Gold Price And Monetary Base: A Bullish Case For Gold

Includes: GDX, GDXJ, GLD
by: Disruptive Investor

Gold has corrected 12% after peaking at $1,895 in September 2011. I discussed the reasons for expecting a further correction in gold in one of my earlier articles. For the long term, I remain bullish on the precious metal. However, there are many analysts who believe that gold peaked in 2011. Just as an example, I read one bearish view on gold yesterday on Seeking Alpha. In this article, I will discuss the relation between gold prices and the monetary base. Related to this factor, I will discuss the reasons for being bullish on gold for the long term.

According to the Federal Reserve Bank of St. Louis, Monetary Base is the sum of currency (including coin) in circulation outside Federal Reserve Banks and the U.S. Treasury, plus deposits held by depository institutions at Federal Reserve Banks. In other words, the monetary base is M0.

I am discussing the relation of gold prices to the monetary base as it can be considered as one of the best indicators of a restrictive or accommodative monetary policy by central bankers. Investors can therefore, see the impact of expansionary monetary policies on gold by plotting the monetary base with the price movement of gold.

To make my point clear, I would like to present two charts below. The first chart shows Japan's monetary base, while the second chart shows gold prices in Japanese yen.

In looking at both charts, it is very clear that the gold price has surged in Japanese yen as expansionary monetary policies were pursued in order to bring about Japan's great reflation. I must mention here that gold prices will continue to surge in yen terms, as the Japanese central bank is becoming more aggressive on its monetary policies. The chart below shows the planned asset purchase program by the Bank of Japan, and underscores my point above.

Coming back to the relation of gold and the monetary base, the monetary base in Europe and gold prices in euro terms also reflects the same trend -- gold prices trend higher with an increase in the monetary base, and trend lower with a decline in the monetary base. The two charts below clearly show the trend I am talking about. I have chosen the euro area monetary base, as it has declined in the recent past, and this counter trend is also evident in gold prices in euro terms.

Through these charts, I am certainly not suggesting that the monetary base is the only factor in determining the trend in gold prices in different currencies. Certainly, these charts show that expansionary or restrictive monetary policies are one of the critical factors in determining the price of gold in different currencies. The ongoing currency war will benefit gold in the long term as countries look to devalue their currencies to be more competitive globally.

If one looks at the trend for gold in dollar terms and the U.S. monetary base, a similar trend emerges. I showed this in one of my earlier articles, which offered a detailed analysis for gold from a fundamental perspective.

The critical point to consider here is, will the monetary base continue to expand for advanced economies?

I am of the opinion that the monetary base will continue to surge as central bankers pursue long-term expansionary monetary policies. Be it the demographic factor, leverage factor, or the diminishing impact of debt on advanced economies, all of these point to sluggish long-term growth. In such a scenario, the monetary base will certainly continue to expand. I had discussed (in detail) the reasons for believing the advanced economies will witness long-term sluggish growth in one of my previous articles.

Considering these factors and the relation between gold and the monetary base, investors can consider long-term exposure to the precious metal on every correction. Over the long-term, gold has the potential to outperform many asset classes. The best way to consider exposure to gold would be physical gold. Investors can also consider the following options:

SPDR Gold Shares (NYSEARCA:GLD) - The investment seeks to replicate the performance, net of expenses, of the price of gold bullion.

Investing in gold mining companies is also a good option at a time when gold prices are expected to trend higher, and gold mining companies are making significant operating level profits.

The Market Vectors Gold Miners ETF (NYSEARCA:GDX) is a good investment option for the long term. The ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The ETF holdings have an attractive P/E ratio of 10.2, and an equally attractive price to cash flow ratio of 5.3.

The Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) is another good long-term investment option. The ETF seeks to replicate, net of expenses, the Market Vectors Junior Gold Miners index. The index tracks the overall performance of foreign and domestic publicly traded companies of small- and medium-capitalization that are involved primarily in the mining of gold and/or silver. Therefore, the risk related to exposure to GDXJ would be relatively higher as compared to GDX. The ETF holdings have an average P/E ratio of 9.0, and an average price to cash flow ratio of 2.2.

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.