After healthy corrections, gold and silver are again table-thumping buys. Indeed it could be argued that the fundamentals for gold and particularly silver have never been as bullish as they are today.
This is due to the myriad factors combining to create likely price moves that will in time make those of the 1970's look small in comparison.
It is important to remember the reality of our situation
In recent times, there have been so many financial events taking place at such speed that it is often easy to forget what is happening before our eyes, and fail to see the wood for the trees.
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Did you ever think you would see a run on a bank in your lifetime? The answer for the vast majority of you would have to be a resounding no. Yet Northern Rock and Indymac have happened and as Alan Greenspan, Paul Volcker, George Soros and others have warned we are now facing the greatest financial and economic crisis since the Great Depression.
Did you ever think you would see oil rise some 1000% in a few years to more than US$145 a barrel, and see the spectre of serious inflation, stagflation or hyperinflation?
For some years we have been advising clientele that gold and silver's inflation-adjusted highs of 1980 of some $2,300 and $150 per ounce would be reached in the coming years, and that a strong allocation to platinum, palladium and especially gold and silver was prudent and sensible given the fundamentals and the increasing risk in the global economy. We continue to advise this and are confident our advice will help our clientele protect their wealth - and indeed greatly prosper - in the coming difficult years.
Big picture fundamentals driving gold and silver markets
What are the fundamental factors making physical gold and silver the most important assets to have in a properly diversified portfolio today?
Macroeconomic and systemic risk
The macroeconomic climate is the most uncertain since the Great Depression and much of the Western world faces the toxic combination of a housing crash and a virulent credit, debt and solvency crisis, plus the spectre of stagflation.
Not only do we face unprecedented macroeconomic risk, we also face massive systemic risk. The IMF has warned that if another major bank fails (a la Bear Stearns) it could take down four or five of the world's largest 15 banks with it.
The monetary and fiscal authorities' response to this crisis will dictate whether this degenerates into a serious and unprecedented stagflation or, worse, hyperinflation. Given the response in the US to date and the likelihood of Fannie Mae and Freddie Mac being nationalised, hyperinflation is even becoming a possibility for the world's largest and most important economy.
Competitive fiat currency devaluations look increasingly likely with obvious ramifications for paper assets such as equities and bonds.
Given the extent of the risks facing the global economy, even mining stocks may not be the 'safe haven' they are touted as, and may not give the returns promised. The threat of nationalisation may become a real one, which will make many mining stocks a risky proposition.
Continuing geopolitical risk
Geopolitically, the world remains beset by many serious risks, any of which could seriously hit Western economies: Pakistan, North Korea, Lebanon and Israel are some of the hotspots posing risks in this regard. This was graphically illustrated when Benazir Bhutto was assassinated in Pakistan; gold surged some $25 on safe-haven buying over fears of a nuclear bomb falling into the hands of Islamic militants in Pakistan.
The crux of the matter is that the Western world, and particularly the US, is massively dependent on oil and gas exports from countries who are at best lukewarm and at worst outright hostile to them. Russia, Venezuela and Iran are some of the more glaring examples of this.
Israel's recent threats to attack Iran have seen increasing safe-haven demand for gold and silver, and geopolitical risk remains a real threat.
Geological realities
All this at a time when the geological impediments of 'peak oil' seem to be an increasing reality. Thus the demand destruction and fall of oil and gas prices of the late 1970s is unlikely to be repeated to disempower OPEC and these strategic competitors.
Indeed, mother nature's bounty seems to have been pushed to the brink and we are now facing a world of increasingly depleted natural resources. The global population has risen from 3 billion to over 6 billion in just 30 years. It is projected to increase by another 3 billion in the coming 30 years. Although, tragically, the dismal Malthus' theories might end up derailing these projections.
The industrialisation of China, India, Russia, Brazil and much of the non developed world, and the growth of huge middle classes seeking the standard of living and over-consumption enjoyed by consumers in the Western world is exacerbating this resource depletion, as the demand for all commodities increases dramatically.
Peak Gold
Add to this falling production of some commodities, particularly gold. Gold production is stagnating, and output in the leading gold producing countries continues to fall year on year, despite higher gold prices leading geologists to wonder whether we may have or may soon have reached the point of 'peak gold' production. The world's biggest producer - South Africa - produced nearly 1000 tonnes of gold in 1980. This was down to 264 tonnes last year, the lowest since 1932.
Gold and silver are cheap vs many commodities and oil
With regards to the price of gold and silver, after the recent healthy correction, they are both now cheap vis--vis other commodities and especially against oil.
Gold, silver and oil are highly correlated over the medium to long term. But oil can often outperform them in the short term before precious metals catch up as higher oil prices lead to inflation-hedging buying of silver and gold.
The long-term average gold-to-oil ratio is 15 to 1 or 15 barrels of oil to one ounce of gold. Today, the ratio is near record lows at 7.1 ($963/ $136 = 6.6). Oil is at over $136 per barrel and so if we multiply it by 15 we get a gold price of $2,040 per ounce. At the higher end of the scale gold has traded at over 30 times a barrel of oil which based on today's oil price would result in a gold price of over $4000 per ounce.
Thus, based on today's oil price of $136, the gold/oil ratio would suggest that gold is very undervalued at a near historic low of 7.1. The ratio will revert to the mean in the coming weeks and months and will thus see gold reaching its inflation-adjusted high of some $2,400 per ounce in the coming years.
Similarly with the silver/oil ratio. The average is 4.4 but at the moment it is at 7.3 or 7.3 ounces of silver required to buy one barrel of oil ($136/ $18.70 = 7.3). Should there be a classic reversion to the mean average of 4.4 that would result in silver prices rising to over $30 per ounce (136/ 4.4).
This happened as recently as 2002 and 2004 and is more than likely to happen again. Indeed the ratio was as low as 2.4 as recently as 1999 when oil traded at $10 a barrel and silver at some $4.50 per ounce. At the higher end of the scale, in the 1970's silver traded at a ratio with oil of between 3:1 and 1:1. At today's oil prices that would mean silver trading at between $42 and $136 per ounce.
Conclusion
In addition to macroeconomic, systemic and geopolitical risk; geological constraints, terrorism, climate change and natural disasters such as Hurricane Katrina; there are other risks that mean that the old Wall Street advice to invest 10% of one's portfolio in gold bullion and hope it does not work is more important now than at any time in living memory. Given silver's even more favourable fundamentals, an allocation to silver would also be extremely prudent as it is likely to outperform even gold in the coming years.
By Mark O'Byrne, Executive Director of Gold and Silver Investments Limited. www.goldassets.co.uk
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