Hundred dollar bills surrounded by gold © Anthony Bradshaw, Photographer (Hundred dollar bills surrounded by gold © Anthony Bradshaw, Photographer)

Certainly, gold has picked itself off the mat. Prices have rebounded, up 9% from the low, as the dollar has weakened, the Fed has softened its message about tightening the money supply, and a surge in crude oil prices has revived inflation concerns.

All those factors favor higher gold prices, because a strong dollar and a softer money supply feed inflation, and the yellow metal is the traditional inflation hedge.

Other factors favor a turn, too, including simple inevitability. Gold is now going for around $1,290 an ounce, down from its all-time high near $1,900, and no trend lasts forever.

So while it's likely too early to jump in just yet, a careful look at what's happened to gold and what might happen next tells me to get ready. Here's why the rebound should continue.

Why mighty gold has fallen

First, consider the combination of factors that has crushed gold (and silver) prices since October.

Inflation, and fear of inflation, waned. Energy prices dropped. Interest rates increased. And above all, the Federal Reserve indicated -- hinting shyly at first before hammering the message home -- that it was preparing to scale back its cheap-money economic stimulus efforts. Specifically, it was looking at "tapering" its $85 billion-a-month bond-buying program.

Image: Anthony Mirhaydari - MSN Money

Anthony Mirhaydari

This stimulus is what gold fans in particular deride as "money printing." It keeps them up at night worrying about the dollar's collapse.

That new Fed direction strengthened the dollar, which gained 8% from its low in September to its high earlier this month. And that pummeled the price of gold, which is valued as an alternative to the greenback that will keep its value. The yellow metal lost 34% in the period, falling from nearly $1,800 an ounce to just $1,179.

Investors bailed, pulling money out of gold exchange-traded funds such as the SPDR Gold Trust (GLD) ETF. And small speculators in the futures market expanded their bets against the metal to a net short position -- meaning that in the aggregate they were betting that prices would continue to fall -- for the first time since at least the early 1990s.

But in the past few weeks, this picture has changed. The Fed blinked. Crude oil prices tested $107 a barrel for the first time since early 2012. And gold bounced.

Can that bounce continue?

Mining may not pay

The first thing to consider is that the price decline has taken gold below the all-in cash cost of production for many mining companies, which are struggling with higher operating expenses, increased political risk (witness the platinum strikes in South Africa) and that fact that new gold discoveries are happening almost exclusively in unfriendly parts of the world.

In short, the problem is that high production levels no longer pay at today's prices -- which means production cuts.

On Monday, in fact, AngloGold Ashanti (AU) cut its 2013 gold production forecast by upward of 10%, to four million ounces, in an effort to remove "unprofitable ounces from our production profile."

Researchers at Barclays Capital estimates that the industry's marginal cost -- that is, the cost to produce an additional ounce of gold at 90% capacity -- is around $1,300 an ounce. The average cost of production -- the cost at 50% capacity -- is around $1,100.

So it's no surprise that supply is being pulled from the marketplace. Already, according to Bank of America Merrill Lynch analysts, one-third of the industry is "underwater" in that prices aren't covering the cash production costs.

Demand has disappeared

The other side of the equation is demand. And in particular, demand from investors.

Yes, there is a small industrial component to demand for gold. About 10% of annual gold production is used in electronics, where it's valued as a high-quality conductor. According to Societe Generale, this number isn't expected to change much in the foreseeable future.

There's also demand for gold production for use in jewelry, particularly in the emerging Asian economies -- especially India, where gold plays an important cultural and religious role. A strong monsoon season is expected to bolster crop yields, which in turn should bolster gold demand later in the year as farmers traditionally snap up a few gold pieces when their harvests are sold. Overall, jewelry demand expanded 12.3% in the first quarter of 2013 compared with the same period in 2012, to 551 metric tons.

The big swing factor is investor demand. And that is expected to rebound later this year, according to Standard Chartered analysts, who are looking for prices to rally above $1,400 an ounce by year's end -- an 8% move from current levels.

