Lessons From The Golden Bear

Includes: GLD, OIL, SPY
by: Eric Parnell, CFA

Gold has been a dreadful performer in recent years.

But following such a deep and prolonged decline, are we drawing close to the time to consider once again an allocation to gold?

Reflecting on the lessons from recent history are instructive in helping to make this determination.

Gold has been a dreadful performer in recent years. Since peaking at over $1900 per ounce in September 2011, the price has fallen by nearly -40% over the four years since. But after such a deep and prolonged price decline, and given concerns about the continued sustainability of the current bull market in stocks that is already the third longest in history at over six years, it is reasonable to consider whether it may be worth considering either a new or increased allocation to gold for portfolio diversification and risk control purposes. In working to draw any such conclusions, it is worthwhile to first evaluate whether it even makes fundamental sense from a supply and demand perspective to do so.

Assets including commodities and gold (NYSEARCA:GLD) are typically priced at the margin. And this pricing process is dependent on the forces of supply and demand. For if demand exceeds supply, the price of an asset will rise, as insufficient quantity of the product exists at the current price to satisfy the quantity buyers wish to purchase. Conversely, if supply exceeds demand, the price of an asset will decline, as producers will be unwilling to sell higher cost units at a loss. It is this key relationship between price, quantity, supply, demand and equilibrium that resides at the very heart of economics. Thus, it is worthwhile to evaluate gold in this context.

Put simply, if assets like gold are priced at the margin and if supply continues to exceed demand, we should have no interest in owning the metal. Staying within the commodities complex, this supply-demand imbalance was the primary reason that we saw oil (NYSEARCA:OIL) fall by more than -60% starting in July 2014, as supply began to meaningfully exceed demand. What has perhaps been more notable with oil since its bottom in March and its +40% rally since is that the supply-demand imbalance remains far from resolved at this point. So what then explains the rally in oil since March? It is at least in part because money from the financial markets from speculative investors is finding its way back into the asset class. This is an important distinction that we will revisit with gold.

Returning to gold, let us begin by reflecting on the price of gold over the last four years since its September 2011 peak. Surely, supply must have vastly exceeded demand over the past few years once the price had gotten so high. How else could we explain the dramatic price drop that we have witnessed in the years since September 2011? It is on this point where the fundamentals surrounding gold become most interesting.

The following is a breakdown of supply and demand data provided by the World Gold Council over the last several calendar years.

We will begin with 2012, which was a year when the price of gold effectively moved sideways after peaking in September 2011. During this calendar year, the global demand for gold was 4,470 tonnes. This included demand from various sources including fabrication for jewelry and technology, bar and coin demand, central bank net purchases, and holdings by exchange traded funds and speculators in the financial markets. Of this 4,470 tonnes in total demand, ETFs and speculators in the financial markets accounted for 279 tonnes of this total demand.

What about supply in 2012? The total supply of gold was 4,415 tonnes of gold from sources such as mine supply as well as recycled gold.

Putting these supply and demand elements together, we essentially had a gold market in 2012 that was effectively at equilibrium. And this goes a long way in helping to explain why the price of gold moved sideways that year.

Let's now move forward to 2013, for this is the year where things suddenly get very strange. According to the World Gold Council, the global demand for gold in 2013 once again 4,470 tonnes. In short, it was effectively unchanged from the previous year. As for supply, it was lower in 2013 versus the previous year to 4,282 tonnes, resulting in a shortage of gold totaling -118 tonnes in 2013.

Before going any further, let's reiterate what took place here. In 2012, the supply and demand for gold were virtually the same, and the price moved sideways. Makes sense. But in 2013, the demand for gold was 118 tonnes in excess of supply, yet the price of gold dropped like a rock in falling by nearly -30%. For anyone that has studied introductory economics, this is a most unusual relationship to explain. Demand has stayed the same if not incrementally increased, supply has decreased, yet the price falls by nearly -30%. Notable indeed. We'll return to this point in a minute.

Since the calendar flipped into 2014, we have seen a return to normal behavior. In 2014, the demand for gold was 4,236 tonnes while the supply was 4,410 tonnes. With supply modestly in excess of demand, we would expect to see the price of gold trending lower. And while it ended 2014 effectively where it started, it did spend much of the year trending lower following a strong start to the year.

As for the start of 2015, we have seen the demand for gold return to an excess of supply. According to the World Gold Council in the first quarter of 2015, 1,103 tonnes of gold were demanded versus a supply of 1,089 tonnes, which represents a modest shortage of 14 tonnes. And while the price of gold has been higher on net thus far this year, it is essentially flat year to date through mid June.

So What Happened In 2013?

We had a normal 2012 followed by a completely weird 2013 followed by a return to normality in 2014 and thus far in 2015. So what the heck was going on in 2013 that caused a -30% drop in the gold price when demand was running measurably in excess of supply? The answer lies among the ETFs and speculators in the paper financial markets. The following is the breakdown.

In 2012, the demand for gold totaled 4,470 tonnes. This included 4,191 tonnes of demand from the physical markets and 279 tonnes of demand from the paper markets. This was largely in balance with 4,415 tonnes of supply.

In 2013, however, the demand for gold once again totaled 4,470 tonnes. But this included 5,387 tonnes of demand from the physical markets. How can it possibly be the case that physical markets demanded so much more than total market demand? It was because the paper financial markets including ETFs and speculators were vomiting out demand at a remarkable -916 tonnes. So despite the fact that overall demand was still in excess of supply, the price of gold was cratering because the financial paper markets were spewing out gold in such an aggressive way. Imagine instead if paper markets did nothing other than hold firm at zero net demand in 2013. While physical markets might not have purchased as much as they ended up accumulating at suddenly lowered prices, it still would have likely led to a result where gold prices would have been substantially higher at the end of 2013 than they had a year before.

So What Now?

One could easily fill pages with theories and evidence of why paper financial markets were selling gold so aggressively and the price of gold fell so dramatically in 2013 at a time when physical demand was so vastly in excess of supply. But what's done is done. What matters more is what we can take away from this history in trying to understand what the price of gold is likely to do going forward. So let's us proceed in this manner.

In 2014, the demand for gold totaled 4,236 tonnes. And while selling in the paper financial markets continued in 2014, it was at a far more measured pace totaling -184 tonnes. And as mentioned above, this left a modest surplus versus the 4,410 tonnes of supply.

What about so far in 2015? The demand for gold totaled 1,103 tonnes in 2015 Q1. But what was notable about this demand total is that in included a positive 26 tonnes of demand from ETFs and financial markets. So in the first quarter of 2015, the demand for gold from speculators in the paper market was positive for the first time since 2012 Q4. Moreover, the supply of gold was 1,089 tonnes in 2015 Q1, which is also notable in that it represents the first net shortage of gold in the market since the first quarter of 2013.

Bringing It All Together

Two important transformations in the gold market - the positive demand from paper financial markets and the return of an overall shortage between supply and demand - are most notable to say the least. For they may be signaling that a return to more normal pricing conditions in the gold and precious metals market may finally be upon us after several very difficult years. These are two conditions that are worth monitoring in the months ahead to see if they continue. And recognizing that on net the cumulative demand for gold has been in excess of its supply since the price peak back in September 2011 suggest that upward pressure on the gold price may be set to resume at some point in the near future if this recent reversal sticks. Even with this, any sustained push higher in the gold price may not be immediate, as other forces like a strengthening dollar and a still rising bull market in stocks (NYSEARCA:SPY) are still at work. Pricing pressures, whether they are inflationary or deflationary, will also play their part. But gold is an opportunity that is starting to look more interesting today than it has over the last couple of years.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.