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GOLD: Understanding the Changing Fundamentals of the Most Misunderstood Commodity

|Includes: CEF, GDX, GDXJ, SPDR Gold Trust ETF (GLD), SLV
Gold, like oil, is a commodity and most people try to mistakenly value gold in the same way they value oil. It seems that the popular consensus is that gold is an inflation story as gold is historically a store of value. After all, central banks are printing huge amounts of paper to fund government sponsored stimulus and deficits that have no end in sight. I believe this is true to some extent as any real asset will increase in price when there is increasing dollars chasing a fixed or declining supply of that asset. This can explain the recent run-up in commodity prices that seem to move in lock step with the falling dollar. The market is signaling that when helicopter Ben stops blanketing the world with free money by raising interest rates, thus, curtailing inflation, this will mark the end of the commodity (and gold) market’s rally. This is shown by gold’s precipitous decline following a perceived positive jobs report that caused a spike in the Fed Funds Futures.  I do not believe that gold will continue this current relationship with the dollar and expect gold to completely disconnect from this paradigm in the near future and rise regardless of the direction of the dollar. I feel that gold is poised to significantly outperform inflation in the next several years.   
Gold is Money 
To understand how to price gold you must understand gold’s use to the world. Quite simply, gold is money. It is a medium of exchange that has preceded every currency including the almighty dollar. As I said before, oil is also a commodity like gold. Oil is energy just as gold is money. However you cannot value oil in the same way you value gold. Oil is consumed while gold is (largely) not. It is highly likely that a piece of gold that was mined 2000 years ago is still around today. It can be fashioned into jewelry or pounded into coins and bars but is inert so it cannot chemically react with any other element. This is just one of the many unique properties that make gold the perfect metal to be used as money. It has substitutes just as oil does – gold’s silver to oil’s natural gas. Gold does have industrial use in electronics and dentistry but this only makes up about 10% of demand (we will discuss this in further detail later). Oil’s price is based on basic principles of supply and demand. Its demand is derived from the need to consume energy for all types of things, such as heat and fuel. As oil related products are consumed they are gone forever, demand is satisfied and the cycle continues. Since gold is not largely consumed, its demand is based on much different principles. 
Demand for Gold
Units in tons
As shown by the charts, demand for gold comes from three main sources: Jewelry, industrial & dental, and investment. Historically, jewelry has accounted for around 70% of total gold demand with investment only accounting for <20%. Over the past three years, demand for gold as an investment has steadily taken up more of the gold demand pie. Further, gold’s price has been increasing in the wake of declining Indian demand for gold jewelry, which is the primary driver of aggregate gold jewelry demand.   As a smaller and smaller percentage of gold’s demand is derived from jewelry and industry, gold as an investment has become the primary driver for the price of gold. 
Does not include purchases from central banks.
I believe this trend conveys a fundamental change in the demand for gold. After decades of being removed from the gold standard society is coming to the realization that a fiat money system is doomed to fail. In the absence of the discipline of the gold standard, when money can be created out of thin air, there will be an eventual collapse of the fiat currency as central banks race to print money to solve economic problems. With no end to bail outs and stimulus, these measures are only acting to reinforce the imbalances that lead us down this road so we can expect more bail outs and more money creation. This is leading both central banks and private citizens to hoard gold in preparation of complete failure of fiat currency (or a return to the Gold Standard). This trend is supported by events such as the Chinese allowing citizens to purchase gold for personal investment and countries such as India, Sri Lanka, and China buying up IMF gold and gold mining companies. 
I believe the price of gold is going to massively surge to new levels in the next few years primarily driven by new investment demand by both private citizens and central banks. The fundamentals of gold have changed from that of the past decade. The bear market in gold that began in the 1980’s, after the peak, experienced reduced demand for investment. These were relatively peaceful times both politically and economically. The world began to believe that a fiat money system could work and gold was not a necessary part of their portfolios. Starting in 2001, after the September 11 attacks many people began to feel uneasy about the potential for an outbreak of major wars. Further, the economic policies pursued by the Bush and Obama administration can be perceived as an all out war on our currency. This has lead people to by gold in droves for fear of total collapse of the dollar.  This fresh new source of demand is going to sop up every ounce of gold that is mined or sold off by the IMF or other Central banks. Production of gold has been flat or declining for the past decade and will severely lag this new demand. This will propel the price of gold to new heights as increased demand cannot be met by a declining and under capacity gold mining industry. 
The Gold Bubble?
Every time gold reaches a new all time high there is talk of it entering the bubble area. Based on these new fundamentals I discussed gold is not even close to a bubble as the average person drastically under owns gold. ‘Sell your gold’ commercials that are flooding financial programs are sure sign that many people still don’t understand that gold is money and they should be exchanging their dollars for gold and not gold for dollars. The smart money is buying gold for fear of the inevitable destruction of paper money. The final rush for gold will come when faith in the fiat money system has completely deteriorated and no one wants to touch paper money. This is when gold could be considered a bubble. By this time I predict there will be a massive restructuring of the global economy to a global currency or some alternative to the current system. 
The gold bull market has just begun. As central banks and private citizen’s rush to buy gold at the same time economic conditions around the world worsen, gold will reach new heights which will dwarf its current price. Since gold has been shunned for so many years, there have a lot of catching up to do. The buying of gold for investment will outpace the massive printing of money as private citizens and central banks readjust their portfolio weighting of gold. This is going to lead to a massive run in gold prices that will significantly outpace inflation. My recommendation is to get in early.   

Disclosure: Long CEF and various gold mining stocks.