Goldprices have risen 20% in 2010, closing Wednesday at $1,336.90 an ounce.Another round of quantitative easing from the Federal Reserve, globalcurrency wars led by the "race to debase," and a weakening eurozonehave triggered gold's recent surge, but those issues don't tell thewhole story.
Gold prices broke to a new record high last week of $1,424 an ounce asinvestors bought gold as protection against the Fed's loose monetarypolicy, and as Robert Zoellick, president of the World Bank, floatedthe idea of a gold standard to solve exchange rate wars rockingcurrency markets.
Gold's rally was fierce and short-lived. New highs failed to attractnew money and momentum traders. No new money coupled with worries thatChina would raise key interest rates to fight inflation slaughteredprices and dragged them down 6%.
Most analysts believe the stage is set for more volatility in goldprices. Global uncertainty after the Group of 20 failed to come to anagreement on how to halt currency manipulation, of which China and theU.S. are both accused, establishes a choppy trading environment.
Gold is also at the mercy of stocks. When equities plummet, investorsare often forced to sell gold for cash, but any significant dip cantrigger a wave of buying as investors purchase gold at "discount"prices resulting in a strong tug of war for prices.
Prices must also contend with speculation. Some investors buy gold asprotection for their portfolios and are unlikely to participate in theday-to-day market action. Traders, however, use gold as a trade, aquick way to make money, which has been aggravated recently as theymust decide whether to let their December future contracts expire orpony up the cash to roll over the contract to February 2011.
Aside from recent market jitters and technical trading, there are fiveother fundamental factors that contribute to gold's strong price moves.
5. Price ManipulationPrice manipulation is the most controversial theory that has circulatedamong gold bugs for 20 years. Some argue that gold prices have beenillegally suppressed over the last two decades by central banks andgovernments. The Gold Anti-Trust Action Committee, or GATA, is thebiggest complainant.
According to statistics from the World Gold Council, central banksreportedly have 32,000 tons of gold, with the International MonetaryFund accounting for 2,966.8 tons. Under the Washington Agreement onGold, its members can sell a maximum of 400 tons a year, therebyrestricting the amount of gold in the open marketplace.
GATA argues that central banks actually have less than 15,000 tons ofgold, and that the missing gold has been secretly sold or leased intothe market to prevent gold prices from rising to their actual value,which should be between $3,000 to $5,000 an ounce.
"The reasoning for the suppression is governments/bankers [look at]gold to be a barometer of the health of economies and countries. Thesesuppressors want to kill or at the very least, greatly slow themessenger," argues Peter Grandich, editor of Grandich Publications. Thesuppression theory means that global economies are in worse financialshape than investors think and that gold should be bought as theultimate safe haven. Texas representative Ron Paul is planning tointroduce a bill in Congress next year calling for an audit of U.S.gold reserves at Fort Knox.
The gold manipulation theory has been gaining traction of late aftertrader Brian Beatty filed lawsuits at the end of October againstJPMorgan and HSBC for conspiring to "suppress and manipulate" silverprices on the Comex.
The allegations are particularly noteworthy because HSBC and JPMorganare custodians of the physically backed exchange-traded funds like theSPDR Gold Shares(GLD_) and iShares Silver Trust(SLV_), which means thebig banks are in charge of storing the metal investors are buying whilebeing accused of manipulating the prices.
Bart Chilton, commissioner of the Commodity Futures Trading Commission,is pushing the commission to prosecute a two-year investigation intothe silver market. According to reports, the CFTC is also looking intoJPMorgan and possible silver manipulation trading.
The belief is that as investors realize that the precious metals marketis manipulated, gold and silver prices will rise exponentially, butuntil then prices will suffer.
"Our complaint is that more often now they're doing it surreptitiouslyas a mechanism of supporting their currencies, supporting governmentbonds and suppressing interest rates," says Chris Powell, secretary andtreasurer of GATA.
Powell also argues that manipulation gives the inside scoop for theinvestment banks who are working for the government and helping themexecute their secret gold trades.
The opposition, however, believes that claims of price suppression arecompletely unfounded. "There's no vested interest on anybody's parts tosuppress prices here," says Jon Nadler, senior analyst at Kitco.com."The allegations remain at that level, simply allegations."
