Memo to gold bugs: reasons to be cautious
September 19, 2011 9:41 am
By Jack Farchy in Montreal
It’s a big week for the gold market – the two major industry gatherings of the year are both taking place (great co-ordination, guys).
At the LBMA conference in Montreal which begins in earnest today, the bullish tone of the meeting has already been established at a series of private events hosted by Deutsche Bank, HSBC and Scotia. Although there is a little more hesitancy in the air than at previous years’ meetings, it is still the case that almost everyone is optimistic. The other gathering, the Denver Gold Forum, is likely to parade a series of mining executives arguing that their share prices ought to be higher.
As a counterbalance to the wave of bullishness that is invariably unleashed when the entire industry comes together in one or two places, it might be worthwhile to take stock of some reasons to be cautious about gold.
1. Dollar strength
The imminent risk to financial markets lies in the eurozone; specifically, the possibility of a Greek default and/or the escalation of tensions in other peripheral eurozone bond markets. That, together with the potential for a sharp outflow of capital from emerging markets which seems to have begun in the past week or two, suggest the dollar could strengthen significantly through the remainder of this year. A stronger dollar typically creates a headwind for gold.
2. Volatility
One of gold’s great strengths over the past couple of years has been that, despite its rapid ascent, the market has remained orderly and volatility has been low. No longer. Since hitting a record high of $1,920 at the start of September, gold has been lurching one way and another in rather violent swings. The cost of options, the market’s measure of expected volatility, has also spiked. Even the most bullish traders believe the ride up is likely to be volatile. And nobody likes a volatile haven.
3. Physical markets becoming more speculative
The physical bullion market – which many traders see as gold’s true fundamentals – has been pulling strongly in the metal’s favour this year. As GFMS, the consultancy, noted in an update to its annual market survey last week, global jewellery demand increased 7.5 per cent in the first half of the year despite significantly higher prices; likewise, scrap supply fell 7.2 per cent. That is bullish for gold. But the reason for the counterintuitive move is a shift in the approach of these two important physical markets to become more speculative; in turn, it means they may not offer their traditional support when prices fall. As GFMS notes, “clear signs of a long term price slide beginning could yield a wave of scrap and poor jewellery demand”.
4. Always be cautious when something becomes consensus
Until recently, most analysts reckoned the gold price was soon about to peak. Gold merrily wrongfooted them and left all their predictions in the dust (the most bullish analyst in a survey of 24 at the start of the year was predicting gold would peak at $1,850 this year). But in the past month or so, everyone has upgraded their forecasts for 2012 – now many predict gold prices well above $2,000 an ounce next year. For example, UBS has recently raised its forecast for the average 2012 price from $1,380 to $2,075, while HSBC has lifted its prediction from $1,625 to $2,025.
5. Miner hedging
Could miners make a return to hedging? The notion is roundly dismissed by most mining executives. (Despite that, there has already been a return to net hedging in the first half of 2011, albeit relatively small at 12 tonnes compared with a hedge book of over 1,500 tonnes just five years ago.) But consider this: there is a huge divergence between the spot gold price and the shares of gold miners. The mining equities are pricing in a gold price of about $1,400 an ounce, according to Patrick Chidley of HSBC. If the disconnect persists, it will surely only be a matter of time before savvy private equity investors start to buy gold companies and sell their future production to finance the deals.
6. Selling out at the top?
Goldman did it for investment banking; Blackstone for private equity; Glencore may have done it for commodities (although the jury is still out on that one). It’s not quite on the same scale, but nonetheless notable that GFMS, the leading consultancy in precious metals, has just been sold by its management to Thomson Reuters. Indeed, GFMS is explicit in its view (long held) that gold fundamentals “argue for notably lower equilibrium prices” in the medium to long term.
7. The financial situation is surely as bad as it can get/gold is overbought/it’s just a great big bubble isn’t it?
I have left this point until last because – although a favourite of gold bears – I do not think there is much merit in it. People have been arguing gold was overbought, or that things could not get any worse, for years now. Then things did get worse and more people bought gold. At some point, of course, the world’s economic and financial state will indeed reach a nadir and then gold will probably suffer a nasty correction (how nasty is a question for another article). But nobody knows when that will happen. And whether or not gold is a bubble seems to me to depend largely on your definition of a bubble – I am not sure that the argument is very informative when it comes to deciding whether to buy or sell bullion.
So, gold bears, be content with the first six points. Gold bugs, as you navigate the presentations and cocktail parties in Montreal and Denver this week, just bear them in mind.
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Copyright The Financial Times Limited 2011.
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