Three Ways to Take Profit in Gold as Inflation Props Up Prices

March 20, 2009 | By: Martin Hutchinson

The U.S. Federal Reserve had been expanding the money supply more rapidly than output for more than a decade, since a policy change in early 1995. That’s why the U.S. economy underwent a series of bubbles, from stocks in 1996-2000 to housing in 2002-2007 to commodities in 2006-2008. Then, when the inevitable crisis hit in September 2008, the Fed began expanding the money supply even more rapidly.

In the six months to March 2, the St. Louis Fed’s Money of Zero Maturity (MZM), the nearest we can get to the old M3, rose at an annual rate of 16.2%, while the M2 money supply rose at an annual rate of 15.9% (the Fed has stopped reporting the old M3, the best measure of broad money growth). Since price inflation was low during that period and the economy was contracting, almost all that extra money has been pumped straight into the economy.

While the global economy is collapsing, all the extra money will have little inflationary effect. In the United States, however, evidence is building that the economy is approaching the bottom. Consider, for instance, that:

• After several months of decline, the Institute for Supply Management indices were more or less flat in the current month;

• February retail sales – excluding automobiles – were up 0.7%; January non-auto retail sales also being revised upwards to plus 1.6%. We may still have a few months of decline to go, but it seems increasingly likely that the U.S. economy will bottom out around the middle of the year – although the ongoing banking problems and huge budget deficits are virtually certain to prevent a rapid economic rebound. As we’ve said repeatedly, once the economy bottoms out, however, the additional infused capital is likely to serve as a serious inflationary catalyst.

Since September, U.S. Federal Reserve Chairman Ben S. Bernanke has repeatedly warned of the dangers of sustained deflation – and not just a few months of falling prices (which we got in the latter part of last year, thanks chiefly to declining commodity prices), but overall price declines over a prolonged period.

What’s the Market Telling Us?

Recent price statistics make it abundantly clear that deflationary dangers just don’t exist. Both the core consumer price index and the core producer price index were up 0.2% in February, and are well above their levels of February 2008. Notably, one of the major factors was a 1.3% jump in the price of apparel, one import that has been holding prices down for the last decade. In other words, rather than the sustained deflation Bernanke warned about, the latest price figures suggest that we should actually be concerned about inflation, which is clearly starting to accelerate.

Indeed, both the unprecedented budget deficits and the very rapid money supply growth point to an inflation rate of perhaps 10% per annum by the middle of 2010. The latest price-and-output figures suggest that any contrary tendency has disappeared. And that points to a strong likelihood that gold may be due for an additional upward run, which may be quite sharp and happen quite quickly.

The gold market underscored the veracity of my scenario in a very clear fashion Thursday: Gold posted its biggest gain in six months after the Fed’s plan to buy debt hammered the U.S. dollar and reignited inflationary fears. Gold futures for April delivery actually jumped $69.70 an ounce, or 7.8%, to reach $958.80.

The yellow metal reached a record high of $1,033.90 an ounce on March 17, 2008 – a year ago this week – when U.S. rate cuts sent the greenback to an all-time low against the euro. Gold prices subsequently declined in concert with most other commodities. It’s up 8.4% so far this year, according to Bloomberg News.

If the hedge funds pile into gold, they will overwhelm the physical gold market, in which 2008’s mine output of 2,407 tons and other supply of 1,061 tons had a value of only about $98 billion at recent prices of approximately $900 per ounce. Gold’s peak price in 1980 of $875 was equivalent to $2,300 in today’s money; it is by no means impossible that the price of gold could soar well beyond that level.

Hedge fund interest in gold was demonstrated Tuesday by the hedge-fund billionaire John A. Paulson, who was probably 2007-2008’s most successful investor, thanks to a strategy to short housing assets that generated profits of more than $10 billion. Now Paulson has gone and bought 11.3% of gold miner AngloGold Ashanti Ltd. (ADR: AU) for $1.28 billion. Paulson’s on a hot streak, so there must be a good chance some of his rich buddies will follow him into the sector; that will inevitably shift the market considerably.

The Yellow Metal Hat Trick: Three Ways to Score From Gold’s Gains

There are three ways to play gold, and you should look at all of them:

• Go for the Gold: Of the three ways to play gold, the first is to buy gold outright, either in bars, or though the gold-linked, exchange-traded fund (ETF) SPDR Gold Shares (GLD). Today, GLD itself holds more than 1,000 ounces of gold, and has a market capitalization of $31 billion. The fund’s price fluctuates in concert with the price of gold, which adds a small mount of risk. On the other hand, however, buying this ETF is more convenient than buying gold bars directly, because the fund dispenses with the accompanying storage problems that comes with actually owning physical gold.

• Bet that Silver Sizzles: The price of silver generally moves in line with gold, but is currently at around $13.50, below its normal historic relationship to the gold price of about 1:30, and therefore possibly offers more upside potential (in 1980, silver peaked at $50 per ounce, equivalent to about $140 in today’s money). That can be done through the iShares Silver Trust (SLV), which works in a similar manner to GLD, and which has a market capitalization of $3.5 billion.

• Go Deep: Third, you can follow Paulson and buy gold mining shares. I actually don’t like Paulson’s choice much; AngloGold made a loss in 2008 because of inept hedging and is mainly in South Africa, whose political risk I don’t care for. However, your big advantage over Paulson is that you’re presumably not so rich that you have to deploy your money $1.28 billion at a time. Thus, you can buy on the ordinary share market some of the other mines that are cheaper, rather than having to do a special deal with a company like the Anglo American PLC (ADR: AAUK), the British mining giant that sold Paulson the AngloGold shares from its own stake in that company.

A Look at Two Top Miners

Gold mines had a 2008 that was less profitable than you might expect. The price of gold was essentially flat over the year, while the price of oil soared to a peak in July, affecting miners’ costs badly, since fuel represents 25% or more of a mining firm’s total expenses. Only in the fourth quarter, as fuel prices declined and gold prices rose, did mining economics improve – but, even then, many miners were badly affected by write-offs in their copper operations, where prices had collapsed after a long bull market.

However, the good news is that gold prices have risen by almost 10% in the 2009 first quarter from the final quarter of last year, while fuel prices have declined even more; hence, the quarterly results to be announced in April and May could be surprisingly juicy.

So if you’re going to look at actual miners, here are two to consider carefully:

Barrick Gold Corp. (ABX) is the largest and financially strongest gold producer, with a market capitalization of $29 billion, reserves of 124.6 million ounces of gold (plus copper and silver), and operations in North America, South America, Australasia and Africa. It took a fourth-quarter charge of $779 million – because of its copper operations – but was otherwise profitable in 2008, with revenue rising 10%. For 2009, it should benefit from rising gold prices and declining costs; it currently sells on a prospective Price/Earnings ratio of 13.7, but of course as gold prices rise, earnings will rise on a leveraged basis.

Yamana Gold Inc. (AUY) is an expanding gold producer with a $6.8 billion market capitalization that made an unexpectedly good profit in the fourth quarter of 2008, and that is expanding both production and reserves (currently 19.4m ounces) with operations in Canada and Latin America. Its expansion increases its likely benefit from rising gold prices; Yamana’s shares currently trade at a forward P/E of about 12, but earnings should rise sharply if gold prices rise.

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