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To describe gold as a hot investment topic would be an understatement. People talk about it often, often in emotionally charged terms. Indeed, gold has been a hot commodity and even aside from emotion, there is a body of opinion that believes gold should be part of a prudently constructed investment portfolio if for no other reason than its low correlation to stocks. And for the record, correlation with stocks has been non-existent. From 11/18/04, when SPDR Gold Shares (NYSEARCA:GLD), the ETF that holds gold bullion and tracks the metal’s price, debuted through the end of 2011, the correlation of daily prices between GLD and the SPDR S&P 500 ETF (NYSEARCA:SPY) was 0.002. But portfolio theory aside, we want more than just low correlation; we also want good returns.

The good news for gold bugs is that we’ve been seeing just that. Figures 1 charts the spot price of gold, and Figure 2 compares price trends for GLD and SPY.

Figure 1

(click to enlarge)

Courtesy of World Gold Council

Figure 2

Prices Indexed: 11/18/04 = 100

Thus far, I’ve mentioned GLD and the price of gold as if they are interchangeable. They aren’t perfectly so. Although, as noted, GLD actually owns gold bullion, the correlation between its daily price changes and that of the gold spot price is 0.864. That’s pretty high, but short of the perfect 1.00 level. That’s to be expected given market friction relating to ETF prices that result from daily trading on the stock exchange and, hence, don’t always perfectly match the underlying value of their assets (slippage). But when we look at this in graphic terms, as we do in Figure 3, it seems pretty reasonable to conclude that given the baggage inherent in holding bullion (storage) or investing in gold futures (contract rollover, often-heavy margin), it’s reasonable to suggest GLD is the vehicle of choice for investors who want to play gold prices.

Figure 3

Prices Indexed: 11/18/04 = 100

One more preliminary point: I’m going to focus today on gold, as opposed to silver, which has its own constituency among precious metals fans. In truth, though, the two are not interchangeable. The correlation of daily price changes for GLD and the silver bullion-owning ETF, iShares Silver Trust (NYSEARCA:SLV), from the latter’s 4/28/06 inception through 12/311 is just 0.370. When it comes to emotional and aesthetic appeal, silver is great and many love it, but rational or not, it simply isn’t gold. On the other hand, silver is much more widely used as an industrial raw material. Figure 4 charts the price trends of GLD and SLV.

Figure 4

Prices Indexed: 4/28/06 = 100

We can see, here, that silver is not necessarily a bad precious metals investment. But it’s clear there are dynamics at play that differ from those upon which gold bugs focus (see below). For now, note the much more abrupt decline in silver as global economic activity suffered in the wake of the 2008 financial crisis as well as the increased two-way volatility it experienced lately due partly to shifting precious-metals sentiment in general, but also to varying assumptions about where the global economy is headed. While there is something to be said for a precious metal with pricing trends that have a larger economy-related objective component, this particular article will focus on the emotional factors, and gold is the play here.

So, what about the investment case for gold.

Traditionally, gold appealed to U.S. investors as a hedge against inflation. If our currency is likely to be devalued, it’s best to own a substance whose value is not likely to be damaged by government fiscal and/or monetary policy. That was definitely at play in the spike surrounding 1980, the last time inflation was a hot topic in the U.S. Some still talk about it, but say what you will about President Obama, at least he’s not going on TV encouraging Americans to wear W.I.N. (Whip Inflation Now) buttons, as former President Ford did. (For those too young to remember, yes, this really happened in the mid-1970s as inflation started to seriously percolate. To make matters worse, cable TV was a rarity so there was little else to watch as all broadcast stations showed these bizarre speeches from start to finish.)

But a funny thing happened on the way to a worthless dollar. We didn’t get there. Disinflation took hold in the 1980s thanks to abrupt then-controversial and now-legendary changes in U.S. economic policy, and gold prices collapsed although with a lag as it took gold bugs a while to realize disinflation was for real. With inflation having stayed relatively low since then, the inflation-hedge case for gold has been dormant. There are, or course, professional worriers who’ve been insisting every step of the way that disinflation wouldn’t be sustainable, but not nearly enough of them to drive the spot price above $400.00 for more than a few brief periods. And if a broken (non-digital) clock can be right twice per day, then surely the domestic inflation hawks ought to wind up looking correct at some point before the end of eternity, but this is not what we look for when trying to build a credible investment case.

