Adrian Ash (The Daily Reckoning):

The collapse in India’s gold demand during 2007-09 might seem good reason to question the fundamental strength of gold buying worldwide.

After all, if the world’s No.1 gold buyers can’t keep up with record-high gold prices, who can…?

But the plain fact, as BullionVault first forecast in spring 2009, is that China has overtaken India as the number one private gold buyer this year. The typical Chinese New Year gold rush has already begun (thanks in part to 3% discounts at major retailers), and robust demand looks likely to continue through 2010 if not beyond.

Full-year 2009 private demand in mainland China could outstrip India, the former No.1 buyer, by one quarter if not one third. Short of a (very unlikely) collapse in Q4 demand, full-year private gold buying – including jewelry and retail investment – is set to have grown 10% from 2008’s record in volume terms, rising 26% by value to equal $13.5 billion or more.

On recent trends, that would equate to more than 2.0% of China’s famously massive household savings (up from 1.0% ten years ago) and account for almost one ounce in every eight sold worldwide.

Basis the GFMS consultancy’s data (published by the World Gold Council), physical gold purchases by mainland Chinese households in 2009 was already running 19% ahead of India’s private demand for Q1-Q3.

Given China’s continued economic growth (certain to hit Beijing’s 8% target according to the Chinese Academy of Social Sciences) – not to mention the surge in money-supply and credit growth over and above GDP (put at 23 and 27 percentage points respectively by Deutsche Bank) – private gold consumption in Q4 most likely remained very robust. Whereas India’s private gold off-take during Oct-Dec. continued to shrink in the face of record-high prices. Indian bank and wholesale dealers have reported below-market bids from their clients throughout the autumn. Comments from the Bombay Bullion Association put Q4 imports 54% lower from 2008’s already disastrous finish.

Fourth-quarter Chinese consumption should be in the range of 116 tonnes (if it adds 37% to Q1-Q3 volume, as per the 5-year average) to 128 tonnes or more (if Q4 tops Q3 by volume, as it has each year since 2004). The running total to end-Sept. was 315 tonnes. It is likely to finish full-year at 431-443 tonnes.

India’s private demand, in contrast, ran 45% below 2008 levels during the first 9 months of the year, most notably depressed during Q1 (down 83% from Q1 08, with Indian investors becoming physical dis-hoarders on GFMS’s data; overall, India was a net exporter of gold for the first time since the Depression according to market historian Timothy Green). Applying the 5-year average ratio of Q4 demand to Q1-Q3 figures (27% added to 264 tonnes), full-year private off-take would come in at 336 tonnes, the lowest total since at least 1991 on GFMS’s data. . . .

Click here for the rest of Mr. Ash’s analysis at The Daily Reckoning.

And I believe a small allocation (5% to 7%) has a useful place in a well-diversified portfolio. Over the long haul, studies confirm it helps increase returns while minimizing risk. A benefit we can all agree is desirable.

But over the short-to-intermediate term – the next six to nine months – I think gold is a terrible investment. After breaching the $1,000 per ounce mark again, as I suggested would happen to my subscribers on February 2, it is overdue for a retracement back to roughly $700 per ounce.

Those of you who expected it to drop the day after I suggested shorting gold need to understand that “short term” doesn’t mean “this week.” Just because it moved higher doesn’t negate the point of the recommendation.

Long story short, I view shorting gold as a way for me to hedge my long-term holdings. For traders, it’s a profit opportunity to consider. And whether we see eye to on this is irrelevant. Ultimately, the market will be the great arbiter of our differences.

For kicks though, let’s address a few of those minor points of disagreement…

Shorting Gold is Not Really Contrarian

A small army of you suggested I was being an “arbitrary” contrarian when I suggested that it was time to start shorting gold. That no evidence, just a warm and fuzzy feeling, existed to back up my call.

Are you kidding?

Sure your “Cousin Vinnie” as chronic poster Todd opined, the trash collector or the newspaper boy might not be investing in gold. But the rest of the lemmings certainly are…

• Investments in coins and bars increased 811% in the fourth quarter, according to the World Gold Council.

• Headlines abound in the mainstream press like this one from The Financial Times – “Gold primed to be ‘mania asset.’”

