In the second of a two part series on the factors driving gold demand, Julian Phillips looks at the investment segment of the market and the effect of traders on prices.

Author: Julian Phillips
Posted: Monday , 14 May 2012

JOHANNESBURG -

Investment demand - emerging world

While western jewellery demand reacts very much to the state of the developed world's economic states, emerging world demand for ‘jewelry' sits on the border of decoration and investment. Thus, we prefer to look at it as investment demand.

In much of the emerging world the number of people in the middle class has rocketed where economic growth is such a powerhouse that it is enriching their entire societies. For example, eventually the middle class of China's population of 1.3 billion people will reach 400 million or so. This equals the population of the U.S. in its entirety. Most of these believe that gold is an ideal form of saving for a rainy day and buy to hold for the long term.

With each of them having a totally different view of the financial system to their developed world counterparts, this source of long-term demand will prove, over time, an overwhelming driver of the gold price, almost equal in power to the central banks demand for gold.

The difference between the two is that central banks, we believe, will eventually want to control the gold market and may in select nations feel it imperative to take their own citizen's gold from them and into the national vaults.

Right now the Chinese government is encouraging its citizen's to buy gold [while making exports illegal] for themselves. Its support is also seen in the development of the Chinese gold distribution networks in that country, through the banking industry. It can now, freely import, distribute and sell gold to its people.

China's appetite for bullion continues to grow. Gold imports by China from Hong Kong increased to 63 tonnes in March from 40 tonnes in February, according to the Census and Statistics Department of Hong Kong. Chinese demand is not as price sensitive as Indian demand [see below] but we summarize the two and emphasize that the sensitivity is related more to volatility than its price level. If it were so then the buyer of gold at $300 in 2005 would be saying that at $1,600 it should no longer be bought. But as a new high is reached and stability achieved, thereafter, at that new price, back into the market they go, looking at the price rise since 2005 as a clear demonstration that it has the ability to keep rising.

Investment demand in the developed world

While the developed world has a sophisticated set of financial markets the emerging world has only had that for the last few years. In China they still have a way to go before they equal the financial skills and infrastructure now seen in the west. In India the financial system has not been able to achieve the sophisticated levels of the west. The inherent distrust in government and its attendant bureaucracy has created a ‘cash' society, independent of the banking system that thrives. Gold is an inherent part of that system. The trust that we see in the west, in their financial systems, is just not present in the emerging world. That's one of the prime reasons why gold is so favored.

That trust in the financial system is one of the prime reasons that gold is not such a favored investment in the developed world. It requires no financial skills to make it earn income or develop a profit-making entity. It is a cold, lifeless, object outside the reach of the entrepreneur. It is insurance against the failure of capitalism and its paper money. That's why we have seen a switch from gold derivative buying to the metal itself.

To emphasize the point, an investment in a Gold Exchange Traded Fund is an investment in a quantity of gold held in a bank against which shares are issued. The fact that it is unallocated gold makes it a profit-seeking investment. As you can see in the table, investment in gold Exchange Traded Funds fell to 25% of its 2009 level this year. Investment in coins and bar gold has doubled. Holding allocated gold, or gold coins, or gold bars takes it out of the financial system and gives it that quality long-term gold investors seek. As doubts about the banking system and debt linger, this trend may well grow. The above figures tell us the story.

We expect this trend to continue and to swell in line with the growing doubts about the financial system in the years ahead.

Add this to emerging world and central bank demand and you have the three main price drivers in the years ahead.

They are enormous, relative to declining supply factors of re-cycled gold and barely growing, newly mined gold supply.

Impact of traders on the gold price.

Traders are solely profit-oriented. Their task is to push movements either way to maximize profits. It doesn't matter if they are dealing in gold, pork bellies, soya or silver. What counts is the extent of price movements. They are made powerful in that they represent moment-to-moment buyers and sellers. If you counted the number of transactions they make to those of a long-term investor, the latter become irrelevant to the day-to-day price movements. Traders call the shots on a daily basis.

But traders are not crusaders for a cause. They are, at best, fickle and uninterested in the fundamentals. Fundamentals count to them, simply to describe the tide, in the picture Technical Analysis paints. If today prompts them to ‘short' the market, they will. And tomorrow the picture tells them to go ‘long' of the market, they will. They are not investors. But they do cloud the picture. Today, they may react to the European elections and the price of the euro against the dollar, and this also changes on a day-to-day basis. Tomorrow the next important piece of news will affect them differently.

But as the long-term buyers take up all the available gold on the market, the Technical picture reflects this and will tell traders the way to go.

COMEX officials tell us that only 5% of its trades lead to the physical delivery of gold. An example of the impact traders can have, the COMEX recorded an unusually large transaction of 7,500 gold futures [750,000 ounces or 23.24 tonnes] during one minute of trading at 8:31 a.m., New York time this last week. The sale took out blocks of bids as large as 84 contracts [8,400 ounces] in one fell swoop and cut prices down to $1,648.80 an ounce [from $1,663.00]. The overall transaction was worth more than $1.24 billion. This smelt like one trader seeing a chance at a quiet time in gold's day to try to squash the gold price. In the past when the gold price was far lower, at $300 an ounce, traders drove the gold price up to $390, then down to $326 afterwards.

Today, this would be far more difficult due too the increasing demand from central banks [in particular on a daily basis] and to emerging world tidal demand narrowing supply and demand, considerably. The present danger to a trader is that he will be caught ‘short' and be forced to pay more than he sold for as he covers his position. The huge trade recorded on COMEX appears to have been successful [if it is now closed?], because central banks will simply wait for the appearance of an offer of physical gold from the market before buying on the dip. Traders have to reinforce their COMEX trades by precipitating a fall in the physical market price or they may not create a fall in the price. If they can't then the price may turn against them. That's why we saw heavy, sloppy sales at the quiet time of gold's day. That was the ideal time to impose downward pressures. But the next day we have seen repeated bounces in the gold prices as the stock sold was bought by equally large, if not larger investors at a busier time of the day.

If Indian buyers see the lower price as an opportunity at say $1,600 and Chinese byers follow through, they too have the ability to squeeze the traders and force them to cover their ‘short' positions and to go ‘long'. This will turn the price back up rapidly. It has the capacity to create an explosive rise in the gold price.

A look at the gold price this decade, rising from $275 to a peak over $1,900 shows what is possible over time. Traders have enjoyed the ups and downs of the gold price all that time, but never fought the trend. We expect this pattern to continue. As of now we are reaching a conclusion to the consolidation period that saw an over $1,900 gold price achieved and a pullback to $1,600 seen thereafter. As we see in the trends described in the GFMS figure for the last three years it is clear that there may well be an explosive breakout upwards, should the gold price retreat below $1,600.

Julian Phillips is the founder of www.GoldForecaster.com / www.SilverForecaster.com

Source: http://www.mineweb.com/mineweb/view/mineweb/en/page103855?oid=151341&sn=Detail&pid=102055