Gold prices: A look back and a look ahead

Today we have a guest post by Michael Bradshaw, CFA, portfolio manager with expertise in investing in gold, other precious metals, and gold-related stocks.

Michael Bradshaw on Gold prices: A look back and a look ahead

Investors who have followed the price of gold this year are probably familiar with the guessing game surrounding the Federal Reserve’s (Fed’s) quantitative easing (QE) policy. That bond-buying policy and the threat of future inflation it brings with it has been one of the short-term supports for gold prices. Some investors expect that once the Fed scales back and then eliminates its bond purchases—currently running at $85 billion a month—the price of gold will pull back significantly. So far this year, however, the markets may have provided a glimpse of how they will respond once the Fed’s tapering officially begins. It’s likely that this year’s fall in the price of gold has already priced in a significant portion of the taper’s effects, with the short-term outlook for gold looking increasingly range-bound. It’s the long-term prospects for the metal—and for gold-related companies—that are more interesting.

Gold prices sold off through the end of June on comments from Ben Bernanke that the U.S. economy may soon be strong enough for the Fed to begin reducing its level of bond purchases. Gold and related stocks then began to recover in subsequent months as Asian demand remained strong, exchange-traded fund (ETF) outflows stabilized, and tensions in the Middle East (Syria) led investors to seek perceived investment safe havens. In addition, stronger economic data out of Europe and China caused the euro and other commodity-based currencies to strengthen relative to the U.S. dollar. Gold prices rebounded in July and August and then receded after Fed commentary suggested it could begin tapering its bond purchases as early as October, thereby introducing further uncertainty about future Fed actions.

2013 gold and gold stock prices
Source: FactSet. Data through 10-23-2013.
Past performance is no guarantee of future results.

Short-term outlook

In the short term, the gold and precious metals stock prices are likely to be range-bound, influenced by concerns over U.S. debt levels, import restrictions for gold into India, lack of clarity on QE elimination, mixed U.S. economic data, and the growing reality that the Fed may not taper its bond purchases until mid-2014 at the earliest.

Longer-term outlook

Over the next few years, the value of the dollar will likely decline and confidence in emerging markets economies could improve, which bodes well for precious metals prices and related stocks. However, gold market appreciation is likely to be driven mostly by physical demand. I anticipate significant purchases of gold jewelry, coins, and bars from China as well as other emerging markets nations. Central bank purchases will also be a likely driver of gold prices.

Sovreign gold ownership
Source: World Gold Council. Information was last updated on 9-2-2013 and was originally sourced from the International Monetary Fund’s International Financial Statistics and other sources where applicable.
Gold in Millions of Ounces converted into metric tonnes at 32,151 ounces per tonne.
Past performance is no guarantee of future results.

While gold prices likely won’t be driven by retail investor demand, the U.S. government’s lack of attention to its debt issues should be supportive for gold price trends. The U.S. federal debt is projected to hit $17 trillion by year-end and to continue to rise from there. Additionally, the Fed is likely to have difficulty scaling back its QE program without strong upward pressure on interest rates. U.S. fiscal and monetary strategies appear unclear, but dollar depreciation, higher inflation, or both seem like they are potential outcomes. Gold has historically had a negative correlation to the U.S. dollar and a positive correlation to significant inflationary pressures.

Total U.S. public debt
Source: U.S. Department of Treasury. Data through 4-1-2013.
Past performance is no guarantee of future results.

In recent months, gold-related stocks have outperformed the underlying commodity as investors gave more credence to company fundamentals and as company-specific merits and asset values were rewarded. I believe gold-related stocks continue to have better appreciation potential than the metal itself. If gold prices remain at current levels, I believe precious metals stocks appear to be undervalued by 30% to 40%. However, stock selection will likely remain important, as company fundamentals tend to drive stock prices. Higher-quality companies with internal growth catalysts, such as effective execution of business plans and mining and production successes, are likely to outperform. Firms with relatively lower costs, lower debt, and solid balance sheets that are located in relatively stable political jurisdictions have outperformed in recent months and should continue to be favored by the market. For example, Alamos Gold Inc. is one of the lowest-cost producers and nearly 25% of its market cap is composed of cash. The firm recently received the necessary permits for a mine in Turkey, which lifted its stock price. I also favor production companies over exploration or development firms because they are more established, generally have positive cash flow, and have less risk of needing to raise capital in the current environment.

Gold prices sold off after the first hint of a taper and after global economic trends began to improve. However, these recent developments have not erased the long-term drivers of gold price appreciation.

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