China's Quest for Gold
Saturday, March 13th 2010
Melbourne, Australia
By Dan Denning


Dear Reader,

Comex gold futures fell $14.20 earlier this week in New York trading. That left the gold price down 1.27% at $1,107. According to wire services, the slump was triggered by technical indicators and speculators. Gold crossed under its 20-day and 50-day moving averages and some of the hot money left the market.

But if you're serious about protecting your portfolio from financial shocks and economic uncertainty, this might be the best time this year to add to your gold position. Here's why...

The technical trading is just noise. The bigger story that spooked investors came from China. Speaking at the National People's Congress, China's foreign exchange regulator Yi Gang told a press conference that, "currently a few factors limit our ability to increase foreign-exchange investment in gold."

Most analysts immediately took that to mean China would not be a buyer of the 191.3 metric tons of gold the International Monetary Fund announced it would sell on February 17th. And if China were out as a major buyer of gold on international markets, speculators reckon the gold price will fall.

But they're wrong. And let me tell you why. China bought almost 50% of the gold purchased by central banks in 2009. China purchased 454.1 tons of gold on its domestic market last year. It didn't have to go shopping overseas.

China can buy its own home-grown gold because for the last three years in a row, it's been the world's largest producer. China produced over 300 tonnes of gold for the first time ever in 2009, according to the China Gold Association.

Incidentally, that means that last year's domestic gold consumption exceeded mine supply. That means the Chinese authorities were buying above ground gold too. And when you learn that the number of producing gold mines in China has fallen from 1,200 in 2002 to 700 in 2009, you can see China is scrambling to produce as much gold as fast as it can.

It's a good strategy. Why bid up the price of gold on international markets when you can buy your own domestically produced gold? As a senior People's Bank of China figure reportedly said:

China should formulate a long-term plan and constantly and secretly increase its gold holdings... PBoC should try to buy as much gold as possible from China's annual gold output of almost 300 tons, while the gold needed by industries and residents could be imported.

The other obvious way for China to increase its gold holding is to simply buy gold mines overseas in places like...Australia.

I wish I could take credit for this idea. But it was sent to me in an e-mail recently by Diggers and Drillers editor Alex Cowie. Alex thinks the Chinese push to buy foreign gold mines is a low profile way for Beijing to increase gold as a percentage of its foreign exchange holdings. China has increased its gold reserves by 76% in the last six years to just over 1,000 tonnes. But gold still makes up less than 1.2% of China's total reserves (compared to 76% for the United States).

That means China's quest for gold is alive and well. And for Aussie resource investors, this gold dip may be a great time to add gold stocks to your speculative portfolio. To read Alex's argument for gold and how he plans to play it, see below.

Regards,



Dan Denning

Dear Reader,

Something important is happening in the gold market.

I'm going to show you what I think are the four best ways you can profit from it in 2010.

Gold has had a decent-sized correction since the elation of early December. From a high of U.S. $1,226 an ounce it fell as low as $1,075 – about 12.5% – in just over two weeks. On one day alone it fell by more than $50, one of gold's greatest daily falls ever. It's now recovered somewhat to $1,109.50.

But was this just a blip in the gold bull? Or is it a sign that gold may be reaching (or has already reached) a high? In this Special Issue of my share advisory, Diggers and Drillers, you'll get some answers. As you'll see, I reckon we're reaching a critical crossroad in the gold market.

I'll show you why pullbacks like the one we saw in December and the one you're seeing now are where you should be BUYING gold, not selling it.

I'll show you why the fundamental benefit of gold – that gold is no government's liability, you can't print it – is more vital than ever as governments worldwide continue to debase their currencies teeter on the edge of bankruptcy.

Most importantly...

I want to slip you advance warning of four Australian gold miners – operating out of Africa – which could reward investors richly in the months ahead.

Whether you act on the specific investment advice offered is completely up to you...

Any way you spin it, the global financial system is still at risk. By far the biggest risk is that one or several European governments go bankrupt or reach a fiscal crisis this year. It is already happening in Greece—where unions are shutting down hospitals, airports, and schools in protest of emergency budget cuts. But it's not just Greece.

