No Gold Bubble

February 23, 2009 | By: Daniel Gschwend

Are we in a gold bubble? Well, since gold is moving virtually unstoppably towards its previous nominal high at $ 1,030 – the question is valid. But the answer is: NO. If an asset class is in the stage of a bubble it has completely different characteristics:

1. Everybody from the taxi driver to the mutual fund manager owns gold and gold stocks and tells you that gold can only go up in price (poised to rise)
2. The price has reached a new high in real terms and shows some kind of a vertical chart

As for gold: most people have no interest in gold or gold stocks and gold has not even closely reached a new high in real terms. Gold in real price terms would mark a new high at approx. $2,400 per ounce (based on the official CPI numbers). Taking the real inflation into account $2,400 is far too low. So, are we near a top? No, not at all. Most bull markets end if an asset class reaches a new high in real terms.

The talk regarding bubble is completely wrong. But I hope that most of the bubble speakers are more thinking about the short term outlook for gold rather a fundamentally based top. I got asked some days ago if gold will hit $1,000 per ounce again. My answer was yes and it is likely that once reached, gold will see some profit taking back to $ 900. But if not, than prepare yourself for a very strong move.

click to enlarge

For the short term, any forecast is very difficult and doesn’t really matter for me. Interestingly, the NY session was positive – no manipulation and not enough COMEX selling from commercials to hold gold back. The leading indicator of net short positions from commercials, as stated in the closely watched commitments of traders, indicates a declining gold price in the near to medium-term. But the indicator has pointed for some weeks toward a declining gold price, but instead gold has steadily risen towards $ 1000 per ounce and finally hit this mark last Friday.

What does this mean? I’d say that gold has been rediscovered as an asset class by a broad base of investors. That is not a guess, that is reality. Let me tell you some observations I made (which are real and not speculation):

1. Some very well known banks based in Switzerland have huge inflows into gold ETFs and physically held gold in vaults by clients – some are having trouble to locate additional space to store gold and inflows are getting stronger
2. Some hedge funds are pushing heavily into physically gold and are trading ‘gold tickets’ in the $ 50 million range. Not just once but continuously
3. Most investors already holding physical gold are not thinking of taking profit, they are rather buying more gold – this is different from last March when gold hit its past nominal intermediate high of $ 1,030
4. There is serious pressure from the public that central banks stop selling gold – selling gold against a bubble currency (that is inflated greatly) is the worst thing to do and truly a disservice for the generations to come

So what does this tell us about the future? Obviously, the main driver of an appreciating gold price is investment demand. Did you know that during the last bull market in gold in the 1980’s – a lot of portfolio managers advised to hold approx. 10% in gold of the overall assets. So where are the gold holdings now as a percentage of the overall assets? 1% or 2% at maximum.

I talked to a number of fund managers and financial advisers and found out that some very deep pocket players (family office managers with assets in the multi billion $ range) are holding 0% (zero!) in gold. I’m asking myself if they have any idea about basic economics and any idea about how inflation does work. Just have a look at the quantity equation and you will find out that inflation is inevitable (in practice) once the velocity of money accelerates. All the money that is been shoveled into the system is not yet working (spent) but just sitting in some ‘accounts’. But once the spending cycle starts, and that’s what all the stimulus packages are intending, than inflation will come back furiously.

These big players with 0% in gold will soon buy gold or gold shares. There is a lot of money entering a very small market. That will drive gold much higher. For some investors, gold is only an insurance against an overall asset meltdown, fine. For some investors, gold is a real asset class. Either way you look at it, gold will benefit. Interestingly, we have insurances against virtually everything. But do we have an insurance against a wealth destruction? Ask your broker or financial advisor which asset class performed best in the last 3 to 5 years? The answer is gold, have you participated in that run? No, don’t worry, you missed the first 200% percent but there is still more to come.

The system as we know it today has some serious problems and governments around the world are doing everything to move asset values up again to prevent an era of global deflation. Re-inflation is the key word or asset dilution against real assets. I just recently had a very informative discussion with a pretty famous professor in economics. He is very sure that we either enter a new era of hyperinflation or a serious deflation. In both ways, he is sure that interest rates will soar.

Deflation and interest rates will soar? Well, I was somewhat confused. But, it is possible. Imagine, we have a severe deflation and everything besides gold and some other commodities (real assets) lose value and therefore the majority of money is chasing these very sparse investment spaces of real assets. In this scenario, liquidity gets absorbed out of the financial system and banks don’t have our savings for credit spending. The only way to attract money back into savings accounts are much higher interest rates. This means that we can have soaring interest rates in an inflation and deflation scenario – both scenarios support gold. To make this clear, gold is the asset to be invested and not silver nor platinum or palladium. Only gold has monetary characteristics.

The next big thing after the current problems are solved, will be a global currency crisis and a crash in the government bond market. Not today, but in the next 3 to 5 years. In this stage, gold will truly soar and enter its bubble stage – but that’s still a long way to go.

So what about gold shares? Besides holding gold, gold shares are offering great leverage and are, compared to physical gold, too cheap. Do I like gold stocks? Yes I do in certain cases. Unfortunately, most gold companies are very poorly managed and have a comparably low profitability compared to other sectors. Besides being only marginally profitable, gold stocks belong to the stocks with the highest risks.

Nevertheless, I’d buy some gold stocks now because of the imminent net profit leverage. Because of poor management and a poor performance in regard to the bottom line, a lot of investors do not invest in gold stocks. That’s also a reason why gold stocks are not commonly found in portfolios. Just a comparison to illustrate this issue:

P/E forward = Price / Earnings Ratio

P/B = Price to Book Ratio

EV/EBITDA = Enterprise Value to Earnings before Interest, Tax, Depreciation, Amortization

Well, I’ve outlined (with red) the key numbers in which sectors such as technology, energy or pharmaceutical are superior to gold mining stocks. Unfortunately, gold mining stocks are very likely in every other category never the best, and therefore they never find their way into portfolios based on such valuation methods. Aside: The most important valuation method for all mining stocks is the NPV (Net Present Value). Just imagine, a mine will be depleted within one or two years, of course the stock will trade on a very low P/E multiple, but this does not mean the stock is cheap. NPV is a good measure to figure out if a gold stock is trading relatively low or high to its NPV.

The same is true for the Gold/XAU ratio (even though this is only a static comparison and says nothing in regard to profitability). Today, the Gold/XAU ratio is approx. 7.5 – in the past, a ratio of > 5 was considered a buying opportunity (gold stocks cheap vs gold bullion). Today, all equities are neglected and therefore also gold stocks trade with a significant discount. Once the overall equity market has found its bottom an ounce risk aversion declines, money will move again into equities and also into gold stocks. There is still room for a 50% upturn and gold stocks are still cheap – in case the bullion price is holding up.

Now, gold stocks are ready to close some of the financial gaps: while input costs are declining (e.g. oil, labour, materials, etc.), sales revenues are rising (gold). Overall, this means that the bottom line will benefit. Most other companies - outside of gold mining - are facing declining profitability. Therefore, investments in senior gold producers are a good idea – my favorites (because of the expected leverage on the bottom line) are Newmont Mining (NEM), Barrick Gold (ABX) and Goldcorp (GG) and more speculatively Randgold (GOLD).

Disclosure: The opinions expressed in this article are those solely of the author and do not necessarily agree with the author’s employer. The author is long physical gold and owns gold shares.

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