Investing in gold: Why you should buy gold now

published 14 September 2007

Should you care that China revalued its currency, the yuan, by 2.1% in July? I think you should and I think you should respond by investing in gold. Not as a knee-jerk response to what's coming, but as a far-sighted one. You see, China's revaluation of the yuan is the equivalent of a hairline fracture in the Hoover Dam: at first glance it doesn't look serious, yet it's the beginning of something very serious indeed for the global economy.

Investing in gold: dollar set to decline

The bulls believe the dollar will never fall from grace. After all, the American consumer is getting along famously and Asian exporters have no better place to stash their cash than US Treasury bonds, hence supporting the dollar. These trends have been in place so long that it's assumed they have no end and that the situation is safe. But it isn't. Even the longest trends end, often abruptly. Bull and bear markets have life spans, just like people. As do empires. Note the words of Winston Churchill, back in 1925. "If the English pound is not to be the standard everyone knows and can trust," he said, "the business not only of the British Empire but of Europe as well might have to be transacted in dollars instead of pound sterling. I think that would be a great misfortune."

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Misfortune it may have been, but it is exactly what happened. So why did the pound give way to the dollar? There are two ways to answer the question.The first is to look at 20th-century specifics. The two world wars devastated Europe and spurred a massive wealth transfer to the US. The US drew strength from an influx of immigrants, the rise of industrialisation and its powerful advantage in natural resources, making it the obvious new superpower. The second way to consider Britain's fall and America's rise is simply to note that change always dislodges incumbents in the end, so it was only a matter of time before the order of things shifted.

Looked at in that light, predicting sunset for US hegemony should not necessarily be considered pessimistic or controversial: change is inevitable. The question is merely who will take over America's mantle, and when. Just who might isn't easily answered: for all the talk of China's rise, it's not a given that one superpower will be replaced by another. It may be that multiple countries take over, with none gaining a clear advantage. No one knows. What we do know is that in the short run, massive change creates turmoil and upheaval and the more it is resisted, the more chaos is created in the transition. That kind of chaos creates financial crisis. This is where gold comes in: it's the best insurance against chaos there is. In times of chaos the gold price always rises.

For the most recent example, look no further than the events of the 1970s. Until then, and for most of modern history, currencies had been tied to gold reserves. Before and after World War I, belief in the gold standard (where paper currencies were backed by gold reserves) reigned supreme. It was only with the onset of the Great Depression that this began to change as UK economist John Maynard Keynes argued that the gold standard which forced austerity and fiscal rigidity (you could only print the same amount of currency as you had gold to back it) had only made the Depression worse. Everyone should forget about gold, said Keynes, and print money regardless of the amount of gold backing it and spend instead. "Suppose we were to stop spending our incomes altogether and were to save the lot," he wrote. "Why, everyone would be out of work Therefore, oh patriotic housewives, sally out tomorrow into the streets and go to the wonderful sales."

Keynes's arguments gradually took hold across the West. By the early 1930s, Roosevelt had declared the right to adjust the dollar/gold ratio as he saw fit.The government then fixed it at $35 per ounce in 1934, where it stayed for almost four decades and where many thought it would remain. But it didn't. In 1971, change came round again and Nixon broke the link between gold and the dollar completely.

Why did he do it? It seems he felt he had no choice. By the late 1960s, after a series of wars and outflows of post-war aid, US gold reserves, once more than plentiful enough to back the county's currency, had fallen to alarmingly low levels, and inflation was on the up. Speculators were also buying up gold, making it hard to keep the price at $35. To maintain the peg, Nixon would have had to jack up interest rates to sky-high levels, potentially triggering depression. The less painful alternative was to shut the gold window, jettisoning the standard that had existed in one form or another since the US Civil War. Peter Bernstein in The Power of Gold chronicles what happened next. "The soaring demand for gold as a safe haven for wealth and as a hedge against inflation drove the price from $46 an ounce at the beginning of 1972 to $64 an ounce at the end of the year. The price broke through $100 during 1973; from 1974 to 1977, gold fluctuated between $130 and $180.A second Opec oil price increase to $30 a barrel in 1978 created a frenzy; the price of gold hit $244 an ounce before the year was out and then doubled to $500 in 1979." The climax came in 1980 with gold hitting $850. Gold had gained 30% a year over 12 years, something that makes even the greatest bull markets in stockmarket history pale by comparison.

