Six Ways to Play Money Morning's Prediction That Gold is Headed for $1,500 an Ounce

By Martin Hutchinson
Contributing Editor

Back in October - when gold was trading at only $770 an ounce - I told Money Morning readers that the "yellow metal" was looking like a very good bet

Since then, gold soared to more than $1,000 an ounce, creating quite a nice return for investors who acted on our prediction. Since achieving that peak, gold prices have declined a bit. In fact, just last week, gold prices dropped below the $900 mark, prompting gold bears to say that the great gold bull market has reversed itself.

Let me say right now: They're wrong.

In fact, now I'm saying that - thanks to three key catalysts - we may well see gold at $1,500 an ounce this year, if not higher.

Those three catalysts - worldwide monetary policy, global supply-and-demand for gold, and gold's past performance - have already ignited a powerful rally that's virtually certain to carry gold to much higher price points, despite the breather the rally appears to be taking right now.

Don't be fooled. Understand the forces at work here. Then watch as gold prices soar.

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Three Reasons Gold Prices Could Vault

Every rally needs a catalyst - something that ignites and then fuels the bullish trend. As noted above, gold has three. Let's take a look at each of them:

1. Monetary policy: More than for any other investment, gold's price depends primarily on the world's monetary policy. When monetary policy is loose, as it was in the 1970s, gold prices soar. When it is tight, as in the 1980s, prices decline sharply. When gold prices advanced sharply after 2000 that should have told the U.S. Federal Reserve and others that monetary policy had once again become too loose.

Indeed, it became too loose after 1995, but gold prices were temporarily suppressed by the world's central banks (the British Treasury, then headed by Gordon Brown, sold the nation's entire gold stock in 1999, at a price of around $280 per ounce - yet another reason for British taxpayers to be annoyed with their current Prime Minister).

The rise in gold prices is thus easily explained. U.S. monetary policy has been loose since 1995, and particularly since the recession of 2001 and 2002, and other countries have followed the United States' lead. According to International Monetary Fund (IMF) statistics, the world's total foreign exchange holdings increased from $1.4 trillion in 1997 to $6.4 trillion last year, an average annual increase of 16.4% - compared with a 7% annual increase in Gross World Product. With that kind of monetary expansion, it is not surprising that gold prices have risen; the metal is universally regarded by both the sophisticated and unsophisticated alike as the premier hedge against inflation.

Since the subprime crisis exploded onto the scene last September, the Fed has been lowering interest rates. And the Fed, the European Central Bank (ECB) and the Bank of England have been providing additional lending facilities to banks and investment banks. The lowering of interest rates has been quite dramatic, from a Federal Funds rate of 5.25% before September to 2.25% now. Even 10-year Treasury bonds, currently yielding 3.6% or so, are providing investors with a yield that remains well below the rate of inflation (currently somewhere above 4% and trending higher). The bailout of The Bear Stearns Cos. Inc. (BSC) and the continuing efforts of the ECB to restore liquidity to the short-term euro deposit market are having the same inflationary effect. As a result, commodity prices have soared in the last six months, as has the price of gold.

Gold has sold off in the past couple of weeks as the market has focused on the U.S. recession, believing that inflation pressures will decline, but that's wrong. Monetary expansion continues and even is intensifying, meaning that inflationary pressures will increase and gold will be the beneficiary.

2. Global Supply and Demand
: For most commodities, price rises have an effect on supply and demand; a higher price increases supply and reduces demand, in "price elasticity." With oil, for example, a 10% rise in price reduces demand by about 1% to 1.5%, meaning that oil has a price elasticity of 0.1 to 0.15. That's what conventional economics tells us, and it's a good thing, too. Without the effect that rising prices have on supply and demand, a shock in the market could produce instability, with prices zooming off to infinity.

Gold appears to be an exception. For gold, rising prices appear to increase demand and decrease supply. According to the World Gold Council, world gold demand in 2007 increased by 4% in volume terms to 3,547 metric tons, or about 20% in dollar terms; the average dollar price of gold increased 16%. Gold supply decreased 3% to 3,469 metric tons. Of that, mine supply decreased 3% to 2,047 metric tons, while official sector sales increased 32% to 485 metric tons and gold scrap recycling decreased 15% to 937 metric tons.

This suggests a gold supply/demand price elasticity of minus 0.4; that is, if prices increased 20%, demand would increase 5% and supply would drop 3% to 4%.

That simply cannot be true in the long run - otherwise, the gold market would explode, swallowing the world economy. Nevertheless, while real global interest rates remain low, gold should retain its current dynamics, with speculative demand increasing as prices rise. Since the pools available for speculative investment are much larger today than they were in 1980, the predicted gold price "spike" could even move well beyond 1980's peak price of $2,250 an ounce (as measured in today's dollars).

3. Comparison with past peaks: If gold had increased in price since 1997 by the same percentage as world dollar reserves, it would currently be trading at around $1,280 per ounce. And the current speculative appeal of gold, compared to its inactivity 10 years ago, suggests it could go higher than this. The 1980 gold price peak of $875 per ounce intraday is equivalent to more than $2,200 per ounce when inflation is taken into account.

