Why Gold Is Not a Dead-Money Investment

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With the resurgence of the United States economy, I keep hearing one recurring opinion: “The precious metals sector is dead.” I respectfully disagree. I imagine gold and silver would not have been around for millennia while fiat currencies have come and gone if the precious metals could somehow be “killed off.” I’m often asked, “Why are the precious metals worth anything?”

True, as a society, we come together in a social contract to apply value to currencies, which are established and maintained by governments, central banks, etc. As a philosophical point, if you think about it, anything could be a currency or a store of value. Recall that bartering was a successful economic approach for many years, and it was the basis for communities developing. People of varying trades came together to form a cohesive mutually beneficial existence. The farmer bartered with the blacksmith, who bartered with the trapper, who bartered with the tailor, etc. Currencies just became a standard form of said barter or a universal bartering tool.

But in theory, we could come together as a society and put an intrinsic value on anything. For all of recorded human financial history, we have come together as the human race and chosen gold and silver as precious objects. That will not change in our lifetime despite any argument the bears may make. In fact, in this article I will present supply and demand data, historical bull market information, and insight into a key component of the metals market, the miners, which could indicate that gold is only taking a breather.

Historical gold bull market

For millennia, the place of gold and silver has been to serve as stores of value. They protect wealth better than any other investment. Look what happened in the 1970s, when we came off of the gold standard and allowed private ownership of gold. Investors, the rich, and middle class and working class alike piled into the metals. At the beginning of the 1970s, gold was at $35 per ounce. Ten years later, the price stood at $870 per ounce. This is a percentage gain of 2,485 percent. In contrast, during the same time the Dow Jones Industrial Average increased from 809 to 839 points. This represents a total gain of 3.7 percent; not per year, but for the whole decade.

Following this bull market, gold entered a 20-year decline/holding pattern with bouts of bearishness. For those calling the metals dead, they see history repeating itself. They believe we are entering a bear market once again. I contend this is incorrect despite the decline in prices over the last six months. Gold and silver got a little ahead of themselves indeed, but they are in no way dead, and I believe the bull market is simply taking a break. The difference between the 1970s and now is that we have little to no inflation. There are fears of deflation.

Further, big money has been dumping the metals to get into stocks. This is unlike what happened at the end of the 1970s, when inflation was high. Inflation will eventually pick up once more, which will be good for gold and silver. The jury is out on whether all of the quantitative easing that has occurred will lead to hyperinflation. For now it is at bay but is one reason gold and silver are worth purchasing. What I find fascinating is that today there is much higher demand for the metals compared to the 1970s and only a finite supply of each, particularly silver.

Gold demand

Demand for investment gold is very strong. Last year, the U.S. Mint ceased production of the one-tenth ounce American Gold Eagle because of high demand. This was a sign of record buying, but what is more interesting was a recent World Gold Council report that focuses the demand worldwide. Highlights from the report include continued strong demand in jewelry, particularly in India.

The report also suggests a decreased demand for investment gold, but further investigation reveals that the decline in investment demand relative was solely attributable to the net outflows from ETFs, which obscured the strong rise in investment demand for gold bars and coins at the retail level. In technology, demand has been stable, holding around 100 tons over the last year and a half. And the central banks? They continue to add, taking advantage of depressed prices. Supply has been around 1,050 tons of gold quarter to quarter, but is not rising.

Production is barely keeping pace with demand. It is painful to be a holder of gold, particularly if you have purchased in 2011 or 2012 as the value decreases while demand is so high. However, for the long term, it is worth holding onto your metals or buying at these levels despite the fear that is prevalent in the market. If central banks are huge buyers at these prices, it would not be illogical to purchase some, as well. Besides severe inflation or a collapsing dollar, what could drive prices higher given that we already have high demand?

The role of mining

With the devastating selloff that began in gold in October 2012, the sector is now being avoided like the plague. However, these same miners could support gold and silver prices. Looking to production cost for gold as an indicator, which relies on several factors and varies globally, a ball park average to produce one ounce of gold is about $1,100. The all-in costs of production vary by miner, but with gold around $1300, cost is a major issue.

Some gold miners, particularly those in Africa and Latin America, are underwater, paying more to produce gold than they can sell it for. It should be noted that the majority of silver miners will now operate at a loss, as well. This has major implications.

If the gold price remains close to or below production costs for a long period of time, it will cause great change for the industry because costs are only seen going higher. These companies have been cutting costs to the bone as metal prices have declined. In order to stay in business, higher gold prices are required to make gold mining profitable compared to previous prices. What we will likely see is smaller miners slowing production or even going out of business. There may also be a lot of acquisition in this period while stock prices are depressed. Mergers cannot be ruled out, either.

If gold prices continue to fall, the situation will be unsustainable. If production goes offline, demand would have to drop off for prices to remain depressed. The information I present above suggests that demand will only increase over the years, especially in technology. Thus, either gold had put in its bottom or prices will decline further, which could result in a major supply-and-demand imbalance in the next few years. Both of these scenarios are likely, and both are dependent on what happens with the miners. However, in either case, gold is very attractive at these price levels.

Looking ahead

The U.S. recovery and global commerce seem to be ramping up, which is an issue for the metals, no doubt. There have been both fundamental and technical reasons for gold’s selloff in the last two years. A large driver of the move in gold prices was that major money moved from the metals and into equities. Keep in mind that if this fragile economic rebound falls off track, people will be looking for safe havens. On the other hand, growth isn’t necessarily bad for the metals, as it could lead to some much desired inflation, which always helps metals.

I cite a lot of data on demand above. The appetite for gold appears undiminished in China. China’s largest gold producer, the state-owned China National Gold, anticipates gold demand in China as likely to exceed 1,000 tons this year. While demand isn’t going anywhere, for the next few quarters it would be prudent to watch the miners, as they are an integral component to what happens with gold prices in the near- to mid-term future. At these levels with recent stabilization in prices, gold is at an attractive entry point for those on the sidelines.

Disclosure: Christopher F. Davis is long physical precious metals and owns stock in several gold mining companies.

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