Stocks have quite a few variables that can impact their prices over the near term. Expectations about free cash flow and earnings per share, "sector rotation," high-frequency-trading, and apparently right now, the whims of Angela Merkel and dozens of other European politicians.
Relatively speaking, gold prices seem simple to derive. It seems like classic economics. There is a downward sloping demand curve, and upward sloping supply curve. You find where these two lines intersect, and you magically have a market price. So simple... Unfortunately, it's not that easy, and the recent volatility in the price of spot gold suggests that the market really can't settle on the efficient market price.
Does that mean free markets don't work? Absolutely not, but we try to find the intrinsic value of assets (or a mid-cycle price/value substantiated by fundamentals), which makes determining the price of gold much more difficult than you might expect. Unlike stocks, you won't see gold paying out cash dividends, nor does it provide any free cash flow. If you think gold can outperform other assets, it literally has to be a supply and demand case. Either the supply decreases or the demand increases, and the price of gold will go up accordingly. Sounds a lot like technical analysis jargon, no? Stocks go up because there are more buyers than sellers...hmm... not much help.
However, the factors driving supply and demand are what truly need to be in question. We believe the demand of gold is driven primarily by two forms of demand: Speculative (investment) demand and end-user demand.
Don't let the name "speculative" scare you away. In spite of popular opinion, there is nothing wrong with speculation. Often speculation can bring more liquidity to markets and undoubtedly has made many fortunes.
In this instance, gold has exhibited many "greater fool" tendencies and the making of a bubble. The aggregate demand for gold has fluctuated, but there's a clear relationship between the price of gold and the tonnage allocated to investment.
|Third Quarter Gold Demand|
|Avg Price (USD $)||1260.83||1702.12||35.0%|
|Source: World Gold Council|
Without question, gold bars and gold coins, along with jewelry are driving the majority of the new demand in gold. In the third quarter of 2011, for instance, demand for gold in dollars increased by 35%, while real tonnage demand only increased by 6%.
But there's going to be some tremendous inflation
At least in the near term, we believe the odds of rampant inflation touted by several pundits and gold bugs are grossly overstated. While the Federal Reserve has been "printing money," inflation has hardly budged. After a brief commodity spike, inflation was minimal in 2011. One might even expect a more rapid increase following a large decline in the CPI, but rampant inflation has yet to hit. Assuming Bernanke continues to target inflation at 2%, we think he'll take the precautions necessary to prevent high inflation when economic growth accelerates.
The total money supply in the U.S. economy (as measured by M2) has grown exponentially, but it appears the Keynsian Liquidity Trap Theory has held up pretty well. The demand for money has remained flat, even as the money supply expands rapidly. Fed Chairman Ben Bernanke's recent comments about keeping interest rates low for some time confirm that the Federal Reserve isn't expecting any inflation. We think the Fed is more concerned about preventing deflation that could absolutely destroy a deleveraging economy.
Oversupply could be on the way
Commodity cycles are susceptible to the animal spirits just like any other asset class. With the price of gold up almost sixfold since the turn of the century, previously unprofitable mines are now ripe for harvesting. Per ounce costs of $500+ were unattractive not long ago, but are now considered highly profitable.
We think increased supply should continue to hit the market as long as the price of gold remains high. However, this means that if the price falls, the real balance of supply and demand will lead to a lower price. Producers of commodities have shown themselves to be incapable of moderating supply in times of robust pricing, and we think gold could easily fall prey to the same trap.
What's the real demand for gold? If we net out jewelry, the real demand isn't much. Real demand for gold varies, but end-uses can include electric wiring, semiconductors, cloth lining, and inclusion in vodka. However useful it is, producers tend to substitute away from gold when suitable replacements exist and are cheaper.
The real intrinsic worth of gold is nearly impossible to determine. There's no way to know what the price would be in a perfectly free market. But we suspect, given the large amount of investment and speculative demand, that the price would be considerably lower than it is today.
As Warren Buffett recently said in his annual letter to shareholders:
Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce - gold's price as I write this - its value would be about $9.6 trillion. Call this cube pile A.
Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (XOM) (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
We completely agree. An ounce of gold will never be more than an ounce of gold, but investors will continue to receive output from smart equity investments (and farms for that matter). Unfortunately, gold has no magical powers, and we think farms, food, water, and shelter make much better doomsday hedges. We're not gold bulls or bears, but gold, itself, doesn't fit well with our investing philosophy.
Our Gold Mining Coverage Universe
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Barrick Gold (ABX)
Yamana Gold (AUY)
Eldorado Gold (EGO)
Goldcorp Inc. (GG)
Gold Resource (GORO)
Kinross Gold (KGC)
Newmont Mining (NEM)