Gold is heading for the first annual drop in 13 years, as we have seen a massive bear-raid in 2013 with gold futures declining by a whopping 22% so far. This bear-raid on gold can be attributable to 4 main factors:
- Increasing fears that the long gold bull market would come to an end after 12 years of boom.
- Improving US economy suggesting that the FED could curb stimulus sooner than expected.
- More risk appetite pushing gold lower and equities higher.
- Less fears about the sovereign debt situation in Europe
What's next for Gold?
Even if I remain bullish on gold in the very long term as I wrote here in a previous article about sovereign debt defaults, even if I think there is still a potential upside in the very short term primarily due to a delayed tapering and a US debt ceiling that is fast approaching as I wrote here; Investors need to know why gold could continue to go lower in the medium term.
Let's have a look at Supply and Demand. The table below sets out GFMS statistics on supply and demand. The demand for gold can be divided into 3 components:
- Jewellery Consumption
- Industrial & Dental: Electronics, Other Industrial & Decorative and Dentistry
- Investment: Physical bar investment, Official coins, Medals & imitation coins and Investment in ETFs and related products
World Gold Supply & Demand (Tonnes)
(click to enlarge)
As seen in the table:
- Gold prices increased from $309.68 an ounce in 2002 to $1,571.52 an ounce in 2011.
- Investment demand rose from to 359 tonnes in 2002 to 1,705 tonnes in 2011.
- Jewellery demand decreased from 2,662 tonnes in 2002 to 1,973 tonnes in 2011.
- Industrial & Dental demand rose from 358 tonnes in 2002 to 453 tonnes in 2011
The behavior of gold demand suggests that Investment demand tends to rise with gold prices (positive correlation) while Jewellery demand decreases slightly with gold prices (negative correlation) and Industrial & Dental demand is relatively stable with gold prices (no correlation).
To confirm this intuition, let's estimate the price elasticity of these 3 demand components for gold obtained from a simple linear regression. I based my work on a simple regression of log(Gold demand) on log(Gold prices) in order to get the elasticity directly from the slope.
The linear relationship between log(Investment demand) and log(Gold prices) is given by the equation : log(Investment demand)= 1.0584 log (Gold prices) - 0.0884
Thus, the elasticity is 1.0584, which means that a 1% increase in the price of gold leads to a 1.0584% increase in demand for gold.
The linear relationship between log(Jewellery demand) and log(Gold prices) is given by the equation : log(Jewellery demand)= -0.2184 log (Gold prices) + 3.9788
Thus, the elasticity is -0.2184, which means that a 1% increase in the price of gold leads to a 0.2184% decrease in demand for gold.
The linear relationship between log(Industrial & Dental demand) and log(Gold prices) is given by the equation: log(Industrial & Dental demand)= 0.1126 log (Gold prices) + 2.3185
Thus, the elasticity is 0.1126, which means that a 1% increase in the price of gold leads to a non-significant 0.1126% increase in demand for gold.
To put it another way, the chart below illustrates clearly the correlation between these 3 demand components and gold prices.
The Price Elasticity Of Demand For Gold
So, what does that imply for the gold market?
The gold market can be in fact viewed as a momentum-based market, which means that the higher the average price of gold the higher the demand for gold. It is likely that investors have allocated more and more capital in gold as momentum has been increasingly positive given the fact that gold has risen in price for 12 consecutive years. Nonetheless, as gold is heading for the first annual retreat since 2000 this year, momentum investors may exit the gold market as the momentum has turned negative this year. This could have already been started as gold ETFs have witnessed a massive redemption since the beginning of 2013 (chart below). As a result, gold prices could decline next year if the yellow metal has difficulty maintaining this momentum.
Investment demand by Category
Source: The World Gold Council
The gold market is not the only one momentum-based market: Tulips (1635-1637), Dotcom (1998-2000) and Housing (2001-2006) are just a few examples.
As legendary investor Warren Buffett put it: "What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth - for a while."
Nonetheless, contrary to what Warren Buffett says, I do not call gold price "a bubble" today because a major sovereign debt crisis is approaching. Nonetheless, it is fair to say that it will end in a bubble someday because long bull markets always end in a bubble.