Despite U.S. inflation still being a non-factor, as we saw in Figure 1, the price of gold suddenly took off in the late 2000s. It’s possible that inflation elsewhere in the world may be driving gold. But this is not a shoo-in: there has seen inflation in various parts of the world in the 1980s and 1990s but that didn’t cause gold to soar. It may be that now, inflation expectations, as opposed to here-and-now realities, are taking center stage and that many fear the dollar and all other paper currencies, while viable today, are about to go into the tank. Indeed, one of my uncles recently called me to ask about putting all his assets into gold after hearing just such an analysis. But further inquiry on my part revealed that this came from a company that wanted to make a profit selling him bullion and then a bigger profit charging him for storage. (I told Uncle Stanley to tell the salesman to get lost and that if he really wanted a stake in gold, to buy GLD and with only a small portion of his assets.)

Interestingly, inflation in the U.S. remains very much under control and a case can be made that it’s too much under control, to the point where price rigidity is choking the economic activity we need. Inflation is more a concern elsewhere, but we’re not seeing the sort of problems we saw in Latin America and East Asia at various times in the late 1980s and the 1990s, and even China is making headway in trying to head off a major inflation problem before it really gets going. So again, we can’t connect gold’s recent rally to that of the 1980 era, when here-and-now inflation was headline number one.

Let’s back off a bit from the gold-inflation connection (we’ll come back to it later, though). Like everything else gold prices are actually based on supply and demand. So with the help of some charts presented in the World Gold Council’s 11/17/11 Gold Demand Trends Report, let’s see if we can get some sense of what’s happening with supply and demand.

I’ll start on the supply side with Figure 5, which charts trends in the number of new gold finds.

Figure 5

This is not a measure of here-and-now supply, but an indicator of potential future additions to supply. Back in the late 1970s and around 1980, when inflation was troublesome in the U.S., gold soared as new finds were up and down. But as often happens, higher prices encouraged suppliers to buckle down and really get to work, so the number of finds increased. As also often happens, new supply comes into being well after demand has peaked resulting in downward price movement. Interestingly, though, in the late 1990s, suppliers seemed to catch the pulse of the market and actually increased the pace of discovery before and during the late-2000s price rally. But look what has been happening since the mid-2000s. With gold prices soaring, a time when you’d think every geologist on the planet would be picking away at every rock he could get his hands on, the trend in the number of new finds collapsed.

The recent drop in finds is very different from the one we saw in the mid-1990s. Back then, gold prices were lackluster and it’s easy to conclude exploration was not a high-priority endeavor. It is possible exploration may now be in low gear, but considering recent price trends, basic principles I remember from Economics 101, and common sense, I’m more inclined to guess that miners are searching like crazy but not finding as much. That is a situation that will have to be monitored going forward. We’ve long heard how the planet will eventually run out of oil, but to date, Joe Average has not been hearing about exhaustion of gold reserves. If this does become a more widely-discussed topic, GLD could be a nice ETF to own.

On the demand side, let’s begin with Figure 6.

Figure 6

Sources: World Gold Council, Thomson Reuters GFMS and LBMA

I started the vertical axis from zero (as my junior high school teacher taught was proper but which few do nowadays) in order to give you a sense of how flat the trend really is. If I used a logarithmic scale (i.e. if I could do it in Excel), it would look even flatter than what we see now. The sense of flatness is important. The next two charts will break down various sources of demand by percent. These will be stacked bar charts and although the vertical axes are, indeed, market shares, you can pretty much give in to a temptation you’re likely to feel to treat them as if they were tonnage figures.

Gold demand can be assessed in terms of three broad categories: technology, jewelry, and investment. These are summarized in Figure 7.

Figure 7

I’m not going to bother discussing technology-related (i.e. industrial) demand. Casual observation is sufficient to make it clear that this has not been driving trends in gold prices.

Our first impression from Figure 6 is that it’s all about investment demand, which seems somewhat correlated with historic price trends and which is consistent with what many of us have been assuming all along. But let’s deconstruct a bit.

Figure 8 shows where investment demand has been coming from.

