The next gold rush has begun

Gold looks ready for another run toward $2,000 an ounce after a long lull. The next four months are packed with big political decisions that are sure to effect the global markets. Global central banks are poised to unleash a strong, coordinated dose of monetary stimulus sure to effect precious metals prices.

By Anthony Mirhaydari
9/5/2012 8:29 PM ET
MSN Money

The next four months are packed with big political decisions that are sure to roil global markets. Investors are worried, and they continue to move out of stocks and into cash and bonds. I think that's the wrong move.

Their focus instead should be on gold.

While stocks are up 8% off of their spring lows, gold is up 11% and gold-mining stocks are up more than 22%. Last month, gold was up nearly 6% compared with just a 2% gain for the Standard & Poor's 500 ($INX +1.79%). What's more, the recent outperformance is likely to continue, with some on Wall Street calling for the yellow metal to take another run at $2,000 an ounce -- thanks to catalysts that will also pinch the fixed-income holdings retail investors are buying now.

Global central banks are poised to unleash a strong, coordinated dose of monetary policy stimulus. Politicians in Europe and here at home face a near-impossible task of balancing growth and budget austerity at a time when the stakes couldn't be higher. And food and fuel prices are heading higher, presaging more inflation.

In this environment, investors can't afford to focus on fixed-income assets that won't protect them from financial turmoil and higher prices. They need to return to an old favorite that's been shunned for more than a year.

Here's why gold is about to enjoy another rush of popularity.

The start of something great

First, a quick look at where we stand.

For months, precious metals have been mired in a tightening range near support from their December 2011 lows after peaking earlier last year. Gold reached a high of $1,923 an ounce in the wake of last summer's U.S. credit rating downgrade, while silver hit a high of nearly $50 an ounce in April 2011 before losing nearly half that.

Since then, gold has found buyers near $1,550 an ounce and sellers near $1,630, and it hasn't broken out of that range. Silver has been stuck around $28 an ounce. Much of this has to do with the value of the dollar, which Merrill Lynch analysts find to be one of the strongest influences on precious-metals prices.

You see, the greenback had been marching steadily higher since early 2011 on a combination of fresh concerns over Europe, a relatively strong U.S. economy (compared with those of China and Europe) and a lack of aggressive action by the Federal Reserve. Not since late 2010 has the Fed unveiled stimulus that actually expanded the monetary base -- which is a very narrow way to look at the money supply. An expanding monetary base is a de facto debasement of the dollar, something that is a big-time positive for gold and silver since a falling dollar tends to be highly inflationary.

Contrast this with the Federal Reserve's "Operation Twist" initiative started in September 2011, which merely took money from one pocket (short-term bonds) and put it into another (long-term bonds) to try to push down long-term interest rates. It didn't actually create new money. It didn't expand the monetary base.

And, with Europe a mess, there wasn't much reason for traders to hold euros. So they didn't. This strengthened the dollar, and precious metals suffered for it.

That started to change in late July, when European Central Bank chief Mario Draghi pledged to do whatever it takes to defend the eurozone. That pushed the dollar down off its highs, helping gold push off its lows via the currency effect (gold benefits from a weaker dollar) and inflation effect (a weaker dollar pushes up U.S. inflation via more-expensive imports, and gold is seen by investors as an inflation hedge).

The move accelerated two weeks ago as the Federal Reserve released the minutes of its August meeting, in which it was noted that many members of its policymaking committee judged further policy easing was "warranted soon" unless the economy strengthened substantially. They added that another round of direct bond purchases -- the eagerly anticipated "QE3" -- would boost business and consumer confidence as well as lower long-term interest rates and ease credit conditions.

These comments opened the door to new stimulus action at the Fed's September meeting -- something that sent the dollar lower, lifted commodities higher and pushed precious metals even higher out of their long downtrend.

As a result, gold is up 7% from its mid-July levels, the Market Vector Junior Gold Miners ETF (GDXJ +3.22%, news) is up nearly 22%, and, by all indications, the moves are far from over.

