I stopped off in Britain this week, en route to an investment conference in Moscow. I want to find out first hand what is going on in the world's cheapest emerging market.
The British are still basking in the afterglow of the London Olympic Games. The gold medals were the largest ever, in terms of weight and diameter – almost twice the size of the medals awarded in Beijing four years ago. But they were hugely debased in value.
This year, the Olympic "gold" medals contain just 1.34% gold. The rest is made up of silver (92.5%) and copper (6.16%). The medals may be prestigious. But their precious metal content is worth just over $500.
There was a time when Olympic gold medals were solid gold. It's typical of our time that the 2012 gold medals are bigger and more "in your face" than ever before. But they are also more debased than ever before.
It's also a reflection of the increasing value of gold when measured against the world's paper currencies. Gold hit a six-month high last month of $1,788 per ounce.
Gold is going to benefit from a further move of real (inflation-adjusted) interest rates into negative territory. There is a long-standing inverse correlation between real interest rates and the price of gold.
The Fed has clearly signaled that it will take its eye off its 2% inflation target and instead target jobs numbers – effectively declaring an open-ended money-printing program.
It is not alone. The Bank of Japan has dramatically upped its own QE program. And although it says it will sterilize any new issuance of paper money, the ECB has announced its own "no ex-ante" bond-buying promise.
This has led Brazil's finance minister to cry foul. He (rightly) claims that this avalanche of new money being emitted by the central banks of the world's developed markets is a de facto "currency war" – what you might call a race to the bottom of the world's paper money.
If history is any guide, QE3 will be supportive of gold. After the Fed announced QE1, the gold price rallied 35% over the next four months. And after QE2, gold rallied 20% over the next 10 months. This suggests that the uplift this time around could be more muted. But the trend higher is still in place.
Alan Greenspan was right. Without gold, there is no way to protect confiscation of savings through inflation.
This is the gold story most investors are (at least dimly) aware of. Even the most dyed-in-the-wool gold skeptic knows that the Fed has the world's biggest printing presses yet no ability to mine gold.
But today, I want to tell you about some of the drivers behind the rising gold price that few investors are aware of – drivers that have little to do with what is going on at policy level in the developed world and more to do with a major shift taking place in the global economy.
But first, let me recap on where we stand with our gold position in the Family Wealth Portfolio.
Asset Allocation Matters
We first recommended you hold a 20% allocation to gold in September 2009. Back then, the gold price was $1,017 per ounce. As I type, it's $1,774 -- a rise of 74.4% over three years.
That works out as a compound return on this simple "beta" play of 20.4% per year. Not bad for something that doesn't pay a dividend or coupon. (Warren Buffett and Charlie Munger can't be too happy about that!)
It hasn't been a straight run. Nothing ever is. Gold started out 2012 at $1,561 per ounce. That's down from its nominal all-time high of $1,919 per ounce in early September 2011. This caused many pundits and investors to speculate on whether this was the start of a "blow-off top" in the metal.
As I reported last August, it's best not to worry too much about price targets when it comes to gold. Gold is a store of real wealth, not a trade. How much gold you own – and when you should buy and sell – should be determined by your strategic asset allocation.
If gold becomes an excessively large part of your portfolio, it's time to sell to bring it back in line with your 20% allocation target. If it falls significantly below 20% of your portfolio, it's time to buy again. (My August 2011 Portfolio Review details how you should deal with a blow-off top in the gold price.)
Bottom line: You should set your strategic asset allocations and make a trade only if they move significantly out of line. This is because the market prices of your gold, stocks, real estate and other assets are moving up or down all the time. You don't want to trade too much.
If you've picked the right assets, they will all move higher in price in the long run – whatever the short-term moves. Although the rates of climb may vary, your asset allocations shouldn't change too much. So you need to resist the temptation to do too much fine-tuning, as this will incur wealth-eroding trading costs.
This is an important distinction between the family office approach to wealth building and the mainstream approach. What is important is that you have an "all weather" portfolio – one that doesn't have too much of a concentration in any one single asset class.
As Chris Hunter, my colleague at Bonner & Partners Family Office, has written extensively, over the course of a generation, there will be ruinous asset classes that will destroy wealth. And you never know for certain which ones they are going to be. The best thing you can do is maintain a portfolio that is immune from any one shock. And that means preventing any single asset class – no matter how much you believe in it – from taking up too much of your portfolio.
What's Really Happening With Gold
As I said at the time, the September 2011 run-up wasn't the start of a bubble and the gold price fell again. By the start of 2012, gold fell to $1,561 per ounce. Weak hands – aka traders – were selling.
Mainstream investors – who hadn't participated in the decade-long rise in prices – began crowing about the end of the gold bull market. Most of them also missed the cause of the dip (and in fact, the most important aspect of the investment case for gold, as I will explain later on).
