Gold’s seven-year performance is nothing short of amazing. Since 2005, bullion investors have enjoyed a return greater than 250%. Investors who made the move to bullion would show a compound annual growth rate of 14.56% on their investment capital in a period where the S&P500 index returned less than 2.8% annually, including dividends.
So is gold a good investment? Can the shiny yellow metal continue its secular bull-run? And how can you value gold to find a fair-value price-tag?
Finding Gold’s Real Value
Commodities are priced solely on supply and demand. Finding a value for a commodity like gold is more difficult than assigning a value to a future stream of cash. We have to determine whether or not demand for gold will continue to outpace supply at lower prices by evaluating sources for gold demand.
Data compiled by Gold.org shows three major sources of gold demand from 2007-2011:
- 55.3% Jewelry
- 32.7% Investment
- 12% Technology
From the data above we can conclude that most gold produced and sold is never actually consumed. Gold used in jewelry or held as an investment can be recycled, reused, and returned to the market at any given time. Companies like Cash4Gold have made a killing doing just this.
The other 12% is mostly consumed in electronics. Some is recycled, sure, but in industry it is often more expensive to recycle tiny amounts of precious metals (usually less than 1 gram) to resell. Prices simply aren’t high enough yet. Instead, this gold finds its place in landfills and garage sales all around the world, never to be recovered.
Betting on Others
Simply looking at the major sources of demand for gold tells us that gold is a bet on a few things:
- Jewelry demand – Is there any reason to believe that this demand will change considerably? I find it unlikely. A trip to your local jeweler can confirm that mark-up, not gold, is responsible for much of the cost of a new piece of jewelry.
- Other investors – As nearly 1/3rd of all gold demand is from investment interest, gold is highly-speculative. Gold tends to rally on fear and risk-aversion. If gold investors suddenly want 10% more gold, demand for all gold increases by 3.27%. This simple shift in demand can vastly affect prices, since neither jewelers nor tech companies really “feel” the pinch of rising gold prices relative to the total cost of their products. Investors push other investors out of the market, not jewelers or technology producers.
- Technology – This part of the demand equation is not price-sensitive. Newer electronics make use of trace amounts of gold – a new laptop is estimated to have less than one-half gram. A half gram is equal to $25, which when included in the price of a $500 laptop is hardly a consideration. As electronics makers all have to use gold, this cost is passed to consumers with ease.
Who Controls the Gold?
A 2011 year-end report of above-ground gold stockpiles notes that 50% of gold is held in jewelry, and 19% in investment portfolios.
Notice a few things about these numbers:
- Most gold can be returned to market at a moment’s notice as it is nearly pure in the form of jewelry or .999 pure in the form of bullion coins and bars. Keep in mind that all gold known to exist is equal to 40 years of 2011 mining and recycling production. So, if 69% of all gold is held as jewelry and investment, there exist roughly 28 years’ of mining and recycling in the hands of people who own gold jewelry or bullion as an investment. Thus, if 1/28th (3.5%) of all gold held above ground were sold on the market in the next year, one-year supplies would double.
- Investment demand from 2007-2011 is running at a pace well in excess of historical norms. If investment made up 32.7% of demand from 2007-2011 yet only 19% of all gold ever brought to surface is held as an investment. We can conclude then that investment interest in the last 5 years is 50% higher than the historical average.
Playing it Safe
Since we know that investment demand is a major driver of gold demand and market prices, anyone who invests in gold should understand that the investment is not without speculative risk. Sustaining gold’s high price requires consistent investment demand well into the future.
I find it difficult to believe that investment interest can stay high forever. As it takes only a small shift in investment demand to start driving up the price of gold, it takes only a small decrease in investment demand to send gold prices lower.
Given the historical ratio of gold held as an investment to total gold outstanding, it’s safe to say that investors are drunk on gold. For how long can investors continue to purchase 32.7% of all gold brought to market, and when will we see a reversion to the historical mean of 19%?
If you truly believe you can predict the future demand from investors, gold makes for a great trade. Otherwise, it’s safe to say that gold is a virtual Ponzi scheme – a large part of demand is speculative, and thus it will be speculators that drive future market prices. No matter the real inflation rate, the reality is that it is investors who define gold’s price tag.
Readers, are you bullish or bearish on gold? Do you think it will revert back to a more historical pricing and demand?
A value investor and blogger who enjoys discovering the hidden gems available on the public markets.