ThxPORTAL - My OnlinE InvestmenT ProgresS

Written by Lara Crigger
February 05, 2010 9:42 AM EST

It's a hard time to be a gold bug. At $1,049/oz, the yellow metal is currently trading way off its lofty highs of December 2009. And it could have even further to fall, says Brian Nick.

Nick is an investment strategist with Barclays Wealth, a leading global wealth management firm with more than $220 billion in assets under management worldwide. In its latest investment call, the firm took a decidedly bearish view on gold, advising investors to short the metal, which had become "significantly overvalued relative to fundamentals."

Recently HAI Associate Editor Lara Crigger chatted with Nick about the bearish outlook for gold, including how ETFs have changed the metal's demand picture, why we're not headed toward inflation and what's gold's real fair value.

Lara Crigger, associate editor, HardAssetsInvestor.com (Crigger): In a recent investment call, you advised investors to short gold. Why?

Brian Nick, investment strategist, Barclays Wealth (Nick): Now is a good time to short gold, but probably a better time to short gold would have been back in November, when it was $200/oz higher.

We think that the run-up in gold was overstated, and we don't think the reasons for it were sound. We think that a lot of the fear driving people to invest in gold has to do with the devaluation of the U.S. dollar, interest rates in the U.S. staying too low for too long, worries about inflation and the U.S. debt, and so on. With all that tied together, people flocked to gold as a store of value. But when you look at the fundamentals, this doesn't seem like an environment where gold should do well.

Crigger: How so?

Nick: If you look at inflation, you see inflation's actually quite low; core inflation is actually decreasing. So we don't have an inflation problem here. Plus, we have 10 percent unemployment and a large output gap still in the economy. So those three things taken together would dictate that the Federal Reserve should be cutting rates to well below zero, probably something like -4 or -5 percent, which obviously they can't do.

So the fact that they're at zero, as contradictory as this may sound, that's actually a relatively restrictive stance at the moment. That's one of the reasons why they took extra measures: because they knew that they had a lower bound of zero, and they needed to do other things to increase the money supply, to get economic activity moving again.

Crigger: That's contrary to a lot of what you hear, with people saying these extra low interest rates are very bad for the economy, even a setup for future inflation. So are we facing inflation in the future?

Nick: No, we don't think we are. Look at virtually any other market where you'd see signs that people were worried about inflation, and they don't exist anywhere except the gold market. Look at TIPS, for example, which should tend to outperform by quite a bit when people are worried about inflation, as breakevens between them and Treasurys rise. But you aren't really seeing that. Today you're seeing a sharp contraction in breakevens. They've been pretty stable for the past three or four months, and they're really only at average levels historically. So there's no inflation premium in that market.

If you look at the U.S. Treasury market, the 10-year rate is now at 3.6 percent, which is extraordinarily low. If there were really concerns about inflation on the horizon, we think the bond market would be reacting. But as it stands, it seems only gold is really pricing in a severe inflation scenario.

Frankly, if you were worried about inflation, there are cheaper ways to express that view, whether by buying TIPS or shorting a Treasury. It's cheaper than entering the gold market right now.

Crigger: On average, gold prices have gone up for the past nine years. Will this trend continue in 2010?

Nick: We certainly don't see it going up in 2010, just because of the significant overvalue relative to where it should be and where its historical average is.

One of the reasons gold tends to go up has to do with the credibility of monetary policy, and the credibility of the Federal Reserve. For a lot of the past 10 years, as you hear a lot of critics saying these days, the Fed kept interest rates fairly low, probably lower than they absolutely needed to, especially in 2003-2004. That's credited with a lot of the bubble in asset prices that we saw pop in 2008.

So we would expect gold to do well if the Fed were being overly accommodating, which, probably for most of the past decade, we think it was. But right now, we don't think it is. So we would have expected to see a sharp reversal in the gold price back down somewhere below its long-term average, between $700-800/oz. But instead we saw the opposite: We saw gold continue to appreciate. And we think that is the result of a misunderstanding or misinterpretation of signals we're seeing from the Federal Reserve, signals we're seeing from economic data. It's due for a correction.

Crigger: Is gold's long-term average of $700-800/oz a fair value for the metal?

Nick: Yes. In fact, if the Fed is a little more restrictive than normal - which we think it is - it should actually be a little below that number. But as we see interest rates start to normalize, and the economy start to improve, I think that's going to work itself out. So a return to an equilibrium price somewhere in that range is what we expect. We don't necessarily have a target date or time horizon, but we think gold will trend lower overall.

Crigger: How does investment demand from ETFs make a difference in gold's demand picture?

Nick: The gold market has really changed, as far as the makeup in where demand is coming from. One of the reasons why I think you've seen such a sharp, dramatic run-up is that it's become a lot easier for the mom-and-pop investors to invest in gold. There are ETFs now, like GLD, that you can buy through your online trading account that hold gold directly in the fund, and you don't have to find a way to store the physical. So it's a lot easier to buy and sell, and it's a much more liquid market than it was.

As a result of that, and as a result of the recession we just came out of, investment demand has really swamped demand coming from end-users of gold, whether they're jewelry makers or industrial users. We've really seen investment demand take over the market.

That worries us, because as quickly as that demand ramped up, it could also unwind. And so you have the potential for so much gold coming on to the market, as people are selling out of their positions, but there's very little demand to soak up the supply. So we think, if the correction starts to happen, it could happen very quickly, because there's close to a decade worth of industrial demand already sitting out there in the gold market. There's no way end-users of gold can absorb all the supply out there without taking much lower prices for it.

Crigger: So bottom line, we're not going to be seeing $2000/oz gold prices anytime soon.

Nick: No, but obviously, it's a very volatile market. Over a long-term picture, being two-three years at least, we think it will trend lower, but there's always the potential to spike.

There's a lot of policy risk out there. A lot of the trepidation around gold, I think, surrounds some of the policies that the Obama administration has tried to push through. I think it's caused a lot of fear about the long-term sustainability of the national debt, and the short-term fiscal deficit.

For example, when the Massachusetts Senate election happened and the democrats went from 60 to 59 in the Senate, the day after that was a very bad day for gold, because it dimmed the prospects for serious, comprehensive health care reform. Rightly or wrongly, I think that was one of the major drivers of gold. There were a lot of individual investors who were worried.

Crigger: You don't really think about the health care debate as driving gold prices.

Nick: No, but I think it's part of the larger picture of people just being uncertain about whether the U.S. will spend itself into a death spiral. I think that was one piece of the puzzle. I don't think health care was necessarily the largest piece - obviously we have some structural problems too. But in the long run, I think there was just a heightened sense of fear that drove a lot of people to gold, part of which was the prospect of having to deal with larger government.

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