Events in India were a big factor. India has been the largest buyer of gold for many years. But Indian jewelers went on strike in March in protest against proposed hikes in import tariffs on gold. As a result, second-quarter consumer demand in India (jewelry, coins and bars) fell 38% from the previous year, to 181.3 metric tons.
So let's step back and see what's happening with gold.
Below is a chart of the gold price over the last 20 years. You can see the tail end of the last bear market... and the start of the current bull market that started in 2002.
Is gold in a bubble?
Looking at this chart, you would be forgiven for thinking that the gold market is in a bubble. The line is curving upward. And the trend seems to be becoming more and more vertical as we approach the right-hand side of the chart.
The Curve Effect
But what you have to remember is that the world is curved. Any chart of compounded constant annual returns will look like an exponential curve (one that gets more vertical with time).
That's because if you add a fixed percentage to something in a year, it gets bigger by a certain amount. Add the same fixed percentage to the new total, and it will get bigger by a slightly larger absolute amount in the second year. And so forth.
The rate of growth can stay the same. But the amount of growth will get progressively larger.
Another way to look at price charts, which strips out this curve effect, is to use a "logarithmic scale" on the vertical axis. This means that, at any point from left to right, the same percentage increase in the amount shown on the vertical axis (the prices) will look the same to the naked eye.
When you use this type of scale, a perfectly smooth exponential price curve -- in which prices grow at a constant rate over many years -- would appear as a straight line rising from the bottom left corner of the chart to the top right.
Below is such a chart of the gold price since 2001.A logarithmic scale tells a different story
Looked at this way, you can see that gold's price progression has been relatively steady over the last decade. There have been moments when it has moved ahead of the trend, followed by moments when it has fallen behind the trend. These, in turn, have been followed by moments of catching up. But overall, the ascent of the gold price has been remarkably smooth.
Most recently, in the top right-hand corner of the chart, you can see the spike up to September 2011, followed by the fall into the May lows of this year. But now gold is back in a catch-up phase, moving back into line with the trend.
In other words, recent price volatility is a short-term blip in a much longer bull market. And similar pullbacks have happened regularly during the last decade.
Conclusion: At writing, gold is up 15.3% since its May lows. If the major trend... and the fundamental drivers behind it... stay intact, gold should be back on trend within three to six months. If this happens, we can expect new highs above $1,900 per ounce in that time frame.
We continue to recommend a 20% allocation to gold.
Demand Is Rising
Each quarter, the World Gold Council (WGC) publishes a report on global demand and supply trends for gold. This contains a lot of useful information and data on the physical gold market.
Using the WGC's historical data series, we can see that the gold market has changed significantly in recent years.
Below is a chart of global gold demand, measured in metric tons (not dollars!), for the years from 2002-2011.
The first thing to note is that demand has been increasing. Taking the end points of the series, you can see that total global gold demand increased from 3,372 tons in 2002 to 4,575 tons in 2011. That's an increase of 35.7% over nine years. That works out, on average, at a little over 3.4% compound growth in demand each year. This compares to global population growth of about 1.1% per year.
Central bank demand turned positive in 2010 for the first time in many years. Before that, central banks were net sellers of gold. They (wrongly) believed that paper assets such as US Treasuries would be better stores of wealth.
In other words, central banks were a source of supply to the international gold market during the period before 2009. But central banks bought a net amount of 458 tons of gold in 2011 – 10% of global demand. This trend is continuing into 2012.
But even without the new central bank buying, global gold demand has grown. It went from 3,372 tons in 2002 to 4,117 tons in 2011 – up 22% over nine years. This is equivalent to 2.2% average compound demand growth – twice the rate of global population growth.
Investment Demand Is Accelerating
Jewelry buying and investment dominate demand for gold. Investment is mainly made up of bars and coins (the red part of the chart). But it also includes exchange-traded funds (the green part).
Jewelry buying has fallen from 79% of demand in 2002 – to just 43% in 2011. At the same time, investment demand (bars, coins and ETFs) has increased from just over 10% to nearly 40% of total demand.
The start of the growth in investment demand and the fall in jewelry demand predate the global financial crisis, which really started hitting the headlines in 2008 (although it started in early 2007 and basically hasn't ended).
Investment demand has accelerated since 2007. In 2008, there was a big jump in the buying of bars and coins. In 2009, it was the turn of ETFs. Since then, ETF growth has slowed. And demand for bars and coins have accelerated.
This is likely because investors are becoming better educated about gold. They understand that they need to have direct ownership to avoid the risk of default by their bank or broker.
