Tuesday, June 29, 2010

Key Indicators To Watch For Gold Prices

Over the past ten years gold prices have shown an inverse relationship to jewelry demand, although it is often assumed that jewelry demand drives higher gold prices. Interestingly, net retail investment is a far better indicator of gold prices than jewelry demand, while human irrationality also plays an important role. See the following post from Expected Returns.

One of the hardest things to do as an investor is to think through investments without presuming anything. The data will tell a story and paint a picture for you that you can then interpret. Most people shun this obvious approach to investing and instead choose to invert the process by allowing their assumptions to cloud their analysis. This is simply not a sophisticated approach to investing.

A combination of history and quantitative data analysis will give you a perspective that 95% of investors do not have. For example, most people alive today have not lived through the gold exchange standard, and therefore have no clue how it functions. To most, it is a peculiarity of our ancestors; a relic of the past; and a product of a crude economic system. They cannot imagine the possibility of gold playing a role in the global monetary system. Their knowledge of history is small, and so is their sense of economic possibilities.

It is presumptuous to assume that gold will not eventually play a role in the international monetary system since it happened before in history. It is also presumptuous to assume sovereign nations will not default since sovereign defaults are prevalent throughout history. Most of the anti-gold arguments are based on assumptions that simply aren't true. Here are a few.

Jewelry Demand?

It is incredibly difficult to argue with someone who pulls the "jewelry demand" card on you. Why? The jewelry demand argument is so false that its defenders are invariably a special breed of stubborn. You can never win these kind of arguments.

Now as investors, let's test the assumption that there is some kind of relationship between jewelry demand and gold prices. As you can see below, if there is a relationship, it is a negative one.

If you invested based solely on an assumed relationship between gold and jewelry demand, you would have lost money 9 out of the past 10 years. While the data suggest we should change our assumptions, most people won't. This is the irrationality of human nature at play that allows a minority of investors to profit.

Investment Demand, Anyone?

The real demand is coming from institutional investors, retail investors, and governments. Chinese, Russian, and Indian central banks have recently become major buyers. This is a positive trend for gold since these governments hold so small a percentage of their reserves in the form of gold. Since the dollar dominates foreign reserves, diversification into gold is equivalent to dumping dollars.

Retail investors have also begun to protect themselves from spendthrift governments. Objectively speaking, retail investment is a far better indicator of gold prices than jewelry demand.

Marginal Demand, Human Irrationality, and Gold

A fundamental tenet of economics is that humans act rationally. Why I have no clue. Nothing in my experience has shown that people act rationally and to their best interest at all times.

Understanding human irrationality is central to understanding the future price movements of gold. For example, are people more likely to buy gold at $250 dollars after 20 years of being the most hated asset in the world or at $2500 dollars? You don't see lines around the block at gold shops at bottoms; they are an indicator of tops. This is a reflection of both gold's unique marginal demand characteristics and the nature of bubbles in general.

The marginal demand aspects of gold run contrary to those of most other assets. Generally speaking, a rise in price results in a decline in demand. For gold, a rise in prices results generally in an increase in demand. This is its natural state. Add to the mix human irrationality and the panic buying that is bound to come and you start to understand that the monster moves in gold are still ahead.

Financial experts are telling us the gold trade is crowded. Ironically, gold will become a crowded trade only when the "gold bubble" experts start buying. Not to be flippant, but this is one of the top 3 indicators I'm looking for to signal a top in gold. Fortunately, the gold bubble experts are still out in force expounding on the threats of deflation- an argument so riddled with holes that it should not be taken seriously. Making linear comparisons between fixed exchange and floating exchange systems is like comparing apples and oranges: It makes no sense and it is bound to result in flawed conclusions.

We should all try to test our assumptions against facts. That most investors don't is great news for gold bulls. We are on the precipice of a major move in gold that will make all blind assumptions concerning gold look foolish.

This post has been republished from Moses Kim's blog, Expected Returns.

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