Tags: Gold/Precious Metals, Mike Caggeso

Making Sense of (and Profiting from) Gold's Dip Below $850

By , Money Morning •

By Mike Caggeso
Associate Editor

The gold bugs must be scratching their heads. After all, it's just not supposed to work this way.

They've watched as oil prices continued to set new records, understanding that global turmoil and rising demand from China means that "black gold" won't be getting cheaper anytime soon.

They've stared as global food prices continued to soar, touching off riots overseas and bringing U.S. lawmakers to the brink of fisticuffs because of debates over whether corn now earmarked for ethanol should be used to fill empty gas tanks, or empty stomachs.

And they've waited expectantly as the good old U.S. greenback - whose historic swoon against key global currencies has been exacerbated by an epic rate-cutting campaign by the U.S. Federal Reserve - suddenly reversed course and mounted a two-week rally (despite last Wednesday's rate reduction, the central bank's seventh since September).

When they occur separately, each of these developments - increasing oil prices, soaring food and commodity prices, and a plummeting greenback - are highly inflationary. But when they happen in tandem, the ascent in prices can be almost vertical. In such an environment, investors scramble to find a so-called "safe haven" for their money. And the best safe haven has generally been gold.

Until now, that is.

Gold dropped below $850 an ounce last week - representing a decline of more than $182 an ounce, or nearly 17%, from the yellow metal's March 17 record of $1,032.

The main culprit: The resurgent U.S. dollar. Since mid-to-late April, the U.S. greenback has gained ground against several major currencies, such as the European euro, the Japanese yen, the British pound, the Swiss franc and the Canadian dollar. And that rally could continue, especially now that the U.S. Federal Reserve has all-but-promised to end the ambitious rate-cutting campaign that it's been operating since mid-September.

But Money Morning contributing editor Martin Hutchinson thinks other forces are at play, too.

"Credit conditions have eased since March because of the Bear Stearns (BSC) bailout and so investors' fear level is less. [The] stock market is up too, which suggests the same," Hutchinson said.

Moreover, gold's meteoric rise from $654 to $1,032 an ounce in a year (a 57.8% gain) attracted a lot of bulls and speculators whose demand helped push prices further skyward. When gold started to slip, gold bulls sold off their holdings, nudging the yellow metal into its current tailspin.

Such a slippery slope is unusual for gold, but those very conditions could be strong drivers of gold's next rally.

"The gold market is quite illiquid, which is why I think a real speculator panic about inflation could send it zooming," Hutchinson said.

And inflation could be the catalyst for such a speculative panic.

Inflation, Interest Rates and Gold

Gold may be down from its high, but it's not out.

"It still looks heavy at this point. The downtrend that we are seeing at the moment is probably going to start slowing down soon," Taso Anastasiou, technical strategist at UBS Investment Bank (UBS), told Reuters.

In fact, gold's current price could be seen as a "discounted" entry considering three catalysts - worldwide monetary policy, global supply-and-demand, and past performance - have already ignited a powerful rally that's virtually certain to carry gold past $1,500 this year.

And, as Money Morning has chronicled, some experts have even predicted that gold prices would reach the $2,000-an-ounce level within the next year or so.

Global inflation will be a key -if not the key - factor. Interest rates have been significantly reduced around the world, with many countries following the Fed's lead.

To fight inflation, central banks will have to raise rates. But central bankers - including the U.S. Fed - won't make those moves without a great deal of thought beforehand, Hutchinson said.

"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," he said.

How to Play and Profit from $1,500 Gold

Until the Fed reverses its monetary policy strategy and increases interest rates, gold is one of the best investment bets available in an uncertain economic climate.

Money Morning suggests six gold plays to consider while gold is priced down:

  • The simplest way to play gold is through the StreetTracks Gold ETF (GLD), which tracks the gold price directly. And with a $17 billion-plus market cap, it has ample liquidity.
  • Barrick Gold Corp. (ABX) is a Toronto-based company with mostly North American production, as well as properties in South America and Africa, 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 of 29.65, but a forward P/E of 13.69. By gold-mining standards, this company has a substantial presence, is reasonably valued, and has little political risk. The company also recently sent some very bullish signals to the market and recently reasserted its confidence in meeting its 2008 output target of up to 8.1 million ounces of gold. [For more details, read a related story about Barrick Gold]. Barrick is scheduled to report its first-quarter earnings results tomorrow (Tuesday).
  • 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 20.98, and its forward P/E is 10.41. 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 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 32.32, and a forward P/E of 16.03. 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 40.56, and a forward P/E of 22.38, the stock looks expensive.

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