Gold had a tough year in 2013. It was down 9.4% in the fourth quarter and 28% for the year. Market analysts like myself who thought the price of gold would be a lot higher than it is right now have been humbled. Despite the overall 2-year decline in the price of gold, the fundamental factors, which ignited the bull market back in 2001, became even more powerful over the past 13 years. While there are several such factors, I want to focus on two, which are commonly overlooked by most Wall Street gold analysts: the enormous demand for physical gold in Asia, specifically and especially China. In my view, this key fundamental market variable is not being factored into the price of gold by the market and could lead to a big upside surprise in the price of gold this year.
Much of the gold market analysis focuses generically on the price of gold, without differentiating between the "paper" futures market and the physical market. The distinction is important, because it is the available supply of actual physical gold that ultimately drives the price. Up until the last couple of years, physical gold supply and demand was for the most part balanced out with the supply from scrap gold recycling and global mine production. But as you can see from this chart, since the middle of 2012, the demand for physical gold deliveries by China started to accelerate (chart source: InGoldWeTrust.ch, edits in black are mine):
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In fact, in 2013 physical gold deliveries in China via the Shanghai Gold Exchange totaled roughly 2100 tonnes vs. 2300 tonnes mined globally.
Until China surpassed India in 2013 to become the #1 gold importing nation in 2013, global demand for physical gold delivered to the buyer was satisfied by mine production, scrap recycling (cash for gold companies, for instance) and Central Bank gold leasing. But with China's rapid increase in gold imports that began when the price of gold declined, the global demand from big buyers - India, Russia, Vietnam, and the Middle East primarily - exceeded mined production plus recycling. The supply deficit was "bridged" by gold that was removed from the GLD Trust and the Comex. About 550 tonnes were removed from GLD and 119 tonnes were drained from the Comex vaults in 2013.
In the first three weeks of 2014, weekly deliveries from the Shanghai Gold Exchange have exceeded the weekly rate of deliveries in 2013. In 2013, weekly physical deliveries averaged 42 tonnes. In the first two weeks of 2014, 99 tonnes were delivered. In this past week, 91 tonnes were delivered. This data can be found on the Shanghai Gold Exchange website. Given that the lower gold price over the last two years has forced several big mining companies to mothball gold production at higher-cost gold mines, it will be interesting to see the effect that China's demand for physical gold will have on the global price of gold. My view is that an enormous physical gold supply/demand imbalance has developed and that it will require much higher prices in order to slow down China's appetite. On the supply side, higher prices will enable mining companies to reactivate shuttered mines and possibly induce traders who have accumulated physical gold to sell some and take profits.
One more point about the demand for physical gold. The Indian Government instituted strict import controls on physical in the middle of 2013, ostensibly to slow down its increasing current account deficit. This was highly unpopular and it significantly curtailed India's import demand. With Government elections coming up in mid-2014, some leading politicians are now asking for the controls to be eased. The price of gold spiked up on Thursday last week when this news story hit the wires. If India relaxes import controls, this will further distort the physical gold demand/supply imbalance and would likely trigger a big move higher in the spot price of gold.
With this enormous and growing demand for physical gold, I want to go through one method to derive a price target for 2014. The graph below shows the 13-year bull market in gold using the weekly price of the Comex gold futures contract:
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During the 13-yr bull market, gold has had three sharp price corrections, as shown in the three green circles. The first two corrections were quite a bit deeper than the 20%/bear market popular convention. Yet, both times the price of gold recovered and eventually hit a new bull market high. Similarly, I expect that the 37% sell-off recently endured by the market will ultimately lead to a new all-time high for gold.
In fact, if I'm right that a bottom has been established that will lead to another big move higher, the big price correction in the precious metals sector has created an investment opportunity not seen since 1976. Gold rose 450% in price from 1971 to 1974. Over the next 18 months, it lost 43%. Many investors lost confidence and sold their holdings. However, during the next four years gold climbed 750% to its then all-time of $850/oz in 1980. A similar percentage increase in the price of gold from its current price would take gold over $10,000/oz.
While I'm not forecasting a $10,000 price for gold any time soon, I do think that gold has a more than reasonable chance of hitting $2,000 in the next 12-18 months. I base this on using the move to new highs that followed the 2006 and 2008 price corrections as "benchmarks." In 2006, the 28% price correction was followed by an 84% move higher. In 2008, the 32% price drop led to a 157% new all-time high of just under $1900.
Price forecasting is as much "art" as it is "math/economics," but if we assume the move from $1183 low is followed by the same 84% rally that followed the 2006 correction, we get a price target of $2,175. Similarly if we apply an arithmetic average (120%) of the previous two correction/new-high cycles, the move that follows this latest correction would lead to a price target of $2,602. Again, I don't want to go on record with an official forecast of $2,602 - although I do think we'll eventually see the price of gold go higher than that. Given both the enormous demand for physical gold, combined with the price behavior of gold historically after big price corrections, I will go on record with a forecast of at least $2,000 within 18 months.
If you think my analysis is valid, there are several ways to play the next move up in gold. First and foremost, I always advise people to start accumulating physical gold. I recommend 1-oz gold and silver sovereign-minted bullion coins like American eagles and Canadian maple leafs because of the purity, difficulty to counterfeit and widespread recognition (i.e. liquidity). For more trading-oriented, shorter-term plays I like the SPDR Gold Shares ETF (NYSEARCA:GLD) or the VelocityShares 3x Long Gold ETN (NASDAQ:UGLD). Both securities have a full array of options.
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.
Additional disclosure: The fund I manage is long physical gold, silver and mining stocks. I am invested in this fund.