• Wannabe gold bugs are paying – willfully I might add – 20% premiums for coins and small bars. Forget buying gold, we should all become coin dealers!

• Investors – like teenage girls at New Kids on the Block concerts in the late 1980s – can’t reach out and touch the SPDR Gold ETF (GLD) enough. It’s now the second-largest ETF in the United States with a market cap of roughly $33 billion. With more than 1,000 metric tonnes of gold, speculators now control more gold than many industrialized nations. If that doesn’t scream “out of whack” I don’t know what does. Many of you respond by saying the investors here are institutions, so the inflows are not indicative of a top. You’re wrong. Individuals, according to Morningstar, accounted for an estimated 60% to 70% of the investments in the last four years.

• The world’s largest gold refinery is pumping gold coin blanks at a rate not seen in 23 years, according to Bloomberg.

• Reuters reports investment consultants are now advising pension funds and high-net worth clients to invest 5% to 7% percent allocation toward gold and gold stocks. After being an investment consultant to such clients, I can confirm such allocations are new. And will be followed, if they haven’t been already.

• If you’re a newsletter junkie, like myself, no doubt you also noticed the sudden explosion in “gold experts” that have some overlooked, stealth play on gold you need to consider. It’s poised for 500% gains (or more), they say! All you have to do is read a 16-page teaser and sign-up for some newsletter. Marketers tap into what’s hot, typically as a trend is cresting. Don’t expect this time to be any different.

• From today’s Wall Street Journal, futures investors are taking delivery of gold at more than double recent levels (4.5% versus 2%). Paranoia anyone?

If the above isn’t sufficient evidence to be a contrarian, I don’t know what qualifies then.

Why should I listen to you, Lou?

Others of you simply wanted to know, why you should listen to me – a Wall Street flunky, “idiot” or a “young analyst who thinks he’s got the magic touch and will never be wrong.”

Forget that the last reader – and yes it’s the chronic poster and my new “buddy” Todd – is completely clueless and didn’t catch my transparent about-face on the dollar here. Or my confession that I flubbed the rebound in financials.

I’m human. I will be wrong. I’m man enough to admit it. But I don’t think shorting gold will be one of those times.

And if I don’t have enough credentials to make such a claim, in your opinion, fine by me. Listen to someone more “qualified.” Plenty of them exist that are also starting to question the merits of investing in gold, or at least acknowledge the mania…

…Newsletter god, Dennis Gartman says, “It’s a little worrisome that so many people are piling in [to gold].” He expects a pullback, too. Just not as far as me.

…Peter Munk, founder of Barrick Gold, says he’s never seen such strong interest in physical gold ownership.

…”This will all end badly, just like all other bubbles,” predicts Leonard Kaplan, President of Prospector Asset Management, a commodities futures brokerage in Evanston, Ill.

…”Historically, when stocks begin to underperform gold, that’s a sign that gold is running out of steam,” according to Ray Hanson, a technical analyst at RBC.

My Biggest Concern

What really scares me is that some people take gold investing to an extreme. They actually believe in a government-orchestrated conspiracy to suppress prices, as some of you revealed in your comments.

It’s pointless to engage in lengthy debates with conspiracy theorists. Logic means little. But let’s suspend disbelief for a millisecond and say you’re right, that the price of gold is being fixed.

Why in the world would you throw hard-earned money after the slim prospects of actually exposing and overturning the fix? Talk about a low probability of success.

But I digress. What’s most troubling is many investors, including some in my industry, say gold is a forever position and they are committed to “a lifetime pattern of purchasing” and will never sell. Some of you even revealed 50% of your portfolio is invested in gold.

Here’s the thing. I know that Christopher Columbus says, “Whoever possesses it [gold] is lord of all he wants. By means of gold one can even get souls into Paradise.” But if financial Armageddon unfolds, which many gold bulls predict and in some sickly way wish for, gold will be priceless and worthless at the same time.

How so?

If world governments collapse, social order goes to heck, (NYSE:MCD) McDonald’s won’t magically be set-up to “make change” for your gold bars. ATMs won’t spit out Krugerrands.

