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									                                                             Analyst                                      K E Y P O I N TS
                                                                        AGENDA                          • Over the past decade, economic and geopolitical fundamen-
                                                                                                          tals have pushed gold prices to ever higher levels.

                                                                                                        • Gold seems to be coming to the end of its normal cycle,
                                                                                                          and some are concerned that the market is in a bubble,

                                        All That Glitters                                                 but experts see more upside potential.

                                                                                                        • Professional investment portfolios comprise a mix of bullion,
                                        “The big money has not been made yet,”
                                                                                                          mining shares, ETFs, futures and options contracts, and
                                        says one gold expert
                                                                                                          other assets.
                                        BY SHERREE DECOVNY
                                                                                                        $300 an ounce and took about five years to climb to

                                                  he gold market has delivered spectacular returns      US$500 an ounce. Since 2009, the price has increased
                                                  compared with most other asset classes. Not           steadily to where it is today. The charts show that the
                                                  surprisingly, institutional investors have taken      latest leg of the bull run started in November 2008. About
                                                  a shine to this sector. While there are solid fun-    a year later, the price broke through US$1,200 an ounce
                                        damental reasons to support the decade-long uptrend in          and then traded back to about US$1,050. By the end of
                                        gold prices, some investors wonder if and when the market       2010, gold hit all time highs of slightly more than $1,420
                                        will run out of steam.                                          an ounce, only to sell off to around $1,313 in the first few
                                             Several short-, medium- and long-term fundamentals         weeks of 2011.

                                        affect the price of gold. Geopolitical issues such as North          “Swings of 6–10 percent in the price of gold aren’t
                                        Korea’s nuclear program, unrest in the Middle East, and         really a reason just yet to be heading for the exit,” says
                                        the specter of European sovereign debt default can move         David Jones, chief market strategist at IG Index. “If we
                                        the gold price on a day-to-day or week-to-week basis.           saw a weakness through US$1,300 an ounce — and that’s
                                             Supply and demand influence the medium-term out-           the low from late October of 2010 — then we could start
                                        look. Supply-side fundamentals such as mine and scrap           thinking maybe this sell-off is slightly different from all
                                        (cash-for-gold) supply are balanced against the demand          the other ones we’ve seen before. But while we’re above
                                        for jewelry, fabrication, and gold bullion-backed ETFs.         there, it still looks like a correction within this latest leg of
                                        Central bank buying and selling is also part of the demand      the uptrend that’s been going for a couple of years now.”
                                        equation. Over the past decade, sales have been limited
                                        and some central banks have been building their reserves.
                                             Monetary and fiscal policy is a lever for the long term.
                                        The U.S. budget deficit has skyrocketed to almost 10 per-
                                        cent of GDP or $1.4 trillion. It is unlikely the U.S. can
                                                      ,                                                                      “The easy money has been
                                        fund its way out of these obligations, and there is limited                           made, but the big money
                                        scope for raising taxes. Several other countries have simi-
                                        lar fiscal problems. Moreover, some economists believe                                has not been made yet.”
                                        inflation is in the pipeline, as evidenced by rising oil and
                                        producer prices.
                                             Investors no longer see the dollar as a safe haven, and    Vedant Mimani
                                        they are concerned about the debasement of other curren-
                                        cies. Credit quality has come into the limelight as sovereign        On the upside, gold has to trade up to about US$1,380
                                        and municipal debt issuers struggle to meet their obliga-       to shake off the recent correction and move higher to
                                        tions. This recipe for uncertainty has driven gold prices to    US$1,450 an ounce. On the downside, a break of US$1,300
                                        ever higher levels, but is gold in a bubble?                    could trigger a sell-off to the next major support level at
                                             “The cycle is long in the tooth,” says Thomas Winmill,     US$1,235.
                                        portfolio manager of Midas Fund. Because gold has been               Although gold is no longer cheap, it is not at the end
                                        in a bull market for a decade and the average cycle is 10–      of its run, notes Vedant Mimani, managing partner at
                                        12 years, people have good reason to be concerned. Still,       Atyant Capital. The last third of a market move can be as
                                        Winmill expects gold will continue appreciating in coun-        much as the first two-thirds. “In baseball parlance, we’re
                                        tries that are issuing currency (which ultimately erodes        probably in the fifth or sixth inning of a nine-inning game,
                                        purchasing power) and not exercising fiscal restraint. The      so almost in the middle,” he says. “The easy money has
                                        gold price will stop appreciating in countries where the        been made, but the big money has not been made yet.”
                                        amount of currency being issued is equal to the growth in
                                        the underlying economy.                                             Bull and Bear Alternatives
                                             Some precious-metals experts point to the steady rise      Investors that want to participate in the gold market have
                                        in price. In 2001, the gold price was around US$250–            a few products to choose from, each with a distinct risk

