Is Gold Getting Too Expensive, Too Soon?

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Includes: EEM, GLD, SLV
by: Joseph E. Meyer

So long as the U.S. Federal Reserve intends to pump nearly a trillion more into the economy by buying Treasurys and filling the coffers of big banks, gold and its closely linked exchange traded fund, State Street's GLD, has a good 10% upside. We could see gold at $1,500 an ounce by year's end from current prices of around $1,368 for the October gold futures contract on Friday.

Some investors are starting to worry this week that we are all getting carried away with gold. The CBOE Gold Volatility Index rose 8% on Thursday and we saw small dips in gold prices during intraday trading on Friday. We are seeing massive volume spikes in GLD and the iShares Silver exchange traded fund (NYSEARCA:SLV), and volatility could take a bite out of these precious metals in the days ahead.

A more significant pullback is likely in the works and a good five percent correction should signal a buying opportunity for those who have yet to get into the precious metals market. Any investor who believes the dollar will get weaker on QE2 should be in gold and here's why.

  1. Global imbalances: The current trade imbalances will continue to worsen in the years ahead. Another $10 trillion will likely be added to the deficit over the next decade based on lackluster job growth in competitive export markets, and hard-to-beat low cost competition from Asia, mainly China. Our August exports were relatively flat. We have a record breaking $28 billion trade deficit with China, the maker of nearly everything our kids play with and everything we have hanging in the closet. (See here.)
  2. Monetary reflation: Fed stimulus isn't generating jobs. Neither has a near-zero interest rate policy. Washington's weak dollar policy is not helping exports much, either. Reflation is a way to fight deflation, or falling prices, by increasing the supply of money, lowering interest rates, and increasing government spending.
  3. Global foreign exchange reserves rising: According to the IMF, there is $8.42 trillion in global currency reserves held by foreign governments. The gold reserve ratio is next to nothing now, but wait a minute...
  4. Gold reserves are rising: China dominates the world's gold holdings, well into the trillions of dollars, followed by Japan and the major emerging market nations. Latin America countries, like Brazil, have gold as a reserve currency (around 1% of the total $250 billion in reserves) and India has around 6.6% of its reserves in gold. If these countries see the dollar weakening, gold becomes more attractive. They won't be massive buyers, but appetite will increase and this provides some decent support for gold fundamentals in the near-term.
  5. Investment demand doubling: In the second quarter of 2010, investment demand for gold as a hard asset nearly doubled from where it was in 2009. Indeed, State Street's GLD started 2009 off at $84 a share. In the physical market, worldwide production rose just 25% from where it was way back in 1990 to 2,500 metric tons. Gold supplies are flat, while demand is up (see here).

The precious metals are now in the strongest seasonal time of the year. But gold futures could correct down to the current 200-day moving average of around $1,186.98 per ounce level, or the 50-day moving average of around $1,268.68. Correcting down the 200-day is plausible and could signal a buying opportunity if weak dollar consensus persists. The lower the futures go, of course, the lower GLD, the gold-linked ETF, will go.

In silver futures we could see a correction in price back down to the 50-day moving average in prices, which is currently the $20.30 area.

If demand for gold continues to rise as production stagnates, and if sovereign wealth funds and the global currency reserves of governments allocate just 1% of the nearly $9 trillion in reserves to gold, then this precious metal can double in price in the long run. The bull market in gold might just be in its teen years.

We all heard Goldman Sachs economists this week forecast gold to topple $1,650 by the end of next year, and a 17% overall increase in precious metals demand over the next 12. We might be wise to take that with a grain of salt. This is the same bulge bracket bank that forecast oil at $200 a barrel in 2008 when it was around $120, and never returned to those levels.

However, GLD and its poor cousin, the iShares Silver (SLV) exchange traded fund, have seen big gains year-to-date and are due for a cool down. State Street's GLD was up 25% as of Thursday's close. BlackRock's SLV was up 45.3% as of Thursday's close. Compare that to other big movers this year, like the iShares MSCI Emerging Markets Index ETF (NYSEARCA:EEM), up just 12.7%.

Wait for pullbacks and consider buying on the dips as a play against Washington's weak dollar policy. Whenever we hear central banks in the developed markets talk about increasing interest rates, then that will hurt precious metals because it makes bonds more attractive. We are not hearing that...yet.

Disclosure: No positions. Talk to your registered investment advisor before buying any securities. The securities named here are not buy or sell recommendations, but only chosen because of their newsworthiness or because of their steady, high volume.