| |
Gold Bullion the Nature of the Gold Bullion Market
|
|
|
CHAPTER THREE (A)
Humans have always equated gold with power, beauty and aristocracy. Gold, historically, has invariably been associated with the Gods, religious ceremony and, in ancient societies, with immortality. In cultures of limited development, precious metals were one of the few ways of advertising wealth and position. Gold was sought and dedicated to the glorification of both gods and rulers.
Gold is twice as heavy as lead and so dense a mere cubic foot weighs over half a tonne. The very characteristic that makes precious metals precious, their density, also makes them cumbersome to store. The Federal Reserve at Fort Knox is built on bedrock and if it were not the gold could not be stored above waist height.
Unlike base metals, which enjoy a sustained growth phase only in the early stages of a society’s or a nation’s economic development, gold mining and demand for its production is still a growth industry.
Gold has no seasonal production, is not influenced by inventory levels and also is not subject to extensive international controls over demand and supply.
Many people see gold as less of an investment and more as an insurance policy that pays off when other investments fail or falter.
THE 11 "Cs" The 11 major "Cs" influencing the price of gold are:
- Commodity price levels
- Consumption patterns for gold jewelry
- Currency changes and trends
- Continental and country changes in economic growth patterns
- Current account trade deficits
- Central bank holding and hedging loans
- Conflict and crises (economic and political)
- Consumer inflation
- Contrarian nature of gold
- Constraints on owning and trading gold
- Canadianization of the world gold mining industry as well as mineral exploration and development funding.
GOLD BULLION — MYTHS AND REALITY
"The obvious is always the least understood."
– Prince Metternich
"Many investment truths and precepts remain untested and cross the line between partial and incomplete truth to ideological dogma."
– Paul Samuelson
For many gold bugs and analysts, illusion is more comfortable than reality.Assessing the supply/demand equation for gold by considering only investment demand and ignoring fabrication demand is akin to forecasting the demand for diesel fuel by collecting the data on bus consumption and ignoring trucks.
Gold analysts and gold bugs regard the metal as a currency of last resort, this causes them to spend a lot of time talking and writing about it. In reality, it is a small market, smaller than the North American sand and gravel market and with only a few direct economic implications.
Once the perfect haven in any storm, political or financial, gold’s function as a call option on calamity has been reduced in recent years.
By the mid 1980s, it was already losing its lustre as:
- An asset class
- Store of value
- As a safe haven, except in the short-term
- Form of insurance
In the process, it has been transformed from a hoarded asset to a tradable commodity. As time progresses, investors see it less and less as providing insurance and diversification within a portfolio and more and more as an asset class to be traded at various phases in the economic commodities and stock market cycle.
THE CHANGING ROLE OF GOLD
"There is no future in living in the past."
– Sparky Anderson
In ancient societies, gold served two major purposes: As instruments and idols in religious services and ceremonies as well as a means of displaying wealth. At various times in history, it was also a form of currency. The arrival of the industrial revolution led to increased mining supply and alternative ways of displaying wealth causing gold’s function as an indicator and sign of wealth and power to steadily decline.
Over the past 200 years, gold assumed the mantle of a bet against your fellow man and their governments, thereby giving the investor a stake in disorder, inflation and political and economic instability. In essence, a call option on calamity.
In the mid 1980s, gold lost much of its function as a hedge against inflation, political adversity and instability. Its function in society as a store of value and as an alternative currency was reduced to the point that it became more of a temporary safe haven.
Major changes in the supply/demand equation, international currency structures and trade regulations coupled with the introduction of risk transferable financial instruments, such as derivatives, helped transform it from a hoarded asset to a tradable commodity. In this transformation, it has returned to its original form as decoration jewelry as well as a display of conspicuous consumption.
GOLD BUGS
"I would rather be a gold bug than a paper worm."
– Nicholas Deak
"You shall not crucify mankind upon a cross of gold."
– William Jennings in seeking nomination at the Democratic Convention in 1896
Gold is very much a religion, as well as a market and as John Maynard Keynes described it, “Always a part of the apparatus and ideology of conservatism.”The typical gold bug is a cheerleader for the price of gold, seeing each falter in its price as a sign of conspiracy on the part of Central Banks, even though the latter have a stronger vested interest in high gold prices than any other stakeholders. Gold bugs yearn for a return to the “yellow brick road” of the Gold Standard.
Psychologists tell us that we tend to see the world the way we are, not the way it is. This is particularly true of gold bugs, who see gold primarily as a currency and ignore the basic underlying supply/demand characteristics of the jewelry fabrication sector. Goldbugs have been described as “Dooms Day survivalists” hoping and praying for the collapse of soft money currencies at the demise of which they hope to obtain a front row seat insured by their gold bullion holdings.