This is the year that Global Financial Crisis has become a Sovereign Debt Crisis. I believe that's bullish for gold. Governments from Athens to Washington to London are beginning to buckle under the strain of bailing out the financial sector. And a second even costlier burden—pensions and retirees—threatens to break them altogether. According to the New York Times:

• Greece's debt-to-GDP ratio is 113.2%. But if you include current AND future pension obligations, it blows out to 875.2%!
• Italy's debt-to-GDP ratio, once you include current and future obligations, is 364.1%
• France's debt-to-GDP ratio inclusive of current and future obligations is 549.2%
• For the 25 members of the European Union, the average debt-to-GDP ratio is 434.2%

What do all these big numbers mean?

I reckon it means Europe—and its currency the Euro—are headed for a massive fiscal train wreck. No matter how you look at it, the levels of government debt are simply not sustainable. The only way out is another round of inflationary, money-printing bailouts. It's either that—or the streets of Europe will be filled with angry and perhaps violent protestors.

Mind you the fiscal situation in the United Kingdom and the United States is not much better. The U.S. just recorded its largest ever monthly deficit in February. For just that short month alone, the deficit was $220.9 billion, according to the U.S. Treasury Department. And earlier in the week the U.S. Congressional Budget Office said the U.S. deficit would reach $9.8 TRILLION dollars over the next ten years.

The Euro is in trouble. The Pound Sterling is in Trouble. The U.S. dollar is in trouble. In fact, it's fair to say all paper currencies are weakening against one common commodity: gold.

Gold is a barometer on the confidence investors have in the financial system itself.

And one way to measure that is the Dow Jones Industrials/Gold ratio. Even though this measures gold against U.S. stocks, it's useful as a general indicator.

The chart below of the Dow/Gold ratio tells a story. But what's the story? As of now the Dow/Gold ratio is 9.57 (Dow of 10,611.84 and gold price of $1,108.20). Another way of putting that is that it would take 9.57 ounces of gold to buy a share of the Dow.

But so what?

Take a look at this chart and you'll see that the smaller the Dow/Gold ratio the stronger the gold price and the weaker the stock market.

The question is whether the ratio will rise or fall from here. It's been rising since March 2009, when stocks began sprinting ahead from their lows. But gold's move to U.S. $1,000 and beyond came just as the ratio reached 10.

Stocks were starting to rise faster than gold. But not anymore.

Ten is an historically important level for the Dow/Gold ratio. You can see in the chart that the ratio found some resistance at 10 in the early 1990s. Once it crashed through, stocks clearly outpaced gold. And by the late 1990s, gold was selling in the mid $200s/oz while the Dow was making all time highs.

Where does that leave us?

What happens if the Dow/Gold ratio again goes above ten soon?

I think this will indicate the monetary and government authorities have succeeded at engineering a reflationary rally in the stock market. As I've said, I find this scenario an indication of temporary success. I think this rally masks unresolved problems in the financial system (toxic debt, too much leverage, low saving rates, high government debt to GDP ratios). It sets the stage for another bigger, rally in gold.

In fact, I think it's entirely possible to see more deleveraging in the global financial system. This means, quite probably, higher gold prices and lower stock prices. Or, in Dow/Gold ratio terms, you could see a decline to around "three".

That's not a number plucked from thin air.

The last time the financial system was rocked by a crisis of confidence was in October of 1987 during the Crash. The two-day loss of confidence in markets brought the ratio back to 3.87.

Could that happen again this year?

You bet it could.

If the rally can't hold and the cracks in the financial system are strained again, the financial stocks (banks, real estate, insurance companies) that have led the market up since March will crack too. And the Dow/Gold ratio will shrink quickly.

How much?

The obvious question to ask is where gold would be and where would the Dow be if the ratio shrunk back to "1," where it was when gold last peaked in 1980. Is it Dow 5,000 and gold $5,000? Is it Dow 6,000 and gold $6,000? Or is it more like Dow 4,000 and gold $4,000?

More on that below...

In all the excitement about gold's new highs it's important to point out that gold hasn't really made a new high. Not yet anyway. Once you adjust for the inflation in the U.S. dollar, as measured by the consumer price index, gold would have to reach $2,367 before it made a new high (see chart below).