So how does this massive bull market relate to 2005? Consider the backdrop against which gold's 1970s bull run occurred. First, we saw invincibility leading to complacency. The US was seen as economically dominant. But with no one minding the store, spending spiralled out of control. This complacency sowed the seeds for future downfall. Second, the US ran up unsustainable debt levels. Its various political commitments over the years diluted its strength. By 1971, too many dollars had been created and spent relative to gold reserves to continue honouring the relationship of $35 per ounce. Third, building speculative pressures meant the status quo couldn't go on. Observant speculators began accumulating gold in the late 1960s, seeing the inevitable before it came to pass and adding to the pressure that would eventually force Nixon's hand.

Fourth, there was a commodity price shock. The oil spikes of the 1970s fuelled inflation, and expectations of inflation, which drove wages and prices relentlessly higher. Fifth, the US ran populist economic policies. Nixon didn't want to contemplate the consequences of big interest rate hikes. So, inflation's rise seemed unstoppable during gold's big run, with policymakers and the Federal Reserve unable to stop it, because the cure was feared worse than the disease. Until Fed Governor Paul Volcker promised to take rates to "levels never before seen in history". Finally, there was stagflation. In the 1970s, the US and the UK experienced rising unemployment and rising prices at the same time.

Now fast forward to the present and consider the parallels. In 2005, we are dealing with most of the same problems. The US had again developed an "invincible" mentality by the late 1980s and is now increasingly complacent. Debt levels are again unsustainable. Speculative pressure is rising: the scrapping of dollar pegs in China and Malaysia is bringing hot money into Asia (selling dollars and buying Asian currencies) in the belief that the small upward adjustments made so far are only the beginning. Then there is the commodity price shock. Oil prices are at all-time highs in nominal terms. And the US is running a populist economic policy with loose monetary policy: just as Nixon was afraid to treat inflation with the harsh medicine of high interest rates, Bush and the next US central banker will hesitate when a crisis develops on their watch. Finally, there is evidence that stagflation is back.

So there are lots of similarities. The big difference, of course, is that the US currency is no longer linked to gold: the dollar has no firm backing other than the "full faith and credit" of the US government. The state of the dollar is now determined not by the gold price, but by something else: long bonds. One could say America is now on the "ten-year" standard, as in the price and yield of the ten-year US Treasury note. Alan Greenspan himself has called it "the most important price in the world". It's also a price that could cause a massive dollar devaluation.

How might this come about? As the value of a ten-year note declines as it would under intense selling pressure the yield on the note goes up. So when bond prices fall sharply, interest rates rise sharply. And a sharp rise in interest rates poses a dire threat to a debt-laden economy. In order to keep the economy from being hit by rising rates, the Federal Reserve would have to be a buyer of last resort for Treasuries in the event of a mass sell-off. But here's the rub when the Fed purchases US bonds in the open market, they have to create new dollars to do so. In mopping up those abandoned bonds, the Fed would be flooding the market with dollars and devaluing it in the process. This would put holders of dollar assets into a panic, sending them straight to the long-term security of gold. 1970s redux, just without the lime-green leisure suits. Thus, in the event of a debt crisis if, say, China or Japan decided to start selling off their Treasury holdings in a big way the current administration would face Nixon's dilemma. They would have to choose. Should they let rates rocket and risk economic collapse or allow for rapid dollar devaluation and deal with the inflationary consequences later?

Given the risks, it would be nice to think the US had a handle on its long-term debt. Nice, but wrong. There is more than $2trn worth of US debt on foreign central bankers' books. Japan is the Treasury-holding champ. China is No. 2. Another $2trn is held by US-based investors and institutions, but they're capitalists: if bonds start to fall in earnest, they aren't apt to respond patriotically they'll sell too. The fact is that when the chickens come home to roost, Uncle Sam will have no more financial control over the situation than Tricky Dick did over dwindling US gold reserves back in 1971. As long as the status quo remains intact, everything is okayish. But if something significant changes, all bets are off.

