Ever since I started buying gold in 2003, people have been concocting stories about why it’s a bad investment and why every pullback is indicative of the top. None of these stories has had much merit, but they all need to at least be explored. The latest thesis goes something like this: gold is a bubble driven by investment demand. Jewelry demand is in free-fall and when investment demand eventually reverses, it will crush the price of gold. The main tenet of this thesis is that gold investors are playing some sort of ‘greater fool’ game. The hedge funds are buying it now and pushing up the price. Then when retail investors are lured in as buyers, the hedge funds will sell out and stick retail with rapidly depreciating gold investments.
This is a compelling thesis and to some extent it is true. Investment demand is driving short term swings in the gold market. In early January, we saw investment demand go in reverse. When the Streettracks Gold ETF (GLD: NYSE) sold off 1.8 million ounces during January, the price of gold declined nearly 10%. However, I think this misses the larger point. Investor demand is fickle—it has upswings and downswings. Over time, investor demand will fluctuate, but let’s ignore it for now. Investors aren’t the true buyers. The real demand is still coming out of jewelry.
I’ve always believed that you can manipulate statistics to show whatever it is that you want. Over the past five years, in total ounces, jewelry demand has indeed been in decline. That is the story that gold bears want you to believe. They want you to think that this is an investor driven bubble of sorts. However, when you turn the numbers around, you see that jewelry demand is more than healthy. It is growing rapidly.
Do jewelry buyers go to a store and ask to see an item that weighs a certain number of grams? Of course not! They have a spending budget in mind and they ask to see something near their price range. As metal prices have gone up, buyers get less metal per dollar spent. This is the reason for the decline in gold ounce demand from jewelry. When the price of a commodity increases 5-fold in a decade, people become price sensitive. The fascinating thing is that as emerging economies get wealthier, they are buying a whole lot more jewelry in dollar terms. This is the key to remember. As long as the dollar size of the purchases continues to increase, the jewelry component of the gold market is quite healthy.
Hypothetically speaking, if gold ever dropped from $1350 to $1000, demand should increase by at least a quarter more ounces assuming that the dollar demand stays constant. In economics, when something drops in price, people usually purchase more of it. What if demand increased by 40% instead of just 25%? Suddenly, the recent decline in jewelry demand is reversed and there is a massive increase in ounces purchased. There is a floor caused by the jewelry market. At a certain gold price, jewelry would represent 100% of total production and completely squeeze out investment demand—even with no demand increase due to lower prices.
The moral here is to ignore the bears, ignore the doubters and explore the math that they are using. To say that the demand in ounces has declined in the past 5 years is disingenuous. Total purchases in dollars have increased significantly. Ignore the swings in investor sentiment. Gold is a commodity like every other commodity. Over time, it should trade at a moderate premium to the marginal cost of adding production capacity which is $1100 to $1250. As investors, we have to stop fixating on the Federal Reserve or the tin-foil-hatters out there. Too many people combine gold with the geopolitical. Just treat it like a commodity whose cost of production has roughly tripled in the past decade and is supply constrained. Focus on the supply, the demand and the marginal cost of production. Everything else out there is noise.