Nadler argues that despite the rumored price manipulation, prices havestill quintupled in value over the 20 years. "If this is suppression, Ithink it's completely ineffectual, and let me have more of it," Nadlersays.
4. Supply and DemandThe supply and demand factor is pivotal in determining the price of gold.
Many analysts argue there isn't enough gold being produced to satisfyrising demand. The above-ground stock of gold is around 160,000 metrictons and grows about 2,400 tons a year, which is only 1.75% ,whiledemand keeps expanding.
In the World Gold Council's recent Gold Demand Trend report, gold minesupply rose 3% in the third quarter from a year ago compared to a 12%rise in total global identifiable gold demand. Mine production grew to702 tons while demand popped to 921.8 tons.
Although mine supply only grew 3%, total supply grew 18% to 1,028 tonsmore than enough to cover demand. The amount of recycled gold incirculation grew 41% as consumers took advantage of high gold prices tocash in on their gold. The WGC says that another price surge, however,is needed to trigger more selling and that for now sellers appear to betiring out, which would further limit gold supply.
From 2005 to 2009, the gold industry received 59% of its supply frommining production, 31% from recycled or scrap gold and 10% from centralbank sales.
Juan Carlos Artigas, investment research manager at the World GoldCouncil, says that as central banks become buyers instead of sellersthe supply picture loses 10% of its gold while simultaneously grapplingwith gold-producing countries that have exhausted their resources.
For example, South Africa produced 74% in the beginning of the decadebut is now down to 19%. "What we've seen is that there's a strongdemand going on at the same time that the supply picture is shifting,"says Artigas. Weak gold grades in the third quarter also contributed todeteriorating supply from mines in Peru and Indonesia. Helping mitigatesome of these losses were better grades and more gold from mines inAustralia, Argentina and the U.S. run by Newmont Mining(NEM) andBarrick Gold(ABX). But the supply picture is still pretty much a miningand production crap shoot.
One factor that could perpetuate a supply and demand imbalance andhigher gold prices is the advent of physically backed gold ETFs. Alongwith the GLD, the iShares Comex Gold Trust(IAU_) and ETFS PhysicalSwiss Gold Shares(SGOL_) hold more than 1,400 tons of gold, over halfof annual gold production.
Over the past three years, cumulative supply has grown 59% while demandhas surged 62%. According to Artigas, this imbalance has "created afundamental support in the development of the gold market and,consequently, an environment of rising gold prices."
This upward trend is expected to continue as investors seek ways todiversify their portfolio. "While there are many factors that affectthe price of gold at any given point, the overall trend has beenunderpinned by the dynamics of supply and demand."
One wild card that has the opportunity to reshape the supply and demandlandscape is the end of big producer de-hedging. Producers are oftenrequired to hedge, lock in gold sales at a certain price, in order tosecure project financing.
In order to get out of this obligation, the producer must buy back itshedges, literally buy gold. As big miners quickly tried to de-hedge asthe gold price soared, massive tons of gold were literally taken out ofthe market.
In October, AngloGold Ashanti(AU_) announced the elimination of itslast remaining 95 tons of hedges. The biggest hedger now is AvocetMining with just 12 tons and it isn't expected to buy back the hedges.
Without big gold companies frantically buying massive tons of gold,prices could lose a key support factor. Matthew Piggott, metals analystat GFMS, says AngloGold's action will force "the [gold] market [to]look to other areas of demand (such as investment) to make up thedifference in the absence of price support from de-hedging activity."
Jon Nadler, senior analyst at Kitco.com, who sees a top in the goldmarket within a year, says if the gold market had "not had thatde-hedging component ... we would be around $900 in gold [today]."
3. Safe Haven and Peer Pressure Buying Traditionally, gold investing was reserved for gold bugs -- those whothought global wealth would be eradicated and gold would be the onlycurrency left standing.
However, as the financial crisis rocked global markets at the end of2008, a trend started to develop of regular investors allocating acertain amount of their portfolios into gold. The GLD held 614 tons theFriday before Lehman Brothers declared bankruptcy and how holds 1,290tons.
The recommended percentage is typically between 5%-20% depending on howaggressive the investor wants to be or just how much he needs todiversify against other assets. Most retail investors still don't owngold, which is one of the fundamental reasons gold bulls think theprice will skyrocket.
