My good friend KY asked me the other day about my thoughts on gold as potential investment.  He really got my intellectual engine running.  I took the time to do a little bit of research on gold, analyzed the current economic conditions, and I must say that I learned a thing or two about gold that I didn’t know before from this exercise.  KY, thanks for your question.  Talking to you is always a pleasure.

Here is a snapshot of some key information on the demand for gold in 2008:

·         Consumption of gold related to jewellery was about 58%   (2137.5 tonnes)

·         Industrial use made up about 25% (860.8 tonnes)

·         Various investments made up about 17% (660.3 tonnes)

Starting with the largest user, jewellery made up more than half of the demand for the world’s yellow metal last year.  We are not even through the first quarter of 2009 and worldwide consumer confidence seems to be still heading south.  When times are bad, it makes perfect sense for people to cut back on major purchases that are unnecessary.  Two years ago, you could’ve gotten away telling people that you had bought that gold bracelet because you needed it.  No one will buy that story today.  Today’s consumer mentality is to buy what you need and put everything else aside for that rainy day.  Things are not looking for the jewellery business.  As of February, India, one of the world largest markets for gold, has yet to import any gold. 

The industrial sector made up the second largest demand group for gold.  There are so many uses for gold in industrial production; I cannot cover every single one of them.  For simplicity’s sake, let’s look at electronic products.  Japan, the world’s second largest economy, relies heavily on exports for economic growth.  Sony, Panasonic, you name it, are key to Japan’s economy.  Japan’s exports fell by over 40%, a sign that manufacturers are cutting back on the consumption of gold. 

Finally, there is investor demand for gold.  While gold has many practical uses such as those mentioned above, gold also has a unique function and that is it can act as store of value.  Over the history of mankind, many empires have risen to power and later crumbled to pieces, taking their currencies with them.  Gold can act as store of value no matter what happens.  People have managed to protect themselves while fleeing their home country from war and from hyperinflation. 

Given that demand is weak in the first two groups, the price of gold could only continue to rise if there is sufficient investor demand.   Investors that look far into the future realize that 1970’s style inflation may be ahead of us and have already flocked to gold to hedge their risk.  (I will write about inflation in my next article, too much information to cram everything here)  This is the last pillar standing to support gold price in the foreseeable future.   If you are considering holding positions in gold to hedge inflation risk, keep in mind that:

·         Many investors have already jumped in the game ahead of you.  This means that the price of gold has already factored in anticipated inflation after the economy recovers.

·         If inflation doesn’t turn out to be as bad as we anticipate, this will put further pressure on the price of gold.

I also learned that the supply of gold is rather rigid.  In other words, you cannot just come up with new supply on demand.  The process of finding gold mines, setting up the equipment needed to mine the gold ore and refining, are projects that are both capital and time intensive.  If mining companies continue to expand their mining operations, the outlook on gold is sliding demand with more than ample supply. 

Personally, I believe that it is still better off staying on the sideline observing the market than jumping into it at this time.    If you still want to invest in gold, there are plenty of ETFs out there so gaining exposure is easy.  (You can go long or short on gold with these ETFs, it’s up to you)   We are amidst one of the greatest financial crises, meaning that great investment opportunities are in the making.  Patience will pay off. 

Hello!  Thanks for reading my first article and your feedback.  Some of you raised interesting questions (I appreciate your email.  It is also possible to post comments on my blog directly) and I'm combining them here so I can respond to them all at once: