A look at recent media reports on gold and the mechanics of the gold market, or:

How gold should not be analyzed.

Today we came across an article in the Wall Street Journal which asks, seemingly rhetorically, 'Is Gold the next Bubble?' Given that we are intellectually friendly toward gold, we actually hate to see such articles in the mainstream press. Luckily, the next article by the same author will be entitled 'The Dangers of Gold'. Phew.


Now, before continuing, the question asked in this article is actually posed the wrong way around. It should rather say 'are paper currencies in an anti-bubble?'. Gold is not a mere commodity after all, or even a mere investment asset. It is primarily money, or rather, it would be money if not for the State's imposition of legal tender. In short, in a true capitalistic free market oriented society, the market-selected money would most likely consist of gold. Moreover, the market in many ways treats gold as if it were money (more on that later).

As long as gold is not in general use as the medium of exchange, its 'money-ness' is so to speak in abeyance, but it still has all the characteristics of a currency competing with the fiat currencies of the world and it certainly continues to fulfill the 'store of value' function rather well.



Gold's dollar price over recent years: anyone keeping his savings in the yellow metal has certainly escaped the debauching of the central bank issued monies that has characterized this period. It is no coincidence that the money supply in nearly every nation on the planet has grown at extraordinary rates over the same time span – click on chart for higher resolution.



Meanwhile though, people invest in gold, or rather, exchange their paper or electronic government-issued tokens for it in the hope of preserving the purchasing power of their savings. We have no quibbles with the theory presented in the article – namely, that although the price of gold as expressed in various fiat monies has risen quite a bit over the past decade, it may well rise a lot more.


An intriguing chart is presented, comparing gold to previous bubbles, all of which it must be noted also were driven by massive expansions in money and credit.



This chart suggests that even after a substantial bull market, in the modern fiat money system, such bull markets tend to morph into bubble-like advances – click on chart for higher resolution.



A more substantial comparison was presented by Haver Analytics and Gluskin Sheff around the turn of the year:



Gold's advance from the 99/00 lows compared to some other bull markets – note that the starting points chosen for the markets concerned are a bit arbitrary. For instance, this includes only the Nikkei's advance during the 1980's, but the Nikkei had by that time risen by an even bigger percentage if 1969 is chosen as the starting point, when the Nikkei's value was at the same level as the DJIA's – around 1000 points (it peaked at over 38,000 points in 1989) – click on chart for higher resolution.



Naturally, even if the bull market in gold is fated to continue and deliver even bigger returns, it will likely be a bumpy ride with frequent corrections – some of which may be quite scary. Recall for instance that in 1987, the stock market suffered a roughly 40% 'correction', the bulk of which occurred in slightly more than one week.

In hindsight, it looks like an inconsequential bump in the road, but at the time when it happened, people were scared to death and thought the world was about to enter a new depression.



The crash of 1987 – at the time many people felt certain the bull market had ended – click on chart for higher resolution.



13 years later, the DJIA had risen about 540% from the 1987 crash low, which registers as a mere 'correction' on this long term chart – click on chart for higher resolution.



The weak economic conditions that are a hallmark of the secular contraction that began in the year 2000 have induced central banks to print more money than ever, while governments have been, and continue to be, on a deficit-spending spree that is the largest of the entire post WW2 era.

Therefore the potential for an even bigger gold price appreciation in coming years is significant. Contrary to the rate of change in the supply of paper money, gold's supply only rises by about 1,5% per year, and not all of that is added to the stockpile of monetary gold (i.e. gold held for investment purposes, which amounts to the same thing).

Furthermore, the final stage of a gold bull market tends to be driven by fear rather than greed – fear regarding the monetary system's continued viability, as faith in the state-issued money is lost. Clearly that fear was present when gold's price rose by about 200% in 1979 alone. The point is that fear-driven markets tend to make even bigger spikes than greed—driven ones.



Beware of flawed analyses

For reasons of not wanting the gold bull market get too crowded too quickly, we prefer seeing articles like the following one which originally appeared in Fortune: 'The coming gold bust'.

However, it is important for people to realize that some of the points made in this article are deeply flawed. Below is an excerpt that purports to demonstrate why the gold price can not only not rise further, but must soon come down again (note here, it may well correct and come down – but it won't be for any of the reasons Fortune has assembled in support of the argument).


  • Barclays Wealth in London predicts gold will fall to a fair value of $800 an ounce by 2012, as investors eventually dump it for riskier trades;
  • Société Générale, the French bank, in April 2009 predicted $800 gold by the end of 2010, though it has reversed its stance since then.
  • Analyst John Nadler of gold dealer Kitco predicts gold will fall to $900 in 2011.

Their reasoning is simple: investors are keeping prices high even as demand from non-investors is cratering.

Take gold jewelry, which accounts for more than half of the world's gold market. Demand there fell 8% in the fourth quarter of 2009 and is likely to continue to fall amid high prices that turn off shoppers. For example, in India, the largest gold buying country, high gold prices this week kept Indians from purchasing metal for the gold-buying festival of Akshaya Tritiya, which in turn drove down prices.

Then there's price pressure from the supply side. Higher gold prices mean miners work overtime. The supply of mine gold around the world jumped 7% last year to 2,572 tons-the second largest increase in history.

