Mark Twain once wrote “A gold mine is a hole in the ground with a liar on top.”
While that may be true in certain instances, the hole investors should be most concerned about is the one with Helicopter Ben Bernanke standing proudly on top – the cavernous hole in household net worth created by the bursting of the Greatest Credit Bubble in our history. Our current Chairman of the Federal Reserve, trapped by Milton Friedman’s view of the Great Depression, and aided by the most aggressive fiscal policy we’ve ever experienced, has promised to resort to all means necessary to reflate this burst bubble and refill the gaping hole in credit, primarily through a policy referred to as “quantitative easing” – a fancy term economists coined for “printing money”.
It is safe to assume that if our Fed Chairman is determined to debase the currency, he will succeed. Historically, gold has rallied in the face of geopolitical instability or inflation, but we don’t believe either is necessary to drive gold prices higher today. Gold should move higher because investors throughout the world are become increasingly apprehensive holding fiat currencies. At home, the size of the Fed’s balance sheet is exploding, and the impact is clearly seen in the Dollar’s Dive. But unprecedented global monetary and fiscal stimulus around the world, have created a sea of liquidity to offset the deflationary forces associated with deleveraging. Investors, who are by definition net long in paper currencies, will increasingly look for insurance in the form of gold.
Undoubtedly, our favorite View from the Blue Ridge is looking down on Wall Street analysts chasing immaterial changes in corporate earnings or economic indicators. Perhaps our greatest advantage is being nestled away in the mountains of North Carolina, where we are better able to focus on the big shifts and important trend changes that drive markets over the long term. We believe it is here, that the greatest opportunities lie. Let’s take a quick look at such shifts in the supply and demand picture for gold:
The official sector became a net BUYER of gold in Q2-09, a significant change of heart for a market accustomed to absorbing substantial volume by central banks over the last two decades (see chart). Note that this shift was largely due to a sharp decline in sales from the Central Bank Gold Agreement but purchases were sufficient to push the sector into positive territory. We think it is likely that purchases continue for the foreseeable future as concerns surrounding the Buck’s status as the world’s reserve currency continue to mount.
China and a growing number of large holders of our increasingly worthless Treasuries have been increasingly vocal about their concerns for the almighty buck. The State Administration of Foreign Exchange announced this year that China boosted its gold reserves to 1054 tons. A trend we expect to continue. To put this figure in perspective, consider that this investment represents 1.9% of China’s $2.1 trillion in reserves. The US, for example, holds 77.4% of domestic reserves in gold. The Euro Area comes in at 59.7% whereas the global average is 10.3%. It’s not hard to imagine the impact that Chinese purchases would have on a gold sector with total supply and demand of roughly 3500 tons over the past three years.
We’ll assume for a moment that most investors understand the potential for significantly higher demand for gold as discussed above. So naturally, the next question we should be asking concerns supply. Surely, as gold prices have risen from a low around $250 per ounce in 1999 to today’s price over $1000 per ounce, miners have aggressively expanded production to maximize the gold they can sell at all time highs, right? Wrong. Gold production has steadily declined annually, since gold prices bottomed around the turn of the century (see chart).
Since rational miners (note we are talking miners here, not investors) would logically aim to sell more gold at higher prices, we can only assume that they cannot find more gold, or it is much harder to find and taking them a lot longer to increase production. Either way, until we begin to detect shifts in these underlying secular trends, we will ignore the short term noise in daily gold prices, and refer back to the most fundamental concept in economics, which even Helicopter Ben and his trusty sidekick Timmy can understand – increasing demand, plus declining supply, equals higher prices.
Disclosure: At the time of publication, author was long streetTRACKS Gold Trust Shares, Market Vectors Gold Miners and iShares Silver Trust, although positions may change at any time.