The typical gold bug’s faith in gold is so strong that he has a tendency to buy and hold and never sell, while the gold “perma-bears” miss out on the large profits that accrue to the astute active gold traders and speculators in gold stocks by never joining the party.
GOLD CYCLES
Since gold was deregulated in 1971, it has demonstrated apparent eight year cycles from low-to-low and high-to-high.
The cycle lows began in 1977 and in 1980 the cycle highs kicked in. If the cycle were to repeat, a major high would occur in 2004 and a major low in 2009. Given that gold bullion is in the early stages of a secular bull market, this scenario has little chance of repeating.
As it would take at least100 years to determine whether or not there was regularity and repetition of such a cycle, the eight year one is merely of academic interest to investors at this stage.
Ever since the price of gold was freed from its fixed price of $35.00 an ounce, it has formed a 68 to 70 month cyclic pattern from high-to-high and from low-to-low.
The first cyclic low occurred in 1977 and the first cyclic high occurred in 1980. If the same pattern were to persist,which is highly unlikely, the first six months of 2004 would form a cyclic high and 2009 would provide a cyclic low, also highly improbable.
Since the price level of the trade weighted U.S. dollar is the most important factor determining the price of gold, we need to keep a close eye on that currency.
Currencies, once they begin a new trend, tend to stay in that trend for years at a time. Since the early 1970s, the U.S. dollar has experienced two declines of eight to10 years and two counter trends of five to six years. A continuation of this pattern or trend would lead to a downward trend in the U.S. dollar that would only end between the years 2008 and 2010.
In the traditional economic and business cycle, the U.S. would be the first country to recover, followed by the rest of the world. The current recovery in world trade began in China and India and, in the process, dragged Japan and South East Asia out of recession.
If, or rather when, the U.S. dollar can no longer provide and act as a world currency, the transformation could prove painful as it did for the pound/sterling in the post World War II period. This could cause a gold bull market in terms of all currencies as occurred in the 1976 to 1980 period.
GOLD SECULAR BULL MARKETS AND PHASES
Ian Notley – Cycle Expert – May 29, 2001 – Commenting on the gold bullion double bottom on the April 2001 chart:
"Gold has moved in a secular downtrend for the twenty-one year period of 1980 to 2001 in U.S. dollar terms and is now forming a secular and cyclical bottom phase."
Gold and gold stocks tend to under perform when there is a major secular bull market in paper assets, but come into their own in the late stages of economic expansion and at the onset of recessions.
Over the past 300 years, there have been six great secular speculative surges in paper financial assets, each time gold has been pushed to the background by such speculation. As the inevitable decline in speculative paper assets occurs, gold is restored to the forefront, invariably creating a three year bull market for gold and gold shares.
Over the past 25 years, every time the Federal Reserve has ended its interest rate “easing cycle”, a gold bullion rally has occurred. Such rallies can also create major turning points for gold bullion. These “Fed End of Easing Rallies” tend to be the most predictable and enjoy the longest duration and highest amplitude of any type of gold rally. Several of these rallies have been so strong and pervasive over 30 month periods that they can be classified as gold bullion bull markets.
Gold prices often do well once a major correction in the equities markets has occurred, as investors expect the Fed to prime the monetary pump to reverse short term economic contractions. Once and if, the stock market gets back on the rails, gold reverts back to its long-term trend.
For instance, in the 1977 to 1980 period, gold bullion appreciated 700% and between June18,1994 and April 6,1995, the Financial Times Gold Index gained124%.
There is a lot of truth in the old investment maxim that in the early stages of any sector bull market, one should be an investor and in the later stages a trader. Once the bull phase of the market is over, it becomes time to pull in your nets and to go for casting. In the initial phases of a gold bull market, only a few “elite” stocks move; these stocks tend to have excellent fundamentals and growth prospects. When all gold stocks are appreciating, it is an early warning that it is time to consider profit taking.
In the early stages of any mining securities sector bull market, look for companies that have made major changes to operating costs, expanded capacity, reserves and resources. In the early 1980s, Inco made dramatic improvements in mining productivity at its various mines but the stock did not reflect this. When base metal stocks began their cyclical upswing, however, Inco was the first stock to surge and went further and faster than other base metal stocks.
Gold bullion prices tend to move more like a staircase than as an escalator, except at major cusps or trend junctures. At such turning points or trend changes, rapid percentage gains are often made in gold mining securities; which in turn feeds momentum; which then attracts a crowd to the sector; thereby creating a large universe of trading opportunities throughout the sector.
In gold mining securities bull markets, the cusps or turning points often occur in the first half of the calendar month, while in declining markets changes in short term trends tend to occur in the latter half of the month.
There is always a bull market somewhere. While gold bullion outperforms the general market in only two out of 10 calendar years, there are often mini bull markets in other precious metals, such as diamonds and platinum group minerals, based on specific sector supply/demand dynamics, as well as new discoveries and new regions for gold exploration opening up.
