The Dynamics Of The Gold Market

|
Includes: DGL, DGLD, DGP, DGZ, DZZ, GEUR, GLD, GLDI, GLL, GTU, GYEN, IAU, OUNZ, PHYS, QGLDX, SGOL, UBG, UGL, UGLD
by: Matthew Allbee

Summary

Retail demand is a growing factor in the gold market.

The changing dynamics of this demand will be important for gold prices over the next few years.

In this article, I go over the ways in which retail demand has contributed to the run up in gold prices and why this demand has already reached its peak.

Since the gold standard was abolished in the early 1970s, academic interest in the gold (NYSEARCA:GLD) market has grown roughly exponentially. With all of this information available, it makes no sense to put yourself at a disadvantage by not harnessing it in your investment decisions. This has been, in part, a consequence of growing investor demand for the yellow metal. As you will see, retail demand for gold has grown significantly since it began floating freely.

In this article, I'll be exploring the findings of the 2015 paper "The Financial Economics of Gold – A Survey" by O'Connor, Lucey, Batten, and Baur. Their report is a review of the academic literature that has accrued over the past 40 years with regard to the growth in retail investment demand for gold. All images presented here are sourced from this research report, and any captions or credits accompanying those images appear as they did in source paper.

Retail Demand Growing

Click to enlarge

The reviewer found that retail demand for physical gold is quickly growing. What started as an expanding pool of safe-haven investments centered on the awareness of rising prices and investment risks from other assets exploded when the financial crisis hit. Demand has remained high ever since. Much of this growth in retail investment has occurred in Asian countries.

What Does This Mean?

Retail demand has become an important part of the gold market, and there is a belief that it may have been a large part of the reason behind why gold prices have risen fairly consistently since the early 2000s. If investment risk is the reason behind this growth in demand, and it appears to be, investor risk aversion will be an important factor in where gold prices go in the future. More simply, gold prices will likely rise if investors become more fearful as a general characteristic, and vice versa.

A recent study on risk aversion backs this belief. In it, they found that fear was likely the motivating factor behind increased risk aversion. This is important because fear will dissipate over time as memory fades and new participants enter the market. If they had found that risk aversion had increased because of, for instance, the sharp decline in prices bringing new information to the market about potential risks, risk aversion could remain elevated indefinitely.

This is important because we are now, or will soon be entering the period during which investors around during the financial crisis will begin to leave the markets and those who remain are starting to have their memories of the crisis fade. I'd expect this purging to take a very long time. It took decades after the Great Depression to sufficiently wipe the slate clean in much of the investing world.

There are already signs that investment demand is starting to falter. As you can see in the chart below, the holdings of gold ETFs peaked in early 2012 and have begun to decline. ETFs are a good representation of investment demand, because ETF holdings grow when the demand for them grows. From the chart superimposed on top of the ETF holdings, you can see that the two are very closely correlated.

Click to enlarge

Interestingly, this slowdown in gold-tracking ETFs occurred while retail demand for physical gold continued to increase. This leads me to believe that the types of investors in gold-tracking ETFs and physical gold are different. Since ETFs seem to correlate with market activity more strongly, I believe this shows that ETF investors are more likely to be engaged in markets, choosing to buy and sell gold on a speculative basis. Physical gold investors, on the other hand, are more likely to buy and hold for extended periods of time - meaning that they will have less influence on the market than regular traders. This seems to stand up to intuition.

Putting It Together

Retail, and all investment, demand for gold is an important factor in determining gold prices. While physical gold investors seem to be important in helping to create the overall trend of gold over the last 10+ years, more sophisticated investors are likely to have a more prominent impact on the future. Either way, it is likely that retail demand for gold has peaked for some time.

Disclosure: I am/we are long DZZ.

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.

Additional disclosure: The DZZ trade is a short-term Brexit bet.