What’s more, even if the price of gold tops, say $5,000 per ounce under such circumstances, what can you do about it? Cashing in on the gains means accepting the thing gold bugs completely despise, paper currency, in return. So indeed, it will be priceless, useless and worthless all at the same time.

Bottom line, the world isn’t set up to handle gold as a currency. Not now. Not ever. It’s merely an asset. And like all other assets, it’s susceptible to bubbles.

If you’re in the speculative mood, I recommend shorting gold in the coming months. Especially since, as the saying goes, “gold goes up on an escalator and comes down in an elevator.”

At the very least, examine your reasons for owning gold. If you believe the end of capitalism is nigh and financial ruin is imminent, just remember you need gold to be liquid, acceptable and portable for your investment to be really worth anything.

All three are big question marks, convincing me John Maynard Keynes was more right than most want to admit. Outside of a small allocation for diversification purposes, gold is indeed a barbarous relic.

I’m off to the message board to prepare for the onslaught of “fan mail”…

Source: Shorting Gold: 8 More Signs Gold is Overdue for a Correction

Last week, I promised to answer this popular question:

“Hey JL, what about all that gold in the vaults of the IMF and Fort Knox? Aren’t you worried they might try to dump it on the market?”

But before we get to that, a quick correction. In Friday’s piece, Europocalypse, I made reference to Colonel Kurtz as a “deranged flyboy lost deep in the Congo.”

The film-buff contingent among you corrected me with relish. Kurtz was in Cambodia, not the Congo, at the height of the Vietnam War when the movie took place.

My apologies… in Joseph Conrad’s novella, Heart of Darkness, Kurtz is a rogue ivory trader lost in the Congo. (Conrad himself drew on personal experiences as the captain of a Congo steamer in writing Heart of Darkness.)

Clearly the book and movie are two distinct entities. In referring to “a flyboy lost deep in the Congo,” I accidentally conflated the two.

Given the glee that some of your e-mails displayed, I’m tempted to hide future Easter eggs in my pop-culture references.

Anyhow, moving on…

A Golden Sword of Damocles?

It’s true – the United States and the IMF (International Monetary Fund) have a lot of gold in reserve. Some of you fear a good chunk of that gold could be dumped on the market, acting as a sharp break to the yellow metal’s rise.

Let’s start by asking the question, just how much gold do these guys have?

The World Gold Council regularly updates the stats on official holdings of central bank reserves. According to December 2008 data from the WGC, the U.S. holds 8,133.5 tonnes (metric tons) of gold. The IMF holds 3,217.3 tonnes.

When you do the math, that adds up to 11,350.8 metric tons (tonnes), or 12,512 short tons, of gold. Converted to ounces at $1,000 per ounce, that’s a touch over $400 billion bucks worth of bullion.

Does this count as a lot? Yes and no.

On one hand, it represents 8-10% (very roughly) of all the gold in the world. On the other hand, there are a heck of a lot more dollars in the world… and demand is the key driver to consider here.

Big Buyers in the Wings

Take Russia, for example. Russia has recently stated its intent to raise total gold holdings to 10% of total reserves.

Again according to the World Gold Council, Russia held 495.9 tonnes of gold as of December ‘08, accounting for just 2.2% of reserves.

We can do the math and see that, for Russia to hit its stated target of raising gold holdings to 10% of reserves (assuming total reserve values don’t change), they would need to purchase 1,758 tonnes of gold in the open market.

By stating a desire to up their gold holdings to 10% of reserves, Russia has all but said “Yeah, we wouldn’t mind owning another 1,750 tonnes of gold or so.” And that’s just Russia.

When you think about it, 10% is a pretty modest allocation. You think China wouldn’t like to have more of its dollar mountain converted to gold?

What central bank wouldn’t want to have 10% of its assets (or more) in bullion at a time like this, with paper currencies getting debased like crazy and creeping geopolitical tensions around the globe?

Below is a table showing a cross section of central banks with sizable gold holdings and low percentages of total reserves.

You can see from the table how many tonnes (metric tons) each of these banks would have to buy in order to get their total allocation up to 10%.

Remember, the U.S. and the IMF hold roughly 11,351 metric tons of gold.

