The Gold Rush

The global credit crisis has left investors feeling drained and devoid of investment options. In such trying times, gold offers a glimmer of hope. Kiran Kabtta and Devangi Joshi tell you why...

TILL RECENTLY, all was well with the world. The markets surged, property prices soared and a bull run was underway in commodities. However, things changed dramatically as Wall Street felt the tremors of an unprecedented credit crisis.
    Now, the markets are in a mess, real estate prices are weakening and the bull run in most commodities has been stifled. Short-sellers are scrounging the market to spot the next target, while investors are questioning every instrument. For those sitting on cash, the market looks singularly uninviting.
    Amid all this action, gold is one asset that has seen a sharp rise in prices. This indicates that more and more investors are shifting from stocks, bonds and derivatives to gold. The yellow metal has suddenly become a safe haven. International gold prices have risen by more than 17% to $870 per troy ounce in less than a fortnight, and there are factors that indicate the bull run may continue. The credit crisis seems to have triggered the gold rush of the year. Here are some reasons which make us so bullish on the yellow metal: The Turmoil And Beyond...
Gold has traditionally been considered as a hedge against uncertainties, financial crises and inflation. The current uncertainty has already spurred buying interest in gold. This was evident on September 17, '08. As the US Federal Reserve promised fund injection, gold logged its biggest advance ever — soaring $120 within 24 hours to $900, beating the $85 daily gain recorded during the bull run of January 1980.
    Roy Jastram in his classic book, 'The Golden Constant' (1977), studied gold prices from 1560 to 1976, examining gold as an inflation and deflation hedge. He analysed the purchasing power of gold over four centuries in the US and England and found it to be remarkably constant. He concluded that this constancy in gold's purchasing power was not because gold moves in tandem with commodity prices, but because commodity prices take a cue from bullion.
    Considering fundamentals, as per the supplydemand data compiled by the World Gold Council (WGC), the supply of gold has remained fairly stagnant over the past few years. Mine production has declined gradually, while net sales by central banks have slowed down. However, higher inflation has lowered the spending on gold jewellery — which is the largest source of demand for the yellow metal. Instead, investment demand has steadily risen over the past three years. The increasing popularity of exchange-traded funds (ETFs) is contributing to investment demand. While high prices may curtail jewellery demand, it will still woo investors looking for safe returns in troubled times.
    International analysts expect gold prices to rise beyond $950 by the end of the year, as central banks and mining companies hold back
sales and investors buy the metal as a haven against falling equities.
Blowing Hot, Blowing Cold
Gold follows a recognised seasonal pattern of rallying between August and January. An international study based on a 30-year analysis of gold price data shows that the seasonal lows occur in March and June. The period between May and mid-August is generally quiet. Join The Glitterati
AT TIMES, after June, a secondary low is experienced in August. This secondary low is usually a little higher than the primary low. Investors who don't buy during the June low usually take advantage of this last opportunity before the Christmas rally starts. Our analysis of average monthly gold prices since '01 shows that barring '06, gold prices have always rallied from August to December.
    And the current market conditions may support yet another sustained rally in gold. This year, gold prices weakened between mid March and early May. This was followed by a sharper correction from mid July till September 10. From an investment perspective, the latest correction may be viewed as a temporary setback. More so, since it tracked the seasonal trend.
Dollar Designs
Gold, as a commodity currency, shares a strong negative correlation — as much as 85% — with the US dollar. Hence, keeping a watch on the dollar is crucial for someone who tracks gold prices.
    The dollar has been slipping since '02. It has witnessed some pullbacks since late July against major currencies like the euro and sterling. This strength in the dollar was partly due to a decline in the US trade deficit from late '07 till early '08.
    The dollar has again shown a rising trend from April '08 due to the sub-prime related credit problems. The trend is now expected to continue on the back of huge infusion of public finds to rescue the US banking sector. This is once again likely to raise the US trade deficit and put pressure on the dollar.
    Till last month, data released by the US showed some degree of resilience. Consumer spending and business inventories were holding steady, fanning hopes of a recovery in the US gross domestic product (GDP). Non-farm payrolls had contracted for seven consecutive months, but the rate of decline was stabilising. All this, coupled with the US Federal Reserve's inclination to tighten monetary policy in view of higher crude oil prices, gave a boost to the US currency.
    Come September and the meltdown of some of the biggest US banks has changed the picture for the US economy and hence, the greenback.
    The layoffs at major financial institutions will raise the US unemployment rate considerably, while consumer spending and consumer sentiment will decline noticeably. As a result, non-farm payrolls are expected to further decline sharply.
    The Fed's massive $700-billion bailout plan to rescue the US banking system is likely to push the country's fiscal deficit to its highest level in over a generation. If the plan is approved, US national debt is expected to rise to around 75% of the GDP, making it one of most indebted nations in the developed world. This will further endanger the value of the dollar versus other major currencies.
Gold Vs Black Gold
Historically, gold and crude prices share one of the strongest relationships. Higher crude prices push up inflation, enhancing the appeal of gold as an inflation hedge. Simply put, their key relationship is represented through a number called goldoil ratio (gold price divided by oil price). The 33-year historical average for this ratio has been around 15, indicating that 15 barrels of oil can buy an ounce of gold. This ratio signals buying and selling opportunities in the two commodities.
    The gold-oil ratio has been weakening since the beginning of the year. Currently, this ratio is hovering around 8.3, indicating that around eight barrels of oil will buy an ounce of gold — much lower than the historical average of 15 and a more recent 10-year average of 10.4. If the number has to move closer to the historical average (or 15), either gold must rise or crude must fall, or both conditions must be fulfilled.
Ride The Volatility
For those who are convinced of a bull rally in the yellow metal, the current volatility in gold prices offers an attractive opportunity to enter at lower levels. Though jewellery has been the traditional preferred mode of investing in the yellow metal, gold ETFs are gaining in popularity, as the purity of the metal is not an issue here. Moreover, since the fund's net asset value (NAV) is linked to global prices, the pricing of gold ETFs is transparent.
    (With inputs by Bakul Chugan)
    kiran.kabtta@timesgroup.com