Fundamentals say Gold Prices Should Rise
The case for higher Gold Prices remains intact – but investors should expect more volatility...
PRECIOUS METALS and mining stocks offer investors the best way to profit from the unfolding global economic mess, according to 'Commodities for Dummies' author Amine Bouchentouf.
In this interview with The Gold Report, he talks about how mining stocks can offer investors the type of diversification and upside potential needed in today's rocky market environment.
The Gold Report: Thank you for joining us today. You wrote "Commodities for Dummies" and are a partner in Commodities Investors LLC, an advisory firm. What is your reaction to the spectacular run-up in metals' prices and recent pullback in the last few weeks? Where are we headed from here?
Amine Bouchentouf: We have to put things in perspective. Let's not forget that gold has been one of the top performing commodities over the last five years, and even over the last year. I recommended gold in 2006 at about $500/ounce (oz.). Between 2006 and today, gold is up about 175%, even considering last week's downturn.
Take it one step further; even this year gold is up approximately 15% while the S&P is down 7%. So, if you were in gold over the last five years or just the last year, you have outperformed the broad market by a wide margin. The long-term uptrend remains intact but these kinds of pullbacks are normal and provide buying opportunities.
TGR: So, with that mind, what are you thinking about performance in the next several months, and where are we going from here?
Amine Bouchentouf: I think we are going to see a volatile fourth quarter. Gold, throughout the year, has been acting as an independent asset. We saw it last week get caught up in the global asset deflationary cycle where, for the first time, every asset class went down with the exception of Treasuries. Equities went down and gold went down with them. That was, quite frankly, slightly unexpected by a lot of market participants. The fundamentals tell me that Gold Prices should go up.
Only 174,000 tons of gold exist in the world above ground. Looking at the supply side, that asset is growing at 2% a year. Last year gold production came in at approximately 2,500 tons. Throw in the physical demand from Asia and the Central Banks — for the first time we are seeing central banks become net purchasers of bullion. This is a new trend that I believe is going to put a floor on Gold Prices going forward.
I've analyzed the holdings of central banks very closely and I think they are going to act as major drivers of physical gold purchases going forward, especially the emerging market central banks.
Let me be specific. The United States holds 75% of its foreign exchange reserves in gold. China currently holds 2% of its foreign exchange reserves in gold. Now we are seeing the Chinese Central Bank, the Brazilian Central Bank, the Russian Central Bank and the South Korean Central Bank all start to acquire gold very aggressively.
Kazakhstan this year announced a very important decision. The Kazakhstan Central Bank now has a first option on all of the gold produced in Kazakhstan. And, Kazakhstan is a Top 10 producer with almost 40 tons of gold coming out every year — in a tight market, that kind of move can have a large impact, especially when other central banks start doing the same thing. We're now seeing a major move by the central banks into the physical market and that's going to provide a broad support for prices going forward.
TGR: Given that demand, if no one is a seller and every one is a buyer, then what happens?
Amine Bouchentouf: Right now what we are seeing is an increase in investor demand. We are seeing exchange-traded funds (ETFs) and more participants in the futures markets. We are seeing more hedge funds. We are seeing more mutual funds start to get physical.
These have added some volatility to the prices, which is what we saw last week. We saw people deleverage. We saw margin calls and we saw the financial markets dictating the physical price. That has added a lot of volatility. Investors should be very careful of that kind of volatility. Going forward, we may be seeing larger spikes in gold than we regularly see in the silver markets, with new participants starting to flood into the gold markets.
TGR: So, the general trend is up with a lot of erratic activity in between.
Amine Bouchentouf: Yes.
TGR: In your writing, you have taken the position that junior Gold Mining companies are more attractive than the ETFs. Tell us why you think that's the case.
Amine Bouchentouf: Well, I would like to first say that the ETFs have helped in the democratization of owning all sorts of commodities. I'm not anti-ETFs by any means. I think ETFs provide an important tool and access point to the market that investors otherwise would not get. I would say that the junior mining companies offer a lot more upside because you have the exploration advantage and the potential for new discoveries through knowledgeable management teams that are out there trying to add value.
If you want to get exposure to gold with additional upside, then I believe the mining equities in general — and the junior miners in particular — offer you a very, very good way to do that.
Also, when you are buying into a junior miner you are getting physical gold at a deep discount. For example, the extraction costs of some of these companies are $350–$450/oz. Even at $600/oz., which is the case of some miners, you are still getting your physical gold at a deep discount when you are buying into a mining equity. In an ideal situation, you would like to own both. You would like to have some physical exposure, but also get the junior mining exposure because the growth in value can be really explosive.
