A Case for Precious Metals

"More gold has been mined from the hearts of men than has been taken from the earth." - Napoleon Hill

"Gold does not rust on the ground and rocks don't get soaked in the rain" - Turkish Proverb

Sentiment for gold has fallen precipitously over the last year as the price of gold has fallen close to 20% from its peak.  The issue is to decide whether this gold price move is a correction within a secular bull market or the start of something more serious.  The gold bull market has been intact for more than 12 years and to me it still has a long way to go.  Furthermore with the loss of favor among portfolio managers this is just the time when adding to a gold portfolio could make sense.

Gold began its meteoric rise in 2000 when the price of an ounce of gold was roughly $260.  Since then the gold price rose almost unabated to September 2011 when it peaked at just under $1,900 an ounce up roughly $1,300 an ounce or over 600%.  Many analysts and investors have called this rise a bubble and have shunned the investment.  So more than a year later the debate rages with the bulls saying that this is a great buying opportunity and the bears saying that the high in gold was the end of its era.

So who is right?  First off we need to understand what drives gold prices.  As gold is a commodity it is completely driven by the forces of demand and supply.  Let's look at supply first.  Means of extraction have remained relatively stable.  There have not been any major improvements to extracting the ore.  Unlike natural gas where fracking has changed the entire industry, gold ore has to be dug out often times at great depths and hauled to the surface for extraction from the mined ore.  You cannot magically blast a hole and have it rise to the surface. 

Gold reserves have not grown at all.  There have not been any major gold finds in the last decade even while exploration has intensified.  What has been discovered is either too remote to access, in countries that are liable to nationalize the mine if the find is too great or open to security risks.  For these reasons gold production has not risen even as the price has.  As there is really no improvement in terms of supply over the last decade all eyes shift to the demand side.

Demand for gold remains strong.  The governments of the world continue to add to their gold reserves and consumers the world over continue to buy gold for gifts, jewelry and as investments.  Furthermore the rise in the gold price is following the trajectory of the massive central government debt mountain.  The demand for gold therefore remains strong while the supply of gold is tepid so the price should rise but since September 2011 it has not. 

Looking at the movement in the price of gold and particularly gold related stocks it is clear that the gold bears are trying to take control of the market.  Gold spikes down on heavy volume only to recover later in the day.  On low volume days a sudden glut of sales orders push the prices of gold related stocks down where they languish but all of this comes on no significant news.  This is not the way that a seller owning a large gold position tries to exit a position.  You do not hit the sell button in a mass panic when there is nothing to report.  Normally you wait for a good spot to exit and then start to slowly unwind your position.

The problem that the gold bears have is that the price of gold and ultimately the gold related stocks is directly related to the demand for gold.  As demand for gold is strong it appears to me that momentum traders and high frequency traders are trying to manipulate the price of the metal and this has never worked for an extended period.  Remember how the Hunt brothers tried to corner the silver market?  They managed it for a while but ultimately could not control it for long.  The same will happen in the gold market.  It is just a matter of time before the order of supply and demand restores itself and the price of gold and gold related stocks rises once again.

So unless there is a magic wand to extract gold and wipe the massive mountains of debt clean from central government books in an instant, it is clear to me that this current market correction is a buying opportunity.