"We're going to go into a period like the high tech market where thereis a mania," says Rob McEwen, CEO of U.S. Gold, who thinks the marketis about half of the way there.
"Your curve is like any other area of the market that suddenly peoplewake up to and say I have to have it and it goes parabolic ... at somepoint up there gold is going to achieve a point where its relativepurchasing power relative to other assets is going to be at its zenithand that's when you want to start thinking about trading out."
This recent shift of gold as a trading tool as well as an investmentwas underscored by gold purchases from big-name investors who hadprofited off of the subprime crisis by betting against mortgage-backedsecurities.
In the fourth-quarter of 2009, legendary investor George Soros almosttripled his gold holdings in the GLD ETF from 2.5 million shares to 6.2million as gold prices hit a then-record high of $1,227 an ounce.Sorossold over 547,689 shares in the third quarter of 2010 but is stillthe eighth-largest holder of the GLD and initiated a new position inIAU of 5 million shares.
The largest holder remains Paulson & Co., run by investor JohnPaulson. Paulson's fund currently owns 31.5 million shares, which ithas held for more than a year.
During the third quarter, large investment banks like Bank ofAmerica(BAC_) and JPMorgan(JPM_) loaded up on precious metal ETFs.JPMorgan doubled its holdings in the GLD to 10.3 million shares andincreased its shares in the IAU by 3.8 million. Bank of America added1.3 million shares to its GLD position and become the largest holderand biggest buyer of the silver ETF, the SLV, by adding 4.6 millionshares bringing its total position to 12.3 million.
Big-name buyers like Soros and Paulson are significant as they cantrigger peer pressure buying. When gold prices pop double digits onhigh volume, retail investors typcially will jump into the trade forfear of missing the opportunity.
Scott Carter, executive vice president of Goldline International, aseller of precious metals, says that "when there's a spike in the priceof gold, it's somewhat counter-intuitive, but you see buyers increaseinto the markets. So it's almost like the train is leaving the station... if gold goes up 1%, 2% in a day we'll see a dramatic increase inthe interest."
On the flip side, when profit-takers sell gold for cash or the crisispremium decreases, momentum buying also slows as investors don't wantto be left holding "cheap" gold.
The advent of physically backed gold ETFs over the past six years hasgiven investors an easy way of speculating on gold. One share of theGLD is equal to one-tenth an ounce of gold. If investors start pilinginto the ETFs, the funds must add more gold, taking more gold out ofthe open market and triggering higher prices. But the reverse is alsotrue. If investors sell gold ETF shares en masse and there are nobuyers, there will be inflows of gold into the market, which will weighon prices.
Large swings in the gold price can also point to buy orders or sellstops. When the gold prices sinks to or rises to a certain level, atrader will be forced to sell or buy gold. This trading restriction isset up to protect the trader from losses and to protect gains, butoften can accelerate sell-offs and rallies.
2. Currency Debasement The most popular reason to own gold is as a hedge against inflation.The theory is as paper currency loses value, gold will retain itspurchasing power, making it a safe place to preserve one's wealth.
Historically, gold has traded in opposition to the dollar. A strongerdollar makes dollar-backed commodities like gold more expensive to buyin other currencies, which weakens demand.
Times of real market panic have altered the dollar/gold inverserelationship as both are bought as safe havens, an alternative tostocks and "riskier" currencies like the euro.
The Federal Reserve's recent announcement of a $600 billion bond buyingprogram, which kicked off Friday, led to an initial dollar selloff asinvestors dumped the currency to buy gold to protect themselves againstthe Fed's printing presses. But this trade has been crimped recently aseurozone issues and contagion worries have weighed on the euro andpushed the U.S. dollar higher.
Investors were acting like the EU debt problems ended with Greece, butIreland and Portugal are finding themselves on the chopping block withboth countries having to defend themselves against bailout rumors.
The EU is trying to pressure Ireland into taking €80 billion in aid andPortugal is warning of a possible bailout risk as well. If the eurokeeps sinking as investors dump the currency, the dollar will keeprising and keep putting pressure on gold prices.
Over the longer term, however, many investors expect the dollar to comeunder strain as the Fed's printing presses debase the currency.
