Current Gold Price Is Not a Bubble

The fact that investors around the world are turning to gold is remarkable. Unlike a bond, stored gold offers no yield and, unlike a stock, gold provides no leverage to the performance of an enterprise. Buying gold is not an investment per se, compared, for example, to buying a gold mining stock, where a company’s financial performance is linked to its resources and production, at the same time providing leverage to the gold price. In fact, industrial applications for gold consume far less than the annual supply, thus investing in gold is fundamentally different from other commodities. According to the World Gold Council (WGC), investment demand for gold, e.g., from Exchange Traded Funds (ETFs), was up 46% in the third quarter of 2009.

Gold is commonly viewed as an inflation hedge and, because it is the only financial asset with no counterparty risk, as a safe haven, but the spectacular rise in the gold price indicates more than caution on the part of investors. Gold hit a low of $713.50 per troy ounce on November 13, 2008 (London Bullion Market Association PM Fixing) and closed at a 52-week high of $1,115.25 on November 11, 2009, up an astounding 56.31% from its 52-week low.

^{Chart courtesy of StockCharts.com}

Central bank gold is the proverbial elephant in the room that no one wants to talk about. With official gold holdings of 29,633.9 tonnes of gold worldwide, compared to world gold production of roughly 2,400 tonnes per year, central bank gold sales, leases and purchases, have a huge influence over the gold price. Central banks are changing their reserve asset compositions and a number of central banks, led by India and China (which has been the world’s largest gold producer since 2008), are buying gold. Evidently, the full faith and credit of the United States of America isn’t what it used to be. Faced with a weakening world reserve currency, the questionable status of the world’s largest economy, and unsustainable US government spending, central banks are rendering a quiet vote of no confidence on the US dollar.

The US economy, the US government, US banks, and US stock markets exhibit various problems including unemployment, looming commercial real estate defaults, the US budget deficit, a massive public debt and huge unfunded liabilities, residual toxic assets on bank balance sheets, mounting mortgage defaults and credit card delinquencies, an emerging stock market bubble, etc. Unless the economic problems of the US can be addressed, the US dollar will quite probably loose its status as world reserve currency. Whether a transition to a new world reserve currency would take place in a cooperative manner, e.g., a managed retreat of the US dollar, or in a more disruptive way is unclear.

Gold Supply and Demand in 2009

Under ordinary economic conditions, a rising gold price might reflect, for example, increased demand, the effects of currency debasement or inflation expectations, but a sustained rise in the gold price characterized by growing global investment demand indicates something more. New York University Professor of Economics Nouriel Roubini has suggested that commodity prices reflect an emerging global asset price bubble fueled by the fast-growing US dollar carry trade. While Professor Roubini’s ”mother of all carry trades“ thesis accounts for the effects of low US interest rates driving global speculation and a decline in the US dollar, it does not specifically consider gold, which has unique supply and demand characteristics.

Based on data provided by the WGC, Gold Fields Mineral Services Ltd. (GFMS), and the US Geological Survey, the world gold supply is expected to be approximately 2,400 tonnes in 2009. Gold demand is expected to exceed supply by roughly 1032 metric tonnes (1 metric tonne is the equivalent of 32,150.7466 troy ounces), a large shortfall equal to 43% of the gold supply.

Assuming the average decline in industrial consumption for all of 2009, compared to 2008, will be roughly the same as that of the most recent quarter:

• The jewelry industry, by far the largest industrial consumer of gold, is expected to consume roughly 1,705 tonnes of gold by the end of 2009. Jewelry demand was down 22% in the third quarter and is expected to account for only 71.04% of the 2009 gold supply.
• The electronics industry, where consumption was down 25% in the third quarter, is expected to consume roughly 76.1 tonnes of gold by the end of 2009.
• The field of dentistry, where consumption was down 11% in the third quarter, is expected to consume roughly 49.75 tonnes of gold by the end of 2009.
• For all other industries, where consumption was down in the third quarter an average of 9%, total consumption is expected to reach 79.08 tonnes of gold by the end of 2009.

