Posts on investing in gold typically offer a variety of explanations for price swings: Central bank actions, buying in China and India, Quantitative Easing by the U.S. Federal Reserve, money supply growth in various countries, future inflation and discord in Europe.
While these are interesting discussions, there is a simpler explanation. The price of gold mirrors the most fundamental relationship in economics: the relationship between prices, supply and demand. Current gold prices reflect this equation:
Declining Demand + Increasing Supply = Declining Prices
Recent price declines (through March 8, gold prices are down 5 percent this year and 17% in comparison with their September 2011 peak) are not an aberration. Total demand for gold (in tonnes, according to the World Gold Council) declined 4% in 2012 compared to 2011.
Among the four categories of demand, three declined in 2012 (compared to 2011):
- Jewelry -3.2%
- Technology -5.5%
- Investment -9.7%.
The only demand category to increase in 2012 was official sector demand. Net purchases by the official sector increased 17%.
Unfortunately for gold bugs, demand trends are not good and prices will continue to decline if demand does not increase.
Take a look at the four sources of demand to see why demand may continue to decline.
|Historic demand for gold in tonnes|
|Investment total includes bar, coin, ETF, etc. Source: World Gold Council.|
Investment Demand -- The 9.7% decline in investment demand (bars, coins, ETFs, etc.) in 2012 seems to reflect typical investor behavior: Buy high and sell low.
Declining or even flat gold prices will cause many investors to switch funds to the next hot category. Falling prices will not tempt these investors to buy; falling prices merely tempt them to stop buying or to sell more. It is not a virtuous circle; it's a wicked circle.
The introduction of gold ETFs (SPDR Gold Shares (GLD) and others) probably helped drive up gold prices. ETFs were a new way to invest in physical gold. They increased demand, partly by allowing investors to shift assets from gold mining shares to the new ETFs and partly by bringing in new investors. As prices rose, more investors piled in, driving prices even higher. When prices flattened and declined, investors began pulling out.
Disinvestment has been readily apparent in 2013. The amount of gold held by the major ETFs declined from the end of December to March 8. For instance, physical gold held by SPDR Gold Shares was down 8% and iShares Gold Trust (IAU) was down 1.8%.
Official sector -- The 2012 increase in official sector demand provides no assurance that total gold demand will increase.
- Official sector demand is the most volatile category. Historically, the official sector has swung from net purchases to net selling and back again. The official sector recorded net selling in 8 of the last 11 years. The total for that 11-year period was net selling of 2358 tonnes.
- Even in 2012, official sector purchases represented only 12% of total demand. The only smaller sector was technology (9.7%).
- Central bank purchases would have to climb much higher to cause total demand for gold to increase. And total demand is what drives prices.
Jewelry -- The 2012 decline in jewelry demand reflects a long-term trend. Jewelry demand in 2012 was 28% lower than in 2002 and 42% lower than 1997. In 2012, jewelry demand represented 43% of total demand for gold. In 2002, it was 94%.
China and India often are mentioned as saviors here; supposedly, jewelry demand from those two countries will increase so much that total jewelry demand will rise in spite of declines in other countries.
Possible, but not likely. Jewelry demand trends in China and India are not a source of growth.
In 2012, gold jewelry demand from India was lower than in any year since 2003. Year over year, Indian gold demand declined every year since 2008. Chinese demand was flat in 2012.
Technology -- Technology demand peaked in 2007. It has declined for the last three years.
Supply -- While declining demand is one reason for recent price declines, another is ever-increasing supply. Total gold supplies ("above-ground gold") only increase; they never decrease. If production stopped, supplies would stabilize but not decline.
Production is not stopping; it has been increasing over time. According to the CPM Gold Yearbook (calculations by the author):
Average Gold Production Per Year Since 1949 (thousands of troy ounces)
1960 - 1969
1970 - 1979
1980 - 1989
1990 - 1999
2010 - 2011
Is gold a bubble that is starting to pop? Demand trends indicate that may be true. Jewelry demand has been in a long-term decline, technology demand is in a medium-term decline and investors seem to have lost a lot of enthusiasm. Total world supply continues to grow. An increase in demand by central banks would have to be huge to counter those trends.
Investors purchase gold on the assumption that some future investor will buy at an even higher price. This is called the "greater fool theory." It's a shaky assumption when demand is declining and supply is increasing. Gold investors should be concerned.