GOLD ANALYSIS

Nervous money will limit gold's downside risks

A more sober assessment of gold's likely price patterns suggests upwards movement may be limited for the time being, but downside risk is also relatively muted.

Author: Lawrence Williams
Posted: Monday , 21 Dec 2009

LONDON - 

There is no shortage of advice for the gold investor available on the internet and much of it is wildly contradictory.  There are those predicting a crash as the price has come off the boil, while others predict heady heights ahead.  You pay your money and you take your choice the expression used to be - but now most of the advice comes thrust at you for free - although in many cases it comes with exhortations to buy some newsletter or investment service or other.

The big trouble with gold is that it is virtually impossible to predict price patterns on normal supply/demand fundamentals as there are so many unknowns on both sides of the equation.  One fundamental which can be defined is that of gold mine production which is seen to be static, or falling slightly, but the other main supply-side item - scrap sales - tends to be a speculative assessment of how much will be unleashed by the current high gold price levels.  The prospect of Central Bank sales has also tended to overhang the market and suppress prices and this is yet another area of uncertainty although the current consensus is that net sales in the year or so ahead are perhaps less likely than they have been in the past.

The demand side though is virtually all purely speculative assessment and thus can be tweaked depending on the underlying views of whichever analyst or commentator is making his/her prediction of where the gold price is likely to head and, to be strictly honest, your guess is as good as mine.  There are obviously underlying factors which can, and will, influence the path of the gold price, but these themselves are not necessarily wholly predictable.  These include the Central Bank purchases or sales, ETF investment, gold coin and bar sales and, perhaps most importantly the strength or otherwise of the U.S. dollar.

While the pro-gold commentators point out that the huge U.S. deficits suggest a devaluing currency - and the fall of the dollar in comparison with the Euro is the most quoted factor here, the Euro zone economy is also facing many of the same problems as its U.S. counterpart arising from pumping huge amounts of fiat money into the economy to try and shore it up against the global downturn.  True the U.S. has perhaps a bigger underlying problem in the form of a huge and continuing deficit on current account, but then the Euro zone has its own problems too in exposure to some very shaky economies indeed and some big pent-up debt problems faced by its major banks in the Middle East and Eastern Europe to which the U.S. banking system is, perhaps, not quite so vulnerable.

Recently we have seen a spate of reports from some of the big banks and financial institutions predicting $1,500 gold in the months ahead, which for a bankers is really sticking one's neck out, but does give an indication of where they feel the U.S. dollar is heading as gold price advance is seen as de facto dollar depreciation - but not everyone agrees with what others would feel is a very conservative prediction.

Australian research consultancy Resource Capital Research (RCR) for example takes a fairly sober view on gold's short to medium term prospects saying it is cautious on the medium term outlook for gold, and expects it to trade down from what it describes as current overheated levels, into the $1,000/ounce to $1,100 ounce band in the next six months, with periods of US dollar weakness likely to produce short term rallies.

Where RCR differs from some of the analysts out there is that it believes  Central Banks, which many believe will be in the market to buy gold, rather than to sell it which has been the pattern in the past, will not actually do so.   RCR points out that the recent rally which took the gold price over $1,200 was largely due to the Indian Central Bank purchase of IMF gold, but it does not believe other Central Banks will follow suit and that such a sustained move by Central Banks is not realistic.  This is due to the liquidity of physical gold markets, and also given that Central Banks are inherently conservative ‘value purchasers' and unlikely to be aggressive buyers of a supposedly ‘safe haven' that has risen by 36% in the space of 12 months.

RCR also considers that gold's strength in the second half of calendar 2009 has not been driven by supply-demand fundamentals.  Key measures of safe haven demand for gold such as inflows into Exchange Traded Funds (ETF's) have been relatively weak in the last two quarters.   It then goes on to say, perhaps rather obviously,  that there is "a high degree of speculative momentum buying behind gold's recent surge, and without support from demand fundamentals the near-term risk for gold at the moment remains very much on the downside." 

But, as we pointed out earlier, supply-demand fundamentals, apart from mined supply, are actually virtually impossible to put a figure on, although some important specialist consultancies are paid good money to make these predictions.  But in the scheme of things such forecasts are by their nature speculative themselves and the consultancies are actually providing informed opinion based largely on past patterns and their perceptions of the mood of the market.  Yes there has been a huge speculative element in the rise in the gold price which has taken most mainstream analysts by surprise - but surely the question is whether this element will continue to support the market, or just fade away and leave gold out on a limb.

Much of the speculation has been due to the so-called safe-haven investment, and in the past two years or so gold has proved to be one of the best stores of wealth out there.  One suspects with perceived further economic trials facing the markets ahead, much of this nervous money will remain with gold, limiting downside risks, but whether there is enough momentum out there now to drive it up to far higher levels in the short to medium term has to be in much more doubt than was seen in the immediate aftermath of the Indian Central Bank purchase.

But, as the Indian purchase showed, one piece of news can move the market dramatically - but this can be down as well as up!  Gold thus looks like it might be in for a period of consolidation at or around current levels, but there is still potential volatility in the market which could see sharp upwards and downwards price movements around current levels.  Ultimately the strength of the dollar is the key, though and if one sees the greenback as continuing to decline in value longer term then gold probably remains a decent wealth protection choice.