Why Buy Gold as an Investment? A Brief Market Overview

By: Mike Ott
3/21/2012

It was asked in this morning’s class why someone may be inclined to buy gold as an investment. The question is especially perplexing given that an ounce of the shiny metal is trading for over $1600 in spot markets, roughly seven times the spot price in year 2000. Nonetheless, I thought I might take a stab at it.

There are three main sources of demand for gold. Jewelry demand accounts for about half of world demand, fueled by fiercely growing consumption in China and India. Demand for gold as an investment accounts for around 40 percent of global demand. The rest of demand is for gold to be used in industry and technology, and will not be a focus of this post.

Jewelry demand is fairly easy to understand, as it has existed for centuries. With vast sources of new wealth coming into the world economy throughout the 2000’s, it is of little surprise that nations such as China and India would become rapidly growing consumers of luxury goods. Investment demand is more complex. Traditionally, gold is a “store of value,” or an alternative to holding cash. Investors have long had the option of holding gold, knowing that they can readily convert the metal back into virtually any currency. In recent times, quantitative easing and Fed monetary policy have increased the supply of US Dollars and created a greater threat of perceived future inflation, forces that weaken the Dollar in foreign exchange markets. A weaker Dollar is gold positive. That is, if an investor buys gold and the Dollar weakens, then that same ounce of gold is suddenly worth more in Dollars, creating return potential. Add to the mix that interest rates are at historic lows. This means that there is little opportunity cost to holding gold. If an investor converts cash to gold, the investor in the current environment is passing up virtually zero interest income. Finally, gold has become a “flight to safety.” Investors that feared a collapse of the Euro during 2011 at least felt comfortable holding gold and soup cans, knowing that they would be fed in the near term and that they could convert their bullion into cash once the dust from the crisis had settled.

On the supply side, gold can be mined or recycled, an expensive process either way. Mining requires equipment, lots of oil, labor and a complex refining process. Recycling involves heating gold to temperatures that liquefy metal. Gold cannot be produced to match demand overnight, and statistics have shown that supply has not kept up with recent demand. This allows demand to heavily influence prices.

It is another post entirely to explain a buy rationale for gold at $1600/oz. However, with strong jewelry demand, plenty of events on the horizon that may cause another flight to safety, potential inflationary pressures, low interest rates and prices that have come down since the second half of 2011, gold may not be such a bad buy after all.