Sunday, December 13, 2009

THE GOLD MARKET: The Players, Part I

The recent strong upward push and rapid decline in the dollar price of gold should provide some grounds for thought. I wouldn’t say concern. Gold is the place for safety from concern.

I decided that this survey might be helpful after seeing and hearing some people respond to the recent gold price movements. They were looking at the market solely from their own perspective and couldn't understand why the market might go down or what it meant regarding their own purposes. By knowing that there are other perspectives and purposes in this market a gold investor can get a better feel for his position and what movements in the market mean to him.

The point is to understand about the recent up and down in the gold market is that it is made up on many different elements. The market is thin enough that nearly any of those elements can drive the price when the mood strikes them. In this case, I think that we have seen a certain speculative group, short-term buyers and sellers move the market. My reasoning is that the fall took place on news, more than rumor, but news that offered a glimmer of economic recovery. It was just a glimmer. The people who sold were taking profits or decided that there was no prospect of immediate profits.

The profit motive is different from the safety motive. If you are thinking profit but also safety in some fashion, your thinking may be confused. Safety from the dollar means that as the dollar depreciates, you maintain your purchasing power by being in gold. There is no profit. In fact there is a lack of profit. Buying gold, regarding it as a currency, is like the late-18C miser who put his savings in the mattress. It didn’t earn him anything. Fortunately for him, it tended to increase in purchasing power during that period. Buying gold means that you believe that the dollar will depreciate faster than the return of any actual reasonable investment over the next few years.

There is a way that you could be increasing your wealth vs. the dollar without there being price inflation or as much price inflation as your gold holding has appreciated. The value of gold should compensate for the expansion of the money supply, inflation. No matter what your view of what price inflation in the U.S. has been over the last twenty years, the money supply has expanded faster. Along with the expansion of our domestic money supply, we have exported hundreds of billions of dollars every year for twenty years. This wild expansion is what has and will fuel the rise of gold. We will see that as well in the fall of the dollar, which as fallen by over a third in the last decade. A recent report on imports showed a nearly 4% increase in import prices alone (year to year). If the world economy heats up, increases in import prices will quicken, the dollar will continue to fall and this will fuel increases in the price of gold. All of this will be true before you add in any domestic price inflation. Thus, your gold investment will tend to gain more than your loss of purchasing power. This will happen regardless of what is happening now domestically because it is the result of the export of all of the dollars over the last twenty years.

In the near future I will discuss the different options that you have for putting your money in gold. I think that these different options relate to the level of risk that you see from the government and society.

But for this entry, I am going to discuss the different elements in the gold market and what influence they have on the market.

Probably the biggest, continuous element in the gold market is the jewelry industry, which includes, in a very broad sense of jewelry, the country of India. Aside from their general fascination of gold, they have traditions that create a large demand for gold during the “marriage seasons”, which are generally warmer weather periods. Up until this year, India was the largest importer of gold. Their demand has fallen slightly, due to the higher price, but they are still a steady constant upward pressure on the gold market. They are more likely to buy newly mined gold since they will melt it down and use it, consume it. Within India there is a large market for gold that has been used, which they will melt and reuse. We see a little of that industry in the U.S., consider the TV ads we have seen offering to buy gold jewelry.

Who is overtaking India as the largest importer? China. As their economy prospers their demand for quality consumer goods is also raising, including their desire for fine jewelry. Again this is consumer activity.

Use of gold for industrial use and jewelry reduces the supply. I don’t have the figures as to how much gold is taken off the market every year by these uses vs. gold production (about 2,500 metric tons). The actual figures aren’t really that much help. What you have to keep in mind is that these uses will continue and that they will reduce the availability of gold for safety purposes, and thus the price will continue to rise faster than you would expect as long as these two elements continue.

Industrial and jewelry consumption of gold will continue but they will be sensitive to price levels. At some price point, jewelry demand especially, will start to fall off. At some price point, jewelry will be melted and return to the world market. We will also see whatever gold is stored in jewelers safes reappear. When this happens, increased supply will begin to blunt the upward price pressure. To what extent will depend upon the general context at the time.

Industrial use is somewhat less sensitive to price. Usually, the amount of gold used in a specific product is very small and makes up a tiny portion of the overall cost of production. The importance of gold is very high in those products, often making the difference between performance and not. So, in those products, the gold price will not make much of a difference. There are other products containing gold that are more a consumer fad, e.g., gold covered sushi. As the price goes up these products and usages will be less popular. At some point we will see gold covered audio cables disappear from the shelves, but that won’t make much difference to the world gold price.

Another important element in the gold market is the professional trader. These are the people who make the market, who have traded in gold for years, or who have been selling gold to people for some time. I would say that they are becoming a smaller minority as time goes on. The diminution of their influence will be seen in wider price swings. They don’t necessarily have any ideological connection to the metal and may consider the market from a strictly technical perspective. They would tend to see the current market as over bought and consider the recent pullback as a much needed correction. They may sell gold short when the market goes up rapidly and would be a breaking force.

Next week, Part II

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