Invest In Gold

When All Else Fails, Go for Gold

The jewellery, industrial and investment markets drive the demand for gold today. Of these, jewellery accounts for more than two-thirds of the total. The Jewellery market follows seasonal trends, peaking during the fourth quarter on the back of the major Indian festival of Diwali and of course Christmas. The first quarter is also a strong period, incorporating the Indian wedding season, Chinese New Year and Valentines Day.

Gold’s industrial uses predominately stem from the metal’s resistance to corrosion and electrical conductivity. The dental industry is also a significant element of overall industrial demand, which totals approximately 12% of the market.

Investment driven demand accounts for some 19% of the market and derives from the precious metal’s role as a monetary asset and a store of wealth. Indeed, gold has featured in financial systems for many hundreds of years.

Due to its weight though, gold is impractical to use on a day-to-day basis. This led to the emergence of state issued coin and paper currencies from around the 17th century, which were exchangeable for gold. 

In the more modern period, the international gold standard was in force from the 1870s through to the outbreak of World War 1 in 1914. There were various attempts to re-establish some form of gold standard following the war. The last of which was the Bretton Woods system that pegged the US dollar to gold at $35 per ounce.

However, the supply of money backed by a finite resource cannot expand at a faster rate than the resource itself. This limits the financial system’s ability to supply credit (not necessarily a bad thing in light of the credit bubble), thereby restricting the value of goods and services that can be purchased. Due to this and the huge costs of the Vietnam War, the United States abandoned the system in 1971.

While gold no longer held its role as an official currency, it has nevertheless remained the ultimate hard currency, against which all paper currencies are measured. Paper currency strength, specifically the US dollar, equals gold weakness and vice-versa. It is in this regard that despite its seeming insignificance relative to jewellery, investment demand is the most important determinant of gold’s price and certainly underpins the metal’s latest price strength. 

As with any asset, the price of gold is determined at the margin. While the Jewellery and industrial markets are subject to cyclical fluctuations, their longer-term level of demand is relatively constant. Investment demand on the other hand can often surge when investors seek the safety of a real asset, as has been the case recently. 

Looking in more detail at the drivers of gold’s recent price action, the yellow metal had been falling against the US dollar following the unwinding of the credit bubble and the associated asset market deflation. In a deflationary environment, the relative value of cash (US dollars) rises as the price of all other assets fall.

As investors around the world pay down debt, assets are sold, cash is raised and debts paid off. This process of deleveraging underpinned the US dollar’s recent rally while at the same time savaging the precious metals and commodity markets.

However, asset price deflation in a highly indebted economy, such as most of the developed world, is a recipe for disaster. Governments and central banks will therefore not sit back and allow the deleveraging process to play out. Massive fiscal and monetary policy stimulus will be required to offset the forces of deflation. Deflation therefore begets inflation.

We have of course already seen large-scale intervention. The US Federal Reserve engineered the rescue of Bear Stearns in March, and the Treasury promised to inject more than US$200 billion into Fannie Mae and Freddie Mac. There have since been billions of additional dollars pumped into the system in the wake of the Lehman’s collapse, which sparked gold’s largest one-day gain in almost three decades.

In the short term, the change in investor sentiment towards gold is the classic flight to safety. However, the actions of the Fed are inherently inflationary and will ultimately leading to further US dollar weakness and long-term gold price strength. This underpins our view that gold is in a secular bull market, with recent weakness simply representing a cyclical correction. 

Turning to the charts, price support is evident at US$730 an ounce, as indicated by the major high of 2006. This level coincides with additional support provided by the 38.2 percent Fibonacci retracement of the 1999 to 2008 rally.

In the shorter-term, we have witnessed a completion of the Elliott Wave ‘ABC’ correction with prices surging back above US$846 per ounce. This move confirms the positive signals recently reflected in the ‘bullish divergence’ on the momentum oscillator indicated below.

“Bullish divergence” arises when prices make a new low, as seen between August and September, while the oscillator makes a higher low. Such divergence often occurs at major price turning points.

While it is important to consider the depth of any correction, time is also an important factor. In our opinion, more than six months of consolidation activity will be required to correct the 8-year bull run. Accordingly, an extensive period of consolidation is likely before gold once again hits new highs against the US dollar.

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Commodity Focus: Commodities Markets Headed For The Biggest Annual Decline; U.S. Crude Oil Future; OIl Price Movements; U.S. Gold Futures

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