In other words, gold would have to more than double from here just to reach an inflation-adjusted all-time high.

It would have to rise over 100% from its current price.

That's a formidable rise. And I'm pretty certain it will not do so in the next three months.

In 2010? Maybe. That means you have time to gain exposure with gold stocks before gold rises again.

If the answer to first question tells us that gold's long-term trend is still up, the answer to the second question tells us gold could still double before matching its previous highs against the U.S. dollar.

This gold rush will be different from any of its predecessors.

It won't take place on a remote desert plateau or a frontier mountain range. And you don't need to become a grizzled prospector to get in on the action.

The American dollar is literally fighting for its life as the world's currency. I think it will almost certainly LOSE – although the Euro may die before it.

Because we're talking about a seismic change in global currency affairs, the upside for gold in this dollar crisis much higher than it was in 1980.

That's why I think you're much more likely to see gold at $3k, $4k, and $5k as the world moves away from the dollar.

But what will that mean for Australia... and for YOU?

As an Aussie investor, you must add a third factor into the gold and U.S. dollar deliberations: the relationship between the Aussie dollar and the U.S. dollar.

As the U.S. dollar falls, the Aussie strengthens. This is partly due to rising interest rates, which make the Aussie attractive on a yield basis. It's also partly due to the migration away from U.S. assets and into Australian tangible assets (both real estate and commodities).

But the basic problem is that if the Aussie rises against the greenback, then gains in the Aussie gold price are not going to happen as quickly for Aussie investors.

And if that's the case, does it make any sense to buy Aussie gold stocks.

If so, which ones and why?

My personal view is that even with rising costs in Aussie dollar terms, Aussie gold producers would make windfall profits on a large spike in the U.S. dollar gold price. The chart below shows that the Aussie dollar gold price is already near record territory. We've seldom been in this situation before, which makes it potentially so profitable.

Now here's the thing...

If Australian gold producers can keep a lid on your costs by incurring them in USD terms rather than AUD terms... you get leverage to a higher gold price without the deadweight of a higher AUD versus the greenback.

So, with that in mind, what should YOU be doing right now?

If you are an Australian gold miner, how can you get a strong Australian dollar to be an advantage instead of an impediment?

The answer is – when the bulk of your costs are in U.S. dollars.

There are many Australian gold miners and explorers that have practically all of their operations outside of Australia, where the costs are often paid in U.S. dollars. Right now, these companies have a huge advantage over companies with purely domestic operations. Costs would now be over 30% lower than in March, and if parity is reached this figure will be more like 40%.

This is the type of gold stock you want to invest in, not a recycled gold mine at home.

So where do you start looking when the world is your oyster?

Well, below is a list of the principal gold-producing countries that Australia has a presence in, and that would be booking their costs in U.S. dollars. I have then ordered them in 'ease of doing business' according to a well-used international ranking system.

This ranking comes from an annually updated list that analysts often use to remark on viability of various overseas operations. It helps you determine where there is "political risk" to a business and where it is relatively safe. There's not much point in investing in a 2 million ounce deposit, if shonky business infrastructure makes if too slow or too cost prohibitive to mine, or if civil war is around the corner at any minute.

There are some countries I have left out because Australia doesn't have much going on there, or that use a currency other than the U.S. dollar. After that sorting, Ghana comes top of the list by a mile at 87th place (out of 183). To get a feel of what that means, China is 84th.

Ghana's government is keen on miners. The country has a good mining support services sector. And from a regulatory perspective, the mining legislation is on par with Australia's. Assay's facilities are possibly even better than you'll find here.

Australia has a strong presence in Ghana when it comes to gold companies, so there's a fair bit to choose from.

And investors often unfairly overlook Ghana as another unstable African country with high political risk. This means there are some good bargains going. Whilst Ghana is Africa's second biggest gold producer, there are some major resources still in the exploration stage.

It is the Australian companies at the advanced stages of exploration that you want to focus on, as one of the best ways to profit from gold is to invest in it just before it is mined. Their costs are in a declining U.S. dollar but they have huge leverage to rising gold prices.