If just these 10 central banks elected to raise their reserve allocations to 10%, they could hoover up all that U.S. and IMF gold by themselves (and still be hungry for more). And believe me, there are plenty more than these 10 with the same thoughts… not to mention institutional demand, don’t even get me started on that.

This doesn’t paint anything close to the total picture, of course. But it should help give you a better grasp of supply and demand. Right now, demand for gold is high and rising… and there just isn’t that much of it left to go round in the world.

“We Hate You Guys”

Part of the reason many of these banks haven’t upped their total gold holdings, by the way, is because it’s hard for them to buy gold without running the price up. You’re just not seeing that much supply on the open market relative to total demand.

This is why some central bankers despair that they have nowhere to go but into U.S. dollars and U.S. Treasury bonds. The amount of available gold on the market is so small, relative to the amounts that would be desirable for them to own, that trying to get the reserve percentages up is a very tough task.

That is why Luo Ping, director-general of the China Banking Regulatory Commission, had this to say a few weeks ago:

Except for US Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option… We hate you guys. Once you start issuing $1 trillion-$2 trillion… we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.

If gold suddenly became easier to buy in the open market, bankers like Luo Ping would quickly change their tune.

“Oh, you want to sell gold in size? That’s wonderful, because we want to BUY in size… something, anything that will hold its long-term store of value better than these stupid treasury bonds! Thank you, Thank you!”

Remembering Gordon “Goldfinger” Brown

The world’s bankers, too, will no doubt remember the lesson of Gordon “Goldfinger” Brown.

Gordon Brown, now prime minister of the U.K., was treasury minister back in May 1999. In that capacity, Mr. Brown decided to dump half of Britain’s gold reserves at 20-year lows, as the Sunday Times reports:

GATHERED around a table in one of the Bank of England’s grand meeting rooms, the select group of Britain’s top gold traders could not believe what they were being told.

Gordon Brown had decided to sell off more than half of the country’s centuries-old gold reserves and the chancellor was intending to announce his plan later that day.

It was May 1999 and the gold price had stagnated for much of the decade. The traders present — including senior executives from at least two big investment banks — warned that Brown, who was not at the meeting, could barely have chosen a worse moment.

…”The timing of the decision was ludicrous. We told them you are going to push the gold price down before you sell,” said Peter Fava, then head of precious metal dealing at HSBC who was present at the meeting. “We thought it was a disastrous decision; we couldn’t understand it. We brought up a lot of potential problems at the meeting.”

…The decision to sell 400 tons of gold is seen in City circles as a financial bungle on the scale of the Tories’ “Black Wednesday” that cost the taxpayer £3.3 billion, according to Treasury estimates.

Dominic Hall, a former gold dealer who now runs thebulliondesk.com, a website for the gold market, said: “Brown was keen to throw mud at the opposition over Black Wednesday but this was a financial disaster on a similar scale.”

Dumping 400 metric tons of gold over the side at prices well below $300 per ounce was an epically dumb decision – something that is all too clear today. At present-day prices, that is much more than the Tories’ debacle of 3.3 billion pounds sterling lost… it is more on the order of ten billion pounds sterling lost.

So it is doubtful that many bankers today will want to emulate the stupidity of Gordon “Goldfinger” Brown, especially with the public so aware of what’s happening in the world. To sell gold now and trade it for what – Dollars? Euros, are you kidding me? – would serve as open invitation to be publicly tarred and feathered.

Bluffing Into the Nuts

We’ll close with a quick poker analogy.

In No Limit Texas Hold ‘Em, to hold “the nuts” means you can’t be beaten – that your hole cards in combination with the board give you the best possible hand.

Needless to say, it is useless to bluff a player who is holding the nuts. Why would they fold? They know they have the best hand. If you raise such a player, they will happily call… or better yet shove their own stack in the middle, a reraise to put you all-in.

If the Fed or the IMF were to dump gold onto the market in this environment, I believe it would be the poker equivalent of bluffing into the nuts. I don’t think the powers that be are that dumb.

But even if they were, what would happen? If they tried to increase the gold supply discreetly, the central banks and institutional holders who are quietly accumulating bullion would simply pick up the pace a little.

