Four Reasons Gold will Rebound

Yes, the precious metal has pulled back with other commodities. But the underlying trends still suggest it will climb to $1,000 and beyond.
Gold bugs have seen their precious metal tarnish this summer.

Devotees of the yellow metal — which they believe protects their wealth against everything from inflation to Armageddon — have watched in horror as gold has slumped 19% in a month to $790 an ounce.

Not even Russia’s invasion of Georgia could rouse bullion, which normally shoots up in times of geopolitical crisis.

The apparent cause of gold’s drop: Many investors are changing a course that saw them buying commodities while betting against financial stocks and the U.S. dollar. A global economic slowdown has raised doubts about sustained demand, and U.S. policymakers have gotten more serious about bailing out the country’s banks.

This reversal has sent the whole commodities sector down, including gold, which flirted with $1,000 an ounce as recently as March (as I had predicted in “Why gold’s going straight to $1,000″).

Gold bugs are about to get some relief. The truth is, despite this pullback, the fundamentals that drove gold higher haven’t changed.

Four reasons gold will rebound
The near-term catalyst for the next move up could be as simple as holidays that call for giving gold as a gift, including Diwali (the Hindu “Festival of Light”), Christmas and the Chinese new year. Demand for gold to produce jewelry should soon kick in.

In fact, looking back over the past three decades, it’s really no surprise that gold is weak right now. “Gold is always a dog in August. Always,” says Frank Holmes, the chief investment officer at U.S. Global Investors (GROW.O), which offers the Gold and Precious Metals Fund (USERX). Then the price climbs as the holiday season approaches, Holmes says.
Most importantly, several factors that supported higher prices (and that led me to be bullish in “Five reasons gold is headed to $1,500″) haven’t gone away. “The key underlying trends are intact,” says Tom Winmill, who manages the Midas Fund (MIDSX).

Over the next six months, gold could move up $100 to trade in the $850-to-$900 range, Holmes believes.

Longer term, Citigroup (C.N) gold analyst John Hill says, gold will trade around an average of $950 an ounce next year and $1,000 an ounce in 2010.

If they are right, that will be good for mutual funds investing in gold, as well as exchange-traded funds, or ETFs, that track gold, like SPDR Gold Shares (GLD.N). Mining stocks are riskier but could do even better because they have fallen even more than bullion has. I offer five picks below.

But first, here four reasons gold will rebound:
No. 1: Limited supply compared with demand
The reason demand for gold jewelry can have an impact on prices is that supply and demand are already tight.

“The easy deposits have been found and mined,” says Doug Groh, a senior analyst with Tocqueville Asset Management, which runs the Tocqueville Gold Fund (TGLDX). “There is limited supply, and it is very expensive and increasingly more expensive to access that supply.”

Overall production from gold mines slipped 4% in the second quarter as fresh investments in new mines failed to offset dwindling output from mature mines, Citigroup’s Hill says.

Meanwhile, demand for gold as an investment has stepped up over the past few years because of the creation of gold ETFs, Groh says. Gold ETFs were recently backed by about 930 tons of bullion, or around 125 days of mine output, according to Tocqueville Asset Management.

Here’s the big picture: The world will see 3,275 metric tons of supply from mining and scrap in 2008. Demand for jewelry and other fabrication will be 3,210 metric tons, and investment demand will call for 365 tons, for an overall shortfall of 300 tons, predicts Lehman Bros. (LEH.N) analyst Peter Ward. He’s projecting even bigger shortfalls for 2009 through 2012.

No. 2: Inflation
At 5% a year in the U.S., consumer price inflation seems pretty high. But consider that the price of raw materials for manufacturing was recently advancing around 40% a year, says the Midas Fund’s Winmill.

The retreat of oil prices to about $115 a barrel won’t help much because oil is still historically very costly.

High inflation also means that investors are losing 2.6% a year in traditional “safe” investments such as two-year Treasurys, which now yield just 2.4% after inflation.

When prices rise and investors lose money in what are supposed to be safe debt instruments, many turn to gold, Winmill says.

No. 3: An uncertain future
We’re not out of the woods yet with the credit crunch. That will keep putting a constraint on lending, the raw fuel of capitalism. Problems in the U.S. housing sector will continue to weigh on U.S. consumers, whose spending drives economic growth. Meanwhile, the potential for big changes in tax and spending policies in Washington, D.C., if the Democrats take the White House, has investors feeling uncertain about the future.

