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Why gold is soaring -- and could keep going
It's not just inflation worries driving gold futures to new highs. Here are some ways you can still stake a claim in the rally by investing in companies that mine the metal.
By Robert Walberg
After spending most of the year confined to a $30 range, gold futures have exploded to their highest level in nearly two decades. Since bottoming on July 15 this year, gold is up 20.5%, with 12% of that gain coming in just the last month. Gold stocks have done even better, gaining an average of 61% since bottoming in mid-May.
The rally is finally starting to draw the attention of investors, who want to know what's behind the big surge in gold prices and gold stocks -- and, more importantly, if it's too late to take part in the rally.
One reason cited for the price move is investor concern over inflation. However, there are many more direct hedges against inflation in today's investment world than gold futures. Oil futures quickly come to mind -- especially considering that the big jump in crude over the last year is largely responsible for the inflationary pressures in today's economy.
Nevertheless, you can't read an article on gold or the sector without a bunch of analysts pointing to inflationary concerns as the reason for the metal's break to new high ground.
Another factor working against inflation as the primary reason for the metal's recent rally is timing. More than half this year's gain has occurred in the last month, after a long series of rate increases by the Fed and after a big price drop in crude. One would think that inflationary concerns would be waning, not heightening, under such a scenario.
If not inflation worries, then what?
The timing of the price move suggests that seasonal factors might be at play. Jewelry demand is often high this time of year and gold jewelry is coming back in vogue. Asian demand for the precious metal is reported to be relatively high and when you factor in the constraints on supply, the demand surge for jewelry would at least help to explain the timing of the breakout. If true, then investors need to be concerned that the rally might run out of gas in the first quarter.
Arguing against such a reversal is the fact that the breakout to new high ground has occurred while the U.S. dollar has been gaining strength relative to foreign currencies. Much of gold's advance into the low $400s came against a falling dollar, compelling many investors to suggest that the metal had become a hedge against dollar weakness.
A weak dollar, especially relative to the yen, made gold cheaper to buy -- and considering that much of the world's gold demand comes from Asia, the stronger yen was seen driving the run in gold. But with gold rallying alongside the dollar this historical link may no longer be valid. Looked at another way, gold may no longer be constrained by the dollar and its movement.
This important decoupling has some gold speculators suggesting that the move in the metal is foreshadowing a period of financial distress. The popping of the real estate bubble and the growing debt crisis in the U.S. are cited as two potential triggers of such a crisis. Frankly, though, such theories have been routinely put forth by gold bugs over the years as reasons why the metal should be purchased and I see no more merit to them today than in the past.
A more simple reason for gold's move might just be that after years of central bank selling, there are now reports that worldwide central banks are starting to add to their gold holdings. Increased buying on the part of central banks, coupled with the seasonal boost in demand and limited supply, make a pretty compelling case for higher gold prices.
Demand grows while mines decline
According to Greg Wilkins, president and CEO of Barrick Gold (ABX, news, msgs), the rally in gold is sustainable because "the underlying factors driving gold prices to $500 are still compelling going forward." Those factors are declining mine supply and a steady increase in demand. Maybe that's why Barrick is trying to snap up Placer Dome (PDG, news, msgs) for a cool $9.2 billion. And maybe the prospect of higher gold prices explains why Placer Dome management is balking at the offer even though it represented a significant premium to the price of the stock when the deal was put on the table.
If Barrick really wants this deal to happen, then look for the company to bolster its offer -- at least a little, as the deal in its current terms still values Placer Dome shares below where the company was trading late last year. Given that Placer Dome closed Tuesday at a price above the offer, the street also thinks a better deal is coming -- either from Barrick or another company such as Newmont Mining (NEM, news, msgs), which has expressed mild interest in Placer Dome.
Either way, the fact that Barrick and others are looking at ways of increasing production suggests that demand for gold going forward is expected to remain brisk. With the cost of mining gold for these companies ranging somewhere from the high $200s to mid $300s per ounce, the profit picture also looks decent. In fact, earnings for the nine stocks reviewed for this article are expected to jump by an average of 57% during fiscal year 2006.
Valuations for many gold stocks reflect much of the improvement, but it should also be noted that very few analysts were forecasting gold to reach $500 by year-end, yet alone go higher. As such, it's a pretty good bet that earnings estimates in the sector will be adjusted higher in the weeks and months to come. Rising earnings estimates is often a good precursor of stock action.
There's still some luster in gold stocks
So while gold and gold stocks have already enjoyed an impressive rally, the favorable supply/demand picture, combined with impressive price and earnings momentum, suggests that higher stock prices are in order over the next year. Consequently, it's not to late for gold stocks to add some sparkle to your portfolio.
I'll dabble in the sector myself, by adding shares of Barrick to my Street Patrol portfolio as of Wednesday's close.
Investors unsure of which individual stock might give them the best returns can consider a couple of exchange-traded funds (ETFs) that would provide increased diversification without the added costs of a gold mutual fund. A couple of ETFs worth considering are StreetTRACKS Gold Shares (GLD, news, msgs) and iShares Comex Gold Trust (IAU, news, msgs).
At the time of publication, Robert Walberg did not own or control shares of companies mentioned in this column.
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