims that the current Indian wedding festival season gold buying and Chinese buyers looking to buy cheap gold explains the recent backwardation in the gold market, could that be it? I don't think so. Gold is not your ordinary, consumable commodity.
The Financial Times reported that lack of liquidity in the leasing markets has caused backwardation-a rare situation that has occurred only a few times in the past 20 years. The most recent gold backwardation began on August 12, 2013. According to James Turk the backwardation ended on Sept. 2nd while Americans celebrated Labor Day. This was an unprecedented amount of time because the first two times in history of gold backwardation the phenomenon only lasted a few days. The two other times were in 1999 and 2008. In Dec. of 2008 backwardation caused gold to rally from $750~ to $870~ in a matter of days and to $880~ by the end of December. After that the price of gold continued to rise until August 23, 2011 when the price maxed out to $1910~ before heading back down. The highest price in gold's history began with a backwardation event.
If that happened again today it should easily push gold up by $228 and knock out a lot of shorts causing a larger rally going into December. The frenzy would begin. In a few years gold would hit $2,500. When intervention no longer works the market takes over. When backwardation takes place the market is saying, "Hmmm, can I trust my paper gold to be converted to real gold for delivery tomorrow or will I receive a promise for delivery in 7 years of gold plated zinc bars with a certificate proclaiming 'replicated' value." One day very soon, the market is going to realize the hammers of intervention hold no more power against gold.
Antal E. Fekete, Hungarian Canadian Professor of Economics and Mathematics, known for his theory of hoarding and his opposition to the helicopter guys like Milton Friedman and Ben Bernanke stated the 2008 Comex December futures for delivery on the 31st was quoted at 1.98% discount to spot and the following Feb. gold futures were quoted at 0.14% discount to spot and changed on Dec 3rd to 2% and 0.29% respectively. The gold basis turned negative and backwardation persisted for 48 hours. "The message of gold backwardation is it costs more to borrow gold than to borrow dollars; gold is more precious than dollars. There is no bid from gold to dollars." -Fekete.
Permanent Backwardation: A current hypothesis is that gold backwardation will become permanent. There are money managers who believe gold is now in permanent backwardation but the bullion banks have cleverly hidden this from the public. Why hide the permanent backwardation? The hypothesis believes the gold futures market will collapse and bring the economy and the dollar down with it. This will cause the spot price to rise. When investors and traders come to the point where they no longer believe or trust their paper gold futures contract or ETF gold fund (NYSEARCA:GLD) for that matter, will deliver them physical gold when they ask for possession of their gold, then it's over. At this point the futures market will fold. The belief is that gold will not have a high enough price to discourage buying once confidence in paper gold and paper currencies has been lost and backwardation becomes permanent. Current perception is that the Fed's intervention is losing its effectiveness and the real market is now intervening.
Physical Gold Rush: Around the world people are buying gold and hiding it. Some people believe burying it deep enough in their backyard so metal detectors cannot discover it is a good idea. The government has nifty ground-penetrating radar so that probably is not going to work. Some people are painting their gold bars black and using them as door stops to hide their gold in plain sight. Some hoarders prefer the traditional safe or vault. Just remember there is no law that says the government cannot pull another Executive Order 6102 on the American People. Why are people rushing to hoard gold and why is gold as a commodity experiencing backwardation? Trust has been compromised.
Art Cashin questions why the gold market sees massive paper sell orders in thin trading. Why are there 80-90 tons of gold dumped on the market at odd hours with very, very light volume? Would a sophisticated trader or investor dump all that paper gold at one time? No. Art Cashin believes the objective is to bring gold back to the levels of June 2013. The April 2013 fall in gold price occurred when the futures market opened to a 100-ton sale. Two hours later another 300-ton sale occurred. The price tumbled to say the least. These dumps on the market only further degrade the lack of trust by money managers, traders, investors, world governments and the public. This lack of trust only further encourages a backwardation condition of gold futures. The last two times gold backwardated was in 1999 and 2008. It marked a pivot in gold prices with several years of record prices. Backwardation has happened again in 2013 for the third time in all of history. But this time its magnitude occurred with an unheard of, elongated span of time. Something is up, and that is going to be the price of gold.
Conclusion: At its current price, gold is a buy. The main strategy for buying gold is two-fold, hedging and physical possession. First, gold is your hedge against inflation. A certain percentage of gold stocks and ETFs can be bought on the dips in price to anchor your portfolio. "Financial advisers have long recommended that you keep 5% to 10% of your portfolio in gold." At this stage of the game I recommend 10% to 15% for your hedge. Once the gold price makes a good run, then scale back a bit. Choose gold miner stocks whose companies have strong balance sheets. Do your due diligence on these companies. I recommend analyzing Barrick Gold (NYSE:ABX) because they are a company that is lining itself up to make a lot of money once the price of gold flies. They have the retaining power to make it through the current volatility, which the gold price is experiencing right now. But diversify and seek out other good companies to analyze. They will become winners when the price of gold makes its move in the coming quarters. If you are unable to handle the volatility you should purchase options several years out and roll them over if needed or sell for a profit at the opportune time.
The second part of your gold strategy should be to hold physical gold. The reason for holding physical gold is the fact when a run on gold takes place you are not waiting in line for your delivery and the supply runs low. When the price of gold dips then buy your coins and bars, storing them in a safe place to be used at a time when the dollar tanks. How to hold on to your physical gold is another matter entirely which you must include in your strategy. Possession is nine-tenths of the law.
Disclosure: I am long ABX. 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.