Conclusion: We continue to favor physical ownership, in the form of coins or bars. But ownership by way of ETFs is a convenient way to have exposure using a regular brokerage account.
"Intensity" Is Growing Too
For the 12 months to end of June 2012, the world's biggest consumer demand for gold – at 828 tons – came from Greater China. (Greater China includes Hong Kong and Taiwan.) Consumer demand is the aggregate of bars, coins and jewelry demand. It excludes ETFs and central bank demand.
India was next in line over the past year, with 774 tons of demand. As I explained earlier, India has been the largest gold buyer for many years. But demand slowed heavily earlier this year due to the buyers' strike. And Chinese demand has been growing fast in recent years.
For the year to June 2012, these two countries made up 49% of global consumer demand. Greater China accounted for 25% of consumer demand in the 12 months to June 2012. India accounted for 23.7%.
The next highest level of consumer demand was from the US. But American consumers' demand for gold was tiny by comparison – at just 5.6%.
India and China are poor countries in relative terms. India is especially poor. But they have huge populations that are becoming wealthier over time. This means they are likely to buy even more gold in future. So I expect these two countries to be the dominant sources of consumer demand – and, therefore, overall demand – for many years.
Below is a chart of so-called annual "gold consumption intensity" for selected countries in 2011. It compares gold demand per capita in grams (on the vertical axis), excluding central bank purchases, to GDP per capita in thousands of dollars (on the horizontal axis).Richer emerging markets consume more gold per capita
What you can see is that the large emerging markets are grouped into the bottom left-hand corner. They have low average GDP per person and also relatively low average gold consumption. India and China are the main ones. But Indonesia (population 248 million) is also in this grouping.
What is really interesting is the comparison of China (which, in this case, means Mainland China) with Taiwan and Hong Kong.
All of these places are populated with people who share similar traditions and culture. I won't say they are the same. After all, Texans have many similarities to New Yorkers. But they have many differences too. But the majority of people in Mainland China, Taiwan and Hong Kong come from similar cultures.
Taiwan is a much richer place than Mainland China on a per-capita basis. Taiwan started booming in the 1970s and 1980s. So it's at a stage of industrial development that is maybe 20 or 30 years ahead of Mainland China. GDP per capita in Taiwan is over 3.7 times that of Mainland China. But gold consumption is over 5.4 times as high.
The questions you need to ask are: What would it take for China's economy to be 3.7 times as large as today on a per-capita basis? And what would Chinese gold demand look like at 5.4 times today's level?
Seven percent GDP growth for 20 years gets you pretty close. If an economy grew at that average rate for that length of time, it would be 3.87 times as big as today. This is possible, although by no means certain, for China.
We can imagine slower rates of growth, as well. Let's try 5%. At this rate, the economy multiples 3.73 times in 27 years. Either way, if China is 20-30 years behind Taiwan in terms of economic development, we can imagine average Chinese gold consumption reaching Taiwanese levels in 20-30 years, all other things being equal.
Supply Remains Constrained
But of course, other things aren't equal. Consumer demand in Greater China was already 25.4% of global demand in the 12 months to end of June 2012. Of that, 95% was sold in the mainland. This means Mainland China already accounts for 24% of global demand.
If Chinese demand increases dramatically in the future, where is the new supply going to come from? Global mined supply volume grew by 3% in 2011. But it was flat when comparing second quarter 2012 with the same period in 2011. And gold is getting harder to find and more expensive to extract.
This is a classic example of finite supply meeting infinite demand. Ultimately, there is a limit to how much gold ore is buried in the Earth's crust. But there is no fixed limit to population growth, money creation or economic growth.
Populations are growing, wealth is being created in emerging markets, and money is being printed. But the aboveground gold stock is growing at a steady – but low – rate. Eventually, it may stop growing altogether.
If Mainland China's gold demand increased by a factor of 2, 3, 4... or even 5... then where would the gold to satisfy that demand come from? Someone will have to stop buying to let more Chinese into the market. Prices could go through the roof. This is the reason why I am long-term bullish on gold (even if I am not "gold buggish").
I don't even dare to think what would happen if Mainland Chinese consumption per person goes to the even higher levels that we currently are seeing in Hong Kong.
The Hong Kong example may be misleading. That's because a lot of the Mainland Chinese buying of all sorts of things, including luxury goods (jewelry) and investments (gold bars) happens in Hong Kong. So the figures could be skewed upward.
But if you connect the dots on the chart above between Mainland China, Taiwan and Hong Kong, you practically get a straight line. In other words, there is a high correlation between gold demand and GDP in Chinese societies. Either way, the potential for gold is enormous, even if Mainland China were to approach only Taiwanese levels of gold buying in the future.
What About India?
