A Formula for $12,000 Gold

Gold has steadily advanced over the last 60 days from $1,600 to this morning’s $1,767. Which is making some people a little nervous.

For instance: “Can you comment,” a reader asks, “on what you think might happen to the price of gold if Romney gets elected?”

We’ll answer that question today in the course of examining some longer-term trends that will prove immune to whatever happens [checking the calendar] 25 days from now [thank God].

One of the most respected gold fund managers sees gold reaching for a new high inside the next 12 months.

In his latest shareholder letter, Tocqueville Gold Fund chieftain John Hathaway bases that forecast on continued negative real interest rates: That is, as long as central banks push interest rates below the rate of inflation, gold performs well.

“Some suggest,” Hathaway writes by way of answering the reader’s question, “that a Republican victory in November would be a game changer for gold. It could bring about the dismissal of Bernanke, the taming of fiscal deficits, the painless elimination of excess liquidity from bloated central bank balance sheets and the restoration of robust economic growth.”

[Pausing while your editor guffaws…]

“All of this,” Mr. Hathaway goes on, “would need to occur within the four years allotted to a new administration while voters patiently awaited the magic to take effect. While this rosy scenario is possible, we believe it would be a long shot.

“Therefore, we regard any possible pre-election weakness in gold and mining stocks based on such a possibility as a buying opportunity.”

A few mainstream analysts, believe it or not, are one-upping Mr. Hathaway.

Bank of America Merrill Lynch has assembled an intriguing chart tracking the expansion of the Federal Reserve’s balance sheet going back to the first round of “quantitative easing” in early 2009… and the price of gold. The chart yields a target both for next summer and the end of 2014.

Those numbers might prove conservative. “This target doesn’t take the love trade into consideration,” writes Vancouver favorite and U.S. Global Investors head Frank Holmes, who brought the chart to our attention.

The “love trade” is his term for the centuries-long affinity that Chinese and Indians have had for gold, in contrast to the Western-minded “fear trade.”

In recent months, Indian demand has slumped as the local currency weakened, driving the rupee price of gold to all-time highs. Now that trend is starting to reverse: The exchange rate is now back where it was six months ago, and UBS reports Indian gold demand at a five-month high.

“In addition,” says Mr. Holmes, “Diwali will be celebrated in November. The Festival of Lights is India’s biggest and most important holiday of the year and is celebrated by almost 1 billion Hindus around the world. Traditionally, on the first day of Diwali, it is considered auspicious to clean the home and shop for gold.”

And what of China, the other emerging-market driver of gold demand?

China’s gold imports via Hong Kong — an imperfect measure, but it’s as transparent as the Chinese get about these things — fell 29% between July and August. But it’s the year-over-year trend that matters… and at 53.5 metric tons, it’s up 22%.

Another way to look at it: In the first eight months of this year, China has imported 512 metric tons of gold — more than the total for all of last year, 428.

“What’s happening in precious metals,” says Gary Dugan, “is that they are becoming more mainstream.”

Mr. Dugan is the chief investment officer for Asia and the Middle East at Coutts — the private banking arm of the Royal Bank of Scotland.

Ten years ago, investors rarely held any gold in their portfolios. Now, he tells Reuters, “We are going back to normality, and the normality is that precious metals are the core part of your portfolio.

“Some of the clients ask where gold prices are going, and I say don’t even think about prices. It’s a store of value.” Music to our ears…

Here’s another way to look at how Fed action is driving gold: It’s called the gold coverage ratio.

It measures the amount of gold on deposit at the Fed against the total money supply. “This ratio,” writes Guggenheim Partners chief investment officer Scott Minerd, “tends to move dramatically and falls during periods of disinflation or relative price stability.”

You might not think we’re living in a period of “relative price stability”, but we’ll take Mr. Minerd at face value: The gold coverage ratio is currently at an all-time low of 17%… yielding two tantalizing possibilities.

“The historical average for the gold coverage ratio,” Minerd writes, “is roughly 40%, meaning that the current price of gold would have to more than double to reach the average.”

It gets better: “The gold coverage ratio has risen above 100% twice during 20th century,” most recently at gold’s 1980 peak. “Were this to happen today, the value of an ounce of gold would exceed $12,000.”

Cheers,
Addison Wiggin