Total industrial demand is, therefore, expected to reach 1,909.93 tonnes of gold by the end of 2009, or approximately 79.58% of the estimated 2009 gold supply.

Although gold is not actually circulated as money, gold coins and bullion bars are in high demand and investment demand was up 46% in the third quarter. Investment demand is expected to account for roughly 1,727 tonnes of gold in 2009, an amount that exceeds the demand of any single industry.

Outside of the electronics industry, where scrap gold recovery is high, and the field of dentistry, gold is not typically consumed destructively. As a result, unlike any other commodity, the vast majority of gold mined throughout history, estimated at 162,780 tonnes by the end of 2009, remains in existence today.

Central Bank Gold and the US Dollar

Despite the fact that it is not generally used as money, gold is held by central banks as a currency reserve and official central bank gold holdings amount to 29,633.9 tonnes worldwide. Official gold holdings represent roughly 18.2% of all gold ever mined and the expected 2009 gold supply is equivalent to roughly 8.1% of official gold holdings.

Since gold no longer served an official monetary purpose after 1971, which marked the end of the Bretton Woods system, central banks began to sell and to lease gold based on their individual requirements and continued to do so until 1999. Prompted by the UK Treasury’s planned sale of 415 tonnes of gold (58.04% of UK gold reserves at the time), the Washington Agreement on Gold was established in 1999 to maintain the value of remaining central bank gold reserves by coordinating central bank gold sales. Under what is now the Central Bank Gold Agreement (CBGA), central banks have sold gold in limited quantities (400 tonnes annually between 1999 and 2004, 500 tonnes annually between 2004 and 2009, and 400 tonnes in 2009). However, official sales do not account for gold leasing.

Central banks lease gold to earn interest thus offsetting storage costs by leveraging what had been until this year an otherwise marginalized financial asset to generate cash flow. Rather than borrowing cash at higher interest rates, gold producers, for example, may lease gold and sell it to raise cash, paying the lessor in physical gold from future production. Gold dealers may wish to lease gold in order to cover derivative positions, such as options or futures, either paying the lessor in physical gold or settling contracts in cash. In cases where leased gold is sold by a lessee into the open market, the gold supply is affected, which might affect the gold price. Although gold lease rates, which have been historically lower than interest rates, and central bank participation in gold leasing arrangements are documented by the London Bullion Market Association (LBMA) and other organizations, gold leasing remains an unregulated market. Since gold leases can be settled either in gold or in cash, it is difficult to calculate the effects of gold leasing on the supply and demand dynamics of gold or on the gold price. In any case, since 2008, central banks have reduced gold leasing at traditionally low rates, e.g., rates below 1%.

What is more important is that central bank gold sales had begun falling short of the annual sales allotment of the CBGA in 2006, declining to an estimated 345.5 tonnes in 2008. Since 1999, the gold supply has averaged approximately 2495 tonnes per year, while central bank gold sales through 2008 averaged an estimated 394 tonnes, equivalent to 15.8% of annual supply on average. In 2009, however, central banks became net buyers of gold and some central banks began to repatriate gold reserves. China, for example, began adding gold to its reserves and India recently agreed to purchase 200 tonnes of gold from the International Monetary Fund (IMF).

Setting aside gold leasing, central bank gold sales, having effectively added an estimated 15.8% annually to the gold supply for the past decade, can only have had a dampening effect on the gold price and as well as on gold investing. Therefore, the effect of central banks rather suddenly switching from net sellers of gold to net buyers of gold is equivalent to a reduction in the 2009 gold supply of approximately 15.8%.

In addition to the projected 43% shortfall in the 2009 gold supply, the US dollar’s precipitous decline led to a rise in commodity prices across the board. The US Dollar Index hit a 52-week low of 74.93 on November 9, 2009, down approximately 16.39% from its 52-week high of 89.624 on March 4, 2009.