If they tried to talk down gold in the open market, blathering about how they planned to sell a huge chunk, gold might take a sizable short-term hit… but then it would bounce back, and then what they do?

Source: Why the IMF and Fort Knox Won’t Put the Hurt on Gold

Normally they hit them both at exactly the same time, but there was a slight difference in yesterday’s pattern. It probably means nothing.

Doubtless there has been massive tech fund long liquidation, but you’d never know it by looking at the changes in open interest over the last couple of days. Wednesday’s numbers (like Tuesday’s) were no exception. Open interest for gold was up 3,643 contracts…and silver o.i. rose as well, but only 59 contracts. This is completely counter-intuitive. Is this shorting by the Cartel or the tech funds, more spread trades…or new buyers? Don’t know. Today’s COT, which will be released at 3:30 Eastern time, will only tell us part of the story. This sell-off started on the 17th and the cut-off for today’s COT was Tuesday the 22nd at the close of trading. Will everything that’s supposed to be reported actually be in this report? Using the past as prologue, the answer is no. We’ll have to wait until the following Friday…May 2nd…to hopefully get a more complete picture. I was interviewed on this subject by Al Korelin yesterday…and if you want to hear me talk about it, you can find it linked here.

The question still remains whether or not the Cartel/the boyz/bullion banks/’8 or less traders’…call them what you will…are trying to get every last possible long they can…like they did in August…when we got butchered last time. Don’t know that either, but this is their modus operandi after a huge run-up like we had in 2006…and now in 2008. Right now the 200 day m.a. in gold is $818…and silver’s is $15.23. Here is the three-year gold chart. Note that the price kissed the 200 day m.a. in June of 2006 before heading higher. Click here.

One thing is for sure, we’re closer to the bottom then we are the top. And as I said before, don’t expect the mining companies, the Silver Institute or the World Gold Council to help you out. We’re totally on our own (and defenseless) against the Cartel. However, the boyz can only win the odd battle here and there, as they are obviously losing the war in the long term.

Another thing of note…in a conversation with Ted Butler yesterday, he informed me that the gold ETF…GLD, has now liquidated about 50 tonnes of its holdings in the last three days and is now sitting about 5% lower in physical bullion than it was four months ago. On the other hand, the silver ETF…SLV, has increased its holding 25% since the beginning of the year, and hasn’t sold an ounce of it (as of this writing) despite the decline of $5 we’ve had in the price since the middle of March. You can read into that whatever you want.

A couple of stories today, the first is silver analyst Ted Butler’s latest commentary entitled “Then and Now”. How Ted can write about one subject year after year…and put a different spin on it each time…has always amazed me. This piece is no different and is linked here.

The second article is on real estate. Yesterday’s new home sales numbers were worse than awful…and well-known economist, Robert Schiller, says we’re a long, long way from the bottom. I couldn’t agree more. The story is entitled “Economist: Housing slump may exceed Depression” and is linked here.

Hank Paulson must have been a happy man again yesterday. Dollar up…check. Dow up…check. Oil down…check. Precious metals down again…check. I’m sure he turned in early last night in preparation for another hard day at the office. Let’s see how he makes out…and all of us at Casey’s Daily Resource Plus will be here on Saturday to talk about it, and we’ll see you then.

Investors are key at the moment, because of the unhappiness with the gold price in Asian jewellery markets. Normally the main supporters of gold, jewellery customers in Dubai or Mumbai do not like its current volatility. When you buy your earrings or bracelets by weight, you want have confidence that you are getting the right number of ounces for your money!

Not that this has made GFMS, or other forecasters, pessimistic. GFMS is confident that the price could easily reach $1,100 this year. If not then, certainly next year!

The reasoning? What this amounts to, at core, is that there is too much bad news around financial markets for investors to go off gold. World credit markets are in a worsening state. But GFMS does warn that the trend lines on the charts will not going straight upwards. And, indeed, they are not. Having broken up into new high ground to reach $1,030 in mid-March, the price has slid back towards $900.

Most of the drivers behind investing are still there

“We were not at all surprised that the market saw a hefty correction in the last few weeks, as the speed of the earlier gains looked a little unsustainable,” said Philip Klapwijk, GFMS’ executive chairman in the report. “However, we do not think current hesitancy means it’s game over for the rally.”

