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Insights: Finance—Golden Reflections

After two decades of doldrums, the future may be brightening for gold investments
Mario J. Gabelli, Caesar Bryan
From the Print Edition:
Gene Hackman, Sep/Oct 00

Wealth is increased and preserved through ownership of many investment vehicles. One that is out of fashion is the ownership of gold and silver, an asset class that has been around a long time. In this article, Caesar Bryan, who manages our open-end, no-load Gabelli Gold Fund, shares with us his reflections on gold.  

The Egyptian pharaoh Tutankhamen was buried in a solid-gold casket weighing 240 pounds. At gold's 1980 peak of $875 per ounce, this casket was worth $3,360,000. At the recent $272 per ounce price, the boy-king's final resting place is worth just $1,044,480. Tut isn't concerned about the precipitous decline in gold prices over the last two decades, but investors holding gold over this period may be wishing they were in his slippers.  

What is responsible for gold's demise? The same forces--low inflation, exceptional economic growth and disciplined monetary policy--that have propelled the dollar and fueled the long-term bull market in stocks and bonds. As long as investors worldwide have faith in the dollar and/or other major currencies, and confidence in financial assets remains strong, gold is not likely to challenge its 1980 highs. However, we believe economic and market forces will fuel a significant rise in gold prices over the next several years. This means opportunity for gold and gold stock investors.  

THE LAW OF SUPPLY AND DEMAND

In a free market, the price of any item is determined by supply and demand. If supply materially exceeds demand, prices fall. If demand significantly exceeds supply, prices rise. In 1999, demand for gold was at record levels--as much as 50 million ounces over annual production.

However, gold is not consumed like other commodities, and therefore, production does not equate to supply. Gold isn't burned like oil, eaten like grain or beef, and, with the exception of those wedding rings that disappear down bathroom drains, it generally isn't thrown away. In essence, most of the gold that has come out of the ground is still around, much of it in the form of gold reserves held by central banks throughout the world. These gold reserves have been providing the supply that has offset rising demand.  

Central banks have been significantly reducing their gold reserves through sales in the open market and gold leasing--lending reserves to gold producers employing hedging strategies and to financial engineers taking advantage of low gold-leasing rates of 1 to 2 percent to finance other investments. This supply may be restrained going forward. Last September, 15 European central banks announced they would limit gold sales and gold leasing for at least five years. In what is being called the Washington Agreement, the United States, Japan and the International Monetary Fund agreed to honor this policy. Gold immediately spiked $70 per ounce to $330, severely damaging the earnings and balance sheets of the more aggressively hedged gold producers and hammering speculators who had effectively shorted gold by selling their borrowed bullion in hope of replacing it with cheaper gold at a later date.  

However, several central banks, most notably the Dutch Central Bank and the Bank of England, responded to higher gold prices by selling gold. The sales were well within the limits of the central bank agreement, but coming so soon after the accord, it sent the wrong signal to the market. Gold quickly gave back most of its gains, undermining the central banks' desire to maintain the value of gold reserves. We suspect that this market whipsaw will make central bank sellers and lenders, and gold borrowers like gold mining companies, hedge funds, and other speculators, more cautious in the future.  

A SHORT SQUEEZE?

Demand for gold should remain relatively strong, supported by healthy U.S. and European economies and the recovery in Asia, whose population traditionally has valued gold both as jewelry and protection against the region's volatile currencies. Growth in production will be restrained by today's low gold price--currently below the cost of production for many gold-mining companies--and the difficulty in attracting capital for additional exploration and development. So, we should continue to see a demand/production imbalance favoring a higher price for gold. If central banks around the world honor their agreement to limit gold sales and leasing, readily available supply will also be constrained.  


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