^{Chart courtesy of StockCharts.com}

Demand for gold in 2009 is expected to exceed the supply by 43%, including a reduction in supply of approximately 15.8% due to the effective termination of central bank gold sales, while the US dollar is down approximately 16.39%. At the same time, there has been a fundamental shift in central bank policy. Eastern central banks in particular, led by India and China, are buying gold, while Western central banks have cut back gold sales and have reduced gold leasing at traditionally low rates.

Setting a Gold Price Target

The 16.39% decline of the US dollar tends to be reflected rather directly in commodity prices, thus the gold price, considering that the demand for gold is global, could reasonably be expected to rise approximately 16.39% from its 52-week low in 2009 based solely on the decline in the US dollar.

The effect on the gold price of the 2009 supply shortfall of 1032 metric tonnes could be extraordinary if obvious shortages were to occur, or it might be nominal if consumers of gold were to substitute another commodity, e.g., silver. Substitution, however, seems very unlikely both in terms of industrial uses for gold and in terms of investment demand. Thus, a naive estimate of the impact of the supply shortfall on the gold price might assume that the gold price would rise no more than the shortfall in supply, i.e., by no more than 43% (inclusive of the estimated 15.8% reduction in supply due to the effective termination of central bank gold sales and setting aside entirely the subject of gold leasing).

Combining the 16.39% decline of the US dollar and the estimated 43% shortfall in supply might suggest a gold price approximately 62.6% higher than the 52-week low of $713.50 (London PM Fix), which occurred on November 13, 2008, 1 year ago, i.e., a naive price target of 1,160.15 as of November 2009. The 52-week high of $1,115.25 on November 11, 2009 was approximately 56.31% higher than the 52-week low, thus the actual gold price at that point was lower by roughly 6.29% compared to the 52-week low than the naive price target of 1,160.15. Based on these estimates, the gold price does not seem to indicate an asset price bubble.

Which Way is the Elephant Going?

The proverbial elephant in the room is on the move and the room is not very big in comparison. It seems likely that Western central banks are holding off further gold sales, at least while discussions on a new world reserve currency, i.e., IMF Special Drawing Rights (SDRs), are taking place. Led by India and China, key IMF members want gold included as a component of the a world reserve currency. As long as using gold as a component of a new world reserve currency is a possibility, not only are central bank gold sales on hold but central banks will almost certainly continue to buy gold in the foreseeable future.

There is no fundamental reason for the current gold price trend to reverse in the foreseeable future, and, despite the steep rise of the gold price in 2009, gold does not appear overvalued. It seems possible, although unlikely, that if gold were to again be marginalized in a new world reserve currency regime, as it was under the US dollar standard after 1971, central banks might again start selling and more aggressively leasing gold at some point in the distant future. In that case, the gold price would eventually fall, perhaps to some stable, lower level, once again reflecting the conflicting desires of central banks to both leverage their gold reserves and also maintain their value. However, given the global financial crisis stemming from of the US dollar’s 64-year reign as world reserve currency, it seems much more likely that central banks will guard their hoards jealously in coming decades.

Alternatively, if a new world reserve currency were to emerge having a significant gold component, what would then be a certainly higher gold price would likely remain at a higher level indefinitely. It also remains possible that the decline of the US dollar could accelerate or that the apparent differences between Eastern and Western central banks could become more acute, in which case the gold price could rise more rapidly and the process of deploying a new world reserve currency might be accelerated as well as potentially disruptive.

The Hindu deity Ganesha, widely revered as the Remover of Obstacles, is readily recognizable because he has the head of an elephant. Gold languished from 1971 until 2009 as a commodity that central banks had little better to do with than to systematically dissipate through sales and leases, while the most significant problem they thought they faced was the risk of dishoarding too much too quickly. From 1971 until 2009, central bank gold entering the market was a factor of the gold price and a risk for investors. After 38 years, the effective termination of central bank gold sales has rather abruptly removed that obstacle.

Desiring to mitigate risks associated with the US dollar, central banks, led by India and China, have, in effect, promoted gold from its 38-year status as a non-financial commodity once again to its historical role as the premier global financial asset. This historic change in central bank policy signifies a profound break with the past and broadcasts a clear message: gold is a world-class financial asset fairly valued at more than $1,000.00 per troy ounce. With this momentous event, the words “as good as gold” again have meaning.

