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Gold A Bubble? Fundamentally Not!

In the past couple of months during the usual summer doldrums there were a number of articles and comments of gold being a bubble. This was after the price of gold went from just above 700 USD/oz to almost 1900 USD/oz in just under 3 years, reaching it's peak a year ago beginning of September. This represented a solid 260% gain of a commodity even the IMF views as a marketable safe assets putting it in the same league with triple A bonds, thereby underlining once again the true function of gold and it's purpose of storing and protecting value. Along with it's other two functions, one being a medium of exchange the other being a unit of account/measure of value, gold first and foremost serves the role as money.

Confusion arises when gold is being viewed as a mere commodity and in consequence wrong interpretations are done, like when looking at the trend of the demand, or comparing price ratios between commodities.

However looking at the evolving structure of the demand trend of the past decade visibility and as such understanding becomes more clear.


The demand can be viewed as being comprised of two different types. On the one side the typical consumer demand in terms of jewellery and technological demand. One the other side the monetary demand, made up out of coins and bars for investment and also the demand coming from ETFs and the like.

More than 70% of the global jewellery demand comes from India, China, the Middle East and other Asian countries, that have far reaching traditions of buying jewellery and other forms of physical gold for the purpose of storing value. In the western civilizations jewellery is used mostly for aesthetic reasons. As such much of the global jewellery demand does also serve a monetary purpose. Yet in order to have robust comparison of the two demand types, I left the data as is and did not dissect further.

As can be clearly seen in the chart below, the overall consumer demand in physical terms has steadily retracted by a total of 20% over the last 10 years, which is about 593t of gold per year by the end of 2011. The total aggregated monetary demand per year by the end of 2011 amounted to 2148t of gold. This is a total increase of 2343t compared to the year 2002/3 which still had an overall negative figure of monetary demand due to sales coming from the so called official sector, i.e. central banks. Thereby the increase in monetary demand offset the decrease in ordinary consumer demand by almost 4 times.

Two things become visible here. Like a perfect economics textbook example of price elasticity, the consumer demand in physical terms is correlating negative towards the price increase of gold, with a factor of -0,05, whereas the monetary demand corresponds in a positive fashion, estimated at around 0,8. This underlines once again, that one needs to distinguish between the types of demand in order to understand the fundamental function of gold and what is motivating its price movements. From that follows the logic, that the increase of the price of gold is directly linked/caused by growing monetary demand, and the decrease in consumer demand is simply a consequence.

The argument that gold is a bubble that will burst due to decreasing consumer demand (jewellery) thereby does not hold any ground.

Taking it a step further I combined the two types of demand to a total demand and put it into perspective with the net supply coming from mine production to see whether the fundamentals over the years have changed. The net supply is made up of total mine production less producer hedging.

It is fairly obvious that fundamentally speaking the supply side of the market is now by far more stretched than it was a decade ago, when compared to the total demand. The reasons for the increase of supply lagging behind the increase of the price are manifold, and I do not want to go into the details at this point. Interested readers can find many good articles or studies on the internet covering the topic.

In order to be fair I also want to make provision for a potential counter argument, that might come to mind and can not totally be dismissed. That being that the gap between the overall demand and supply is continuously being bridged by recycled gold coming from the various sectors of demand. Technically speaking this is true, but on the other hand it does not change the fact that the gap between total demand and total mine supply on average is growing year over year, as can be seen in the chart below.

The net increase in demand is the calculated difference between the total demand and the net supply of gold coming from mine production.

The positive correlation of the net increase in demand to the POG is even bigger, showing a price elasticity on average of about 1,6. This means that with the price of gold rising the net demand increased by 1,6 times as much as the POG did over the last 10 years up until the end of 2011.

Again this does not look like a bubble to me. In the contrary, at some point one or the other has to give, and either the net demand (mid-long term) comes down significantly, which I for the reasons stated earlier but also due to the global financial situation simply do not see happening, or the price of gold will have to react and move up again.

With respect to technical patterns I agree that gold indeed did consolidate after reaching it's peak beginning of September last year, following an almost 3 year long more or less straight rise. This however is nothing unusual, anything else in fact would have been.

That leaves us with trying to understand or anticipate future demand from today's level.

The IMF published the Global Financial Stability Report in April this year, stating amongst others..

"The report probes the implications of recent reforms in the financial system for market perception of safe assets"

In the foregoing summary of chapter 3 of that report it states in the context, that "..heightened uncertainty, regulatory reforms and crisis related responses by central banks are driving up demand" for safe havens.

However the IMF also sees a potential reduction of "..some $9 trillion of the supply of safe assets by 2016"

Since even they do consider gold a marketable safe asset, as shown on page 89 of that report, the implications of the evolving scenario for the price of gold could be substantial.

Playing the numbers, this is what it could look like on the back of an envelope.

If just 2% of the $9 trillion diminished supply of safe assets would become increased demand for gold at today's price of about 1720 US$/oz, that would make 3255t of gold or 930t pa (3255/3,5) of additional demand on top of the current net demand. With the price elasticity of net demand being 1,6 that would give you a POG in the next year or two in the range of 2330 US$/oz or more.

Now these are just number games, and by no means am I able to foretell the POG, but it also does underline the current fundamental situation and advocates future higher prices, concluding that gold is a bubble today as it was 10 years ago.