IS THE GOLD WINDOW
OPENING UP AGAIN?
Robert Lutts, President and CIO
Les Satlow, CFA, Portfolio Manager
December 31, 2007
“It was a crime to possess gold from 1933 to 1975.
It may be a crime NOT to invest in gold from 2007 to 2010.”
INTRODUCTION
Gold investors suffered 20 punishing years of weak price performance (see “Spot Price of Gold” chart), with
the price of a troy ounce falling from a hysteria-driven peak of $870 an ounce in 1980 to a dot-com
boredom price of about $250 in 1999. Meanwhile, the stock market’s benchmark, the S&P 500, chalked up
15% annual returns from 1980-2001, while gold’s annual return over the same period was a loss of about
2.5%.
However, since bottoming out in
2001, gold has turned in a shining
performance over the past six years,
with the spot price rising more than
300% to $784 at the end of
November, 2007, or about seven times
the S&P 500 return over the same
period (including dividends).
This paper briefly discusses the
supply and demand fundamentals for
the physical asset – gold. We argue
that there is likely to be strong
demand for the foreseeable future,
driven by the rapid increase in
demand for gold as a viable asset class
and by the gradually rising
consumption demand in the Emerging
Markets. Global production will take five to ten years to increase output materially, aside from a one-time
jump in 2006. The most prominent risk to this scenario will come from the elasticity curve: higher prices
could hamper demand growth. We witnessed this elasticity effect on the jewelry demand in India in 2006
(see more detailed elasticity discussion below). In addition, should the Emerging Markets—India and China
in particular—falter, demand would fall significantly.
SUPPLY AND DEMAND
According to the World Gold Council (WGC), global demand for gold in 2006 was 3,386 tons, which is
slightly lower than the 3,556 tons of supply that came on the market during the year. What makes the
supply/demand fundamentals of the gold market so interesting is the breakdown (see “Supply and
Demand” charts). The vast majority of usage—more than two thirds of the bullion—is for jewelry. And
what many investors don’t realize is that the leading jewelry consumer for gold is not the US, but India,
which alone accounts for over 20% quarter of all gold jewelry sales. America comes in second, followed by
China, Turkey, and Saudi Arabia.
These trends are discussed in
greater detail below.
Of the 3,556 tons of supply,
mines supplied about 2,100
tons, which represents over
90% of production levels seen in
1997. The remainder of the
supply comes from the official
sector—central banks selling
into the market—as well as gold
scrap sales.
By contrast, consumption of
tonnage in 2006 was 3,386,
down 20% from 1997. This is
due primarily to lower demand
from China (and the rest of Asia)
and the Middle East following
the Asian financial crisis and
very low oil prices in the late 1990s. This has begun to turn around somewhat over the past three years,
with estimated jewelry demand growing in China by 22% from 2003 to 2006. The Middle East jewelry
demand, however, declined by 13% in the same period. In the recent history, 2004 was a noteworthy year,
in that demand outstripped supply by 162 tons. Were it not for strong central bank selling, the imbalance
would have been much more severe. The situation was the same in 2005 and 2006: without central bank
gold sales, demand would have outstripped supply by 470 and 181 tons, respectively.
Not surprisingly, South Africa is the lynchpin of global supply: according to the US Geological Survey, the
country holds 40% of the world’s 90,000 tons of underground gold reserves, and produces about 350 tons
a year, or 15% of global output. Following South Africa are the US, Australia, and China. However, output is
slow to increase: mining is extremely labor and capital intensive, and requires significant regulatory
hurdles before full-scale production can come online. In addition, low levels of capital investment over the
past ten years will limit the industry’s ability to ramp up production in the immediate future.
A CLOSER LOOK AT DEMAND: Surging Consumption and Investment Interest
There are two major drivers of demand that we would like to highlight: growing wealth in the Emerging
Markets (EM) and the “Asset Class Revival” effect.
