Predicting the gold price
February 06, 2004

So the gold price is down more than six percent from its high this year, and it’s only February. Fortunately, as investors watch their brokerage accounts shrivel, fundamental research gives me comfort.

In previous columns here on Kitco, we explored the relationship between currency exchange rates and the gold price, and how this relationship is impacted by a declining dollar. The dollar’s continued decline, however, is only one of the reasons for my bullishness on gold. I have also done an extensive analysis of the gold price versus the absolute inflation of the US dollar (the topic of future columns), which gave me more reason to expect much higher gold prices. You can listen to the conversation I had with Stanlie Hunt of The SmartStox Talk Show about this analysis at www.smartstox.com.

Sticking, for the time being, with the initial analysis already covered in this forum, we saw that the gold price in US dollars fell almost forty five percent below the average worldwide gold price in 2001 because the US dollar more than doubled, on average, against foreign currencies (The US dollar and the gold price, January 23, 2004).

While the average, worldwide gold price has increased roughly forty five percent since 2000, at a compounded annual rate of approximately thirteen percent, the US dollar gold price has increased even more. In US dollars, the gold price has increased by about sixty percent over the past three years; that’s almost seventeen percent compounded annual gains. The extra increase in the US dollar gold price is, of course, due to the dollar losing value on foreign exchange markets.

This phenomenon, that the US dollar gold price increases more than the average, worldwide gold price, is one that I think is going to continue for many more years: at least until the United States has resolved its trade imbalance. For the dollar to erase its gains of the Nineties, which is the only realistic way to eliminate the trade deficit, it would have to decline by about thirty seven percent against the basket of currencies in the PVE Index (see A New Gold Index, January 16, 2004). Such a decline in the US dollar would cause the dollar-gold price to increase sixty percent more than the average, worldwide gold price.

Assuming that the average, worldwide gold price does not increase at all while the US dollar weakens, then gold would be trading for $650 an ounce when the US dollar returns to reasonable trading levels. But static worldwide gold prices are unlikely.

Since 1998, the average, worldwide gold price has been increasing at a compound annual rate of almost ten percent. If we assume it takes five years for the dollar to return to a more natural trading range, and we assume that the average, worldwide gold price continues to increase at roughly ten percent per year, then gold should be trading for about $1,000 an ounce in 2008.

There are many problems with this type of extrapolation, and an analysis of the gold price strictly from an exchange rate perspective also has intrinsic problems. I will discuss some of these shortcomings in the future. If it weren’t for the fact that I reached a very similar price target using a completely different, independent method, I would have far less confidence in the result. But, as I will show in due course, expecting gold to reach a thousand dollars an ounce over the course of the next few years is not at all far-fetched.

As far as I am concerned, these price targets are sustainable trading levels for gold, unlike those memorable spikes in 1979 and 1980. In the probable event that psychology overrules common sense, we could easily see the gold price exceed a thousand dollars an ounce and perhaps even two thousand dollars an ounce. To a speculator who tries to hold on to some of his gains from time to time, price volatility that is not based on any fundamentals represents an opportunity to cash out. But we are still a long way from gold being overvalued and, in the meantime, there is an awful lot of money to be made in this sector, especially in mineral exploration companies.

Despite some similarities, there actually is a difference between investing and gambling. Winning or losing is not a statistical probability. Every time you buy a stock, another real, live human being is on the other side of the transaction. The buyer believes the price will go up, the seller believes it will go down. One thing is for sure: one of the two is wrong. If you want to succeed as an investor you need to be right more often than wrong; this means you need to have a competitive advantage of some sort. Mine are the work I have done on the gold price, and my familiarity with mineral exploration.

I currently invest primarily in small mineral exploration companies for two reasons. One, I am convinced we are going to see a much higher gold price going forward. Two, there has been a dearth of mineral exploration and mining is a depleting business: the more you mine, the less business you have left. Without adequate exploration, mining will cease and, for almost a decade, there has been insufficient exploration to ensure the mining industry does not self-liquidate.

Every week I get several emails asking for my opinion of specific stocks, or asking why I don’t talk about stocks here on Kitco. If you want to know what I am doing with my own money, you can subscribe to my newsletter: www.paulvaneeden.com. That is where I discuss specific companies and investment opportunities.

Because I believe the gold price is going much higher, it doesn’t disturb me one bit when it declines, as it has since the second week in January. What I see is an opportunity to buy stocks that others are selling in panic. Happy buying!

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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