Buy Into Gold’s Pullback

Ryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Gold recently had its biggest quarterly loss since 1974 -- dropping by more than 20% from April to the end of June. The price of gold (and precious metals in general) plummeted because rising interest rates and an improved US economy make other investment vehicles look more attractive and lessen demand. Based on a cursory analysis of July, a month where gold is up slightly so far, it looks like the price of gold and other commodities have stabilized. After all, gold is up a few percentage points for the month.

Fiscal and monetary policies

Fear over US fiscal and monetary policies -- high deficit spending and low interest rates -- made gold an attractive alternative to investments that were not keeping up with inflation. Over the past couple of months, however, the Fed has signaled that interest rates may increase. When interest rates are 2% higher than inflation, gold prices tend to decrease.

Why gold won’t plummet -- and why it might get a nice pop

First, gold prices are currently below the amount that it costs many miners to get it out of the ground, process it, and make a profit. When companies cannot make a profit, mines sit idle and expansion plans are delayed. Supplies tighten and prices either stabilize or increase to meet demand. And tighter supplies cause speculators to think twice on betting on lower prices.

Second, I know a lot of people who buy gold and silver bullion and they all have described a strange phenomenon: the price differential between spot and what these precious metals are actually selling at is the largest that they have ever seen. A few years ago, for instance, they could walk into any one of the stores that sell bullion and purchase minted bullion for 50 cents to $1 over the spot price of an ounce of silver and $20 over the spot price of an ounce of gold. Today, though, that differential appears to have roughly doubled.

Third, another interesting phenomenon is happening with the Shanghai Gold exchange where gold is reportedly selling for about $30 an ounce more than the London Benchmark.

Fourth, buyers in China and India, the two countries where demand in precious metals has sharply increased over the past decade, dramatically increased consumption of gold in April, after the price of gold fell sharply by more than $200 an ounce. That type of purchasing behavior will help to establish a price floor and may result in a nice pop in the price of gold.

Fifth, historically gold has owned the 3rd quarter. That is because refiners and fabricators increase production in preparation for jewelry and gift purchases in anticipation of the holidays in the United States, Europe and China and the wedding season in India. In fact, since 2000 gold prices have risen on average by approximately 6% during the July through September time period. Traders are aware of this phenomenon and speculation should result in gold getting a nice pop.

Sixth, over the next few days I expect that some of the largest gold miners will write-down their assets when they report their quarterly earnings. Those will be in addition to the $17 billion announced in write-downs announced through July 1st. That will signal to investors what many of us already intuitively know: that the supply of gold is contracting and that a bottom is very imminent.           

China debt argument

For the past several years, we have been receiving goods from China in exchange for paper. After all, if the price of gold rises to $4,000 an ounce, then we might have enough gold to pay back our debt to China! Inflating away our debt is an alternative.

How to buy gold and silver

You can purchase shares of iShares Silver Trust (NYSEMKT: SLV) or iShares Gold Trust (NYSEMKT: IAU). These investments seek to reflect the price of silver or gold owned by the trust less the trust's expenses and liabilities -- which are somewhere around 0.25%. These funds are intended to constitute a simple and cost-effective means of making an investment similar to an investment in silver or gold. You can also purchase SPDR Gold Shares (NYSEMKT: GLD) or even companies like Randgold Resources ADR or Silver Wheaton that mine gold and silver. Or you can purchase shares in one of the largest mining companies, Freeport-McMoRan Copper & Gold.   

3 factors to consider when investing in precious metals

1. Supply and Demand. The expectation for tighter supplies and rising demand should not only establish a price floor but also result in a nice pop for gold and silver.

2. Volatility. Gold and silver have always been -- and will continue to be – susceptible to big moves. When the Federal Reserve, for instance, signaled that its easy-money policies were coming to an end, the price of gold plummeted. Then the Fed went back and said that the economy would require easy money for some time and gold prices popped.

3. Uncertainty. Gold and silver prices tend to increase when there is global uncertainty, market declines, growing national debt, inflation, war and unrest.

My foolish take

I believe that gold and many other precious metals will bottom out over the next few weeks as companies write-down their assets and then have a nice run in the double digits during the August/September time period. Whether that rebound will stick, however, will depend on whether or not the Federal Reserve makes a dramatic move. I recommend considering only those companies that have scale (market cap of at least $1 billion) and investment vehicles that seek to reflect the price of gold or silver.   

Ryan Peckyno has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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