And this is even before considering the potential future demand in India. We don't have the same comparisons to make to India, in cultural terms. We can usefully compare China to Taiwan or Hong Kong since the main populations are ethnically Chinese. But we don't have similar data comparisons for India.
What we can say is that India's GDP per capita is about a quarter that of China. And yet gold demand is already about one-third higher per capita in India. So could India be on a trajectory to catch up with Thailand, which has relatively high demand, compared with GDP? We can't tell for sure. But the prospect of decades of growth in India, China, Indonesia and other emerging markets certainly makes a strong case for holding onto gold for the long run.
There are a couple of caveats. In a genuine supply crunch, prices rise fast, demand is slowed, and equilibrium is reached. So as prices rise, Chinese or Indian demand may take much longer to reach Taiwanese or Thai levels than I've indicated. But I still recommend you continue to be long gold, as fast-expanding demand collides with slowly expanding supply.
Also, emerging markets such as China and India have relatively unsophisticated financial markets. Richer Chinese and Indians may buy more jewelry in future. But at the same time, they may choose to invest in different ways as more financial products become available.
Deeper capital markets, growing pension fund industries, more fund management products -- these all mean that Chinese and Indians may allocate a smaller piece of their wealth to gold in the future. The absolute amounts may grow, but less slowly than overall wealth levels.
That said, demand from these emerging market giants looks set to continue to grow faster than the gold supply, putting a floor under the gold price.
This should result, over decades, in a gold price that rises faster than CPI inflation in most developed countries. But this doesn't mean that shorter-term price cycles (over a few years) couldn't move significantly to the upside or downside of the longer-term trend.
Profiting From the Big Trends
You'll recall that we believe there are two "mega trends" at work in the world today:
1) The US dollar-based money system is cracking up.
2) Wealth and power are shifting to emerging markets.
Gold is a powerful way to tap into both these trends. Most commentators tend to focus a lot on how gold is a way to play the gradual crack-up of the fiat money system. But less attention is given to how it's also a play on richer emerging markets.
This is something I've touched on in the past. But our view remains that the emerging markets dominate the gold market in ways that most investors don't understand. By my reckoning, emerging market demand for physical gold is about 75% of the global total. This is an estimate. But the margin for error is not that great.
Jewelry, bars and coins account for 73.2% of total global gold demand, according to the World Gold Council. According to its figures, 90.4% of jewelry demand and 71.3% of bar and coin demand came from emerging markets in the year to end of June 2012. That's 2,677 tons of emerging market demand right there. That figure could even be slightly higher. Emerging market investors could be buying gold coins and bullion in developed market locations such as Switzerland. And it is well known that tourists from China, Russia and the Middle East buy large amounts of jewelry when visiting cities such as London or Paris.
Then, I've assumed that 95% of central bank demand is from emerging markets, adding another 483 tons. There are no hard figures here. But central banks in developed countries already tend to have large gold reserves. And central banks in emerging markets are keen to play catch-up.
For technology, I've taken a rough guess of 50% of demand. Most of this is for electronics. It could be a bit more or less. But at 220 tons, this is a much lower contributor than jewelry, bars and coins. So it doesn't make much difference to the overall figure if I'm off a bit.
Finally, there is ETF demand. I've penciled in 20% for emerging markets. There are few of these products offered onshore in those countries. But there is a lot of offshore money that belongs to people from emerging markets. Think of investment accounts in Switzerland, Singapore and Hong Kong... or Miami, for South Americans. In any case, this is the smallest part of the total, at just 49 tons in the past year.
Add these together, and the total is 3,429 tons, which is 76.9% of total global demand for the year to June 2012. I could be out a bit. But on balance, it seems likely that emerging market demand is in the 70-80% range of global demand. Around three-quarters in other words.
Gold Miners Are Go
Physical metal is not the only way we get exposure to this trend. On the recommendation of our strategic partner in the resource sector, Rick Rule, we switched 3% of our 20% recommended allocation to physical gold into gold miners last October by way of the Tocqueville Gold Fund (TGLDX: NASDAQ).
I said that if gold miners continued to underperform gold, we would increase our allocation to miners. This is exactly what happened. And in June, I recommended increasing the allocation to the Tocqueville Gold Fund by another 2% – taking our total allocation to gold miners to 5% of the 27 Family Wealth Portfolio. This left a 15% allocation to physical gold.
Since then, gold is up 9%. And the Tocqueville Gold Fund is up 16.3%. Buying as prices fall is a difficult concept to grasp for most investors. But if your investment logic hasn't changed – and the market price an asset sells for drops – it makes sense to be a buyer, rather than a seller.
Conclusion: Our reasons for owning a diversified basket of gold miners over the medium to long term have not changed. Maintain the current allocation until further notification.
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