After more than a decade of uninterrupted year on year gains, it seems the run-up in gold prices is on not only on a temporary breather but a permanent break from the bull market trend. The loose monetary policy, the continued fears of economic turmoil due to historically weak global economic growth prospects and even the uninterrupted prophecy of impending inflation and devaluation of fiat currencies, all classical reasons to expect gold to go higher are failing to push the trend back on the upswing. So, is gold headed for a long period of weakness, or outright price collapse? Some things point to this being a period of price stagnation or even further downturn, not unlike the previous bull market end, which was followed by a decade long period of price weakness. Current talk about the impending Fed taper is also considered to be a negative for gold prices. On the other hand, could it be that this time is different?
The main factor going against gold.
The main reason the run-up in gold prices ended is quite a simple one. It ran out of steam once it approached the $2,000 per ounce spot price because the realization took hold that there are many other investment assets with higher potential for returns. US Stock indexes more than doubled in value since the lows of 2009. It was hard for gold to keep up, especially given that it was going on 12 years of uninterrupted gains. Not keeping up meant it became less attractive, and less attractive meant that fewer people were willing to invest, making it less attractive still. It became a vicious cycle, which could only stop when prices hit the current marginal price of gold production, which is commonly viewed to be around $1,200 an ounce.
Even this support level can be breached easily because in the absence of a clear path to regaining upside momentum, thus making gold an attractive investment opportunity again, demand destruction can occur in the physical gold market, which then will allow for a new marginal production price at a lower rate of production. We could conceivably see gold prices go below $1,000 per ounce and remain there for perhaps a few years.
We currently have a net outflow from gold ETF holdings, therefore there is added pressure on physical gold holders and the jewelry market to consume the new mined production coming on to the market. ETF holdings reached a record of 86.5 million ounces a year ago, while currently we are looking at 63 million ounces. We could continue to see a net outflow of as much as a million ounces per month for some time to come, continuing to add pressure on gold prices.
Reasons to be bullish.
Limits to continued ETF outflow.
In many ways, the ETF outflows, which is a reason to be bearish, we should also see as reason to be bullish. There is only so much gold that can flow out of the ETF holdings. I doubt that these holdings will ever go to zero. At some point, there will be a reverse of the outflow, at which time it will act as a new source of increased demand. How long the current outflow can continue to last is unknown, but we know it cannot be forever.
Lack of future new mine production.
Given the current downturn in gold prices there are already some companies reconsidering or delaying projects. The Pebble mine project in Alaska recently suffered a blow when London Based Anglo-American (AAL), which was the owner of half of the mine project, pulled out, rendering the project dead for now. In 2010, it was estimated that there are 67 million ounces of gold technically recoverable at the mine. This mine alone contains more gold than the total currently held in ETF holdings. At current prices, it will never commence production because estimates put the breakeven price of production at $1,500 an ounce. At some point there may be a new partner in the project, but for now the mine is dead.
Taper not a reason to be bearish on gold prices.
Much has been made about the recent talk about the Fed pulling back from stimulus, which should be bearish for gold. The theory makes much sense, because rising interest rates and perhaps a firming of the dollar usually both tend to be a negative for gold, because gold does not pay interest or dividends. While conventional wisdom may dictate that this may indeed be true, perhaps some of us may have noticed the rather unconventional nature of our present economic situation.
It is in fact the Federal Reserve stimulus which in my view killed the gold rally, because it stimulated demand for stocks. As the stock rally took hold gold became less appealing given that it already had a decade long bull run, thus questionable upside remaining once it got close to approaching the $2,000 per ounce price. With interest rates going up, it is the stock market which will become less appealing in my view, Fed moves to tighten up on stimulus measures will lead to an economic slowdown, driven by a drop in consumer demand growth, caused by a lack of household income growth.
As I pointed out in my previous article (link), US median household income peaked in 1999, most likely forever. Even as the recovery started taking hold in 2010, median household income continued to drop, with the average family giving up about 2% of their income since then. Since the peak in 1999 of $56,100, we are now down to $51,000, which is a drop of 10%. As consumer demand will slow down, given that families cannot afford to spend more on credit if credit becomes more expensive, so will the stock market rally. At that point, gold will actually become a desired asset, because there will be little else available aside from cash in such circumstances. Current bets are on Federal Reserve tightening of stimulus, in the form of reducing bond purchases sometime next year. By then ETF holdings will be even lower, while it is possible that lack of new mine supply will start to bite into global gold supplies. It is possible that we will see a new rally in gold starting sometime next year. In the meantime, there might be more pain ahead for those who decided to dig in and wait out the current sell off.