And he added: “Many of the drivers behind this investor push after all – dollar weakness, skeletons in banks’ closets – are still very much with us,” said Klapwijk. “But quite where it will top out is a difficult call – maybe $1,100 is achievable this year, but $1,200 plus could be going a bit far”.

The demand / supply balance is currently put at about even by GFMS. While it expects jewellery buying to fall by 200 tons, it believes investors will compensate. This is based on the interplay between investors and the jewellery sector in 2007.

Investors replaced jewellery in the second half of 2007

During the first half of last year, western investment fell but gold remained supported mainly by jewellery demand, GFMS said. Then investment was the key driver for prices from September onwards, as the credit crisis flared up globally.

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Highly Recommended

‘City under Siege’

The UK economy relies on the finance sector for one third of its output. But let me ask you this…

What do YOU think would happen to the domestic economy – and to YOUR savings and investments – if Britain’s ‘Miracle Money Machine’ has its output slashed by one tenth… one third… or even half?

Get ready, because you’re about to find out. Below you’ll find the link to a new Crisis Report published by The Fleet Street Letter.

They’ve also identified three stocks poised to benefit from the finance sector-led recession. Go here for the full report.

Forecasts are not a reliable indicator of future results. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Please seek independent financial advice if necessary. Fleet Street Publications Ltd. Customer Services: 0207 633 3600.

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“Driven by growing risk aversion, a weakening US dollar, a clearly problematic financial services sector and expectations of lower equity prices, investors have increasingly recognized gold’s safe-haven attributes,” Klapwijk said. The consultancy group expects the credit market crisis to persist in the medium term, fuelling continued risk aversion and creating a bearish outlook for the US dollar, the global economy and equity markets.

So, who are these investors, and what sends them to gold? You, me, hedge funds, mutual funds….anyone with savings. The World Gold Council is creating more and more of them by promoting the setting of Exchange Traded Funds around the world. These are currently the top investment medium. They’ve been nick-named the “People’s Central Bank” and are currently make up the 7th largest gold holding.Exchanges are playing their part setting up new futures trading markets – India is the latest.

An important part in investor psychology is local currency. Those currently to watch, to go by the GFMS survey, are the Euro, Australian dollar, Turkish lira and Indian rupee. Price gains in non-dollar terms from these currencies were far more restrained than the previous year – so some investors were in less of a rush to hedge into gold.

Since then, gold soared to more than $1,000 an ounce, creating quite a nice return for investors who acted on our prediction. Since achieving that peak, gold prices have declined a bit. In fact, just last week, gold prices dropped below the $900 mark, prompting gold bears to say that the great gold bull market has reversed itself.

Let me say right now: They’re wrong.

In fact, now I’m saying that – thanks to three key catalysts – we may well see gold at $1,500 an ounce this year, if not higher.

Those three catalysts – worldwide monetary policy, global supply-and-demand for gold, and gold’s past performance – have already ignited a powerful rally that’s virtually certain to carry gold to much higher price points, despite the breather the rally appears to be taking right now.

Don’t be fooled. Understand the forces at work here. Then watch as gold prices soar.

Three Reasons Gold Prices Could Vault

Every rally needs a catalyst – something that ignites and then fuels the bullish trend. As noted above, gold has three. Let’s take a look at each of them:

1. Monetary policy: More than for any other investment, gold’s price depends primarily on the world’s monetary policy. When monetary policy is loose, as it was in the 1970s, gold prices soar. When it is tight, as in the 1980s, prices decline sharply. When gold prices advanced sharply after 2000 that should have told the U.S. Federal Reserve and others that monetary policy had once again become too loose.

Indeed, it became too loose after 1995, but gold prices were temporarily suppressed by the world’s central banks (the British Treasury, then headed by Gordon Brown, sold the nation’s entire gold stock in 1999, at a price of around $280 per ounce – yet another reason for British taxpayers to be annoyed with their current Prime Minister).