Gold bullion dealer Kitco says places like China and Russia will help boost the amount of gold from mining by 4% to 6% a year through 2014. Because it costs miners about $480 on average to extract an ounce of gold, they plow ahead when prices are high, eventually leading to an oversupply situation.

Gold at $1,200 also brings out the sellers and resellers. In 2009, scrap supply-all those gold pendants, necklaces and coins people have lying around-hit an all-time high of 1,700 tons. All those "we buy gold" signs, Internet advertisements and late night television commercials? Well, they're starting to work.

That scrap supply high is actually a 27% rise from 2008, according to Kitco. "So long as prices remain above $1,000-$1,100 we will continue to see a river of secondary gold actually starting to compete with mine production," says John Nadler, a Kitco analyst.


Unfortunately for gold bears, if this is the ammunition they rely on, they will be sorely disappointed. Neither jewelry demand nor mine supply nor scrap supply are of any lasting importance to the gold price. Just as these arguments are invalid as bearish arguments, they are invalid when they support a bullish stance as well (for instance, many bulls like to cite stagnant or falling mine supply as a bullish datum). The one argument that may make sense if we lived in a different era, would be the one about investors potentially preferring other investment avenues. Everything else is simply rubbish.

Gold can not to be analyzed as a commodity – it must be analyzed like a currency. It has an extremely high stock-to-flows ratio, as nearly all the gold ever mined in history still exists. Gold is not 'used up', which is one of the reasons why the market selected it as the money commodity.

Jewelry demand reached an all time high more than 10 years ago, in 1999 – just as gold hit a near 20-year price low. Ever since, jewelry demand (in terms of ounces) has been in decline. It hasn't kept gold from rising over 400% since the 1999 low. Jewelry demand is certainly price sensitive, so when investment demand for gold is low and the price falls, it tends to rise and vice versa.

However, it is impossible to spin a valid bearish argument relying on 'a decline in jewelry demand' or any other non-investment related demand. Consider that the above ground stock of gold is estimated to be 160,000 tons. With that kind of potential supply, what does it matter if mines produce 2,500 or 2,600 tons per annum, or whether jewelers buy 2,800 or 3,000 tons?

The answer is of course: it hardly matters at all. For the gold market, these are rounding errors. The same holds true for central bank buying and selling. While gold certainly received a psychological boost from India's purchase of 200 tons of IMF gold, the IMF could have just as well sold this amount on a sleepy morning at the LBMA (London Bullion Market Association), where some 600-700 tons trade every day. The amount is simply not all that relevant.

The two most important factors influencing the gold price are direct investment demand and so-called reservation demand. Of these terms only reservation demand requires perhaps an explanation – what is meant by this is the willingness of current holders of gold (naturally, with all the gold mined still in existence, someone owns it at all times – there is no unowned above-ground gold, except perhaps at the bottom of the ocean in sunken Spanish galleons – and that's not exactly 'above ground') to sell their gold at prevailing prices.

This reservation demand is not directly measurable, and is therefore simply left out of official supply – demand statistics. Also, we think that the so-called 'implied investment demand' used in analyses by e.g. the WGC (World Gold Council) or GFMS (Gold Fields Mineral Services) is a seriously flawed measure – it attempts to indirectly measure direct investment demand (respectively 'de-hoarding') by adding up mine supply and scrap, and deducting known jewelry and industrial demand, as well as industry de-hedging from that sum – the residual amount is thought to represent 'investment demand'.

It should be clear that in reality, total investment demand must be far higher. How else do we explain trading of 700 tons of gold every working day at the LBMA alone – when only about 2,500 tons are mined annually, and some 160,000 tons in potential supply are known to exist? Note here that not all of the 160,000 tons are theoretically or practically available for purchase – for instance, central banks are thought to hold some 31,000 tons in their vaults, and a certain amount of gold is used in industrial applications or remains in jewelry form, instead of as the bars and coins preferred by investors.

The upshot of all this is: one should ignore commodity-type approaches to analyzing gold. They will consistently lead to exactly the wrong conclusions during both bull and bear markets.

Our next article will look at how to actually best approach fundamental gold analysis and discuss other aspects of the gold market worth knowing. For today, we leave you with two near term charts:



Gold priced in US dollars – the recent uptrend appears intact. Net speculative futures positions have increased quite a bit, as they always do when gold trends higher (one more piece of evidence that investment demand is the main driver of the gold price), and while this is reason for caution when extremes are reached, it is not per se a negative as long as the technical condition of the market remains in bullish mode – click on chart for higher resolution.



The gold price in South African Rand vs. the share price of Harmony Gold, South Africa's third largest producer. One has risen, the other has languished – such a wide gap may represent a short term opportunity, as the earnings of S.A.'s producers are highly leveraged to the Rand gold price due to their relatively high production costs (however, one must of course keep in mind company-specific risks) – click on chart for higher resolution.



In the context of the final chart, we thought we'd bring you a recent humorous and apropos quote by famed fund manager Bill Fleckenstein, which a friend has mentioned to us:


“I keep waiting for the day when folks realize that if you invest in the shares of a gold mining company, you basically own a piece of "the money-creation machine." It's sort of like owning a central bank that isn't staffed by losers. “


We concur.


Charts by:

StockCharts.com, TFC commodity charts, Wall Street Journal, Haver Analytics / Gluskin Sheff, FactSet Research Systems, BigCharts.com



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