TGR: So, basically ETFs provide a sort of mutual fund approach to investing whereas the individual stocks provide bigger upside with potential pops, if a company comes up with something really spectacular.
Amine Bouchentouf: Exactly right. ETFs are similar to a tanker ship, which provides you with slow, steady exposure. Whereas the junior miners and the mining companies are more of a speedboat, which can give you a lot faster upside than a tanker would.
TGR: Pure commodities trading offers futures and options and that sort of thing. That's a whole different game for people who are interested more in gambling. Is that a good way to describe it?
Amine Bouchentouf: I wouldn't necessarily characterize it as gambling. I would say that the futures/options space is for experienced market players. If you don't have experience trading options or futures, don't do it because the losses can be dramatic. And, you can actually lose much more than your principal. One of the red flags of futures and options is that you can trade them on margin, often with low margin requirements. So, I think if you want to get commodity exposure, ETFs, equities and slight hedging positions, if you are experienced, are really the best way to go.
TGR: When you look at these junior companies, how do you categorize them? What criteria do you use?
Amine Bouchentouf: You have the three categories: explorers, intermediate producers and senior producers. Depending on which playing field you are in, you are going to get a different risk profile. If you want higher risk with potentially extremely high reward, then I would recommend looking into the explorers. We have recently seen companies make big discoveries and their stock price going through the roof. That's not just in the mining space, but in oil and other commodities as well. For the more high-risk/high-reward play, I would recommend looking at explorers.
The intermediates offer a steady base from which to build an investment portfolio. The reward might not be as high, but it establishes a floor because the company already has production. Any upside it can generate will flow down to the shareholder, and that's where you can benefit.
Seniors are already producing and have very substantial reserves. The upside will come from acquisitions or ramping up existing production or issuing dividends to existing investors. So, as an investor going to the mining equity space you really have a wonderful universe of companies to choose from that fits every investment profile.
TGR: What do you think metals and mining investors should be concerned about in the coming months as we are going through all this turmoil?
Amine Bouchentouf: I am watching the European sovereign debt situation and any potential spillovers it may have. If Greece defaults, that may trigger a cascade of defaults across Europe that could dwarf the effects after the 2008 Lehman collapse. So, in this case, I think hard assets do provide you with good exposure. Gold, in particular, provides safety in inflationary times. In addition, if we see large inflationary trends, which we have already seen through Quantitative Easing (QE) 1 and QE2, that's another reason to be in gold. There is a direct correlation between increase of money supply and the increase in the Gold Price. I've studied this very carefully and determined that for each 1% increase in total money supply in the United States, we see a 0.97% increase in the price of gold.
So, if you are going to see the Federal Reserve and Bernanke print more money, that is a bullish sign for gold, not for Dollars. As an investor looking out in the marketplace right now, I want to be in physical assets like gold and silver. Let's not forget that gold and silver have been currencies for centuries. Let's say that 100 years ago I showed up with a bar of gold in one hand and some green paper in the other, which do you think would get me what I want? The gold, because gold has that monetary aspect to it and it is a store of value. So, in this time of turmoil and market volatility, you want to be in gold.
TGR: Are you saying that the prospects for gold are good regardless of the intermediate little panics where people play games? Ultimately the metals should outweigh the paper?
Amine Bouchentouf: Absolutely. The hard assets are a store of value and a great place to be. Going forward, we should see a big increase in Gold Prices. Silver is a little bit trickier; silver is a schizophrenic commodity because it is 50% industrial and 50% investment oriented. These two undercurrents are always at play in the silver markets.
That is why we see such violent swings in silver. If we see a collapse or if we see inflation in Europe and in the United States combined with robust industrial demand from Asia, these are two market drivers that will be bullish for silver. Again, I would like to point out that it is very important for investors to be careful when investing in silver because it can move violently, especially if you are trading the futures or options.
TGR: Is there anything else you would like to leave with our readers?
Amine Bouchentouf: Right now, valuations are very attractive in the mining equity space. Gold is still an institutionally under-owned asset. We're seeing strong physical demand from the central banks and from investors. We are seeing strong physical demand for jewelry. So, I believe the future for gold is bright. And, in a period of tremendous market dislocation, you want to be in an asset such as gold.
TGR: Those are good words of advice for our readers and they can make their decisions accordingly. We will just have to stay tuned and see what happens.
Amine Bouchentouf: Exactly.
TGR: Thanks for joining us today. We'll look forward to speaking with you again to see what develops.