2013 was a dire year for gold. It started the year at around $1,700 an ounce; by the end of June it had plunged to $1,200; after a late summer rally, it ended the year just a little above its low.
If you believe the City, worse is to come. Moody’s is the latest firm to trash the metal, setting a price target of $1,100. Goldman is even more pessimistic, forecasting a drop to $1,050.
Now, we’re happy to hang on to some gold as portfolio insurance. It’s a great diversifier for your portfolio if things turn really bad. And if things keep improving and gold keeps going down – well, the rest of your portfolio is doing well. That’s the point of diversification.
That said, gold is so widely loathed at the moment that we can see various reasons why it might do better than most people think this year. And if that’s the case, any rebound could be very good for the one asset class that is even more hated than gold – gold miners.
The big name investors have been dumping gold
Investor behaviour moves in cycles, swinging from bullish to bearish and back again. One sign that it has hit one peak or another is when ‘capitulation’ occurs.
This is where investors – particularly high profile ones – who have been moving in the opposite direction to the market throw in the towel. The bears turn bullish, and vice versa. However, they usually change course at just the wrong moment – because when the last bull turns bearish, there’s no one left to sell the market.
For the gold market, the most high-profile buyer has probably been hedge fund titan John Paulson. In 2010 he launched a gold fund. Last year its value fell nearly two-thirds, from around $1bn to $370m.
Not only has Paulson ‘rebranded’ the fund (to be fair to him, his other funds were extremely successful last year), he has also advised investors not to put any more money into it. He also slashed his other gold holdings in 2013.
He’s not the only one. George Soros and Daniel Loeb (who runs the $14bn Third Point Hedge Fund) have also sold their holdings in the main gold exchange-traded fund. These moves at least suggest that we have seen some sort of ‘capitulation’.
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The return of the eurozone crisis
One of the reasons that gold did so badly last year is that it has been seen as a ‘safe haven’ against either a euro breakup or mass money printing by the European Central Bank (ECB).
But the ECB’s promise 18 months ago, that it will do everything possible to save the euro, seems to have convinced markets that everything will be OK. Interest rates for the high-debt countries have fallen, and the euro has actually gone up in value – even although the ECB hasn’t actually done anything much.
However, this state of affairs may not last. Weak lending and monetary data suggest that there is a real risk of deflation – inflation is at a multi-year low. That’s enough to have any central banker feeling jittery.
Meanwhile, after several years of austerity and recession, anti-euro sentiment is reaching a critical mass. In France, the far-right Marine Le Pen has experienced a surge in popularity. In Italy, the disgraced Silvio Berlusconi is re-emerging as an anti-Brussels populist.
And, as Matthew Lynn recently pointed out, the fact that Greece is now running a trade surplus makes it easier for the stricken country to bring back the drachma (or at least threaten to). While a breakup isn’t the most likely scenario, the ECB could be forced to turn on the printing presses, which would push up the value of gold.
Asian consumers might get the go ahead to buy more gold
Another big driver behind the rise in gold over the past decade has been the surge in demand from consumers in India and China. These increasingly affluent buyers have been looking for a reliable home for their savings. The falling gold price has boosted Chinese sales, estimated to be up by 15% over the last year.
Demand in India, meanwhile, was so strong last year that the government was forced to outline punitive import tariffs and export restrictions, because of its impact on the trade balance.
Before the measures, India’s gold imports were only second to its oil imports. But while the measures reduced official imports, they also led to a huge amount of smuggling. It also created a backlash. And that suggests the restrictions will be lifted soon as India’s economy improves. That’s likely to provide a big boost to global demand for gold.
Gold miners are very cheap
Rather than buying gold, if you think the price is going to rebound, you could look at the mining sector. Falling prices and rising costs have hammered gold mining shares. As a result, many trade at very low multiples of current earnings. While some of these low valuations are justified, there are potential bargains out there.
One company that looks very interesting is Medusa Mining (LSE: MML), a gold producer in the Philippines. Unlike most of its rivals, it is a low-cost producer, meaning it should keep turning a profit, even if the gold price falls further. It trades on a price/earnings ratio of 7.3. And it trades at a premium of only 3% to its net assets, compared with the 50-100% premiums of firms such as Ashanti and Randgold.
Medusa is far from the only beaten-down gold mining stock. If you’re interested in the sector, and cherry-picking possible bargains, you should take a look at what my colleague Simon Popple has to say about it.
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