Gold: Too Fast too Soon but Fundamentals Still Very Positive

Jeff Nichols warned that the summer run-up in the gold price was too far too fast and predicted a big fall but still feels that fundamentals support much higher prices ahead.

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NEW YORK

"At some point, however, we will see a correction, perhaps a sizable one. After all, even strong bull markets never move up in straight lines. I would not be surprised to see gold stumble - falling back $100, $200, or even $300 - before prices begin working their way higher once again."

That was my view published here on Mineweb in late August.

Gold has certainly taken a dive - and could stumble further in the days immediately ahead - but I think we will see the yellow metal begin its comeback sooner rather than later, possible in the next few days.

This summer we raised our year-end price forecast to $1,850 an ounce - but remained reluctant to adjust our expectations upward as the price moved past this level and briefly traded over $1,900 an ounce in early September.

Although physical demand in world bullion markets remained firm, it seemed to me that the price was moving up too fast too soon as institutional speculators extended their "long" positions in "paper" derivative markets.

SHOOT THE SPECULATORS

Now - rather than any dramatic reversal in world physical markets - it looks like the precipitous price decline in recent days can be blamed entirely on these same speculators (including some prominent hedge funds and the trading desks of the big Wall Street banks) reversing their positions or cashing out of gold altogether.

Nothing that has occurred in the past few days in any way diminishes my long-term enthusiasm about gold-price prospects. The same bullish gold-market fundamentals and macroeconomic trends that I have been discussing for many years now remain in place and promise significantly higher gold prices over the next five years or longer.

It is important to remember that violent sell-offs in equity and other asset markets typically spill over into the gold market . . . but after an initial selling wave, gold tends to disassociate itself from and act independently to other asset markets.

At first, when other assets are under extreme pressure, as has been the case this past week, gold's immediate reaction reflects reflexive selling by institutional speculators - including momentum, program, and other "black box" traders. Short-term trading in derivative markets may, at times, produce a great deal of gold-price volatility but, in my book, it does not affect the long-term price trend. In a sense, gold is an "innocent bystander."

NOTHING WE HAVEN'T SEEN BEFORE

While the magnitude of gold's decline seems stunning in absolute terms, keep in mind it is not unusual for gold prices to correct by 10%, 15%, 20% or even more after a run-up the likes of which we've seen this year. Old timers may recall the 1970s, when we saw at least a couple of bigger percentage corrections in the midst of a long-lasting bull market.

Now, from its September 6th all-time high around $1,923 an ounce to this Friday's (September 23rd) low around $1,628 an ounce in New York trading, we are off just about 15 percent - certainly not so much when you consider the previous advance . . . certainly not so much to those who remember gold's volatile price history . . . and certainly not so much as to cause much alarm among those who pay close attention to gold's fundamentals.

FUNDAMENTALS COUNT

And speaking of fundamentals - with the exception perhaps of India - physical demand in recent days has held up fairly well. Meanwhile, it is not unusual for more price-sensitive trading-oriented Indian gold dealers to pause, at times like this, for the dust to settle before stepping back as buyers. For sure, there is nothing here to diminish India's long-term appetite for gold.

Meanwhile, my China contacts report no immediate diminution in retail gold demand from the world's biggest national gold market. Driving Asian demand - in India, China, and elsewhere has been the continuing rise in household incomes in tandem with worrisome inflation - and this pro-gold combination is unlikely to change in the foreseeable future.

WATCH THE CENTRAL BANKS

For the past few years (in speeches, published articles, client reports, and on my website NicholsOnGold.com), I've been talking a lot about the revival and growth of central bank gold interest - and its long-term significance to the market and the future price.

I believe that a few central banks - central banks that have been fairly regular buyers, acquiring gold month in and month out - have already stepped up their purchases in reaction to the lower, more attractive, price levels now prevailing. And other countries are likely to add to their own gold reserves in the days ahead as it becomes more apparent this correction has run its course.

The central banks of Russia and China (which does not report or publicize its on-going gold purchases) are the first that come to mind, but quite possibly other central banks will also use this episode of gold-price weakness to acquire metal without causing any overt market reaction.

In my book, gold's own supply/demand situation and other recent-year institutional or structural changes in the gold market per se (such as the introduction and growth of gold exchange-traded funds or the legalization of private gold investment in China) suggest more gold price strength ahead.

AND SHOOT THE POLITICIANS TOO

So, too, does the inability and disarray among of our economic policymakers and politicians, those entrusted with our financial and monetary wellbeing, to frame appropriate policies that would deal effectively with today's economic realities.

Indeed, U.S. and European economic prospects continue to deteriorate, suggesting we will see still more desperate monetary stimulus from the Fed and the European Central Bank (the ECB) before the end of this year.

Here in the United States, the Fed will be facing continued signs of renewed recession or recession-like business and employment conditions.

Across the Atlantic, the ECB will be struggling to prevent the approaching Greek sovereign debt default and the insolvency of some European banks holding Greek sovereign debt. Some fear this would be a catastrophe far worse than the Lehman Brothers bankruptcy - with dire consequences for the world economy.

While these problems are unlikely to trigger any immediate policy response from the Fed or the ECB in the next week or two, as pessimism grows among investors and traders, expectations of further monetary accommodation could stimulate more investment demand in the days and weeks ahead.

So, too, could U.S. Congressional bickering and inaction on both the U.S. Treasury debt ceiling and on the Federal budget impasse as these issues again become headline news.

LONG-TERM BUYERS RULE

To recap: Short-term trading in derivative markets may, at times, produce a great deal of gold-price volatility but, in my book, it does not affect the long-term price trend. What governs the price of gold over the long term are the market's real-world supply and demand fundamentals - and these have been decidedly bullish and are becoming even more so. Hence, my long-standing forecast of much higher gold prices in the next several years.

Importantly, to the gold-price outlook, today's buyers, both private investors and central banks, are likely to be long-term holders. Much of this gold, once bought, is unlikely to be resold any time soon even at much higher price levels. For central banks, the holding period will be measured in decades if not longer. This promises less liquidity, more volatility, and much higher prices in the years ahead.

Jeffrey Nichols, Managing Director of American Precious Metals Advisors, has been a leading gold and precious metals economist for over 25 years.