There are two plausible scenarios for how this eventually plays out for gold. First, the drawn-out ascent. If central bankers manage to contain the coming crisis, or at least head it off at the pass before it becomes a catastrophe, the dollar could conceivably be "managed" downward. This would allow gold to continue rising steadily for some time. Or we could get a big bang. The name says it all. If central banks fail to manage the dollar down, or a surprise crisis scenario triggers a dump of US assets and a panicked rush for the exits, we could move straight into a replay of January 1980 with gold running to $1,000 in the space of days or weeks. The big bang remains a lower probability than the drawn out ascent, but it's a genuine possibility. So why not hold gold? The fact that the price has been moving upwards in every currency for the last few weeks it has hit a 17-year high in dollars and is at its highest-ever level against the euro suggests a great many other people are doing just that.

Investing in gold does not have to mean investing in a safe the size of a room, with a matching security system. It's certainly possible to buy physical gold. You can store it at home, or if you hold an allocated gold account, it is possible to leave your gold with a bullion dealer. However, there are many easier and cheaper ways (bullion storage costs are high) of making the most of the long-term bull run in the price of gold.

Gold Bullion Securities (GBS) started trading on the London Stock Exchange last year. A GBS is a listed security that carries an entitlement to about 1/10th of one fine (very pure) troy ounce of gold bullion and which can be bought in the same way as any other share on the stockmarket. Every time an investor buys a GBS, an amount of gold, of the same value as the purchase, is deposited with HSBC in London, the custodian bank, or delivered to a trader with a London bullion account. The advantage of using GBS is not only that the management fee is a low 0.4% a year (this covers all trading and storing costs), but that the market is also highly liquid. To buy a GBS is really as simple as calling up your broker and buying it direct. For more information, visit Gold Bullion Securities. Alternatively, you can invest in gold exchange-traded funds (ETFs). These operate in the same way as GBS. Barclays iShares offers one gold ETF, the iShares Comex Gold Trust (IAU), which started trading on Amex, the American stock exchange, at the start of the year. The ETF physically holds gold bullion and so reflects the gold price at any given time (see www.ishares.com).

If you don't want to pay the fees associated with a unit trust, there are also a number of favourably placed gold stocks. One is debt-free and cash-rich GoldCorp (GG), which, as we noted last week in MoneyWeek, is the lowest-cost producer in the industry. This year's output of 1.1 million ounces will be achieved at a cost of just $60 an ounce. The shares are on a 2005 p/e of 29, but with earnings expected to jump by 163% this year and by an annual 30% over the next five years, this is not expensive. Goldcorp is one of the blue-chip miners recommended by Tom O'Brien, editor of the newsletter Gold Report. O'Brien also likes a smaller, low-cost producer, Gammon Lake Resources (GRS), as does John Sheehy of the Marketscope newsletter. Gammon's primary asset, the Ocampo gold and silver mine, will begin its first year of commercial production in the second quarter of 2006, says Sheehy, when cash flow should reach $1.11 a share. Meanwhile, Steve Sjuggerud of Investment U suggests Barrick Gold (ABX); Anglogold (AU); PlacerDome (PDG) and GoldFields (GFI).

One UK-listed miner worth exploring is Celtic Resources (CER), says Shares it specialises in developing gold mines in the former Soviet Union. Concerns that it may be losing the battle for control of a gold mine in Russia have buffetted the shares, but Michael Jivkov notes in The Independent that analysts reckon that, even without the Russian gold mine, Celtic is undervalued, as its existing assets are around 300p a share.

Finally, investors can buy gold coins for a small premium to the gold price: the best-known is the South African Krugerrand, but investors can also buy the Britannia, the USA Eagle, the Australian Nugget, the Canadian Mapleleaf or the Chinese Panda, among others. If you take this route, though, make sure you buy from a reputable dealer, who can give you an unconditional guarantee that the coins are genuine and accurately graded.

