Here’s How To Tell When To Move Back Into Gold

Gold has officially entered a bear market with a 20% drop from its peak in 2011. Exchanges recently halted trading to decrease intraday volatility.

The chorus of bears has grown just as loud as the holdout bulls, who point to massive easy-money programs. The range of possibilities is astounding.

The one certainty is that no one knows where gold’s price will go. So what can you do to establish an outlook and a fair value for something that can cause such a speculative craze?

When the market panics and investors rush for the exits, you have to have a calm assessment of value. Looking at long-term supply and demand can help you put a floor on any asset and develop a trading strategy.

Gold Still Glitters
First, we have to really look at the impetus behind the biggest sell-off in gold prices in the past 30 years. The metal got caught in a perfect storm of data and rumors — some temporary, others possibly longer-lasting.#-ad_banner-#

Recent economic data out of the U.S. and China have been weaker than expected, leading to subdued pricing pressure and less need for an inflation hedge in the form of gold investment. The single biggest factor came from Cyprus, which may need to sell as much as $525 million in gold reserves for debt payments.

The massive loss in gold over a couple of days led many traders to get margin calls, when their portfolio values fall below set limits for borrowing capacity. To satisfy the margin requirements, traders needed to sell off more assets, sending prices down further.

Despite the near-term pressure, the longer-term upside for gold is still strong. The Federal Reserve has quintupled the size of its balance sheet in just five years to almost $4 trillion. The Bank of Japan just announced a two-year plan to double its own balance sheet and set an explicit target to jump-start inflation from -0.7% to 2% annually.

That may not mean much to most investors, but to economic geeks like myself, it’s huge. Rates and inflation are fairly benign right now, but a pickup in the economy or a hit to central bank confidence could cause both to surge. When this happens, the assets held by the Fed and the Bank of Japan — which are not regularly revalued to current rates — will be worth less than the value they hold on their books.

When this happens, the value of the dollar and yen will drop, and the value of gold will jump.

What’s more, odds are that Europe will have to join in on the great money print as well. Massive austerity isn’t working, and the region just saw its third consecutive quarter of negative GDP growth. It’s only a matter of time before creditor countries like Germany jump on the easing bandwagon or just let the whole unified experiment go down the tubes.

Either way, gold wins big.

Constant Supply, Growing Demand
Unlike other commodities, gold is not consumed. Nearly 100% of all the metal ever mined is part of the current supply, which grows at about 1.7% annually. Supply is stable and easy to estimate.

Demand, on the other hand, is less easily estimated and can be extremely volatile. Commercial demand is the more stable of the factors. Jewelry accounts for about 42% of annual demand; another 10% is used in technology and dentistry. Investment accounts for another 35% of demand, with the rest attributed to central bank reserves.

Despite the recent weakness and rumors of Cyprus selling, demand from sovereign nations has been fairly stable as many countries try to diversify their assets away from the constantly depreciating dollar.

The last piece of the puzzle is gold’s value increase due to changes in the value of the dollar in which it is priced. Despite the massive amount of monetary easing around the world, the inflation rate is still fairly benign. The 10-year average rate of inflation is 2.3%; estimates for the next few years are around 3% on the high end, and possibly higher after that.

Information from the World Gold Council shows that growth in demand during the past 10 years has been about 2.6%, with demand for jewelry decreasing 3.5%, technology increasing 2.1% and investment demand skyrocketing by 16% annually.

Even if investment demand drops on price weakness, the trade-off between commercial and investment demand is pretty strong. As prices come down, investment demand falls but commercial demand increases, so we can assume that overall demand remains fairly constant.

Applying an annual growth in demand of 2.6% on top of the inflation rates to gold’s price since 1989 yields an intrinsic value of $1,269, or 9% lower than its current close.

Price of Gold since 1989 and Fair Value Estimate to 2015

Applying the 2.5% inflation expectation and 2.58% demand growth to 2015 estimates yields an intrinsic value of $1,400.

While gold’s rise over the past decade has been meteoric, it doesn’t appear to be that far off of a fair-value estimate. Another round of selling could bring prices down to a level I would feel comfortable with for a long-term investment.

Physical Gold For Protection, Miners For Income
I don’t think the sell-off is quite over in gold, so I would be hesitant to buy into the physical commodity just yet. However, the longer-term drivers are still intact. A good strategy for investors may be to hold a small position in the SPDR Gold Shares (NYSE: GLD) for inflation protection combined with a position in the gold miners for current income.

While the gold miners may not provide as much upside return should gold shine again, their shares provide a good opportunity through continual revenues and dividend distributions.

StreetAuthority’s Nathan Slaughter recently sold off some positions in his Scarcity & Real Wealth portfolio but is holding on to Goldcorp (NYSE: GG), which has the strongest balance sheet among the miners. The $22 billion miner trades for a premium against peers at 14 times trailing earnings but pays a 2.2% dividend.

I also like Freeport-McMoRan (NYSE: FCX) for its diversification in copper and gold, making it a play in both metals. The shares trade relatively cheaply at 9.2 times trailing earnings and pay a strong 4.4% dividend. The sell-off in commodities has pushed the shares to a four-year low, which may represent a good long-term entry point for investors.

I would look for another sell-off in gold prices before buying into the commodity itself, maybe another 10% off the current price. The recent weakness may already make for a good entry point into some of the miners.

Risks to Consider: There still exists potential upside in the price of gold on speculative demand and global uncertainty. Europe is far from out of the woods, and the emerging markets may not be able to support global economic growth. Investors waiting for a better entry point run the risk of missing out on some upside.

Action to Take –> The long-term drivers to be bullish on hard assets like gold are still intact, but the speculative fervor in the metal is just too high right now. Look for the yellow metal to fall closer to its intrinsic value before putting your money in for the long term.

P.S. — If you’ve been looking to add resource stocks to your portfolio, now may be the time. The global trend for commodities is rising demand coupled with shrinking supplies. That’s why we’ve seen soaring prices for years… and it means short-term sell-offs can be rare buying opportunities. To learn more about Scarcity & Real Wealth, which focuses solely on the market’s best resource investments, visit this link (without watching any promotional video).