That occurred in a period when equity investments had fallen deeply out of favor [remember the famous August 1979 "Death of Equities" BusinessWeek cover story?], when bonds had performed miserably for more than 30 years and when oil was not yet significantly publicly traded. Thus, when inflation rose to a frightening level above 10%, the world's entire investment pool flooded into gold - and, to a lesser extent, silver.

Today, while the Fed and other central banks keep interest rates below the level of inflation (roughly 2.5% with an inflation rate of about 4.0%), gold prices are likely to continue increasing at a rapid clip, though they may retreat temporarily for a few weeks at a time. Nevertheless, while the global investment pool is many times larger today than in 1980, it has recent memories of making good profits in stocks, so a money-fueled bubble would be unlikely to flow entirely into gold as it did in 1979 and 1980. However, if gold is unlikely to reach $2,200 in the short term, its greater attraction to investors today compared with 1997 suggests that it will rise well above $1,280.

How high can gold go?

Just let me show you...

Price Projections for the Yellow Metal

At some point, with monetary policy as loose as it is currently, inflation will probably accelerate to a point that will force the world's central bank policymakers to take action. When that happens, interest rates will have to be sharply increased. Then - and only then - will the risk-reward potential for gold change enough that wise investors should sell.

That final peak might come immediately before this sharp uptick in interest rates. Or it might lag by a few months, as it did in 1980 [Fed Chairman Paul Volcker's first big interest rate rise was in October 1979; gold finally peaked in January 1980]. Remember that recessions don't stop gold prices from rising. Gold's first major peak was in the middle of the 1974 recession and its second was well into the first part of the 1980 recession.

As inflation accelerates, it will probably take a few months for clear inflationary signals to cause the Fed to reverse its policies and attack inflation. And during that period, expect speculative demand for gold to intensify and its price to increase steeply. The longer the period before the Fed is forced to increase interest rates, the higher gold will go.

For example, if rates aren't increased before the end of 2009, gold could easily soar well through $2,000 - a price point we said was possible back in July, when gold was trading at $650 an ounce.

Even if $2,000 seems to be a somewhat aggressive price target for gold (because rising inflation is likely to cause the Fed to reverse policy before it gets there), understand that a target price of $1,500 certainly is not. And it seems very probable that with speculative demand tending to increase, gold could reach that latter level before the end of 2008.

The bottom line: Until the Fed reverses monetary policy and increases interest rates, gold is one of the best investment bets in an uncertain world.

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Six Gold Plays to Consider... Now

  • The simplest way to play gold is through the StreetTracks Gold ETF (GLD), which with $19.8 billion outstanding has ample liquidity, and tracks the gold price directly. Alternatively, you should consider buying gold mining shares. Here are five possibilities:
  • Barrick Gold Corp. (ABX) is a Toronto-based company with mostly North American production, as well as some South America and Africa properties, and some copper and zinc add-ons. It has a $38 billion market capitalization, so there's plenty of liquidity. It has a trailing Price/Earnings ratio (on the most recent 12 months) of 34, but a forward P/E (on the next 12 months) of 16. By gold-mining standards, this company has a substantial presence, is reasonably valued and has little political risk. And, as Money Morning reported, the company also recently sent some very bullish signals to the market and then this week said it was confident that it could meet its 2008 output target of up to 8.1 million ounces of gold [For more details, read a related story about Barrick Gold in today's issue].
  • Yamana Gold Inc. (AUY) is another U.S.-listed Canada-based company, but this one does its mining in Brazil, Argentina, Chile, Honduras and Nicaragua. It has a market cap of $9.7 billion and a trailing P/E of 40, but its forward P/E is only 14. Despite its geographic reach, it faces only a medium geopolitical risk. Expect the company to double production to 2.2 million ounces per year by 2012, primarily in Brazil and Argentina. 
  • Gold Fields Ltd. (GFI) is a South African company that mines in South Africa, Ghana, Australia and Venezuela (where it just sold control to a local company, reducing its exposure to an arguably risky market). The company's market cap is $9 billion, its trailing P/E is 24, and its forward P/E is 11. It faces a somewhat upper-medium political risk, depending on what you think of South Africa, where the electricity supply to the gold mines is currently unreliable and where there's a good chance of Jacob Zuma winning the presidency in April 2009. Given his record as an anti-Western leftist, and the corruption charges he faces, his potential return can only be viewed as a major negative.
  • Kinross Gold Corp. (KGC), another U.S.-listed Canadian company, engages in gold and silver mining, with primary operations in Canada, the United States, Brazil, Chile and Russia. In February, Kinross issued shares to buy a large Brazilian/Russian company. Political risk is low-medium. It has a market cap of $14 billion, a trailing P/E of 39, and a forward P/E of 19. It looks somewhat expensive. 
  • Royal Gold Inc. (RGLD) is a U.S.-based company with mines in Nevada, Mexico and Argentina. It faces low political risk. But with a market cap of $905 million, a trailing P/E of 44, and a forward P/E of 25, the stock looks expensive.

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