The rise in gold prices is thus easily explained. U.S. monetary policy has been loose since 1995, and particularly since the recession of 2001 and 2002, and other countries have followed the United States’ lead. According to International Monetary Fund (IMF) statistics, the world’s total foreign exchange holdings increased from $1.4 trillion in 1997 to $6.4 trillion last year, an average annual increase of 16.4% – compared with a 7% annual increase in Gross World Product. With that kind of monetary expansion, it is not surprising that gold prices have risen; the metal is universally regarded by both the sophisticated and unsophisticated alike as the premier hedge against inflation.

Since the subprime crisis exploded onto the scene last September, the Fed has been lowering interest rates. And the Fed, the European Central Bank (ECB) and the Bank of England have been providing additional lending facilities to banks and investment banks. The lowering of interest rates has been quite dramatic, from a Federal Funds rate of 5.25% before September to 2.25% now. Even 10-year Treasury bonds, currently yielding 3.6% or so, are providing investors with a yield that remains well below the rate of inflation (currently somewhere above 4% and trending higher). The bailout of The Bear Stearns Cos. Inc. (BSC) and the continuing efforts of the ECB to restore liquidity to the short-term euro deposit market are having the same inflationary effect. As a result, commodity prices have soared in the last six months, as has the price of gold.

Gold has sold off in the past couple of weeks as the market has focused on the U.S. recession, believing that inflation pressures will decline, but that’s wrong. Monetary expansion continues and even is intensifying, meaning that inflationary pressures will increase and gold will be the beneficiary.

2. Global Supply and Demand: For most commodities, price rises have an effect on supply and demand; a higher price increases supply and reduces demand, in “price elasticity.” With oil, for example, a 10% rise in price reduces demand by about 1% to 1.5%, meaning that oil has a price elasticity of 0.1 to 0.15. That’s what conventional economics tells us, and it’s a good thing, too. Without the effect that rising prices have on supply and demand, a shock in the market could produce instability, with prices zooming off to infinity.

Gold appears to be an exception. For gold, rising prices appear to increase demand and decrease supply. According to the World Gold Council, world gold demand in 2007 increased by 4% in volume terms to 3,547 metric tons, or about 20% in dollar terms; the average dollar price of gold increased 16%. Gold supply decreased 3% to 3,469 metric tons. Of that, mine supply decreased 3% to 2,047 metric tons, while official sector sales increased 32% to 485 metric tons and gold scrap recycling decreased 15% to 937 metric tons.

This suggests a gold supply/demand price elasticity of minus 0.4; that is, if prices increased 20%, demand would increase 5% and supply would drop 3% to 4%.

That simply cannot be true in the long run – otherwise, the gold market would explode, swallowing the world economy. Nevertheless, while real global interest rates remain low, gold should retain its current dynamics, with speculative demand increasing as prices rise. Since the pools available for speculative investment are much larger today than they were in 1980, the predicted gold price “spike” could even move well beyond 1980’s peak price of $2,250 an ounce (as measured in today’s dollars).

3. Comparison with past peaks: If gold had increased in price since 1997 by the same percentage as world dollar reserves, it would currently be trading at around $1,280 per ounce. And the current speculative appeal of gold, compared to its inactivity 10 years ago, suggests it could go higher than this. The 1980 gold price peak of $875 per ounce intraday is equivalent to more than $2,200 per ounce when inflation is taken into account.

That occurred in a period when equity investments had fallen deeply out of favor [remember the famous August 1979 "Death of Equities" BusinessWeek cover story?], when bonds had performed miserably for more than 30 years and when oil was not yet significantly publicly traded. Thus, when inflation rose to a frightening level above 10%, the world’s entire investment pool flooded into gold – and, to a lesser extent, silver.

Today, while the Fed and other central banks keep interest rates below the level of inflation (roughly 2.5% with an inflation rate of about 4.0%), gold prices are likely to continue increasing at a rapid clip, though they may retreat temporarily for a few weeks at a time. Nevertheless, while the global investment pool is many times larger today than in 1980, it has recent memories of making good profits in stocks, so a money-fueled bubble would be unlikely to flow entirely into gold as it did in 1979 and 1980. However, if gold is unlikely to reach $2,200 in the short term, its greater attraction to investors today compared with 1997 suggests that it will rise well above $1,280.