An analysis of supply and demand fundamentals suggests that the current gold price does not indicate an asset price bubble, and the historic change in the status of gold by central banks implies a major revaluation not yet reflected in the gold price. As the restructuring of the global economy continues, particularly with respect to the world reserve currency, there is a clear possibility that the gold price will move up sharply from current levels.

Comments

[O-B-WON:]

For me, gold is part of my insurance policy for financial security... not an investment..

I don't really care about day-to-day fluctuations...

plus I never have to renew my policy...

It all depends how you look at it...

Nov 15 08:28 AM

[BePrepared:]

I believe that America's economy is in great change. No longer can we be be a consuming nation that does not produce. People who do not go bankrupt, will get their debts paid in the years to come and become savers of wealth not consumers...there are hard times to come for those who have saved nothing for their future. Since the dollar is very unstable and unreliable, ( a reflection of our economy), I have chosen to invest in what I can of precious metals to hopefully hold something relatively stable. The really sad thing is that so few people are even aware of what is happening.

Nov 15 09:18 AM

[john s. gordon:]

when the present gold bubble pops the u.s.$ will appreciate vs. other world currencies.
the hedgie funds love to puff up bubbles.
> jack

Nov 15 10:06 AM

[Vortex:]

As a long term "Goldbug", I have purchased gold in small amounts over a long period of time, day to day fluctuations or even a bubble would have little effect on my purchasing of gold. If gold goes up - the gold I have is more valuable but more expensive for me to buy. If gold goes down just the opposite. I think the only possible way to be on the "losing" side of gold is to puchase large amounts over a short period - that would be risky.

Nov 15 12:31 PM

[5142152-337:]

BePrepared: You are so right! Did you see the clip where NO ONE would buy a Canadian Maple 1 oz gold coin for FIFTY DOLLARS!!!!!! This guy was walking around with a coin and a camerman and NOBODY would even hint at taking his offer of the coin for FIFTY BUCKS! It just goes to show that the average person out there has no concept on what gold is, its value, or more importantly, actually, is its role in this world RIGHT NOW! When these sheeple start to become aware, and start BUYING gold (and silver) is the day I start emptying my two safes and letting them have all they want!

Nov 15 12:39 PM

[Brian McMorris:]

Gold may be a hedge against inflation, but it does no good against a deflationary contraction. To deflate assets requires the value of the currency those assets are denominated in to increase (this is math that most goldbugs can't handle) as the quantity decreases. In essence, $15T of dollars were destroyed or disappeared (not physically, but notionally with debt paper markdowns). Less supply at a given demand = higher price / value. Central bankers everywhere understand this dynamic. So, in a coordinated way to restore stability to global assets, currencies are being expanded to replace those notionally destroyed (through markdowns during 2008 of the paper that underpinned all those assets, CDOs, RMBS, etc).

The most intelligent dissertation I have seen on repairing a deflation was printed in Barrons last February. Ray Dalio, a rare Barrons contributor, was interviewed. I reference this interview on my blog

wealth-ed.com/2009/11/.../

Nov 15 01:07 PM

[Brian McMorris:]

I suppose your contrarian assumption about the timing of gold is correct, but who is to say that time has arrived? It hasn't. I think the example given is off-the-mark. There are so many cons today, who can blame people for passing up the offer of a supposed gold coin. No one wants to get taken. I think people are generally aware that gold is worth $1000 an ounce. It is all over the press.


On Nov 15 12:39 PM 5142152-337 wrote:

> BePrepared: You are so right! Did you see the clip where NO ONE would
> buy a Canadian Maple 1 oz gold coin for FIFTY DOLLARS!!!!!! This
> guy was walking around with a coin and a camerman and NOBODY would
> even hint at taking his offer of the coin for FIFTY BUCKS! It just
> goes to show that the average person out there has no concept on
> what gold is, its value, or more importantly, actually, is its role
> in this world RIGHT NOW! When these sheeple start to become aware,
> and start BUYING gold (and silver) is the day I start emptying my
> two safes and letting them have all they want!

