Gold is many things to many people, but to those reading this and similar articles, gold is an investment vehicle used to make money or hedge against other investments. Understanding how gold got to this price and how gold reacts to market influences could be helpful in predicting the future path of gold.
Let's start with the assumption that the price of gold should follow the fundamental rules of supply and demand. Many articles have been written and many more will follow discussing the intricacies of small fluctuations for short term investors, but I wanted a simple and obvious answer for what has occurred over the last rally. A few months back, after reading a few articles my curiosity peaked and I went looking for the reasons why gold became such a sought out investment. In light of recent events, I found it relevant to post what I have learned over the past few months. Seeking to explain the price of gold using public information, I was able to draw some conclusions.
The graphic below shows the correlation between supply and demand for gold (metric tons); clearly, as demand has increased, so has the price. The delta between production and demand over this time span correlated strongly with the increase in the price of gold. No surprises here.
Breaking out the major constituents of demand shows two major trends; overall demand has increased due primarily to increasing demand from investments and central banks.
[Data collected from World Gold Council]Click to enlarge
Playing the timeline forward, I speculate that central banks will continue to purchase gold, but that investors' demand will wane. Reasoning is that central banks, due to low interest rates and continuing diversification of reserve assets, will seek gold as an acceptable answer regardless of cost. Most net purchasing countries have publicly announced their continued interest in the purchase of gold. Central banks that were selling in the past have stopped and have not voiced an interest in selling any in the future. Another, less clever reason, is that governments tend to be the worst at market timing.
Most investor purchases of gold have no other intention than to resell it to someone else. Any pricing support, once removed will lead to a lack of confidence and diminished demand. Rationally, Jewelry demand is better indicator of the value of gold as customers associate a value and have alternatives such as other precious metals. Jewelry slow fall shows that price has climbed to quickly for rational consumers. Irrationally, gold will continue to rise as long as someone thinks they can flip it to someone else. This bubble, as many other articles have pointed out, may be bursting.
Clearly, it takes more than one sector to drive overall demand; it would take both central banks and investments working in tandem to drive up the price of gold. Rationally, if the price continues to rise, demand in Jewelry will continue to decline working in opposition to higher prices. With a stacked deck against future demand, this would suggest a static gold price at best and more likely, a falling gold price over the next decade.
Although I prescribe to the notion that money is made on current information and not historical, I see a direct correlation between the demands of over the past decade in gold and speculate that the current trend of diminishing demand will continue for the next decade. I do not wish want to imply short term results that result from short term variations in the markets. My prediction is that gold will go out as a whimper, it will not crash like the equity or real estate bubbles that preceded it. Whether or not gold stays put or drops significantly, only time will tell.
Disclosure: 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.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.