The chart below shows just how severe the pullback in investor demand has been. Assets in the SPDR Gold Trust ETF, which are backed by physical gold, have fallen 50%, returning to early 2009 levels.

SPDR Gold Trust

For gold to keep going, this picture would need to turn around, a trend that tends to be somewhat self-fulfilling. As gold prices rise, so does demand from investors, which in turn would push prices higher. A good dose of inflation worry would help as well.

The good news for gold investors is that it looks like all that might just happen.

Good news for gold bugs?

Consider that the 24% increase in oil prices since April is starting to trickle into inflation measures. Consumer price inflation, which bounced in June, is now rising at a 1.8% annual rate as prices at the pump climb. At the producer level, raw material inflation has reaccelerated back to a double-digit year-over-year rate for the first time since the inflation scare of 2011.

You can see this in the chart below.

Producer Price Index

And while demand for "paper" gold via exchange-traded funds such as GLD or gold futures remains weak, demand for physical bars and coins reportedly has surged in the past few months as hoarders, collectors and conspiracy theorists backed up the proverbial truck at these prices.

That has pushed out lead times on new bars from gold refineries to more than a month.

The Chinese have been buying as well, with the premium for physical gold in Shanghai rising from an average premium of 0.8% over London's prices in 2012 to an average of 2.2% in May.

In fact, China's identifiable jewelry and investment demand for gold is running at record highs right now, according to Bank of America Merrill Lynch calculations.

Those analysts note that rising demand from the newly affluent looking for gold as a store of value or a luxury item is set to dramatically reduce the metal's reliance on Western investors. By 2016, they estimate, investors would need to purchase only around 600 metric tons a year (a level not seen since 2008 and just one-third the level of demand seen in 2012) to hold prices at $2,000 an ounce.

Compare that with current global demand of around 963 metric tons.

Other long-term supports for higher gold prices include:

  • The fact the Federal Reserve has swelled the monetary base from around $800 billion before the recession to $3.3 trillion now, an unprecedented experiment in money printing that is bound to lower the dollar eventually.
  • A rise in energy that confirms that the anti-inflation benefit from the boom in inexpensive shale energy is largely behind us.
  • The ever-rising costs of producing new gold.

South African gold analyst David Davis at SBG Securities believes that, conservatively, mining cost inflation is running between 12% and 15% annually. For new projects, it's closer to 20%. Many companies are deferring expensive new mines simply because they are no longer profitable. North American miners alone have deferred more than $20 billion in capital expenditures, pulling future supply off the market.

More idling is likely. Kinross Gold (KGC) is expected to defer a new mill at Tasiast in Mauritania in West Africa next year, saving $3 billion. Iamgold (IAG) is looking at its Côté Gold project in Ontario, which would be one of the largest open-pit mines in Canada, with a feasibility study to be completed by the end of next year.

And so, the strategy

Add it all up, and gold is likely trading near a hard price floor that will be held steady by a combination of Far East physical buying and cuts in gold production. The price seems unlikely to go much lower, which should ease worries that the gold market is still in a bubble.

How much it recovers, and eventually gains, will be determined by the path of inflation and Fed policy. The latter seems to favor pricier gold, since the Fed appears ready to keep the cheap money going, with the U.S. economy growing at a piddling 1% to 1.5% a year pace. The dollar's newfound weakness should help gold as well.

It's still too early to pull the trigger on either gold or related mining stocks just yet. But with prices of both stabilizing, I'm keeping an eye out for opportunities. Gold stocks are trading at a significant discount to their five-year price-to-cash-flow valuation metrics -- at a time when cuts in investment spending are poised to boost cash flow, despite lower gold prices.


Before I move in, I'll look for a breakout to confirm my theory, represented by a push above upper Bollinger bands in precious metal and mining ETFs such as GLD and Market Vectors ETF Trust Gold Miners (GDX) before moving in. A few individual stocks are already pushing higher, including Asanko Gold (AKG) and Franco-Nevada (FNV), so traction is building.

Stay tuned.

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At the time of publication, Anthony Mirhaydari did not own or control shares of any company or fund mentioned in this column in his personal portfolio, nor had he recommended them to his clients.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.