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Why Gold’s Rally Is Far From Over

For 11 consecutive years, investors in gold bullion have seen only gains. Those involved in financial markets know that no winning streak lasts forever, so the question arises if it makes sense to chase the Midas metal at the present lofty price levels.

While anything can happen on a three- to six-month horizon, none of the drivers of the rally in gold bullion have gone away. One could credibly argue that they’ve gotten stronger.

The total amount of all gold ever mined since the beginning of civilization is 166,600 tonnes ($56.6 million/tonne @ $1,770/oz., $9.4 trillion in total present value). Of that, only 30,808 tonnes is part of the gold reserves held by central banks at last count. Since central bank gold buying hit 40-year highs in the fourth quarter, it’s difficult to see how gold’s price can decline precipitously from here.

Corrections are possible, if not probable, but central banks are increasing their gold buying for very good reasons and are likely to emerge as aggressive buyers on any (large) dips. This is because total foreign exchange reserves held by central banks have increased to $11.4 trillion — mostly held in U.S. dollar-denominated debt instruments — and this constantly growing amount needs diversification in other currencies and assets.

Fewer Alternatives to Diversify

The euro seemed like a good diversification option a couple of years ago, but developments in the eurozone sovereign debt crisis have cast a shadow on the common currency’s ability to survive. Suddenly, the largest single alternative to the dollar no longer seems like a credible option.

Among the problems: There are 17 different eurozone countries with 17 different finance ministers, but one central bank with a common monetary policy. Fiscal and monetary policies are in outright contradiction in some countries. The only way the euro survives is via complete fiscal integration — difficult to imagine — which is why even the recent (second!) Greek bailout may not prevent a eurozone breakup, in my view.

The deliberately slowly ever-appreciating Chinese yuan will become fully convertible some day and will rival Japan’s yen as a reserve currency. Having recently surpassed Japan by GDP size, China now is the world’s second-largest economy, so it’s only normal for the yuan to gain international prominence. But it is the Chinese themselves who have the most at stake in the forex reserve diversification conundrum because they hold $3.18 trillion in forex assets, approximately two-thirds of them dollar-denominated.

A Euro Breakup Is (Ultimately) Bullish for Gold

The worst-case scenario — which isn’t what I am looking for — is a disorderly euro breakup that could result in a sharp, but temporary, dollar spike as it did in 2008. Since the response to the 2008 crisis was more money-printing, the dollar’s exchange value is unlikely to remain lofty against sounder currencies with higher real interest rates or against hard assets like gold.

This suggests that any corrections from present levels are likely to be short-lived and will ultimately lead to new highs for the price of gold bullion, likely in most major currencies.

If you’re looking for exposure to gold bullion, don’t buy only gold stocks. Such stocks are stakes in operating companies that are very different from hard assets: Physical bullion is a hedge, while mining stocks are leveraged investments.

Furthermore, there are a lot of conspiracy theories about the $72 billion worth of gold held in the SPDR Gold Trust (NYSE:GLD). Paper claims on gold bullion via swaps, futures and the like aren’t the same as audited gold bars. While proving conspiracy theories is beyond the scope of this missive, the recent shrinkage to 2.5% premium to NAV of the Sprott Physical Gold Trust (NYSE:PHYS) makes the shares of this trust so much more attractive.

When originally launched two years ago, PHYS shares for a while traded at a 20%-plus NAV premium, making them initially unreasonably pricey (see since inception NAV distribution) compared to physical bullion (a major marketing angle is the ability to PHYS shares to be exchanged for the underlying gold bars with a large enough amount). As the performance of GLD and PHYS has now largely converged, the current 2.5% NAV premium is well worth the piece of mind you get knowing that the physical bars are audited on a regular basis in a Canadian vault.

Silver Isn’t a Perfect Alternative for Gold

While the Sprott organization also launched the Sprott Physical Silver Trust (NYSE:PSLV), with similar characteristics allowing for the exchange of the shares for physical silver bars with a large enough amount, investors should not treat silver as an alternative to gold. Silver is predominately an industrial metal — the same way platinum and palladium are — and it tends to be weaker than gold in times of economic uncertainty. While U.S. economic data is notably improving, Europe’s economic statistics have been deteriorating.

It’s no wonder then that silver topped out in late April 2011, just as the European situation notably got worse, and it hasn’t been able to recover all its losses since then. The same goes for platinum and palladium. If you’re looking to invest in precious metals as a hedge against central bank extreme monetary policies, stick with gold.

Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own.

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