Gold is insurance, not a market bubble

I’VE been at pains over the past couple of months to reinforce the underlying strength in the gold market, despite enormous financial uncertainty in the world economy.

While gold did fall rapidly from an all-time high of $US1920 per ounce to a low of $1531/oz, we predicted the recovery would be solid and sustained. And that’s exactly what we’ve seen – which provides reassurance for all gold investors.

In the aftermath of gold’s recent plunge, I said the metal would likely form a base around $1600/oz, which is the metal’s long term trend line. Gold is now consolidating between $1750 and $1800/oz, and given the ongoing scale of European and global credit uncertainty, the next step for gold appears to be a move comfortably back above $1800/oz over the next few weeks.

It’s already been a remarkable resurgence by the precious metal. During the June quarter, it had rallied by more than 25% to $1920, so the subsequent fall had to be seen in this context.

The important thing about the recent price correction and the aftermath of the global financial crisis in late 2008 is gold has been sold because it is a profitable asset. It is being used to fund losses on declining assets elsewhere in investors’ portfolios, like equities. This means gold has undergone a large degree of forced selling.

However the metal’s fundamentals remain sound due to the extremely high level of macroeconomic, systemic and monetary risk, while the technical picture also appears to be improving. Gold’s recent price retreat has flushed out fresh buying.

And gold’s allure isn’t being harmed by the ongoing spectre of negative real interest rates in the world’s major economies. Last week the US Federal Reserve left its federal funds rate in a range of 0-0.25% and European Central Bank’s interest rates remain at 1.5%.

The degree of denial regarding the ramifications of the crisis is akin to that seen prior to the bursting of the property bubble in 2007. Investors have indeed been lulled into a false sense of security.

As we’ve discussed, growth in the US economy since the early 1980s was based on easy credit – low interest rates, high consumer spending and asset inflation.

As a result, the money supply over the past two decades spiralled violently out of control and it is now an almost impossible job to rein it in. What’s even harder is curbing the credit mentality and high levels of debt without a serious amount of economic pain for everyone within the international economy.

Ironically, the solution to the problem seems to be more of the same stuff that got us into the mess in the first place – near-zero interest rates and high government spending.

The currency trashing that is currently occurring as a result of profligate economic policies means gold investors are best positioned to benefit. Prices of more than $2,000/oz are inevitable in 2012 and prices as high as $5,000/oz are certainly within the realms of possibility within the next five years as a result of low interest rate policies being pursued by governments and toxic levels of bank debt. There’s every chance of $100/oz silver spot prices within the next few years. In fact it’s virtually inevitable.

The key message is to stay away from banks (now matter how cheap they might appear, how safe some might appear to be and how attractive their yields might be) and instead invest in gold and gold equities, along with silver and silver equities.

Some of the key explanations for gold equity underperformance include:

• Investor nervousness about equities generally
• Higher risks associated with gold equities (operational issues)
• Influx of funds into ETFs which previously would have gone into gold equities
• Rising price of gold has been accompanied by rising production costs for gold miners

Gold is the ultimate insurance policy and should form part of your investment portfolio. In addition, its track record over recent years is at least equal to virtually any other asset class, so it won’t only save you money but it can make you money as well.

And let’s not forget the traditional seasonal boost to gold demand provided by Dhanteras and Diwali, the season for festivals and weddings. In India, gold prices have surged by more than 30% so far this year, compared with gains of just 15% in the share market. This is clear proof of gold’s capacity for value generation as well as wealth preservation.

The thing about the rise of gold is that it in no way represents a bubble. While prices have regularly hit record highs, the increase has been solid and sustainable, driven by broadly-based investment demand over a period of more than a decade now.

The rise of the gold price in recent years does not resemble the magnitude of previous asset bubbles, with gains just a fraction of those seen during the NASDAQ bubble in the 1990s.

The recent gold price correction brings gold prices back to their 10-year growth trend, with little evidence to date that prices have witnessed the exponential gains associated with recent financial market “bubbles”. And the rationale for holding gold is just as compelling now as any time over the past decade.