Emergiing Markets’ Demand: In Jeopardy? As
mentioned above, Emerging Markets’ demand for jewelry
over the long term should in theory help the global growth
for gold, although in the short term the higher physical
price will take a toll on tonnage demand. The “Share of
Gold Jewelry Demand 2006” pie chart illustrates the
dominance of India, China, and the Middle East (where
Turkey and Saudi Arabia dominate), which together
consume half the world’s jewelry gold. The blistering
growth rates of those countries, as well as their deep
cultural affinity for gold, have combined to produce a
three-year (2003-2006) annual demand growth rate of 8%
in China and 11% in India in spite of soaring bullion prices.
In addition, the Chinese government began to liberalize its control over gold production and sales in 2003,
allowing foreign companies to enter the market with Chinese partners and sell gold. The US embassy in
Beijing noted in a 2003 brief that this would stimulate gold sales in the country and “ease the shortage of
gold supply for jewelry in China.” Indeed, from 2002 to 2006, jewelry consumption increased from 235
tons to 275 tons, a jump of 17%.
The Middle East is another area that investors need to
watch carefully as a barometer of gold demand. The per
capita jewelry demand in the Gulf (i.e. oil exporting)
states is dramatically higher than in the West—the UAE
in 2002 consumed 31 grams per capita, versus 1 gram
per capita for the US, for instance (Dubai’s nickname is
“the City of Gold”). The region as a whole (including
Turkey) accounted for 13% of global jewelry demand in
2006. With oil prices at current levels, it is reasonable to
assume that a healthy portion of an increasing mountain
of “petrodollars” will find its way from “black gold” into
“yellow gold.”
Of course, it should be noted that gold demand will be
very sensitive to economic conditions in the emerging markets. Asian consumers responded to their
collapsing markets in 1997-1998 by dramatically reducing their consumption of gold—total Southeast
Asian jewelry demand fell a whopping 46% in a one-year period. Turkish demand fell 34% during its crisis
in 1998-1999. During 2002, a poor monsoon season and higher gold prices in India resulted in a sharp
decline in jewelry demand (gold down 20% year-on-year).
In addition, the price of gold itself clearly depresses –
and has depressed – demand: jewelry demand in 2006
fell 16% from 2005 and was 29% lower than the
comparable 2000 figure. This should not be surprising,
since the dollar price of gold rose 134% over the 2000-
2006 time period and the laws of economics dictate
some sort of demand destruction response. The gold
price, which has been exacerbated by a sharply
deteriorating dollar versus most foreign currencies, has
risen less in most currencies than in dollar terms (only
half as much in euros as in dollars!), but marginally so
in India and China, whose yuan currency is tied to the
US dollar for now.
Investment Demand: Back in Business. Gold as an investment is where all the excitement is these
days. As an individual asset class, gold is gaining attention but still is largely neglected. Typically, major
Wall Street houses lump it into either the Basic Materials sector (mining stocks) or in the “hard assets”
category, which mostly favors Commodities like oil and gas, and real estate.
However, there is a case to be made for the inclusion of gold as a class on its own. Gold has a correlation
coefficient of 0.008 to the S&P 500 from 1976-2005, indicating that there is no meaningful correlation at all
between the two, and therefore provides a powerful tool for risk-reducing asset allocation within at least
the two-asset-class framework. The metal also benefits from the perception that it will gain value in an
environment of inflation or US dollar depreciation, or geopolitical instability. So, far during this current
cycle, then, it appears to be functioning according to the playbook.
Given the strong performance of gold and precious metals over the past five years (the Philadelphia Gold
and Silver Index posted a 133% return from 2000-2006), capital flows are likely to continue to enter the
segment, creating a possible snowball effect given the relatively small size of the investable gold market.
Perhaps the best example of this is the meteoric rise
of the two exchange-traded funds that track the
price of gold bullion, the StreetTracks Gold Trust
and the iShares Comex Gold Trust. StreetTracks
launched in November 2004 with $13 million in net
assets: by December 2007, the ETF reported that its
assets had exceeded $15 billion. The latecomer
iShares gold ETF launched in January 2005 with $6.4
million in net assets, and as of December 2007 has
$17.6 billion.
