etfguide $1,000/oz Gold - New Reality or New Bubble?

By Simon Maierhofer

'Gold represents tangible value, that's why a gold bubble is simply impossible.' If you think along those lines, you may want to consider the following:

1) After reaching a record high of $850/oz in January 1980, gold prices fell over 40% in two months. It took gold 28 years to reclaim the $850 level.

2) Many thought there could never be an oil bubble. Oil, similar to gold, is a limited resource. Oil production, just like gold production, has peaked. Therefore, oil prices were supposed to consistently move higher. Contrary to conventional wisdom, however, oil prices fell more than 77.5% from their July 2008 top to their February 2009 bottom. A similar drop would equate to a $229/oz gold bottom.

What is causing the gold rally?

Just as a car mechanic would want to find out what is causing a certain problem before making an estimate, investors should find out what caused the recent gold spike before making a buy/sell decision.

Deciphering the cause/effect equation will also shed more light on gold's future. Isolating the cause of gold's spike will also bring us a step closer to finding out whether $1,000/oz is sustainable.

Since gold, as other commodities, is traded in U.S. dollar denominated units, the fluctuations of the greenback may have a direct bearing on gold prices. If demand for gold truly outweighs supply, gold prices measured in various currencies will go up. If a weak dollar is causing higher gold prices, gold denominated in U.S. dollars will be the main or sole beneficiary.

As the chart below shows, dollar denominated gold has risen while euro denominated gold has been stagnant. Therefore, Gold's future seems tied to the fortune of the U.S. dollar.

Will the dollar continue to weaken?

Contrary to popular belief, our analysis shows that the greenback is about to start (or has already started) a sustainable rally. The government's efforts to re-inflate the U.S. monetary system should be outpaced by the amount of dollars destroyed by the continuation of the bear market. Here's why:

The US dollar is by far the most inflated currency. It is also the most commonly used currency in the world. As such, most of the debt - and toxic assets - in the world is US dollar denominated. As those toxic assets continue to deflate, US denominated wealth will continue to shrink.

The law of supply and demand teaches us that scarcity of any product results in higher prices. In other words, the fewer dollars in circulation the more valuable the remaining dollars will become. Not only are the amount of dollars in circulation already declining, the velocity of the remaining dollars is slowing as well. This means consumers tend to 'park' their dollars in savings account rather than spending.

In summary, a strengthening dollar will push gold once again beneath $1,000/oz.

$1,000/oz gold - a foregone conclusion

At no other time in history have investors been as bullish about gold as they've been over the past 18 months. The SPDR Gold Shares (NYSEArca: GLD - News) had net inflows of 347.21 metric tons in just the first quarter of 2009. Globally, gold ETF holdings have surged 42%, or 16 million ounces, since the beginning of 2009. Gold ETFs now hold a total of 54.23 million ounces of gold. This is almost as much as last year's total world production.

Bullion purchases for 2008 reached 862 metric tons, twice as much as in 2007. The US Mint, the federal agency in charge of making America's coins, has had to step up its production as well. This year's sales have already exceeded the 794,000 American Eagles peddled in all of 2008 by a large margin. Earlier this year, it had to freeze sales of some of its gold items due to an order backlog.

Not only are investors feeling jolly about gold, major corporations are too. Barrick Gold, the world's biggest gold producer, just announced that it plans to eliminate all of its gold hedges. Gold hedges are futures contracts that commit a company to selling the metal at a set price. Such hedges protect producers against falling prices and limit profits in an environment of rising prices. Barrick Gold intends to spend $3 billion to eliminate and pay off all current hedges. In essence, Barrick is going 'naked' long on gold. Declining gold prices would result in losses much greater than the $3 billion spent to neutralize their hedges.

$1,000/oz gold - too good to be true?

The fact that nearly all investors have morphed into goldbugs over the last 1-2 years should raise a major flag for gold bulls. As explained in the article - The Herding Effect, Why Investors Are Usually Wrong - extreme levels of optimism usually foreshadow lower prices, often significantly lower. Here's why:

The 18-months run on gold has increased the base of gold owners. People wanting to own gold have already converted from wanna-be buyers to owners. Therefore, the pipeline of new buyers is drying up to a point where there's not enough buying volume to drive up prices any further. This is compounded by the fact that owners are reduced to either holding or selling, neither of which can propel prices.

As the base of gold owners has become un-proportionately high, the cycle reverses. Inevitably, some owners give in and start selling. As prices start to decline, more gold is being sold and selling becomes the new trend. The unusual high level of gold ownership provides a consistent flow of gold supply being put up for sale, resulting in rapidly declining prices.

According to some estimates, up to 90% of all traders are currently bullish on gold. With such a large base of investors and goldbugs owning gold, there are simply not enough buyers left to propel gold prices much further from here.

By the way, just as gold traders are extremely bullish, dollar traders are extremely bearish. This means that most traders have already sold the dollars they want to sell, leaving the door open for buyers to push the greenback higher.

Practical examples

The ETF Profit Strategy Newsletter issued the following market calls based on an analysis of investor sentiment and other indicators: 1) A 2008 Dow Jones (DJI: ^DJI) bottom below 7,500 2) A sell signal early January 2009 with the Dow (NYSEArca: DIA - News) sitting at above 9,000 3) A buy signal at Dow 6,800 and S&P (SNP: ^GSPC) 680 on March 2nd, 2009.

Further examples of extreme optimism are the market's all-time highs reached in October 2007, followed by a 54% drop in the S&P 500. Lest we forget about the top of the dot.com bubble which reached its crescendo early 2000, when the Nasdaq (Nasdaq: ^IXIC) peaked above 5,000 for two brief days.

Gold's impact on U.S. stocks

Gold is more than just a precious metal. Unlike paper currency, gold is not someone else's liability. Its worth is specified by investor's willingness to own the yellow metal. As such, gold is the only true currency.

On a daily basis, we read or hear about 'the Dow.' The Dow is up, the Dow is down, etc. The Dow as it's quoted to us is quoted in U.S. dollars, inflated U.S. dollars. This has skewed the Dow's real worth over time, since it's not measured by a real currency.

Back in 1999, one share of the Dow was worth 42 ounces of gold. Today, one share of the Dow is worth a mere 9 - 10 ounces of gold. In real currency, the Dow has already declined 78% since 1999. Will the Dow denominated in fiat dollars follow the path of the gold Dow?

While the destination for stocks is pretty much mapped out already, gold is likely to undergo two stages over the coming years. One stage will be influenced by the extreme optimism present today, while the other stage should be closely linked to a continuation of financial (NYSEArca: XLF - News) turmoil.

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