Sent: 07-05-2013 09:18:02
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What's going on with gold?
A dramatic plunge in the gold price not only reverberated through the resources sector but led to doubts about the ongoing usefulness of the precious metal in investment portfolios. While many reasons have been advanced for the change in direction of gold prices, a flow of fresh buyers remains critical.
Unlike coal or copper or gravel, gold is only rarely destroyed by its users and new supplies are insignificant. A rising gold price depends on a stream of new enthusiasts who are willing to buy from the owners of pre-existing supplies. This contrasts with other markets in which established buyers are continually replenishing their needs.
As long as new buyers are entering the gold market, the price stands a good chance of rising. Once the flow of new buyers dries up, the market is in danger of collapsing on itself. Consequently, this is a market with a peculiar dependence on zealous promotion in which fundamental analysis very often plays second fiddle.
Sometimes fundamental analysis also comes off second best to the sheer illogicality of well established behaviours.
Here is a commodity to which investors flock because central banks cannot be trusted to manage the fiat money supply. And, yet, all holders of gold rely desperately on the judgements of those very same central bankers to support the gold price by buying more or, at least, not selling any of the nearly 32,000 tonnes they hold in their vaults. This is just one of the many ironies pervading the gold market.
Sensible investors would surely eschew other markets in which almost all of what has ever been produced is squirreled away and where returns depend on a small group of buyers to prop up the price at the urging of paid lobbyists for the industry.
Every year, miners die as they burrow in dreadfully inhospitable conditions to get more, sometimes at the behest of people in large investment funds who otherwise profess an intense commitment to financial market ethical standards. And, yet, the contribution to the total supply from these miners putting their lives on the line is statistically unimportant.
Then, among the ironies, the mining companies exchange their physical gold for cash as quickly as possible. They almost universally prefer to hold greenbacks as they spend millions of dollars urging central banks to hold other people's wealth in the yellow metal.
Since gold has no intrinsic value and very little usefulness, its price can be anything buyers and sellers decide without risking any meaningful impact on supplies. Some analysts have argued recently that the cost of mining gold has been rising to such an extent that gold prices below $1,000 an ounce will curtail production.
This is certainly a cogent analytical argument in other commodity markets in which new demand is serviced overwhelmingly from new mine supplies and only to a very limited extent from pre-existing production.
The reverse is true in the gold market. Annual mine supply is equivalent to slightly more than 1.5% of available global supplies. Put another way, the amount available for purchase would be altered by something like 1.5% if all of the world's production, not just the marginally profitable, were to cease for a full year.
Such an event in the copper or oil markets would be catastrophic for global economic conditions because those products are needed. No doubt the more enthusiastic supporters of the precious metal would begin to hyperventilate at the possibility of the resulting upward price pressure but the world's needs could still be met since miners contribute so little to the total pool.
Supply side constraints have almost certainly been a positive marginal influence on gold prices. Over the last dozen years, gold mine output has risen at a tiny 0.8% a year but that simply reinforces the extent to which historical supplies dominate market outcomes.
Perhaps the biggest surprise in the gold market over the past decade has been how tepid the gold price rise has been against a background of generalised commodity price inflation, constrained mine supplies and macroeconomic mayhem.
Exchange traded products have become a popular way for investors to get their gold exposure. Financial news services are reporting on dramatic falls in ETP holdings of gold as one source of the downward pressure on gold prices. Bloomberg has recently estimated a 142 tonne drop in ETP holdings in the first three weeks in April.
Despite the popularity of the ETP structure, the effect of changes in ETP holdings are prone to exaggeration because they are so noticeable and easily reportable. The ETP on its own is not a reason for higher or lower prices. It simply describes the form in which gold is held. Total gold holdings are not affected. Attributing large price movements to ETPs would be similar to saying that moving funds from a Westpac cheque account to a NAB account will change interest rates or the size of the money supply.
ETPs are being sold because something is happening within the gold market that warrants a reduction in the holdings of gold by investors. Saying that ETPs are to blame is a lazy way of avoiding the more fundamental question.
Since gold does not have any income stream, it will tend to be most attractive when incomes from other assets are falling (or are expected to do so). One would expect reduced demand for gold if interest rates and corporate profits were on the rise (or investors expected that to be the case).
While gold prices were rising, proponents of holding gold were putting the higher prices forward as evidence of a threatening global economic environment. Paradoxically, falling gold prices do not imply, according to the gold cheer squad, that conditions are improving.
One of the most analytically unsatisfying aspects of the gold market is the determination of gold promoters to make it out as an investment that is always appropriate. They will be right as long as they are able to persuade a stream of buyers to join the queue.
With the possible exceptions of North Korea and Cuba, people everywhere have enjoyed greater freedom to reallocate their funds across borders and across asset classes over the past two decades. Rising living standards added to the potential number of gold buyers.
So, aside from the growth of global liquidity some of which ended up in the gold markets, the last two decades were peculiarly helpful in fostering gold demand. But the revolutions that created that demand have largely run their course.
Just like market scams that rely on a flow of new participants to keep the game alive, there was always going to be a risk that, at some point, all who were going to buy had done so.
By 2011, the rapid popularisation of gold during the 2000s was making it increasingly difficult to find new buyers to sustain the market momentum. Past a point, the price would turn in the other direction as the pyramid toppled and existing holders took flight to avoid larger losses.
There is no effective limit to the gold price downside. Neither physical usage nor variations in supply are possibly large enough to swing the result. Fundamental conditions will matter less than the persuasiveness of the gold advocates as they seek to restore confidence. So the question to be asked by anyone considering an investment in gold is this: am I the last one in the queue or is there someone I can count on to buy my gold when I want to sell?
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