2009 was a good year for gold investors. The gold price increased by 24% in USD and by 21% in EUR. So far in 2010, this positive performance has continued in 2010 with the gold price gaining a further 13% in USD and 32% in EUR. Such gains raise the question of whether gold has entered overbought territory and whether a price bubble is forming.

I have often said that it is hard to regard gold as anything other than speculation: its economic applications are limited and it does not generate any form of cash flow. Its lack of intrinsic value makes it impossible to put a price on it, at least by conventional yardsticks. It only derives value from the fact that others find it valuable. The only way to make money with gold is to find someone else willing to pay an even higher price. To quote Warren Buffett: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

That said, there have been periods in history when buying gold has produced outstanding results. Between 1976 and 1980, the price of gold quintupled and in the last 10 years, it has gone from 300$ to 1200$. It is therefore interesting to look at the catalysts that favour higher gold prices.

Gold Price since 2000 (in USD)

Gold basically goes up when people lose faith in paper money. Broadly speaking, this is the case when they perceive that there is a high risk of rising inflation or when solvency risk escalates, i.e. when people fear that their bank is no longer trustworthy or that governments will no longer be able to repay their debt. Both these risks are prevalent in the current environment given the dangerously high levels of government debt. Gold is the currency of fear. It acts as a gauge for the health of the financial and monetary system.

It is important to note that given the small size of the gold market, it only takes a small number of investors to buy gold for the gold price to go up. The total amount of gold available for investment purposes (i.e. excluding jewellery and industrial applications as well as central bank reserves) represents about 0.5% of total global financial assets. Even a small increase in demand for investment purposes represents an amount of gold that cannot be met by mining or recycling, at least not in the short-term.  According to the Canadian research firm, the Bank Credit Analyst, a one percentage point increase in the share of gold in investors’ portfolios would be consistent with a tripling in gold prices from current levels.

Apart from rising inflation and solvency risk, two other factors are supporting the gold price.

On the demand side, there is the emergence of Asia where gold has greater significance than in the western world. Last November, India agreed to purchase 200 tons of gold from the IMF. China will have to continue buying gold if it wants to maintain its current share in terms of total reserves. If China decided to bring that share back to the level of 10 years ago (China’s reserves have grown so rapidly over the last decade that the share of gold in its total reserves has fallen), this would significantly boost the demand for gold. Central banks of other emerging countries also seem prepared to buy gold at market prices in order to diversify their reserves.

On the supply side, output from gold mines peaked in 2001 at 2,600 tons and has been drifting down since then, especially in the traditional producer countries (Australia, Canada, South Africa and the USA). This decline cannot be easily reversed. Peter Munk, the founder of Barrick Gold, has recently said that nobody realizes how serious the supply situation is, with large deposits nearing the end of their useful lives while new production is becoming ever more difficult and expensive. 

Because it is impossible to value gold using conventional metrics, analysts often look at the long-term relationship of gold with others assets or with economic variables. These include:

- the ratio of the gold price to the stock market. The ‘Gold/Dow Jones Industrial Index’ was 1 in 1980, the end of the last bull market in gold (Gold price: 850$, DJII: 850), fell to 0.025 in 1990 (Gold: 290$, DJII: 11,500) and has since risen again to 0.12 (Gold: 1200$, DJII: 10200). Some people think that this ratio could go back up to 1 again with the equity market losing half of its value and the gold price rising to 5000$ an ounce. It is important to note, however, that if one excludes the extremes, the ratio of gold to the stock market is currently more or less at its long-term median;

- the ratio of gold to oil. In 1973, one ounce of gold would have bought 42 barrels of oil. In July of 2008, one ounce of gold would have bought six barrels of oil. The current ratio of gold to oil is close to its long-term median;

- the ratio of gold to GDP. In 1980, the market value of the above-ground stock of gold relative to global GDP peaked at 25%. It fell to below 3% in 2002 and currently stands at 8%. Again it is important to bear in mind that 1980 and 2002 were extremes. If we compare the gold price to G7 per capita income, for example, we will find that this income is currently equivalent to about 40 ounces of gold whereas over the past 40 years, it has been equivalent on average to 60 ounces.

Finally, though gold has recently hit new highs in nominal terms, it is still nearly 50% below its 1980 peak in real terms, i.e. adjusted for inflation. To bring it back to that peak in real terms, a nominal price of 2,300$ per ounce would be needed. In this respect, it is interesting to see that commodities typically set new all-time highs on an inflation-adjusted basis during bull markets.

An investor looking to buy gold should however be aware that the gold price has now become highly dependent on continued investor interest. One of the properties that make gold attractive as a store of value - the fact that it is virtually indestructible – is also its weakness. Almost all of the gold ever mined is still in circulation today. Thus, even with stagnating or declining mining output, the amount of gold that could potentially come to the market is huge. According to the World Gold Council, a total of 11,125 tons of new gold supply entered the market between 2007 and 2009. This consisted of 6,402 tons from mines (gold production), 757 tons from central bank sales and 3,966 tons from the recycling of old jewellery into new gold products. During that time, only 7,646 tons were bought for the purpose of creating jewellery or for industrial and dental applications. The remainder was purchased for investment purposes. In 2009, investment demand thus accounted for nearly 40% of total demand, compared to 5% in 2000. The potential mismatch between supply and demand is even increasing given that jewellery and industrial demand is proving price-sensitive and is therefore declining because of the increase in the gold price (jewellery demand has fallen by nearly 30% between 2007 and 2009, industrial demand by 20%). There is also the possibility of some countries selling part of their gold holdings in order to consolidate their budgets. However, the fact that the Central Bank Gold Agreement, which stipulates that a maximum of 400 tons of gold per year can be sold by the central banks of the main industrialized countries, was renewed in August of 2009 for a period of five years should limit that risk. Finally, de-hedging of gold producers seems to be coming to an end (de-hedging reduces total mine supply).

To conclude, I do not think that a “gold bubble” is forming, similar to what happened (with hindsight) in 1980. Back then, the gold price increased by 80% in one month, fell back again, before going into 20 years of hibernation. By contrast, even though gold has risen a lot over the last years, there have been regular corrections of more than 10% and there has never been a parabolic increase in the price. This type of behavior is much more typical of a bull market than a bubble.

Gold Price between 1976 and 2000 (in USD)

Whether one thinks that this bull market is coming to an end or is still at an early stage depends on one’s view on the economic and financial situation. I started by saying that gold only derives value from the fact that others find it valuable. However, the same can be said about paper money. The integrity of paper money is now being questioned with more and more people fearing its implicit (inflation) or explicit (depreciation, currency reform) debasement. If the worst of the crisis is behind us, these fears should abate and investors’ interest in gold should wane. Otherwise, the future for gold remains bright.