Gold: Still Cheap Despite New Record High

Includes: DGL, GLD, IAU
by: Adrian Ash

"Gold feels frothy today," wrote Société Générale analyst Dylan Grice in a detailed report, "but [last month's] Indian purchase of IMF Gold eerily parallels the French purchases of the late 1960s. And ill policy winds are blowing in gold's favor."

The gold price leapt in the professional market to yet another all-time Dollar high early in London on Wednesday, coming within 50¢ of $1150 an ounce as global stocks held flat on the MSCI World Index.

The price of gold in both Euros and Sterling also jumped once again, hitting the highest level since Feb. 25th and recording a London AM gold fix within 2.0% and 1.3%, respectively, of the all-time highs set one week earlier.

Can this dumb lump of metal get any livelier?

Well, claiming that "there is a case for gold being 'cheap' at current prices," thanks to what Grice calls the "market displacement" of huge monetary expansion worldwide, he believes the gold price has yet to undergo four further stages of a "Minskian mania" – boom, euphoria, crisis and, finally, revulsion.

Encouraged by India's decision, "We've had the displacement and are only now entering into the boom phase," says SocGen's behavioral analyst, who replaced James Montier at the French bank's London strategy team in September.

"The mania phase lies well ahead. But that is a long way off."

Market historian, merchant banker and professional doomster Martin Hutchinson concurs in his much-respected and ever-excellent column at Prudent Bear this week, claiming that with gold decisively above $1000 an ounce, "The opportunity for the world's central banks to change policy and affect the economic outcome has been lost. The world economy is now locked on to an undeviating track towards another train wreck."

Hutchinson sees a repeat of 1978-1980 now unfolding, with the price of gold vaulting to perhaps $5000 an ounce by the end of next year.

"If expansionary monetary and fiscal policies are pursued regardless of market signals," says Hutchinson, "the US will head towards Weimar-style trillion-percent inflation...As I said, a train wreck. Probability of arrival: close to 100%. Time of arrival: around the end of 2010, or possibly a bit earlier. And, at this stage, there's very little anyone can do about it; the definitive rise of gold above $1,000 marked the point of no return."

Even London's more reserved, typically cautious "commodity-gold" analysts -- focused on the blunt numbers of demand and supply -- are sounding awfully bullish on gold right now, with this month's Fortis Financial Gold & Hedging Report from the VM Group announcing "Central banks to the rescue as dehedging draws to a close..."

"On average in the eight years since 2002, gold dehedging" – the reduction by gold mining companies of those forward sales they made when prices fell during the 1990s – "has meant an additional 374 tonnes of gold demand [per year]...more than South African gold production or US jewelry demand over the same period."

Now cut to barely 300 tonnes of outstanding forwards – and down by 90% from the peak of 2001 – the global hedge book of gold mining companies is as good as closed, says VM. That suggests the gold market has to find a new source of demand (or lose a source of supply) to remain stable.

But "central banks are a key player in gold hedging," the consultancy goes on, "as their [lending] gold makes it possible. Hedging equals gold flowing out of central banks; dehedging equals gold flowing back in...similar to when central banks sell or purchase gold.

"Importantly, although dehedging is now declining, net central bank gold sales have fallen even faster. In fact, 2009 is likely to see net central-bank purchases, meaning central banks continue to be net takers of gold off the market."

Noting India's official purchase of 200 tonnes of IMF gold in October -- plus news that the central banks of Sri Lanka and now Mauritius are adding to their gold reserves -- "It is the sentiment that matters" and not the size, says VM analyst Gary Mead in the latest BNP Paribas Fortis Metals Monthly.

"The bottom line is that the gold price rally has got everything going for it right now: Few official sector sellers, some official sector buyers, a low-interest rate environment, and a weak US currency.

"It's a perfect storm," he says – at least for bullish analysts. Yet there's still no rush to physical gold, despite what CNBC is saying. It's not even a rush into the ETFs either, despite the top-flight institutional analysis now urging fund managers to take a position. The trust funds have barely added anything since March. Coin-dealing premia also remain subdued, way below the true mania levels of this time last year.

Instead, this current rush into gold remains all in the derivatives, hence the importance of cheap money in Grice's analysis for SocGen. Speculators playing futures and options have never been so long as they've got during this 20% surge since Sept. 1st. And only gold as a leveraged, margined credit product – i.e. the opposite of what investors typically take it for – is driving this current phase of the nine-year bull run.

The trouble for would-be physical gold buyers, is what to do if the price doesn't "correct" as expected? Gold offered few "buying dips" during the six-month surge of 2007 and 2008, starting in Sept/Oct and running pretty much straight through to Feb/March. Lacking the cheap credit or balls to play gold on leverage, will more cautious investors chase it further after the leveraged hedgies have pushed it up? Or will they sit it out as talk (and evidence) of inflation & looming currency crisis grows?

All told, we spy yet more mischief from cheap money. Because the cost of insuring against today's credit-excess is being inflated by precisely the zero rates and money-printing that gold might be hoped to protect you against.

In short, if you think buying now feels a hard decision, what would you think 50% or 100% higher from here....?

Disclosure: Long physical gold