GOLD – ELASTICITY OF DEMAND AND SUPPLY PRICE ELASTICITY OF DEMAND (PED)
Economists define the sensitivity of demand for a specific commodity or product in terms of the ratio between a percentage change in the price to the percentage change in demand. If a 1% change in the price causes a 1% change in demand, price elasticity is defined as one.
Gold jewelry fabrication demand has one of the highest price elasticities of any commodity. A 1% change in price causes an increase or decline of 2.6% in demand, this contrasts sharply with gasoline, where a 1% change in price causes a mere 0.2% change in demand.
Jewelry fabrication demand is very sensitive to short-term price increases in bullion, but once prices stabilize at a higher level the demand tends to return slowly.
Fabrication demand increased from approximately 1,000 tonnes per annum in the 1970s to over 2,000 tonnes in 1991 as disposable income increased and new markets in developing countries were opened up by deregulation. Demand reached over 3,000 tonnes in the late 1990s, but as gold prices appreciated, fabrication demand fell to close to 2,700 tonnes, its lowest level since 1994.
In each year since 1987, when the price of gold bullion declined, jewelry demand increased and vice versa. This is the main reason for predicting an “escalator” longterm upward trend for gold instead of the “elevator” price escalation that occurred in the 1970s when jewelry demand was a less significant factor in the Demand/Supply equation for gold bullion.
GOLD DEMAND
The World Gold Council categorizes four separate demand forces for gold:
- Jewelry Fabrication
- Retail Investment
- Industrial & Dental
- Institutional Investment*
(*Investment by high net worth individuals is not included.)
The WGC estimates that their survey covers 95% of world demand.
Gold demand, unlike that for base metals, has been in a long-term secular growth pattern; growing for centuries at a steady 1.75% per annum rate.
INVESTMENT DEMAND
Individual or retail investment demand is still lower than industrial demand, while non-monetary demand has almost doubled in each of the past two decades and investment demand has remained relatively stable.
GOLD DEMAND AND SUPPLY
Gold and oil are good examples of commodities that have gone through dramatic changes in the geography of both supply and demand.
Over time, as market structures and boundaries change, new market characteristics develop and emerge and in the process, new geographical regions and economic classes become both consumers and producers.
As for all commodities and currencies, demand is much more important than supply in determining long-term secular price trends. Mining and industry analysts tend to study and emphasis supply because it easier to measure than demand. In the short run, however, supply disruptions such as strikes or political turmoil can have a major impact on prices.
While demand for base metals correlates 95% to changes in industrial output, gold bullion demand for jewelry correlates most closely with consumer confidence.
Supply is determined less by annual mine production as it is by above ground inventories.
Unlike platinum and silver, which tend to be consumed, gold inventories are extremely large in relation to annual mined production.
THE CHANGING STRUCTURE OF GOLD DEMAND AND SUPPLY
In attempting to predict the future of gold and of the international gold mining industry, we need to assess a multitude of diverse and conflicting trends in demand and supply over different time frames. Over the past 20 to 30 years, significant changes have occurred in the supply/demand equation of gold bullion. The international gold bullion market over this time period has been expanded, globalized, commoditized and democratized.
The demand and supply of gold is as malleable as the metal itself. When real inflation rates decline, the gold price is determined more by its own supply and demand characteristics than by macroeconomics.
Speculators and hedge funds can be influential when demand for gold is high, especially when the U.S. dollar is weak; they have little or no influence when demand and supply prices are in stable balance,which causes the market to be driven by basic fundamentals.
The growing influence of Asia on gold tends to have a stabilizing effect. Unlike in the West, where people buy high and sell low, Asians tend to buy low and sell high.
Reginald W. Ogden
Canaccord Capital Corp.
****
This article is solely the work of the author for the private information of readers. Although the author is a registered investment advisor at Canaccord Capital Corporation ("Canaccord Capital"), this is not an official publication of Canaccord Capital and the author is not a Canaccord Capital analyst. The views (including any recommendations) expressed in this article are those of the author alone, and are not necessarily those of Canaccord Capital.
The information contained in this article is drawn from sources believed to be reliable, but the accuracy and completeness of the information is not guaranteed, nor in providing it does the author or Canaccord Capital assume any liability. This information is given as of the date appearing on the article, and neither the author nor Canaccord Capital assume any obligation to update the information or advise on further developments relating to the information provided herein. This article is intended for distribution in those jurisdictions where both the author and Canaccord Capital are registered to do business in securities. Any distribution or dissemination of this article in any other jurisdiction is strictly prohibited. The holdings of the author, Canaccord Capital, its affiliated companies and holdings of their respective directors, officers and employees and companies with which they are associated may, from time to time, include the securities mentioned in this article.
|
