Looking past near-term turmoil and gold market weakness

So apparently the gold bubble has burst, at least according to the media. The weakening value of gold over the fortnight in particular has led to a rash of negative comments with respect to the metal’s future. One really has to take a step back and put a commodity’s price fall into its proper perspective.

Gold is 12.0 per cent weaker (or US$226.90 in price terms) than it was a month ago, but by the same token the metal is still 25.7 per cent higher (or US$338.70 in price terms) than it was 12 months ago, even accounting for the latest price correction. As the price chart below clearly demonstrates, it’s hardly a matter of the gold bubble bursting.

The graphic demonstrates a steady climb in the price of gold (black line) for the past five years, although prices have surged over recent months. What we are seeing is a price correction that is indeed healthy for the market. And of course it’s clearly evident that there was a similar correction back in the latter part of 2008.

 

These types of corrections are normal and not unexpected. Since the start of the quarter, gold bullion had rallied by more than 25% to its recent record high of US$1,920 on the back of investor nervousness. At US$1,600 gold has merely reverted back to its trend-line.

The graphic also reflects one of the major anomalies of gold’s strong price run since late 2008 – that being the corresponding underperformance of gold equities. The gold line above represents the Philadelphia Gold Index. What’s apparent is that during the immediate sell-off in the wake of the GFC, gold (like everything else) was hit, hard but gold equities were hit even harder.

And gold equities have maintained their relative underperformance since late 2008 until now. In fact, the performance divergence is once again growing.

What this means is that investors have remained somewhat nervous about equities of all types since 2008. Whilst gold equities should naturally benefit from the strong underlying performance of gold, investors have remained nervous about share market exposure. Hence, they’ve opted for the relative safety of physical gold rather than investing in gold stocks.

The important thing that investors have to understand about the recent gold price correction and the correction back in late 2008 is that gold has been sold off because it has been a profitable asset.

It has effectively been utilized as a source of funding for margin calls made on declining assets in investors’ portfolios, like equities. This means gold is effectively undergoing forced selling.

Many inexperienced investors and market-watchers have an unrealistic expectation of how gold performs during a crisis. Gold, like everything else, gets sold down during the midst of a crisis as desperate investors attempt to raise cash. During the GFC this amounted to a 25% price fall for gold, from which the metal both strongly and rapidly recovered.

This time around it’s been a fall from a high of US$1,920 to a low of US$1,531 on 26/9/11 (a fall of 20%), but the price has already rallied more than 8% (or US$129 in price terms) from that low. Again, you have to stand back and judge gold’s performance over a period that’s much more representative than merely just a few days.

When you do this, a la 2008, you do get an appreciation that gold indeed does retain and deserve its safe-haven status.

It’s also worth examining a long-term gold price chart that highlights the relative inactivity in the metal during the 20-year period between 1980 and 2000. In fact gold averaged US$400 during this period.

 

It’s little wonder that some investors have had trouble grappling with the concept of a rising gold price, given that modern history taught them that gold never moved much and was a poor investment performer.

Over the next few months it is likely that the US$ will retain its strength and that the price of gold will underperform for the time being, in a scenario similar to that post-GFC. This provides a period of consolidation for gold and a buying opportunity for investors, before the next upward leg in gold’s price climb. US$1,600 in my view is the critical gold buying level for investors.

Market disenchantment with the US Federal Reserve’s Operation Twist and the likely clambering in some quarters for some form of additional fiscal stimulus (potentially QE3) to help resuscitate the ailing US economy, are all factors that are likely to kick-start the next phase of gold bullion’s price ascent.

As a result, I’m maintaining my positive outlook on gold and gold equities.

Gavin Wendt is the founder of MineLife, publisher of the MineLife Weekly Resource Report