Supply, demand, and investor behavior seems simple enough. However, the way these factors work together to affect the price of gold can sometimes be counterintuitive. Let’s dive in.
How does the relationship between inflation & market confidence affect gold?
Studies show that gold prices have positive price elasticity, meaning their value increases along with demand. As with any asset with positive price elasticity, the more investors turn to gold, the greater the price is driven upward. What’s unique for gold is the correlation between low stock market/economy confidence and high demand. This combination causes the gold price to perform well under both good and bad economic conditions: it maintains value when the economy is healthy and increases in value when the economy is troubled.
But investors will be investors, and they want massive growth, which comes when times are bad, so history has proven that investors flock to gold in times of financial crisis. When the Great Recession hit, for instance, gold prices increased many times over. As the stock market bottomed out, gold was valued at $700 an ounce, and then for over 2.5 years, it kept rising even as the economy started to recover. The price of gold peaked in 2011 at $1,825 with the cheapest physical gold products at $1,950.
How does the gold supply affect the price of gold?
Gold is both a monetary instrument and a global commodity, much like oil or coffee. However, unlike those commodities, gold is not consumed: Almost all of the gold ever mined still exists, and more gold is being mined every day. At first glance, this might make you think that, over time, the price of gold would decrease due to the continuous supply, but looking back through history we clearly see that isn’t the case. How come?
Aside from the fact that the number of people wanting to buy gold is increasing at an even faster rate than the supply of gold—due to the increase in population—jewelry and investment demand offer additional foundations to the rise in the price of gold.
For investors, gold is held for a very long time after purchase—it’s highly unusual to invest in gold and then quickly sell it. The class of gold day-traders is very small. The same goes for gold jewelry—people are more likely to put it in a drawer or pass it down to a family member than cashing it in for a new TV. This means that new demand for gold has to be satisfied to a large extent from newly mined gold, and there just isn’t enough to go around when demand hits.
What role do central banks play in gold prices?
Central banks hold gold in their balance sheets but not as commodities as Wall Street would like you to believe gold is. According to central banks’ regulations, gold is money, and it’s being recognized as money in reserve that cannot be printed and is not dependent on a foreign power.
Central banks are a major factor when gold prices are decreasing. During times when foreign exchange reserves are large and the economy is buzzing along, which means that growth for gold is low, a central bank will sometimes decide to exchange a portion of the gold it holds for a higher-growth asset. At the end of the day (and unlike what we are led to believe), central banks are businesses that are expected to make a profit..
The problem they face is that this is exactly when gold demand is not at its peak. Central banks are, not surprisingly, aware of this fact, so they take careful steps to manage their gold sales in a manner to maximize their portfolios or the markets. In fact, there is something called The Washington Agreement, which essentially states that the central bank of each country will not sell more than 400 metric tons of gold in a year. Signed on September 26, 1999, by 13 nations, this agreement is highly respected between the parties involved, and it was strengthened in 2004 and extended in 2009.
Gold retains value
Since gold has been an important part of society for thousands of years, it’s literally the oldest recorded asset around, which allows us to simply look through history to analyze and understand its ability to retain value.
Let’s compare the salary of Roman soldiers 2,000 years ago to what a modern soldier would get today, based on how much those salaries would be in gold. Roman centurions (officer rank) received 38.58 ounces of gold per year.
Assuming $1,800 per ounce, a Roman centurion (roughly equivalent to a captain) received $69,444 per year, while a US Army captain today gets $52,596 or 29.22 ounces at $1,800 per ounce. Seems like salary conditions for senior military staff have worsened through the years. Or is it really that the value of gold grows over time (see more about this below), and by paying the military with paper currency and not gold, governments have found a way to effectively get their service for much less.
This comparison lets us see that the purchasing power of gold has, at a minimum, stayed consistent over thousands of years and holds value beyond its market price. If we wanted to be precise, we would say that the purchasing power of gold actually grows. Here’s why.
Gold gains in value
Gold not only preserves purchasing power, but it also tends to even increase it over long stretches of time. This is one of the biggest secrets of the investment world and one that dictates that holding gold is even more beneficial when it’s a long-term investment. Some say that this tendency of gold is evidence that the government’s inflation numbers are too low. The hidden inflation is reflected in the price of gold rising higher than expected.
Others say that since technological advancements lower the cost of production and therefore also the price of goods, we should see an increase in the purchasing power of gold. Think about it this way: What investment asset do you know that has a built-in mechanism to gain in value over time? One that’s been proven for over 5,000 years?
But you don’t need to see how gold gains in value over hundreds or thousands of years. A couple of decades is ample time. If we compare the purchasing power of gold to that of the US dollar over the last 50 years, it becomes pretty clear how strong an asset gold is:
The bottom line
When looking at gold prices, a great place to start is the current state of the economy and where you think it’s headed. As economic conditions worsen, the price of gold will typically rise.
The world’s smartest investors are always diversified in gold because, as smart as they are, they never know when the economy will deteriorate and to what extent, and it’s virtually impossible to time the markets. Keeping gold as a hedge in a percentage that is large enough to provide insurance and protection when the economy or the markets deteriorate provides the investor with peace of mind and improved performance by reducing their losses and the volatility of their portfolio, thus providing increased stability and security.
In simpler terms: In good times, gold will keep its value, and you will sleep well at night knowing you are prepared for the worst. In bad times, you will thank yourself for having a portion of your investments in gold. In the worst of times (think about the 1970s or after the Great Recession), gold will be one of the very few assets that will save your portfolio.
Where do you think our Federal Reserve’s money-printing schemes will eventually take our economy, and do you plan to be here when it happens? Will you have the protection of gold at that time?