Golden Observations

April 2006 Dr. Hans Black

Despite our generally bullish view on gold for many years, we keep getting asked why gold is so strong at the present time. For years investors have been told that gold returns nothing in the way of income, and, as a “barbarous” relic, is merely some expression of a store of value from the past. Indeed, central banks made a lot of noise during the 1990s as they unloaded their gold holdings in order to use the profits “more productively”. Notably, the Bank of England (selling ironically at the lows of the current move) and the Swiss National Bank were in this category. But by the early months of 2006 gold had doubled from the prices at the last auction by the Bank of England just five years ago. Interestingly, we tend to meet few people who profess to owning gold and amongst them very few money managers.

Even our own group thinking over quite a number of months has been that a pullback is imminent — perhaps only to $480 or $500, but certainly a pullback. However, we are amazed at the resilience and persistent upward pressure we are seeing in the price of the precious metal. Having briefly traded close to $600 an ounce within a week of writing this essay, questions are coming with increased persistence. Is this the time to sell? Is it time to take profits? But gold seems to march on in a world of its own. Some have speculated that the appointment of the new head of the Federal Reserve Board, Ben Bernanke, was instrumental, since the announcement of his arrival last fall coincided with the most recent upward move in the price of gold. Indeed, looking at some of the academic papers and pronouncements of Mr. Bernanke leads one to the inescapable conclusion that when pressed into a corner he will err on the side of money creation and printing. It should be pointed out that this was also the case with Mr. Bernanke’s predecessor, who never hesitated to push adequate liquidity into the system when he perceived the need. Instead, looking at central banks globally, it is apparent that many smaller countries have been interested in increasing their gold reserves on the grounds of diversification. Speculation is mounting that large Asian holders of foreign exchange, like China, will soon do the same. The implication is that, for some, fiat paper money is losing its luster. The corollary is that gold is moving more persistently than at any point in the past 20 years.

Perhaps other answers can be found in current political developments. As this is being written, the situation in central Iraq is clearly worsening and if you believe the recent words of Thomas Friedman in the New York Times, the situation is now bordering on outright civil war. No matter how one wishes to view the progress or lack of progress in Iraq, the prospect of an expanding civil war is surely nerve-wracking not only to Iraq but to a number of the neighboring countries in the region. Recent pronouncements by several of the Gulf States such as Bahrain and Oman tend to underscore these concerns. Surely Kuwait, which has had its own dismal experiences as a neighbor of Iraq sixteen years ago, has every reason to be nervous. Whether it is proven that the insurgency or civil war is being stoked by elements from Syria and/or Iran, it is probably irrelevant at this point; the fact is they are occurring. (Needless to say, further deterioration in the Middle East, where tensions are already on the rise over Iran’s pursuit of nuclear capability, could have profound implications for global energy sources and prices.)

Is there any surprise, therefore, that gold is moving up? As readers well know, we are still favorably inclined to the dollar as the alternatives are no better. Buying the euro, given the medium and long-term problems we are seeing in Europe, is for us not a proper response. Even more so, buying the yen, given the enormous fiscal difficulties of the Japanese government, is not an answer either. So those who need to buy currency will likely buy the dollar and obtain a decent income yield. But some are clearly opting to direct purchases of gold including the newly established Exchange Traded Funds (ETFs). At current prices, the world’s annual production of gold is worth approximately $50 billion. Although twice what it was worth just four years ago, this is indeed a tiny amount given the huge amount of wealth invested in the form of stocks, bonds and cash (and indirectly through Hedge Funds, etc.), especially in an open market where even modestly higher demand can quickly send the price dramatically higher.