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:

*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.