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A Bearish View of Gold

 Over the last year, we have seen gold increase in price from approximately $1125/oz to a high last week of $1410/oz., a 25% increase, exceeding its ten year CAGR of 16.7% (a somewhat misleading figure, given that the vast bulk of this growth occurred in the last two years). This leads to the question of what causes the price of gold to continue higher and can a long or short case be made for gold? As you can tell by the title, I conclude that a short  case is the only rational position and that a tremendous number of investors (and, more horrifying, a vastly increasing number of individual retail investors) will be left bathing in a sea of red.

1. General Concept

An axiom of financial theory is that an investment’s value is the sum of its future cash flows discounted to the present. Adjustments can be made for the riskiness of these cash flows, in essence judging the expectation of actually receiving them, but the base case is that we project cash flows outward, then discount them back to today, summing to reach the intrinsic value of the asset. Value investors seek to pay less than that intrinsic value, fools pay more.

2. Gold’s Cash Flows

Gold has three categories of cash flows:

  1. The first and simplest is the negative cash flow from purchasing gold.
  2. The second category includes storage costs which are also negative. You pay to store gold.
  3. The third and most complex is the future positive cash flow from selling gold.

So, in the case of gold, the amount of the future positive cash flow must be greater (once discounted to today) than the sum of all of the negative interim storage costs (each discounted to today) and the immediate negative cash flow from purchasing gold. Moreover, the amount by which the discounted final cash flow must be greater than the sum of the discounted interim cash flows must be of such magnitude as to compensate for the opportunity cost of negative cash flows, otherwise it would be a relatively poor investment.

3. The Final Cash Flow

Let us now turn to what affects the final positive cash flow from the ultimate sale of the gold. Economics tells us that the equilibrium price of a thing is, at its base, reached by the intersection of supply and demand. When supply exceeds demand, the price falls until demand catches up. When demand exceeds supply, the price rises until demand declines or suppliers rush to increase supply.

3.a) Supply of Gold

Nearly the entire amount of all gold ever mined from below the earth’s surface still exists today. In other words, gold is not a material that is destroyed, like oil or natural gas. Gold is mined and refined and some portion of it is turned into items for sale, but it is not destroyed. The conclusion we can draw from this, knowing that gold production continues today, is that the world supply of gold is on an upward march and has been since the first ounce was mined. I should be more specific here, since the worldwide supply of gold is fixed (the sum of the below and above surface amounts) and say that the world commercial supply of gold (that is, the amount available for sale and affecting the supply/demand balance) is increasing.

By how much is the supply of gold increasing? When the price of gold is low, many mines are too expensive to operate and they are mothballed. These mines are too expensive because the amount of gold they produce for the amount of capital spent to produce that gold is not justified by the ultimate sale price of the gold. On the other hand, when gold increases in price, more of these financially marginal mines become profitable and are recommissioned (a process that has a long lead time, so despite the run-up in the price of gold over the last three years, the acceleration of production still has quite a bit of steam left). The conclusion we can draw from this is that, due to the high price of gold today, the commercial supply of gold is both increasing and accelerating as more mines come online and production at existing minds ramps up.

Another interesting thing happens when the price of gold increases. The supply of secondhand gold begins to increase as people seek to cash in old jewelry (and businesses begin recycling electronics and other items in order to recover gold). This gold had previously been sold and was effectively removed from the commercial supply. As the price of gold increases, it is added back to the commercial supply, due largely to the massive proliferation of gold buyers advertising everywhere imaginable, encouraging individuals to sell their old jewelry (often at a massive discount to the current market price). The conclusion we draw from this is that the recovery of previously sold gold begins to add to the commercial supply of gold as the price of gold increases.

To conclude this section, we can say that the supply of gold is increasing, and as the price continues upward, the supply will continue to increase at a somewhat accelerating rate.

3.b) Demand for Gold

An increasing supply of gold in itself is insufficient to lead to a decline in price. The price could remain steady if, for example, demand increased at an equal rate. However, if demand increases at a slower rate or if demand stays stable or if demand declines, then the price will decline to reach an equilibrium.

There are two categories of demand for gold: consumption-demand and investment-demand. Consumption-demand is derived from demand for end-products, such as jewelry, dental products, and electronics. Investment-demand is due to a belief that the final positive cash flow will exceed the sum of interim negative cash flows (all discounted to present) by an amount greater than an equal investment in a different asset.

The World Gold Council provides research data that help in identifying the relative amounts of consumption-demand and investment-demand for gold. These data are available here. From the charts on that page, we can see that jewelry consumption declined 20% from 2008 to 2009 and then an additional 5% Quarter on Quarter for 2010 Q2. Industrial demand, on the other hand, is up 14% QoQ for 2010 Q2, after a 15% decline from 2008 to 2009. However, Industrial demand  is just 1/4 the absolute size of jewelry demand, so it is somewhat less relevant than jewelry demand. Overall, what we are seeing is a slight decline in consumption-demand following substantial declines from 2008-2009. At best, we may see a slight increase, though it appears that stablizing demand is closest to what could be hoped for.

In contrast to consumption-demand, investment-demand has skyrocketed over the last few years. There was a 14% increase from 2008-2009, but a 118% increase QoQ 2010 Q2, with ETF demand driving this (414% QoQ!). With consumption-demand flat to possibly up *slightly*, we see that overall demand is being driven by investment-demand.

What can we conclude from this? Demand is being driven by investors who believe that the final cash flow will exceed the interim negative cash flows (all discounted to present) by an amount that exceeds the return found on other investments. Let’s be a bit more explicit about what the final positive cash flow represents: the final cash flow is a sale to another investor. How can we know this? By looking at the demand for gold and seeing that consumption-demand is flat. If investors rush for the exits, consumers of gold will not be picking up the slack. We are left with demand being driven by a belief that future demand will be even higher (which it must be in order to both compensate for the increasing supply AND justify the expectation of a return exceeding that of other investments, including those that actually generate positive cash flows!).

4. Conclusion

The conclusion I draw from the above is that, with supply increasing and demand driven by a belief that a future investor will want to buy at an even higher price (and, to be clear, that future investor must also believe in this), gold is unsustainable at present levels. Scenario 1 is that investment-demand is stable. This scenario will lead to lower gold prices, as supply will continue upward. Scenario 2 is that investment-demand declines. This scenario will lead to drastically lower gold prices for a period of time until supply begins to decline (as mines are mothballed and the gold recycling market declines). The only alternative to these scenarios is a short-term continuation of investors entering the market with the belief that future investors will pay more. This is no more sustainable than tulip-mania and will ultimately leave many investors worse off.

Read more: A Bearish View of Gold | Frankly Speaking 
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Disclosure: Short Gold