Gold: Don't Get Out Before the Bankers Get In

Gold bears say the only thing propping up the market are speculators hoping someone will come along after them to pay an even higher price. Nonetheless, that someone is lining up now – and they've got very deep pockets.

Gold: The dollar's only serious rival
Swiss bank UBS organizes an annual seminar for sovereign institutions, which includes central banks, sovereign wealth funds, and transnational institutions such as the IMF. This year, the bank asked participants -- who represented $8 trillion in reserve assets -- what the most important reserve asset would be in 25 years. Roughly half answered the U.S. dollar, but more than one-fifth fingered gold. The shiny yellow metal was the second-most-popular answer, well ahead of the euro or Asian currencies (responses weren't asset-weighted).

That result suggests a sharp reversal in central bankers' views of gold. Indeed, in 2009, managers of reserve assets were net buyers of gold for the first time in two decades.

Lessons from another market
This reminds me of when George Soros went long on the Japanese yen going into a September 1985 meeting of G5 finance ministers. The outcome of the meeting -- the Plaza Accord -- stipulated that all five countries would intervene in currency markets to bring the dollar down. The yen opened sharply higher on Monday, and Soros' traders began congratulating themselves and taking gains on their yen positions. Undeterred by the price action, Soros burst out of his office and ordered them to stop selling.

As Soros' former associate Stanley Druckenmiller tells it: "Soros was looking at the big picture. The government had just told him that the dollar was going to go down for the next year." By the end of 1987, the dollar had fallen 54% from its February 1985 high.

Is this a signal?
Are central banks now telling us that gold will rise for the next few years? The parallel isn't perfect: There is no joint commitment on banks' part to drive the price of gold up, or even to make any purchases at all. Nonetheless, I think we may be witnessing an important shift in the way central bankers perceive gold, which could become a powerful and long-lasting trend. Consider these factors:

  • Developed economies typically allocate more than half of their reserves to gold, whereas emerging economies have a much smaller allocations (China's is 1.5%, for example). We should expect the allocation in emerging economies to rise – particularly in light of growing concern about the stability of the dollar.
  • The reserves of the world's largest emerging economies have been growing at a blistering pace. China alone added nearly $50 billion to its foreign exchange reserves the first quarter. Although the pace of growth may slow in the coming years, it's unlikely to reverse.

Gold gets more of the pie
In other words, emerging economies look set to allocate a larger piece of their reserves to gold, and the size of that pie is growing quickly. With regard to the duration of a shift toward gold, central banks are conservative, lumbering organizations.  If their view on gold has changed significantly, it probably marks the start of a multiyear trend.

As central banks increase their demand for gold and reduce the amount they supply to the market higher bullion prices could result. Gold miners, in turn, benefit from any price appreciation, and those with the lowest production costs benefit the most. Here's how some of the large gold miners stack up on that measure:

Company

Cash Production Cost ($/ oz.)*

Goldcorp (NYSE: GG  )

$295.0

Agnico-Eagle Mines (NYSE: AEM  )

$347.0

Newmont Mining (NYSE: NEM  )

$417.0

Barrick Gold (NYSE: ABX  )

$466.0

AngloGold Ashanti (NYSE: AU  )

$575.8

*Latest annual. Source: Capital IQ, a division of Standard & Poor's.

(Note that some miners may lock in a sale price in the futures market, so they wouldn't necessarily benefit fully from a rise in gold prices.)

A brilliant investor who likes gold
The government sector's not the only one bullish on gold, either. The senior keynote address at the UBS seminar came from John Paulson, the hedge fund manager who made $3.7 billion personally in 2007 by betting against subprime mortgages. According to an SEC filing, at the end of the first quarter, Paulson & Co. had a $3.4 billion position in the SPDR Gold Shares ETF (NYSE: GLD  ) , as well as shareholdings in at least seven gold miners, including Barrick Gold and AngloGold Ashanti.

If you're concerned about slowing growth and massive government debt levels in the U.S. (and other developed markets), there are alternatives for your money. Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy


Read/Post Comments (11) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 30, 2010, at 7:04 PM, susan400 wrote:

    Gold: Don't Get Out Before the Bankers Get In"

    TMF sell signal !

