How to Understand Gold’s Mixed Signals

Source: Thinkstock

Source: Thinkstock

Gold prices closed last week at just under $1,300/ounce. This has been a very important level psychologically, and as the market trades below it, the bears are becoming more confident in their position. Analysts from Goldman Sachs and Credit Suisse continue to assert their belief that the gold price is going to fall to $1,050/ounce or lower as the economy recovers and as investors sell out of gold in order to buy stocks.

This negativity, however, is extremely bullish. It wasn’t that long ago that the gold price was $400 – $500 per ounce higher and that analysts from these firms were claiming that the gold price would rise to $2,000/ounce, or even as high as $2,500/ounce. Investors need to be contrarian in order to be successful, and it seems more and more that the contrarian position is to be bullish of gold, not bearish. Thus, I think that while the near term pain may not be over in the gold market that there is far more upside potential than downside potential, and investors should consider buying.

Bears like to point to several factors for their position. The first is the recovering economy. They claim that this will push investors into stocks and out of gold. But investors, especially in the United States, hardly own any gold. It became a somewhat mainstream investment in 2010 and 2011, but that’s about it. If you pick up any literature on portfolio management it is likely to say that investors should hold a balance of stocks and bonds that is determined by the age of the investor — the older and more risk averse you are, the more bonds you should hold, and the younger and more aggressive you are, the more stocks you should hold. Some investment advisors will recommend a 5 percent – 10 percent gold position as an “insurance policy.” But despite the fact that gold has been an integral part of the Western monetary system for centuries it has virtually no role in the modern portfolio.

So, in short, there are no investors to sell gold in order to buy stocks. There are a few who were late to the party in 2010 – 2011, but that’s it. Those who held gold before then are people who have been in the market for many years who understand its monetary role and the fact that fiat currencies will lose value over time even if they haven’t lost value in the recent past.

The second is the ridiculous notion that gold has no fundamentals, and that it is just a psychological trade. First of all, even if this is the case, then it would make sense to buy gold now because gold sentiment is very negative — especially in the West. But more importantly, gold most certainly does have fundamentals. Fundamentals boil down to supply and demand. How much gold is being produced, how much is entering the market, and how much gold do people want? The fact is that while American’s don’t want gold, the Chinese, Indians, Arabs, and Russians are stockpiling gold. This is taking place both at the central bank level and at the civilian level. Demand in China alone last year was about half of global gold production, and while Indian demand fell due to high gold import tariffs, these are being rescinded and investors are coming back.

Meanwhile, supply is down. Central banks, which used to be supplying gold to the market, have gone from being net sellers to being net buyers. Furthermore, mine supply is down because prices are down. There are several mines that are uneconomical at $1,300/ounce gold. Several companies are reducing production in order to focus on only the highest grade deposits. Thus, it follows that the fundamentals for gold are very strong.

Third, investors like to argue that gold didn’t go up during quantitative easing, and that therefore an increase in the money supply is not bullish for gold. But now that there is a tapering of quantitative easing the gold price should fall. Investors fail to realize that just because an asset’s fundamentals improve doesn’t mean that this improvement will be reflected in its price. Markets aren’t mechanical like that. A company can be growing its earnings and its dividends while still declining in price. That doesn’t mean that rising earnings and dividends is bearish for an asset. It just means that the asset in question is offering better and better value as it falls. The same can be said about gold. Lots of investors bought gold in anticipation of inflation and quantitative easing. When they didn’t get the market reaction they wanted, they sold, and this created downward momentum and increased bearishness in the gold market. Ironically as tapering has begun gold seems to have found a bottom, and the gold market fails to decline significantly on days in which additional tapering is announced.

Ultimately, the gold market has been extremely difficult to navigate. That is because there have been several mixed signals coming from the gold market, especially in its reaction to the Fed’s loose monetary policy. While the bottom may not be in yet the upside potential outweighs the downside potential, and bearishness should be bought, regardless of what the so-called experts are saying.

Disclosure: Ben Kramer-Miller owns gold coins and shares in select gold miners.

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