Is gold fever back to stay?

The gold price has been toying with the magical $1 000 level for more than a week, rekindling interest from both gold bulls and gold bears. With the price up more than 16% in US dollar terms since April, investors are asking why gold is going up and if it will continue its upward path.

According to Dr Prieur du Plessis, Plexus group chairman, gold has been rising steadily over the past eight years. “Few people realise that gold in dollars has outperformed the US stock market fourfold over this period, even with the reinvestment of dividends,” he says.

US investment icon Richard Russell of the Dow Theory Letters fame recently published a graph of the weekly Dow-to-gold ratio, a graph that gold-haters are loath to acknowledge (see Graph A). The graph shows that since August 1999 the Dow has lost 80% of its value against real money, namely gold. In 1999, one share of the Dow would buy over 44 ounces of gold. Today the Dow will buy only 9,54 ounces of gold. There is no way of telling how low this ratio will go, but Russell believes it could drop to below five.

Gold bulls believe the gold price is increasing mainly due to investors’ expectations of rising inflation. Gold predicts inflation because of the relentless wave of money the US Federal Reserve and other central banks are printing and pumping into the system to reignite economic growth and, more importantly, stem the possibility of a global depression and deflation. While Du Plessis believes this may be so, he is aware that the correlation between gold and inflation in the US over the last 25-plus years has been zero.

Legendary US hedge-fund guru John Mauldin believes the rise in gold above $1 000 does not indicate the future of inflation. In his opinion, if the Fed were to withdraw from the current economic battle, the forces of deflation would be felt in short order. Mauldin contends the answer to the question "Will we have inflation in our future?" is "You better hope so!"

Du Plessis agrees with Mauldin’s belief that the value of gold is rising against most major fiat (paper) currencies because it is considered a neutral currency. According to Mauldin, the Fed and the Obama administration seem to be pursuing policies that are dollar negative, and give no hint of letting up.

“The declining dollar has been one of the main catalysts for gold’s rise. Although the gold price recently reached new highs in dollar terms, it is important to note that the gold price has also been rising in most other major currencies since mid-2007,” adds Du Plessis (see graph B).

Du Plessis believes another driver of the rising gold price is China’s loss of confidence in the US dollar. “The Chinese are concerned about their large exposure to the US dollar (most of their foreign reserve holdings are invested in US bonds) and have been diversifying into other currencies such as the euro and yen, as well as gold and other commodities,” he says.

“It was recently announced that China has doubled its gold reserves to 1054 tonnes in the last few years. This makes that country the world's fifth-largest holder of gold, just ahead of Switzerland, and among the six nations plus the International Monetary Fund that have reserves of more than 1000 metric tons,” says Du Plessis.

According to Mauldin, the steady rise in gold over the last eight years to the current level of just over $1 000 has roughly tracked the emergence of China as a superpower in foreign reserve holdings, which now stand at $2 trillion.

With the uncertainty regarding the sustainability of the current improvement in the global economy and the recent strong rally in global stock markets, Du Plessis believes an investment portfolio should include exposure to gold. He agrees with Richard Russell: “Gold is the standard; it can't go bankrupt, it will rise in value if the dollar tanks or inflation takes off, and it will sky-rocket if the US tries to inflate its debts away.”

Investors could gain gold exposure by buying the JSE-listed gold ETF NewGold, which effectively represents an investment in gold in rand terms. “Although a strong rand may negate some of the potential returns from a higher dollar gold price, this holding will provide some hedge against the current uncertainty,” says Du Plessis.

Alternatively investors could buy a combination of gold shares or invest in a gold fund. “Keep in mind that gold shares are highly geared and thus tend to show more volatility than the gold price. Also, problems with regard to poor management of mines, such as safety aspects and strikes, could also affect profitability - and your investment return,” says Du Plessis.

Graph A

 (Click on image to enlarge)

Source: Dow Theory Letters

Graph B

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Source: Plexus Asset Management (based on data from I-Net Bridge)