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All Aboard the Gold Train

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Gold keeps barreling along like a Shanghai maglev train ahead of schedule, hitting new highs for the year -- and, increasingly, looking like it could break through it's all-time high any day now.  All this at a time when the dollar is surging against the euro and oil prices are under pressure.

Not so long ago, market pundits were claiming a strong dollar and a weak oil price would have the opposite effect on gold, pushing the yellow metal lower.  Now, they're saying that risk-averse traders and investors are losing confidence in the euro and are running to the greenback and to gold as safe havens in uncertain times.

More on Gold ETFs

In large measure, as noted in my last NicholsOnGold post, the influx of money into gold exchange-traded funds, is fueling gold's advance and has supercharged its ascent.  By facilitating gold investment for individuals and institutions, we are seeing significantly more investment demand than would otherwise be the case.  Never before, has it been so easy for so many to buy gold.

As of Friday, February 13, the eight major gold ETFs traded on stock exchanges around the world were holding some 1432 metric tons (46.1 million ounces) on behalf of investors, of which 985.9 tons (31.7 million ounces) were held by the New York Stock Exchange traded SPDR Gold Shares trust.  By today, February 17, the SPDR Gold Shares trust had grown to 1,008.80 tons (32.4 million ounces) -- an astounding increase of 228.6 tons (7.3 million ounces) or 29 percent from the end of 2008.

Gold bugs and gold bulls are enjoying their time in the sun.  Rightly so, but many are ignoring the clouds that could rain on gold's parade and brake its upward climb.  Importantly, the ease of investing in gold via exchange-traded funds could be matched, in the future, by the ease of disinvestment.  Just as quickly as gold-ETF depository holdings have grown so might they shrink when sentiment changes.

Sentimental Surprises

Don't get me wrong: I firmly believe that gold is going much, much higher in the next few years, to levels that many think unimaginable.  But market's do not go straight up for long . . . and, when everyone is jumping aboard, watch out for surprises.

In the current world economic climate -- where things seem to be coming apart at the seams the only thing certain is continuing uncertainty -- economic and investment expectations are volatile and sentiment can shift suddenly.

Judging from media accounts, investors and traders have been reacting to:

  1. News that eastern European economies are in worse shape than previously thought and western European banks with big loans to the former east-bloc countries are in great jeopardy.
  2. The Obama-Geithner plan to shore up the banks and credit markets along with the stimulus package passed by Congress and just signed into law by the President. The plan could cost some $2 trillion on top of the $787 billion stimulus package.  Some gold investors think this is only throwing good money after bad while others are worried about the longer-term inflationary consequences of this government bail out.

Tomorrow . . . or next week . . . or next month, when (or if) the eastern European lending crisis is somehow patched over . . . or investors feel more comfortable with the progress in righting the U.S. economy,  there may be a suddent abatement of investment demand in gold ETFs -- and a wave of selling could quickly push the metal much lower.

Modeling Gold

It's instructive to consider a two-sector model of the gold market:  In one sector, the ordinary forces of supply and demand for gold as a commodity operate.  High prices bring forth more supply and, at the same time, constrain non-investment demand for high-value-added jewelry popular in Europe and the United States as well as the low-value-added jewelry bought throughout the Middle East and Asia both for adornment as well as investment.

In the other sector, gold is bought and held exclusively as an investment, diversifier, and hedge asset.  Here, demand is a function of inflation, currency stability, financial market performance, geopolitical considerations, etc. in the key geographic markets.

Unlike ordinary demand (for gold as a commodity), investment demand, for long periods of time, is positively correlated with the metal's price.  In other words, a rising price trend tends to attract more investment buying until which time prices become so much above or below equilibrium that suddenly investment demand shifts into reverse.

Looking at the situation today, high prices are eliciting a surge in secondary supply in the form of scrap from old jewelry that holders are selling back to the market.  Last year, old scrap from jewelry and industrial recycling totaled roughly 1000 metric tons (32 million troy ounces).  This recycled gold is melted and refined into good-delivery bars, indistinguishable from new mine production or central bank sales.  The increase of recycled metal coming from the price-sensitive markets of India, the Middle East, Turkey, and elsewhere will likely amount to hundreds of tons this year, a sizable quantity that can feed much of the investment demand we are seeing for gold ETFs, bullion coins and small bars.

On the demand side, gold jewelry fabrication and retail sales in the United States, Europe, and elsewhere is falling sharply in response to falling incomes, rising unemployment, and job-market uncertainty.   Worldwide gold jewelry was about 2,400 tons (77 million ounces) in 2007, fell to some 2000 tons (64 million ounces), in 2008 -- and is likely to fall further this year, by my reckoning, to perhaps as little as 1500 tons (48 million ounces).

Be Warned

The rise in scrap supply along with the decline in fabrication demand may explain why gold has not already broken through its historic high into virgin territory.  Be warned, however, that these trends also suggest the price is more vulnerable to a drop off in investment demand -- so an easing of investor interest could bring a sizable, though I believe temporary, correction in the yellow metal's price.