Again, this cloud will have investors turning to safe-haven gold.

No. 4: Everyone is too bearish on gold
Typically, when sentiment gets overly bearish on an investment, that’s when it is hitting bottom and about to reverse. We are probably there now with gold. Investments in the Rydex Precious Metals Fund (RYZCX) recently dropped to lows not seen in three years, points out Jason Goepfert of SentimenTrader.com.

Plus, the recent plunge in the price of gold has been so severe that it’s bound to reverse if the past is any guide, says U.S. Global Investors’ Holmes.

“Buying after a big correction like this means the margin of error is lower, as Warren Buffett likes to say,” Holmes contends.

The strong U.S. dollar ‘problem’
One problem with calling a rebound right now is that the U.S. dollar has been strong lately, which is typically bad for gold. Gold is priced in dollars, so a strong dollar makes gold more expensive for buyers outside the U.S. This lowers demand and puts pressure on prices.

Here’s why I’m looking past this. James Paulsen, the chief investment strategist at Wells Capital Management, agrees that the U.S. dollar will continue to see strength against developed countries’ currencies. Economic weakness is spreading to these regions, so they will cut interest rates, making their currencies — say, the euro — less attractive.

However, Paulsen thinks the U.S. dollar will keep losing ground against the currencies of developing countries such as China, Mexico, India and Russia. The reason: They’ve suppressed their currencies against the American dollar to promote exports. But the underlying imbalances are too great, so they’ll soon have to let their currencies gain ground compared with the U.S. dollar.

This would to make gold look cheaper to buyers in developing countries, even as the U.S. dollar gains ground against developed-world currencies.

The gold plays
All of this should help the following stocks move up 50% to 100% over the next six to 12 months:

* Newmont Mining (NEM.N). Newmont is big, which makes it tougher to grow, and, like all mining companies, it’s struggling with costs. However, David Haughton of BMO Nesbitt Burns, an arm of BMO Capital Markets, thinks new projects in Peru plus cost containment will lead to significant cash-flow gains, two reasons he has a $60-a-share price target on the stock, which recently sold for $42.

* Agnico-Eagle Mines (AEM.TO). The shares of this mining company have been hammered — falling to $51 recently from above $80 in July — in part because of declines in zinc production and prices. But on the bright side, Agnico-Eagle operates in politically safe countries like Canada and Finland. Its huge LaRonde mine in Quebec and five development projects should support an advance in the stock to $82 in 12 to 18 months, says CIBC World Markets analyst Barry Cooper. This is the “go to” stock in the sector. “When gold runs, investors all run to Agnico,” Holmes says.

* Kinross Gold (K.TO). A big Kinross project in Russia adds an element of risk because the Russian government has a history of putting its straw into lucrative natural-resource assets on its turf. “The market hates risk now, but when investors get back into risk mode, stocks like Kinross will be biggest beneficiaries,” says Winmill, who owns shares in his Midas Fund. Analysts predict the stock will move to $25 a share in a year, according to Thomson Financial, up from $15 today.

* Yamana Gold (YRI.TO). Shares of this company have been hit so hard that Yamana now sells for less than the value of its assets, Winmill calculates. He thinks it could advance 30% to 40% once the gold sector comes back in favour. One plus is that Yamana has solid assets in politically safe regions of South America. Haughton at BMO Nesbitt Burns has a $21 price target on the stock. It recently sold for $11.

* Freeport-McMoRan Copper & Gold (FCX.N). It’s nowhere near a pure gold play because it gets so much of its revenue from producing copper, but I’m also going to sneak in my favourite play on a gold and commodities rebound. Freeport-McMoRan’s Grasberg mine in Indonesia is not only the biggest copper and gold mine, it’s also one of the best, believes Lehman analyst Ward. The company’s recent acquisition of Phelps Dodge adds growth. Plus, the stock looks cheap, and insiders just bought a boatload on the pullback. Ward has a $200 price target on the stock, which recently traded for $84.

Expert Picks
With this column I’ll add shares of Freeport-McMoRan Copper & Gold to my tracking portfolio in our Expert Picks section, and we’ll see how it does from here.