Nov 15 01:12 PM

[Brian McMorris:]

This is one of the smarter posts on gold I have read. It is exactly right, holding gold cannot be considered an investment. It is an inflation hedge, pure and simple. Over the long run, the best gold can do is match inflation (devaluation) of fiat currencies.

There are better ways to invest to benefit from inflation, including most prominently, commodities that are consumed. Another good way would be TIPS Treasury bonds, which with their guaranteed return above the rate of inflation, will outperform gold as long as the American government is viable, which is to say, a long long time to come.


On Nov 15 08:28 AM O-B-WON wrote:

> For me, gold is part of my insurance policy for financial security...
> not an investment..
>
> I don't really care about day-to-day fluctuations...
>
> plus I never have to renew my policy...
>
> It all depends how you look at it...

Nov 15 01:18 PM

[Brian McMorris:]

One of the points I disagree with here: "Central banks are changing their reserve asset compositions and a number of central banks, led by India and China (which has been the world’s largest gold producer since 2008), are buying gold. Evidently, the full faith and credit of the United States of America isn’t what it used to be."

ANY world government that hopes to have a respected (aka Strong) currency will need some gold reserves to back up the currency. That China, Russia and India are adding to their gold reserves is more a refleciton of their growing economies and less a direct reflection on the status of the US dollar. In fact, the American government is strongly encouraging China to delink the US dollar as its reserve and to float its currency, which requires gold reserves to some degree. There is a lot of talk about the weakness of "fiat" paper currencies, but every major government Central Bank has a large inventory of gold to underpin the value of their currency. There exists in the world today a soft linkage to gold in world currencies implied by national reserves, though it is commonly not known or understood.

The CB demand and inventory completely dwarfs the float, which is why gold speculation is so fruitless and dangerous.

Nov 15 01:37 PM

[Jason Hamlin:]

Agree. Gold is heading much higher. $1350, $1,500, $2,400 and beyond.

I also believe CEF is a great buy at the moment, since they just had an offering and their premium came down. It almost always catches back up in the following few weeks.

Nov 15 03:42 PM

[Beach Bubba:]

All I know is, I have been buying some silver whenever I can since the early seventies. I moved to Mexico a few years ago and continue to buy the Mexican Libertads which seem to always be available (buy or sell) in the Elektra Home stores. I like the feel of gold and silver...I remember as a child in the 40s and 50s the thrill of holding silver dollars, which were often given to kids by relatives, and then putting them in a secret place; I still have them. If the sh** hits the fan (and it will) I will buy a few beans and tortillas with the silver I have stashed. Ultimately, PM coins have nothing to do with inflation and deflation; they are money, pure and simple (read history).

It will never be a bubble to me.

Nov 15 09:25 PM

[CLH:]

Was gold a bubble in 1980? Most people didn't think so and lost their shirts. Times change but people never do.

Nov 15 11:56 PM

[Ron Hera:]

The changing composition of central bank reserves, i.e., increasing gold holdings, is a direct effect of the currently weak US economy and US dollar, which has lost considerable value in recent months. All other things being equal, strong economies offer investors superior returns and lower risk compared to weak economies, thus the currencies of stronger economies are always preferred over those of weaker ones and have a higher relative value as a function of supply and demand. Of course monetary inflation and monetary deflation influence the value of a currency in terms of supply. This is clearly illustrated by the Zimbabwean 100 trillion dollar note, which only has value today as a novelty sold in venues such as eBay.

In a world financial system composed entirely of fiat currencies, where no currency is redeemable in terms of hard assets, money is a necessarily abstract claim on production and the value of one national currency relative to another can only, ultimately be a reflection of the performance of the underlying economy that the currency represents (performance being inclusive of the consequences of its monetary policies), i.e., a claim on its production. Thus, if an economy is in decline, i.e., its production is falling, its currency, over time, must also decline. Conversely, there can be no doubt that if the US economy were exhibiting robust growth, i.e., if production were increasing, the US dollar would certainly gain value, but, unfortunately, that is not the case currently.