The case made by Justice Little for gold depends on financial crisis. But even those who don't accept this as a possibility should still consider gold: there is an excellent supply and demand case to be made too. Demand is soaring. During the first half of this year, it was "21% higher than a year earlier in terms of tonnage and 29% in dollar terms", says the World Gold Council. In India, retail gold sales rose by 47% in the second quarter of the year, with jewellery up 42%. The Chinese are also increasingly buying gold jewellery: greater China is now the world's second-biggest consumer of gold, and its consumption rose by 13% in the second quarter.

For decades, gold bears have suggested gold is a pointless metal as, although it can be used as a hedge to currencies, it has no practical applications. But that's not true anymore. With the march of technology, gold demand is being fuelled by medical uses such as pacemakers, stents, and in drugs for rheumatoid arthritis, and testing kits for HIV, fertility and allergies which are in growing demand. Industry is also discovering gold. Thanks to its unique chemical properties, it's being used for everything from catalytic converters to nanotechnology applications. It is widely used in mobile phone and computers for welding and circuitry. It is also perfect for recordable CDs, as it is highly reflective, and unlike the alternatives (silver and copper), it doesn't tarnish.

And let's not forget gold teeth: this is now a multimillion dollar business and some 68 tonnes of gold is used globally per year in dental procedures. In Japan and China, gold is also regularly eaten in soups and on cakes, largely for status-related reasons. Gold mining firm Harmony has also teamed up with a winemaker to put 24-carat gold flakes in wine. The result? The ultimate celebratory drink', apparently. We're not so sure we'd say it was just a waste of money but that said, anything that boosts demand is good news for the gold price. Other factors boosting demand for gold include aeroplane and space shuttle applications, where it is used, amongst other things, to reflect harmful UV rays and reduce overheating from sunlight. This use has also been picked up on by the construction industry and gold is now being used to coat office windows (when it is purified it becomes see-through) to reflect a high proportion of heat without reducing light. That might sound expensive, but apparently what you spend in gold, you save on air-conditioning: useful when oil is so expensive.

And while demand for gold keeps soaring and looks to keep heading higher for the foreseeable future supply can't keep up. From April to June this year, demand outstripped supply by 81 tonnes. And although there was a "small increase in mine production" in that period, it still wasn't able to keep up with increases in demand. Last year, global gold production dropped 5%: demand has been higher than supply since 2003. This means that mines need to get moving to increase output, but that is easier said than done. It takes four to seven years to bring a new goldmine online and the gold industry in the biggest mining country South Africa is in "terminal decline," says Eric Hommelberg in the Gold Drivers Report. New, less pure sources are being found, but are they are more expensive and less productive than the traditional sources that are running low. With demand up and supply down (see also the column to the right), there is only one way the long-term price can go; no matter what the gold price does in the short term, and whatever happens to the dollar. Perhaps gold isn't just a pretty-face metal after all.

Gold means so many things to so many people that there are always conspiracy theories knocking around about it. However, one of the most persistent is the idea that the price of gold has long been kept low by central banks overstating their reserves. During the 1990s, banks and hedge funds were able to borrow gold from central banks at very cheap interest rates. They would sell the gold in the market and invest the money at a higher rate of interest than they were paying for the gold. With the price falling, they could then buy back the gold at a later date and return it to the central bank, pocketing the profits and making piles of free money. So far, there is nothing legally wrong with this. But the conspiracy theorists say that when central banks loaned the gold out, they still reported it in their reserves meaning that the borrowed gold (much of it still not returned) has been counted twice. According to protest group GATA, central banks claim they are holding about 31,000 tonnes of gold in reserve, but they could have as little 12,000 tonnes. This overstatement of supply means the gold price is lower than it should be.

Many are sceptical about all this, but central banks do have a motive to keep gold cheap. As gold guru Doug Casey points out, "the value of the world's fiat currencies, particularly the dollar, rests mainly upon the confidence of the public and the one thing most likely to destroy it and set off a full-scale monetary panic is a runaway gold price". Therefore, it makes sense to suppress the price. It's going to be hard to prove price manipulation, but GATA's questions "are valid and deserve answers".

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