    Paulsen isn't go d.

    China could bot anytime in 20 yrs,

    now because you know that have liottle you think they buy?

    GOld has been a disaster for CBs

  • Report this Comment On June 30, 2010, at 7:48 PM, TMFAleph1 wrote:

    @susan400,

    Can you clarify the meaning of this sentence:

    "China could bot anytime in 20 yrs,

    now because you know that have liottle you think they buy?"

  • Report this Comment On June 30, 2010, at 8:51 PM, Starfirenv wrote:

    Wow, John Paulson of Paulson & Co. Aren't they the guys on the hot seat with GS for hand picking and gift wrapping the most toxic subprime $hit available, gift wrapping and "slinging" this "designed to fail" mess on the unsuspecting? Wow 3.7 BILLION personally. I'm impressed. All I want to know is how he sleeps. You're a better stooge than Fool, and I understand, as Paulson & Co. COO is one of your Board of Directors. Zero cred for you. How do you sleep?

  • Report this Comment On June 30, 2010, at 10:00 PM, TMFAleph1 wrote:

    Goldman Sachs may be on the 'hot seat', but Paulson & Co. isn't. They haven't been accused of anything illegal and I think you'd be hard pressed to show that anything they did in this matter was unethical.

    My guess is that John Paulson sleeps has no trouble sleeping at night.

  • Report this Comment On June 30, 2010, at 10:03 PM, MegaEurope wrote:

    I think SDRs (IMF Special Drawing Rights) are going to be used much more widely in the next 25 years, possibly even becoming the dominant reserve currency.

    Nations currently hold around $8T in currency reserves and $1.2T in gold reserves so it would take a pretty massive shift for gold to dominate.

  • Report this Comment On June 30, 2010, at 10:06 PM, MegaEurope wrote:

    In other words I think the 20+% who answered gold are wrong, even assuming gold continues to appreciate. Maybe "talking their book".

  • Report this Comment On June 30, 2010, at 10:16 PM, TMFAleph1 wrote:

    MegaEurope,

    That's an interesting point, but I don't expect SDRs to become the dominant reserve currency.

    After all, the SDR's value is simply based on a basket of 4 major currencies, so SDRs don't address the declining confidence in the stability of the U.S. dollar (and other major currencies, particularly the yen, euro, sterling).

    Best,

    Alex D

  • Report this Comment On July 01, 2010, at 3:36 AM, reflector wrote:

    i don't quite follow this reasoning:

    "Gold miners, in turn, benefit from any price appreciation, and those with the lowest production costs benefit the most. "

    i would think it would be the opposite?

    e.g., if gold rises from $1200/oz to $1300, the profit margin of a miner that has a production cost of $1100 has DOUBLED from $100 to $200.

    but the profit of a low cost miner whose low production cost is only $200 an oz has gone from $1000 ($1200 - $200) to $1100 ($1300 - $200), a gain of only 10%.

    it seems to me that the high-cost miner has benefitted the most.

  • Report this Comment On July 01, 2010, at 3:46 AM, whereaminow wrote:

    If the other 80% of central bankster gangsters and SWF managers don't see gold as being as valuable, I wonder why they aren't selling it?

  • Report this Comment On July 01, 2010, at 11:46 AM, WalterMiddy wrote:

    Reflector:

    I'm more simple minded, I guess. But the first miner pays $200 to make $1300; the second guy pays $1100 to make $1300. Isn't the first guy benifiting more in that his profit is larger?

    Or maybe another way: A $100 increase in price over $200 in costs seems better than a $100 increase in price over $1100 in costs.

    Not a math major so that might explain if I'm missing something.

  • Report this Comment On July 02, 2010, at 12:30 AM, reflector wrote:

    walter,

    the premise was, that the *increase* in the gold price benefits low-cost miners more.

    in the example i gave above, when the gold price goes from $1200 to $1300:

    the low-cost $200 miner sees an increase in margin from $1000 to $1100, their margins have gone up 10%

    but the high-cost $1100 miner sees an increase in margin from $100 to $200, their margin has increased 100%, it's doubled!

    having your margins double should have a much more significant effect on your share price, than having your margins go up 10%, it seems to me.

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