Inflation is currently low. The core Consumer Price Index was unchangedin October leaving inflation up 1.1% year over year, well below theFed's modest 2% target rate. If inflation stays low, the Fed could comeunder pressure to print more money to spur growth. Any moves like thatwould buoy gold as a safe-haven asset.
In the meantime, high inflation in other countries like China haveinvestors worried that central banks will follow South Korea and raiseinterest rates. Any signs that governments will fight growing inflationwill be a negative for gold, which is what triggered gold's doubledigit sell-off on Tuesday.
The more pressing currency issue, at least in the U.S., is deflation ashigh unemployment is forcing consumers to save more, spend less andwait for prices to fall. Some experts say that gold will perform welleven in a deflationary environment.
"If we have a severe bout of deflation, gold might actually, whilefalling, become a very decent reverse hedge," says Nadler. "[That is]it could fall less than other asset classes would in such a situation.Let's say stocks, and bonds and real estate."
Whether deflation or inflation, the U.S. is currently more than $13trillion in debt with $224 billion in interest payments due in fiscalyear 2010 fueling rumors among doomsayers that the dollar willeventually be worth zero.
"Intrinsically, the dollar is worth nothing. It's a dream painted on apiece of paper," says Rick Rule founder of Global Resource Investments.Rule predicts higher gold prices in the future because the U.S. dollarwill eventually depreciate in value. "There's no particular reason whyyou, despite the fact that you live in the U.S., need to be a prisonerof the dollar ... use gold money, export your capital."
Recent talk of currency wars have also highlighted the fragility of thepaper market. Countries like Brazil and Japan have been watching theircurrencies rise in value as speculative money looks for currencies withhigh yields. However, the downside is that these countries' exports aremore expensive to buy elsewhere which crimps their growth.
Other nations like the U.S. and China have been accused of forcingtheir currency lower to help their export growth. At the recent Groupof 20 meeting in South Korea, countries agreed to promote global growthand avoid competitive currency debasement but couldn't agree on anyspecifics.
Talk of currency and trade wars only boost investors' lack of faith inpaper money which will shine a light on gold's appeal as a safe havenasset.
1. Central Bank Buying Huge double-digit price movements in gold could mean that there are big buyers and sellers in the market like central banks.
"There has been a fundamental shift in the behavior of central banksover the past few quarters," says Natalie Dempster, head of investmentfor the World Gold Council. "Central banks on the whole have been netsellers of gold for the past two decades."
Since the second quarter of 2009, however, central banks from emergingmarket countries have transitioned into net buyers. The Reserve Bank ofIndia has been actively buying gold from the IMF . India now holds 7.5%in gold reserves, which is still considerably lower than the 20% ofgold reserves it held in 1994.
One of the biggest buyers is China. Over the past five years, thecountry secretly increased its gold holdings from 600 tons to 1,054tons. China currently holds only 1.6% of its reserves in gold. Dempstersays that if the continent were to reallocate its holdings to 3%, itwould need to buy 1,000 tons of gold. Compare this with the U.S. andPortugal, which hold 70% and 80% of their reserves in gold,respectively.
China has said that it will not be buying anymore gold for itsreserves, but is encouraging its citizens to buy and is opening up thegold trading market to spur demand. China, however, is unlikely toannounce if they are buying gold for risk of triggering a rally in theprice.
"Some banks like India," says Dempster, "have been rebalancing as thepercentage of gold in total reserves has fallen over time. Others arelooking to diversify away from dollar-based assets, and with sovereigndebt concerns continuing to grow around the world, gold'sattractiveness as a reserve asset that bears no credit risk continuesto grow."
In the third quarter, purchases by central banks outweighed sales by21.9 tons according to the World Gold Council. Eurozone banks held onto their gold while Russia bought 46.2 tons, Philippines bought 4.2tons, Thailand added 15.6 tons to its reserves and Sri Lanka increasedits holdings by 6.9 tons.
Central banks in general regard reserve allocation as an ongoinggovernment policy. Although the governments consider fundamentals likedollar weakness and the sustainability of gold as money, they don'ttrade gold; they buy it as an investment. They will buy gold when theyfeel gold reserves are too low when compared to its other holdings.
Central banks tend to be price agnostic, but are heavy buyers and sellers.