One of the great things about the markets is the way narratives evolve. It doesn't matter the story - Apple's (NASDAQ:AAPL) fall, the fiscal cliff, the housing recovery, whatever. In the end, the narrative begins to take on a life of its own and a whole lot of energy builds up on one side of the trade without looking critically at the current scenario. Gold (NYSEARCA:GLD) bears are currently working overtime to convince themselves of something that runs counter to the fundamentals and use the current 18 month long correction as a blunt instrument to shout down bulls while the market builds energy against their case. At this point, the extreme level of bearishness in the gold community is itself now part of the bearish narrative - an unhealthy spiral of despair of the kind Keynesians believe falling prices create.
Nothing could be further from the truth.
Falling prices, of course, are a boon to consumers, but consumers do not profit from the production of money and debt, bankers do. Therefore the story is told that inflation good, deflation bad. If there was ever a group talking their book when it comes to inflation, it is the banking class. If there was ever a group that needed to preserve their savings against inflation, it is consumers.
Pictures at 11
So, for the gold narrative this week, the big news comes out of China where 114.4 tons of gold were imported through Hong Kong in December. Now I note that no one wants to credit the more than 200 tons of demand from China that showed up in the last two months of 2012, continuing to focus on the drop off in demand that occurred in the previous two months. So, here's my first chart for today which I'll title "Blatantly Obvious Example of the Law of Supply and Demand"
The narrative was spun and is still being spun that demand primarily responds to price. Reporting a two-month lagged drop in Chinese demand as an indicator that the gold bull market is over is as misleading as financial journalism gets, and yet nearly everyone gets the situation wrong regardless, up until recently including me. But, raw supply and demand numbers are ultimately irrelevant to prices paid, though they make a good story.
The Paradox of Thrift
Zerohedge ran an article recently by Robert Blumen who did a credible job explaining why raw supply and demand numbers for gold don't matter. I'd rather not rehash his work here, but suffice it to say Blumen concluded gold demand because it is both not consumed - marginal new supply has little effect on price - and is held as an alternative to cash savings, represents a paradox that resists normal supply and demand side analyses.
The fundamentals of gold are the current purchasing power of money; expectations about the future purchasing power of money; the growth rates of various national money supplies; the volume of bad debts in the system; expected growth rates of bad debts; the attractiveness of other available investments; and the investor's preference for consumption rather than investment. These factors do not act directly on the gold price. Instead, they are focused through the prism of investor preferences, which are not measurable. The price is the ultimate measurement of how investors view these factors. Gold presents a paradox: that which drives the price cannot be measured, that which can be measured does not drive the price. (Blumen, 2013)
Even though, I just put a chart up above which seems to contradict that I agree with him, it doesn't. All it says is that if the price of gold rises Chinese demand quantity rises and vice versa. There is correlation but not causality, which is a point Blumen makes in his article. Now we are back to Statistics 101 after visiting Economic 101. What we can say if you look closely is that the quantity demanded at a particular price is steadily rising - compare February's demand with September and October's or March's and December's.
Was this rising demand from China due to shrinking supply? No. As the gold bears will happily tell us, overall gold demand dropped for most of 2012, according to the World Gold Council. In addition, 2012 supply was higher. There was plenty of gold to be had. The question, as always, is at what price? The year-over-year closing price rose 6% on falling demand and rising supply. If this were a stock the price would be down ceteris paribus.
The quantity of investment demand has to be based on something else then. If supply and demand numbers mattered, the quantity of money transacted for gold would remain relatively flat and also negatively correlated with price. So, here's the first chart transformed into quantity of money paid.
This would support Blumen's analysis. Quantity demanded at a particular price has nothing to do with available supply. What it says to me is that at those prices, in later 2012, Chinese buyers felt gold was undervalued and bought all they could.
Blumen leaves out the myriad hypothecation schemes which overstate marginal supply and forces higher marginal demand to move the market than would otherwise be needed. Hence, why looking at a physical market where the buy price is a 3% arbitrage over the current settling futures price, is far more telling of investor sentiment than the price itself quoted on the 15-minute ticker by the CME Group (NYSE:CME) on the COMEX.
One of those is telling the real demand story.
So, now you know that a change in quantity demanded or supplied should neither change nor form your investment thesis on gold. The numbers are meaningless. Total dollars exchanged for gold is what is important and changes in them reflect changes in investor sentiment.
Money flow trumps tonnage.
To Save or Not to Save
Warren Buffet is ultimately right about gold as an investment. It isn't one. That's not a paradox, that's simply another false narrative. You don't invest in gold. You save in gold. If you want a return on your savings then you have to invest it. When you buy gold you are saving, not investing. No wonder Keynesians hate gold. When you sell gold you are preparing to either consume or invest by cashing it in for the local money stock.
Ultimately, gold is odd because it is a currency that trades like a savings vehicle. Silver (NYSEARCA:SLV) does as well, but to a lower percentage of its total trading activity. Your investment thesis for gold should always be predicated on the effects of changes to the quantity of money relative to its demand. If your analysis leads you to believe that quantity will rise faster than demand, gold will rise to compensate - protecting the value of your liquid savings. If your analysis leads you to the opposite conclusion, you should expect lower gold prices. And no one factor should sway you. The current structure of gold's demand was built by a million little rules and their complex interplay.
And they all make for great copy.
When the market acts opposite to your investment thesis, you should act with respect to gold the same way you would to a company's stock whose current narrative is more bearish than its fundamentals and business prospects -- be comfortable with buying more. Moreover, when the narrative being spun contravenes what you are seeing, you should be wary of it. The concentration of reports calling for the end of the gold bull market in the face of QE and surging dollar savings demand should remind you of what I said at the beginning of the article.
Some stories are the exact opposite of the truth.
If you are not a trader, then don't time the market. If you are, then pinpoint your entries and exits using purely technical or quantitative means. But, bull or bear, do not be swayed by supply and demand numbers for the metal itself. It is not part of the story.
Disclosure: I own physical gold, silver, a few goats and what's left of my sanity. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.