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If you look at gold demand as presented by the World Gold Council, there is a clear drop in basic usage of gold jewelry as the price has increased. Note the steady drop in jewelry usage as the price goes up in the chart below of Demand (tons) used by type compared to price per oz.
[Click all to enlarge]
Gold Demand by Type
Investment in the chart above is labeled as "Total Non-Jewelry Investment" in recognition of the fact that in many parts of the world high karat jewelry is sold as investment. I first encountered this when I tried to buy the scratched up (because it was so soft) cheap brassy-gold color (because it's 24 karat) bracelet on the arm of the guy trying to sell me a rug. I couldn't afford the rug or the bracelet.
It's interesting that demand for gold jewelry has plunged in the Middle East, where it is a traditional investment. The only places goal demand has grown more or less consistently is India and China. If you look at the chart below, you can see that these countries have become a greater and greater part of gold jewelry sales and finally surpassed the entire rest of the world in the year ending Q1 2011.
Gold Jewelry Demand by Country
The best explanation for why Indians and Chinese are continuing to invest in gold jewelry appears to be that they are trying to hedge against rampant inflation in their countries.
Inflation rates from the CIA World Factbook are given below for China, India and the United States. As you can see, data from India shows a clear inflationary trend. Chinese data, on the other hand, shows somewhat faster inflation than the United States, but nothing that would explain the rapidly increasing demand for gold. Most experts believe the Chinese government significantly under reports inflation and jewelry purchases support this belief.
Comparative Annual Inflation Rates
2007
2008
2009
2010
China
4.8%
5.9%
-0.7%
5.0%
India
6.4%
8.3%
10.9%
11.7%
United States
2.9%
3.8%
-0.3%
1.4%
Source: CIA World Factbook
Netting the Indian and Chinese purchases out of jewelry and into investment makes the chart of demand below look even more lopsided towards investment -- which is better called speculation, as most investors are either anticipating further run-ups in gold or hedging against potential inflation.
China and India Gold Jewelry Demand Netted into Investment
The 2002 World Gold Council report noted that the change in administration (Clinton to Bush) was generating excitement in gold due to the potential that Bush would push the dollar lower. It looks like these efforts have succeeded in either lowering the dollar value or in accelerating inflation in countries that maintain undervalued currencies.
A perhaps unintended consequence is that gold is in a classic bubble: Demand is driven by investors/speculators and usage is being curtailed due to high price. The result is increased stockpiling/hoarding. Gold is not going to run into a wall where there is no longer storage space, so the downside risk is an event that will change the value equation.
Perhaps it will turn out that all those gold bars that investors thought they were buying were actually tungsten-filled like the bullion that recently deflated the gold rush in Vietnam.
More likely, if China’s efforts to slow down its economy and reduce its inflation are successful, we will see a significant drop in total Chinese demand for gold. China's success may already be showing up in slowing commodity prices. If basic commodities take a serious dive (over 20% and stay there due to a poor economy), gold will surely follow.
There will be no inflation to drive up gold, so it will drop. How far depends in part on how hard the world governments go in trying to ignite inflation (they need inflation to save the housing industry) and also on the whims of fashion.
Gold in America today is not only considered too expensive, but it's also not very fashionable. My daughter's engagement ring is platinum, her fiancé's wedding ring will be titanium and she won't wear anything that is yellow gold -- it's just not in style. The yellow metal look is so out of style that brass fixtures are being replaced in homes across the country. This lack of “style” means that gold will have to fall very far to bring jewelry demand back up to the levels it was in 2001.
If you do get caught holding gold during the fall, take heart: The government will almost certainly overshoot its inflation targets -- but not until 2013 at this rate.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: The Gold Bubble: Falling Usage, Increasing Speculation, And Out of Style