by James Turk
Predicting year-ahead price action for any asset class is tricky, and gold, with its sensitivity to political as well as economic currents, is trickier than most. But tricky does not mean impossible. The way a Wall Street analyst might look at stocks versus bonds and conclude that one or the other is undervalued; it's possible to use gold's supply/demand trends and value relative to other assets to gain an idea of how it should behavein the short run. Here are two such approaches, both of which (surprise) are flashing screaming buy signals:
No asset, including gold, exists in a vacuum. Stocks, bonds, real estate,and precious metals all compete for the same limited pool of capital,which means that for gold to be attractive, its prospects must be not just good, but better than those of, say, growth stocks.
One way of making this comparison is the Dow/gold ratio, which compute show much gold it takes to buy the Dow Jones Industrial Average of majorAmerican stocks. As you can see from the chart below, this relationship has been rather volatile.
In 1971, gold was $40 per ounce ($1.28/gg) and the Dow was 890, meaning that it took about 22 ounces of gold to buy the Dow. Nine years later,less than one ounce would buy the Dow. By the end of 1999, the two haddiverged once again, with gold at $279/oz. ($8.90/gg) and the Dow at about11,497, for a Dow/gold ratio of 41, far higher than its early-1970s peak.But note that this time around, both numbers in the ratio have an extra zero. That's because of inflation. A dollar purchases today what 10 cents purchased in 1971, so we need 10 times as many dollars to buy an ounce ofgold or the Dow Industrials.
A Dow/gold ratio at the high end of its range implies two things. First,if historical relationships hold, gold is more likely to rise versus stocks in coming years than to fall. Second, the distance between the 1971high and 1980 low gives a hint of how far gold can run this time around,especially with the financial gale now at its back.
One of the shocking things about gold is how little there is of it. In our sometimes frantic 4,000 years of searching, we've found perhaps 135,000 tonnes. Today, the world's entire hoard of gold would occupy a single (admittedly very heavy) cube 60 feet on a side - equivalent to the volumeof three good-sized houses or the bottom 10 percent of the Washington Monument. To put this in perspective, the U.S. produces about 240,000 tonnes of steel each day.
But unlike steel, where production can be expanded by simply building more factories, the supply of gold increases only when we find and mine new deposits. Since 1492, there has never been a year in which the world'sabove-ground gold stock increased by more than 5 percent. The nineteenth-century average was about 2 percent, which is one reason that inflation was non existent for gold-standard currencies: The world's money supply was constrained by nature to a low-single-digit growth path. Although gold no longer circulates as currency, it still has both monetary and commercial uses. The demand from these sources is estimated at around 4,000 tonnes each year. The output of the world's gold mines is currently about 2,500 tonnes, creating an annual supply shortfall of more than 1,500 tonnes, or approximately 50 million ounces.
For most commodities, a supply/demand imbalance of this size would cause either the price or the level of production, and probably both, to soar.But commodities are consumed after they're produced, and gold, remember,is not just a commodity. Gold is money, which, once discovered, tends to be hoarded. So the vast bulk of what has been mined is still around, andthe current deficit is covered by owners of previously mined gold. Central banks, as you know, sell and/or lend millions of ounces per year, which,together with other forms of "dishoarding," like people selling their jewelry and gold coins, fills the gap. So while an annual supply shortfallof 50 million ounces is clearly a positive, absent a big jump in demand,above ground stocks of gold are more than sufficient to make up the difference. In other words, current mine production is far less important for gold's exchange rate than are trends in demand.
And on the demand front, things are looking up, thanks to the emergence of Asia's sleeping giants. The whole world is setting up factories in China,both to exploit its cheap, highly motivated workforce and to gain access to a billion new consumers. This is bad news for U.S. and European factory workers, but for China, the result is an embarrassment of riches,including a trade surplus that exceeds $100 billion a year with the U.S.alone. By the end of 2003, China's foreign exchange reserves - mostly inthe form of dollars - exceeded $400 billion. And Chinese leaders, showing an historical savvy currently lacking in the West, were eyeing gold.Beijing is rumored to be buying much of the gold Western central banks areselling (and considerably more than the annual 100 tonnes it reported to the International Monetary Fund the past two years).
In 2002, Beijing removed the Communist-era ban on its citizens owning gold. In a survey quoted in the Hong Kong edition of China Daily, 20percent of Chinese respondents said they were willing to move 10 to 30 percent of their savings into gold. An analyst quoted in the same story put the resulting increase in gold demand at about $36 billion, or about 300 tonnes annually.
India, meanwhile, is attracting almost as much foreign capital as is China, and in October 2003 ended a four-decade ban on bullion trading.Because India has traditionally been a huge market for precious metals(much of the gold mined in the West already ends up in Indian safes oradorning Indian women), the combination of rising incomes and more liberal ownership rules should have the same effect there as in China.
How will this suddenly much wider gap be filled? It's possible thatcentral banks - which, as you'll see shortly, are more concerned with minimizing gold's exchange rate than maximizing the value of their gold reserves - will step up their sales. And they'll certainly try to talk the exchange rate down through anti-gold propaganda. But neither will do thetrick, because government resources - of both gold and public credulity - are limited. Much more likely is that gold's exchange rate will rise untilthe rest of us start converting our jewelry and coins into dollars.