More gains to come

I can't say enough about how good the surge in the precious metals is looking now. All the pieces are lining up for continued gains in the coming weeks.

Sentiment remains subdued, with investors still not moving heavily into the metal funds, such as the Market Vectors Gold Trust (GLD +0.79%, news) or the iShares Silver (SLV +1.82%, news), as they have near previous tops for gold and silver. There is technical strength in the charts. And there is fundamental support from central bank easing and incipient inflationary pressure. In addition, currency trends are favorable, with the dollar weakening.

We've also got the specter of supply disruptions out of South Africa, with fresh violence between government and labor leaders feuding over profits and safety. This has already resulted in fatal bloodshed. Separately, miners also reportedly attacked a remote village in Venezuela's Amazon jungle, killing dozens.

These disputes are big, because the long-term supply situation for gold and silver is worrisome as production costs rise. Mining companies are now focusing on undeveloped reserves in some of the most inhospitable places in the world.

As a result, South African gold analyst David Davis at SBG Securities believes, conservatively, mining cost inflation is running between 12% and 15% annually. For new projects, it's closer to 20%. Looking at the replacement cost for an ounce of gold for mining companies (operating cost plus capital cost of equipment plus exploration costs), and assuming a 15% cost inflation rate, Davis estimates that the floor for gold prices will be near $2,000 an ounce in 2015.

If it falls below that, producers would likely cut back on production until the price increased enough to make operations profitable again.

The team at Capital Economics in London is also looking for gold to cross the $2,000-an-ounce threshold, but for a different reason. It believes that the eurozone project, as it stands now, is doomed and that one or more countries (Greece plus another) will exit -- pushing the price of gold "significantly higher" on panic buying and worries over the fate of the euro, even if those worries lead to a stronger dollar. This would be a repeat of what happened during the initial panic over Greece in mid-2010.

Don't forget the cliff

The other big political risk is from the U.S. "fiscal cliff" -- those tax hikes and spending cuts equaling about 5% of the U.S. gross domestic product set to hit in early 2013 unless Democrats and Republicans in Congress can act together. We're also once again nearing the nation's debt-ceiling limit.

This has the Merrill Lynch team thinking that the political uncertainty and "worst case" thought exercises by investors could cause gold prices to spike as people seek a safe haven.

Plus, there is the very real chance that political failure will cause the credit-rating agencies to dole out another downgrade of the U.S. Treasury. Remember that when Standard & Poor's slashed our AAA rating, it was in large part because of our dysfunctional politics. When that happened in August of 2011, it was a catalyst for a big run-up in gold.

And finally, any additional monetary easing from the Federal Reserve in its Sept. 13 policy announcement would be icing on the cake for precious-metals investors. Davis notes that, aside from the supply/demand dynamics, the other big driver for gold prices is real, inflation-adjusted interest rates.

Real interest rates are -- and have been -- negative after inflation as the Fed and other central banks do all they can to bolster economic growth. If the Fed unveils QE3 later this month, it will likely push this rate deeper into negative territory as interest rates stay low but inflation creeps up. But there is also a chance that the Fed pushes one of its policy rates -- the rate it pays to banks holding deposits in its vault -- into outright negative territory given recent comments from St. Louis Fed President James Bullard.

This would be a big deal, because many believe 0% is as low as interest rates can go. And unlike real rates, which require some calculation and are somewhat academic, this is something the average Joe could understand. Société Générale economists believe such a move could boost interest in gold as people consider the inflationary ramifications of a world with negative rates.

How to play it

For investors joining the party and looking to add new money to gold and silver, I think the focus should be on the mining stocks that are just now starting to move. While the GLD, SLV, and GDXJ funds would be easy options, they are a little extended now but would be good buys on pullbacks.

Fresh ideas include Newmont Mining (NEM +1.41%, news) and Keegan Resources (KGN +1.00%, news), both of which I've recently recommended to my newsletter subscribers.

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