A gold bubble still waiting to burst

A recent sharp dip in the gold price indicates the commodity is inflated way beyond its real value due to unthinking central bank demand and market speculation.

Gold is pretty – pretty useless that is. Why it gets a mention on financial news bulletins, why it is seen as a viable asset class and why it fuels passion from those thinking it has some underpinning for financial markets is difficult to comprehend.

To be sure, gold was first seen as a valuable metal a few thousand years ago when it was used to make coins and thus it became a medium of exchange. This trend has continued to this day where some coins are made from gold although very few of them are in circulation anywhere in the world. In other words, its value is as a novelty, not a medium of exchange.

The price of gold is underpinned because it is reasonably scarce or rather, it is currently difficult and therefore expensive to mine. The price is also supported by the demand from people who want to buy it and lock it up in a vault or an exchange traded fund, hide it in their undies drawer or bury it in a biscuit tin in the back yard. It serves no purpose in this form.

Of course, there is demand for gold from the jewelry market as it can be crafted into delightfully attractive rings, necklaces and bracelets. It is very attractive in this form, which obviously supports its price in a more fundamental sense. As a substance, therefore, it is like aluminium or steel, which can be crafted to make things like drink containers, window frames and car parts.

The massively inflated price for gold is a reflection of it being fashionable on the one hand, which seems legitimate, but in recent years there has been the ongoing perception that it is a store of wealth and while enough suckers believe this, its price is likely to stay high.

As with any item, the price of gold is determined by demand and supply. It is just another commodity and to that extent, it is little different from soya beans, tin or other commodities.

One issue the gold bugs rarely if ever deal with is what happens to its underpinning, hedge against inflation or store of wealth if there is a massive discovery of cheap and easy to mine gold? What if those people or groups with lots of gold in their vaults, such as central banks, rush to sell it? What happens to its value as a store of wealth, hedge against inflation of some other made up issue invented to justify its high price if there is a sudden glut?

It’s price would fall like a stone, like the price of any commodity falls when there is excess supply.

The vulnerability of the gold price has been evident in recent days where even a vague discussion of the US Federal Reserve ending its quantitative easing strategy and the Bank of Cyprus selling a tiny amount has seen the price drop from around US$1,750 an ounce in November 2012 to around US$1,500 at the moment.

It is hard to say how much the price would fall if the US Fed sold even half of its 8,133 tonnes of gold, or if the Bundesbank in Germany sold half of its 3,391 tonnes of gold holdings. It would be a bursting a bubble that would make the Nasdaq tech-bubble crash look like a picnic.

According to the World Gold Council, the ten largest holders of gold – that is central banks – currently hold an estimated 21,400 tonnes in reserves with total central bank holding estimated to be around 31,600 tonnes. That is just the central banks!

New mine production of gold is around 2,400 tonnes a year, while a further 1,400 tonnes is recycled – the melting down of old jewelry and trinkets that adds to fresh supply.

Use of gold in jewelry and in manufacturing is estimated to be around 2,600 tonnes a year. An additional 500 tonnes or so is used in manufacturing and other industrial usage, which means very simply that there is an excess supply of gold, by a large amount, from what might be termed true demand.

The reason for the price surge over the past decade or so is that there has been a frenzied demand for gold for “investment” or speculation reasons. In the five years until the end of 2011, this investment demand rose by 534 per cent, a frenzied bubble of demand that clearly underpinned the price.  

What happens when these investors sell their holdings? 

The price of gold is at the current elevated level because there is demand for jewelry and some manufacturing but more so because there are enough people buying it thinking it is a store of value or a hedge against some disastrous event.

Gold is also a dud for other reasons. Very simply, gold is expensive to hold. Either it has to be insured against theft or one must have elaborate security in place to stop the thieves. It is also a dud because in investible quantities it does not earn any return – no interest, dividend or rent. In other words, it needs to rise a good 5 to 7 per cent a year, every year, to cover direct costs and opportunity costs of cash in the bank.

Making the gold price issue all the more complex, is that much of the turnover in gold is on paper – its traded in a futures market where the turnover is many multiples of all the gold ever mined. Its price can be influenced and distorted by derivative traders and punters and has nothing to do with its true value.

Does that sound familiar with other derivatives blowing up from time to time?

If you want to buy gold and hold it – go for it! 

I would say the same for those wanting to buy soya beans, pork bellies, iron ore, wine or fine art. Good luck to you – I hope you make lots of money. But for me, I’ll be sticking to something that has a stronger underpinning and is an important part of the real economy.