The fact that, overall, central banks are reducing US dollar holdings and increasing gold holdings is simply a matter of preserving the value of their reserves in the face of developments influencing the value of the US dollar, e.g., the US dollar carry trade, which is exacerbating the problems with which the US dollar has been beset.


On Nov 15 01:37 PM Brian McMorris wrote:

> One of the points I disagree with here: "Central banks are changing
> their reserve asset compositions and a number of central banks, led
> by India and China (which has been the world’s largest gold producer
> since 2008), are buying gold. Evidently, the full faith and credit
> of the United States of America isn’t what it used to be."
>
> ANY world government that hopes to have a respected (aka Strong)
> currency will need some gold reserves to back up the currency. That
> China, Russia and India are adding to their gold reserves is more
> a refleciton of their growing economies and less a direct reflection
> on the status of the US dollar. In fact, the American government
> is strongly encouraging China to delink the US dollar as its reserve
> and to float its currency, which requires gold reserves to some degree.
> There is a lot of talk about the weakness of "fiat" paper currencies,
> but every major government Central Bank has a large inventory of
> gold to underpin the value of their currency. There exists in the
> world today a soft linkage to gold in world currencies implied by
> national reserves, though it is commonly not known or understood.
>
>
> The CB demand and inventory completely dwarfs the float, which is
> why gold speculation is so fruitless and dangerous.

Nov 16 04:24 AM

[5142152-337:]

Brian: Thank you for your comment! My reason for highlighting the "survey" was merely to bring to light the fact, and it is a FACT, that the average guy/gal out there DOES NOT HAVE A CLUE about gold or silver, or precious metals in general. I tried it Sunday. I inquired of strangers (those who know me are aware of PMs) on the price, value, overall makeup of the PMs arena. Overwhelming consensus is that people "don't want to be bothered" by what they perceive as unaffordable. Then there is the pure unadulterated lack of knowledge. I stand by my mantra: When Joe Sixpack is talking about PMs, I will be SELLING!


On Nov 15 01:12 PM Brian McMorris wrote:

> I suppose your contrarian assumption about the timing of gold is
> correct, but who is to say that time has arrived? It hasn't. I think
> the example given is off-the-mark. There are so many cons today,
> who can blame people for passing up the offer of a supposed gold
> coin. No one wants to get taken. I think people are generally aware
> that gold is worth $1000 an ounce. It is all over the press.

Nov 16 08:36 AM

[Zmartmoney:]

From the site you reference:
"As is pointed out, gold is worth nothing unto itself. And worse, gold is not consumed, so supply forever increases. This ever-increasing supply dynamic is NOT the hallmark of a good investment."
How much "money" is in circulation now, as compared to 50 years ago? One need only compare the supply dynamic of gold to the supply dynamic of paper money to see that paper is outstripping gold at a horrendous pace. The fact that investors around the globe bought worthless investment "paper" in the form of CDOs, etc, highlights this fact. There are plenty more trees than mines. Anything I can print on the color copier in my office takes a back seat to having to dig something out of the earth and refine it.


On Nov 15 01:07 PM Brian McMorris wrote:

> Gold may be a hedge against inflation, but it does no good against
> a deflationary contraction. To deflate assets requires the value
> of the currency those assets are denominated in to increase (this
> is math that most goldbugs can't handle) as the quantity decreases.
> In essence, $15T of dollars were destroyed or disappeared (not physically,
> but notionally with debt paper markdowns). Less supply at a given
> demand = higher price / value. Central bankers everywhere understand
> this dynamic. So, in a coordinated way to restore stability to global
> assets, currencies are being expanded to replace those notionally
> destroyed (through markdowns during 2008 of the paper that underpinned
> all those assets, CDOs, RMBS, etc).
>
> The most intelligent dissertation I have seen on repairing a deflation
> was printed in Barrons last February. Ray Dalio, a rare Barrons contributor,
> was interviewed. I reference this interview on my blog
>
> wealth-ed.com/2009/11/.../

Nov 16 11:00 AM