How high can gold go?

Just let me show you…

Price Projections for the Yellow Metal

At some point, with monetary policy as loose as it is currently, inflation will probably accelerate to a point that will force the world’s central bank policymakers to take action. When that happens, interest rates will have to be sharply increased. Then – and only then – will the risk-reward potential for gold change enough that wise investors should sell.

That final peak might come immediately before this sharp uptick in interest rates. Or it might lag by a few months, as it did in 1980 [Fed Chairman Paul Volcker’s first big interest rate rise was in October 1979; gold finally peaked in January 1980]. Remember that recessions don’t stop gold prices from rising. Gold’s first major peak was in the middle of the 1974 recession and its second was well into the first part of the 1980 recession.

As inflation accelerates, it will probably take a few months for clear inflationary signals to cause the Fed to reverse its policies and attack inflation. And during that period, expect speculative demand for gold to intensify and its price to increase steeply. The longer the period before the Fed is forced to increase interest rates, the higher gold will go.

For example, if rates aren’t increased before the end of 2009, gold could easily soar well through $2,000 – a price point we said was possible back in July, when gold was trading at $650 an ounce.

Even if $2,000 seems to be a somewhat aggressive price target for gold (because rising inflation is likely to cause the Fed to reverse policy before it gets there), understand that a target price of $1,500 certainly is not. And it seems very probable that with speculative demand tending to increase, gold could reach that latter level before the end of 2008.

The bottom line: Until the Fed reverses monetary policy and increases interest rates, gold is one of the best investment bets in an uncertain world.

Six Gold Plays to Consider… Now

• The simplest way to play gold is through the StreetTracks Gold ETF (GLD), which with $19.8 billion outstanding has ample liquidity, and tracks the gold price directly. Alternatively, you should consider buying gold mining shares. Here are five possibilities:

• Barrick Gold Corp. (ABX) is a Toronto-based company with mostly North American production, as well as some South America and Africa properties, and some copper and zinc add-ons. It has a $38 billion market capitalization, so there’s plenty of liquidity. It has a trailing Price/Earnings ratio (on the most recent 12 months) of 34, but a forward P/E (on the next 12 months) of 16. By gold-mining standards, this company has a substantial presence, is reasonably valued and has little political risk. And, as Money Morning reported, the company also recently sent some very bullish signals to the market and then this week said it was confident that it could meet its 2008 output target of up to 8.1 million ounces of gold [For more details, read a related story about Barrick Gold in today’s issue].

• Yamana Gold Inc. (AUY) is another U.S.-listed Canada-based company, but this one does its mining in Brazil, Argentina, Chile, Honduras and Nicaragua. It has a market cap of $9.7 billion and a trailing P/E of 40, but its forward P/E is only 14. Despite its geographic reach, it faces only a medium geopolitical risk. Expect the company to double production to 2.2 million ounces per year by 2012, primarily in Brazil and Argentina. 

• Gold Fields Ltd. (GFI) is a South African company that mines in South Africa, Ghana, Australia and Venezuela (where it just sold control to a local company, reducing its exposure to an arguably risky market). The company’s market cap is $9 billion, its trailing P/E is 24, and its forward P/E is 11. It faces a somewhat upper-medium political risk, depending on what you think of South Africa, where the electricity supply to the gold mines is currently unreliable and where there’s a good chance of Jacob Zuma winning the presidency in April 2009. Given his record as an anti-Western leftist, and the corruption charges he faces, his potential return can only be viewed as a major negative.

• Kinross Gold Corp. (KGC), another U.S.-listed Canadian company, engages in gold and silver mining, with primary operations in Canada, the United States, Brazil, Chile and Russia. In February, Kinross issued shares to buy a large Brazilian/Russian company. Political risk is low-medium. It has a market cap of $14 billion, a trailing P/E of 39, and a forward P/E of 19. It looks somewhat expensive. 

• Royal Gold Inc. (RGLD) is a U.S.-based company with mines in Nevada, Mexico and Argentina. It faces low political risk. But with a market cap of $905 million, a trailing P/E of 44, and a forward P/E of 25, the stock looks expensive.