Figure 8 – Investment Demand

Investment demand from North America, the region that played a big role in sparking the circa-1980 excitement (helped by the mid-1970s ending of restrictions that had inhibited direct ownership of gold by Americans), has been good, and a lot higher than a decade ago. Ditto Europe. The change from 2000 is particularly noteworthy. The absolute numbers now are not meaningfully higher than in 1980, but the uptrends seen in demand are comparably significant. Back then, the reality of inflation was a factor. That’s not so today. But that doesn’t mean we can relax about the economy. For one thing, fear of future inflation is arguably exerting upward pressure on gold prices. Given our budget deficits and the Euro mess, it’s easy to see why today’s fears are present. But there are also credible fears of recession or even depression and deflation, as many cite these as a likely consequence of tax increases and/or spending cuts (more the latter) being undertaken to address budgetary woes on both sides of the Atlantic, not to mention the social dislocations that seem likely to accompany such developments (which are already starting to be seen in the U.S. and elsewhere). So arguably, the economy-related case for gold has broadened. Once upon a time, gold was seen as a hedge against one particular dysfunction; inflation. Now, purchases may be motivated as a hedge against generalized economic fears, whether inflationary or deflationary. That could be important. One can build an argument against the recurrence of inflation. It’s a lot harder to argue against increased economic volatility.

What about demand from emerging economies in the Indian Subcontinent and East Asia? Are investors there being crowded out? Are they less interested in gold? Figure 8 might suggest that. But Figure 9 tells a different story.

Figure 9 – Jewelry Demand

Make no mistake about it: People in Asia are quite gold hungry. They may not be quite as enthusiastic about storing gold bars or owning ETFs that own and store gold bars, but they still like their gold. And having seen lots of gold jewelry in Chinese and Indian neighborhoods of Queens, New York, it’s easy to see why. This stuff is really striking! An interesting question is the extent to which these buyers are thinking in terms of inflation hedging (an understandable concern in those parts of the world) or other kinds of economy-related buying motivations, but in a more aesthetically pleasing manner (visually, a gold figurine trumps a brokerage web entry showing “GLD” any day of the week), as opposed to simply acting like newly empowered consumers who simply want luxury items. There are probably elements of both at work here.

So, we have increasing North American and European demand for gold based largely on fear. Remember, we don’t absolutely have to have bad data to bring this about. Fear about what may happen in the future is quite sufficient. In fact, the fear need not even be rational. But as long as the Euro is a mess and as long as Republicans and Democrats squabble so childishly over the very-much adult-level deficit problem in the U.S., it’s hard to argue with the fears that exist today. We also have rising demand from Asia reflecting some sort of combination of inflation fears (and in some cases, realities) coupled with newly-empowered consumers wanting to flex some economic muscle. And although there are challenges economically (Can China manage inflation without busting its economy? Can India chill the corruption and get serious about its economy?), there is long-term upside here which may bring still more people into the consumer class. (Besides Asia, will Africa ever wake up and will Latin America become more than the small-potatoes gold buyers than they are today?) And to top it all off, this potential for increasing demand is set against supply that has been flattish for a long time and may diminish unless mining-company geologists can do better than they’ve been doing lately.

There are no sure things here. We can never be sure about a major new boost in supply (Russia is certainly a question mark). And as a fundamental analyst, I continue to find it hard to be as comfortable I’d like with a thing demand for which is based so heavily on emotion and desire, rather than need. But the prospect of sharply escalating supply is based so far on talk, rather than data, and the emotion-desire thing has been going on for much of human history to the point where it seems unlikely that some sort of new Assembly of Global Humans is going to convene and agree that granite will replace gold as the new coveted inflation, etc. hedge.

Admittedly, some gold bugs come off as being annoyingly kooky (like people who make tin-foil helmets to protect against alien radio waves tapping into their brains). But that’s just an image thing. There’s much to be said for rational gold bugs that study supply and demand, and follow economic and political developments. So perhaps a case can be made for inclusion of GLD in a diversified investment portfolio, despite its recent correction, or even perhaps because of it.

But GLD is not the only game in town. We can also own shares of gold-mining companies. They don’t move in lockstep with gold prices. But those that are able to increase production (by finding or obtaining new reserves or more aggressively exploiting the reserves that have) would seem able to outperform spot gold prices and GLD. Not all companies can deliver in this regard. Indeed, as noted, global supply trends are iffy. But vast differences can arise when we look at individual companies and in my next article, I’ll show how stock screening can help us identify firms that have the potential to add luster to an otherwise worthwhile gold stake.

Source: The Case For Investing In Gold