Now let’s put it all together: we’ve got falling
demand for jewelry in recent years due to the higher
price of the bullion, and soaring demand from
investors seeking shelter from a weak US dollar.
Thus we illustrate the paradox of gold prices from a
supply and demand perspective. As the price of the
bullion rises, demand for consumption is likely to be
restrained, keeping overall consumption down. On
the other hand, higher gold prices attract hordes of
investors seeking the metal for the reasons
mentioned above. Our analysis shows that there is a
60% correlation between the change in investment
tonnage and the price of gold over the past seven
years. Recent data from the third quarter of 2007 also
supports this thesis: investment demand skyrocketed
72% from a year ago, as the price of bullion rose 14%
during the quarter alone and the dollar sank over 5%
against the euro.
For now, jewelry remains the dominant determinant
of demand, and is likely to remain so for the
foreseeable future, given that is nearly 90% of overall
demand. Still, our belief is that there could be a
groundswell of demand from the investment
community for exposure to the physical commodity. It
may surprise many investors to learn that gold bullion
has “outperformed” the S&P 500 in the past six.
Consider the following scenario: frustrated with
lackluster and increasingly volatile US equity large-cap
returns, US stock funds make a miniscule shift into
gold, say 0.1% of their $7 trillion in assets. This
translates into $7 billion in additional assets scrambling to be deployed into gold. At current levels, that
would represent an increase of about 10% in global demand for bullion. Bearing in mind that $1 billion
represents about 47.3 tons of gold (at $800/troy ounce), and that mines produce only 2,500 tons per year,
the math becomes very simple: every $5 billion in new investment demand for bullion will soak up nearly
10% of total annual mine production, which struggles to pull more gold out of the ground in the best of
times.
So, why will the demand for gold as an investment class rise? Two reasons: first, it has tacked on
spectacular investment performance over the past seven years. That alone is usually sufficient to attract
droves of investors who chase performance. The second reason is related, but more suitable to long-term
investors: the main US equity benchmark, the S&P 500, has recouped much of the lost ground from 2000-
2002, but no longer has the post-recession earnings acceleration to drive share prices much higher in many
areas of the equity market. A sustained sideways large-cap equity market will leave investors no choice but
to seek as many substitute asset classes as possible in their quest for higher returns.
GOLDMINES OF INFORMATION
1) World Gold Council. An industry-sponsored site that offers a wealth of information on supply and demandstatistics for gold, as well as informative discussions on gold-related topics ranging from history to how a gold mine operates. www.gold.org
2) Goldsheet Links. A good source to track the price of gold and other metals, as well as a good starting point to investigate global mining companies. www.goldsheetlinks.com
3) US Geological Survey. www.minerals.usgs.gov/minerals/pubs/commodity/gold The home page of the Gold Section of the USGS. Useful statistics on gold production and a link to the monthly Gold update report (for a list of all mineral surveys, go to: minerals.usgs.gov/minerals/pubs/commodity/mis.html
4) The National Mining Association. www.nma.org/statistics/pub_gold_silver.asp Poorly updated, but links to an interesting interactive gold price chart: www.nma.org/enumerate/gold/gold.htm
5) The Gem & Jewelry Export Promotion Council. Industry-sponsored web site with good statistics on the state of the global jewelry import/export business.www.gjepc.org/gjepc/gjepc.aspx?inclpage=Uinfo_St_Statistics§ion_id=6"
The views expressed represent the opinions of Cabot Money Management and are not intended as a forecast,
a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. There can
be no guarantee that Cabot Money Management will select and hold any particular security for its client
portfolios. Earnings growth may not result in an increase in share price. Past performance is no guarantee of
future results.
Any advice or suggestions are provided for informational purposes only and is not a solicitation to purchase
any investments or services described herein. Please consult your advisor to determine if an investment
strategy is appropriate for you. Past performance of either the domestic or international markets or any
specific investments is not predictive of future results nor will diversification alone protect from loss.
Email this Article to a Friend 
Printer Friendly Version