Why the Gold Rally May Just Be Getting Started

The gold price has started to rally, clawing back some of the gains after it hit the skids in March and fell below $1,700 an ounce. One hedge fund recently outlined a bullish view, and an analyst even went so far as to say that the yellow metal could test new highs again this year.

Gold nuggets on top of American paper money representing gold stocks
Source: Shutterstock

In his first-quarter letter to investors, Paul J. Isaac of Arbiter Partners said their mining basket, which mainly consisted of producers, was a modest net loser for the quarter. He added that the decline in the gold price offset positive corporate developments in the sector.

Premier Gold merged into Equinox Gold Corp (NYSEAMERICAN:EQX), which Isaac describes as a “larger, more liquid, aggressive, but relatively unleveraged, mid-tier miner and mine developer.” He believes Equinox trades at an attractive forward price/cash flow at current gold prices.

Arbiter also bought shares of I-80 Gold Corp (OTCMKTS:IAUCF), a new company run by former Premier management. Equinox will have significant interest in the new company, which has some “interesting” mining development projects in Nevada.

The fund’s other large holding, Medusa Mining Limited (OTCMKTS:MDSMF), finally reinstated its dividend, although it was only 5 cents Australian. However, Isaac added that the dividend implies a 12% annual rate going forward, and Medusa’s shares trade at 1.5 times net cash.

After subtracting the company’s net cash, it trades at 1 times EBITDA and 1.5 times earnings, although for a “smallish” underground property in the Philippines that produces about 100,000 ounces per year.

Arbiter on the Price

Isaac also dove into the debate about the precious metal’s price, noting that the yellow metal was up against “controversial prospects” this year. He explained that Arbiter is mostly focused on the American markets, but the gold market is global with “tight international linkages.”

When weighing the question of where the price will go from here, he noted that real interest rates are historically low and likely to decline further due to the accelerating inflation, accommodative monetary policies and accelerating nominal GDP growth.

Isaac added that a sharp increase in supply is not an issue for the gold market, especially since global gold production is less than 2% of the global gold stock. He explained that the scale required of new mines and tighter environmental and social regulation have lengthened the development processes for most new mines.

As a result, aggregate supply responses to recent higher prices in the coming years will probably be limited. Additionally, Isaac said increased geopolitical tensions and rivalries are causing some central banks to hold a larger portion of their reserves in gold, marking a reversal of the trend in the last century. He believes gold will remain a significant reserve and safe-haven asset, if not the dominant one. However, he also thinks cryptocurrency has taken a bite out of gold’s demand as a safe haven.

What’s Next for the Gold Price?

Isaac isn’t the only one who’s bullish on gold right now. Fat Prophets analyst David Lennox told CNBC he sees “a fairly big tick” ahead for the precious metal. Like Isaac, he pointed to accelerating inflation as a factor in the gold price. Lennox noted that the core personal consumption expenditure index for April rose faster than expected recently. Central bank officials consider the measure to be the best inflation gauge.

Lennox believes higher inflation readings will be a “boon for gold,” adding that inflation is coming back due to the significant surge in money supply in the U.S. Past surges in the money supply have been accompanied by higher inflation about five or six months later.

Lennox suggested two possible ways to play the gold price rally, depending on your timeframe. He suggested that investors could look for a gold exchange-traded fund if there ends up being a “solid surge in the gold price.” Investors who have more of a long-term mindset might look at investing in gold miners instead, just as Arbiter Partners has done.

Tailwinds

Although the gold price was weak earlier this year, there are reasons to expect the recent rally to continue. As Lennox and Isaac both mentioned, inflation generally drives the gold price higher, and all the stimulus we’ve had over the last year has already been driving higher inflation.

Gold ETFs have also seen money flow into them in recent weeks as investors sought hedging from inflationary pressures. Total ETF holdings backed by bullion have seen steady inflows of 51 tons since bottoming out at 3,090 tons in April, according to Saxo Bank. The firm also said that hedge funds have also been buying gold, marking the third consecutive week of buying. The net long rose 12% to 107,000 lots, marking the highest level in 16 weeks. Gold hasn’t seen buying of this magnitude among hedge funds since June.

Another potential tailwind for the yellow metal is a weakening U.S. dollar. Lennox expects the dollar to weaken because of rising debt and the increase in physical money, also called the U.S. dollar pool. Gold recently soared to its highest price in five months, driven by a lower U.S. dollar and higher crude oil prices. The Bloomberg Dollar Index has fallen to within 0.25% of the key support level from where it has bounced on two other occasions, most recently in January.

Technicals Look Good

Saxo Bank’s head of commodity strategy, Ole Hansen, also said in a recent note that gold approached a technical level that, if broken, would signal a renewed focus on a return to the record high in August of more than $2,000 an ounce.

He said the next key level for the yellow metal is $1,923, which marks the 81.8% retracement of the August to March correction. If it breaks above this level, it will have a technical tailwind and raise the possibility of a renewal of the August record high at $2,074 an ounce.

On the date of publication, Michelle Jones did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.


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