32                                                                                 CFA   MAGAZINE       MARCH–APRIL 2011
profile. Among them are bullion, mining company shares,
funds, exchange-traded funds (ETFs), and futures and
options contracts.                                                                            “I just think it’s an
     Gold bullion is attractive because it has tangible
value; however, it has a negative carry cost because                                       extraordinary situation.
owners have to pay for insurance and safe keeping. The                                    They all have dividends,
bid–ask spread on institutional lots is tight, but that is
not the case for lots under 400 ounces. In addition,                                        they’re all beating the
prospective buyers need to investigate the tax implica-                                      Street regularly, and
tions. U.S. investors may have to pay a state sales tax or a
collectables tax, which is 28 percent, whereas the capital                               they’ve really tightened up
items tax on shares is 15 percent.                               Thomas Winmill            their financial picture.”
     Historically, mining shares have a beta to the gold
price of two to three times because there is operating lever-
age in a producing mining company. To extract, process,          of gold, but smaller investors may not be able to take
and sell gold costs about US$600 an ounce. If gold is sell-      delivery of the gold if they choose to do so. To this end,
ing at US$1,000 an ounce, the gross margin will be US$400.       several physical ETFs were created, which can trade at
If an investor buys gold at US$1,000 an ounce and the            a premium or a discount to bullion depending on the
price goes up US$100 to US$1,100, the return will be 10          product. Among them are the Sprott Physical Gold Trust
percent, but the mining company’s gross margin will              (PHYS), the Central GoldTrust (GTU), and the Central
increase 25 percent from US$400 to US$500 an ounce.              Fund of Canada (CEF), which holds a mix of gold and silver.
     The cost of production has gone up over time but not        ETFs also can be used to gain exposure to mining compa-
at the same rate as the selling price. As the price goes up,     nies. Market Vectors Gold Miners ETF (GDX) is a basket
extraction becomes more economically feasible, so the            of the major gold miners, and Van Eck Global’s Junior
total reserve base increases. For the first time in years,       Gold Miners ETF (GDXJ) is a basket of smaller companies.
companies have excess capital to increase production in               Those who think gold has peaked can effectively take
existing mines, reinvest in exploration, and acquire junior      a short position by investing in the PowerShares DB Gold
mining companies.                                                Double Short Exchange Traded Note (DGZ) or the
     Winmill points out that shares can have a positive          PowerShares DB Gold Double Short Exchange Traded
carry to gold if the company’s management team can pro-          Note (DZZ). This type of product is designed for sophisti-
duce a good return on capital over its costs. Mining com-        cated, short-term investors. The objective of the double
pany shares are selling at cheap valuations compared with        exchange traded notes (ETNs) is to double the rate for the
historical norms because of the perception that gold has         day, and it does not track the underlying gold price over
peaked or is in a bubble. Newmont, which is one of the           time. If gold goes down 1 percent on the day, the double-
largest U.S.-based gold mining companies and has opera-          short ETN should go down 2 percent on the day.
tions worldwide, currently trades at six times cash flow,             Finally, investors can participate in the gold market by
whereas it has historically traded around 15–20 times cash       buying or selling futures and options contracts. These prod-
flow. Barrick, regarded as an even better-managed com-           ucts have a risk profile different from bullion, mining com-
pany with slightly superior projects, is trading at about        pany shares, or ETFs, and they tend to attract speculators.
nine times cash flow, and its historical norms are the same           Like other commodities, gold is still perceived as
as Newmont’s.                                                    being a fringe investment, but it is gaining legitimacy
     “I just think it’s an extraordinary situation,” says        among mainstream institutional players. If the gold mining
Winmill. “They all have dividends, they’re all beating the       companies continue to make profits and pay good divi-
Street regularly, and they’ve really tightened up their finan-   dends, conservative investors, such as pension and trust
cial picture. I would say at this moment in time, in addition    funds, may be more interested in becoming stakeholders
to those betas, you’ll get multiple expansion, maybe going       and the market will grow. The economic fundamentals and
from 6 to 12 times.”                                             technical analysis support the continuation of the uptrend,
     Mining can be precarious, so some investors prefer          at least in the short to medium term, and the long term
to put their money with a specialist fund manager who            will be anything but dull.
can diversify the portfolio among companies and types
of metals, as well as geographically and politically. For        Sherree DeCovny is a freelance journalist specializing in
example, Midas offers the Special Fund, the Midas Fund           finance and technology.
and the Perpetual Portfolio fund. Atyant Capital offers
the Global Opportunities Fund, and Oppenheimer offers
the Oppenheimer Gold and Special Minerals A.                     RECOMMENDED RESOURCES
     ETFs are popular among institutional and retail play-       “Book Review: The Power of Gold: The History of an Obsession”
ers. The SPDR Gold Trust (GLD) closely tracks the price          Financial Analysts Journal (Jan/Feb 2001) (

                                           CFA   MAGAZINE        MARCH–APRIL 2011                                                33

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