Don't Miss This Gold-Buying Signal

Last week saw gold ETF holdings reach a new record of more than 83 million ounces, according to the latest figures from ETF Securities. More than half of this is held in just one fund -- the SPDR Gold Trust  (NYSEMKT: GLD  ) , with the remainder split among smaller funds such as the iShares Gold Trust  (NYSEMKT: IAU  ) , Gold Bullion Securities  (LSE: GBS  ) and ETFS Physical Gold  (LSE: PHAU  ) .

Investors in these funds have driven strong demand for gold over the last few years, and the buying has continued this year, delivering returns of more than 9% for the year to date. Despite this, total investment buying of gold this year looks likely to be lower than it was in 2011.

What's more, industrial demand and jewelry demand are also likely to end the year lower, according to the latest figures from the World Gold Council. So what's supporting the price of gold?

The only growth market for gold
There is one area where demand for gold is continuing to rise. The World Gold Council calls it the "Official Sector," but to you and me it's central banks -- in particular, emerging market central banks, led by the 800-pound gorilla of all emerging markets, China.

Until 2009, the world's central banks were net sellers of gold -- they were getting rid of it in favor of holding Western currencies, mostly U.S. dollars. China remains the biggest foreign holder of U.S. government debt, and has a massive $1.1 trillion of U.S. Treasury bonds in its bank vaults.

Since 2010, central banks have become increasingly worried about depending on the dollar and have become net buyers of gold. In 2011, central banks accounted for 10% of total gold demand and so far this year, central banks have provided 12% of total demand.

Coming late to the party
The problem for many emerging market economies is that they don't really own much gold. Although China had 1,054 tonnes of gold at the end of November, this accounted for just 2% of its total reserves.

In contrast, the United States' 8,133 tonnes of gold represents 77% of its foreign reserves. Even the U.K. holds 17% of its foreign reserves in gold, despite Gordon Brown's unfortunate decision to sell much of our gold at the bottom of the market.

China is taking robust action to increase the proportion of its foreign reserves held in gold and is said to be buying all of its domestic gold production and importing additional gold from foreign producers.

Not just China
It's not just China that's buying gold, either. Russia has a stated policy of expanding its substantial gold holdings, while numerous smaller economies are focused on adding gold to their foreign reserve holdings.

During the third quarter of this year alone, South Korea increased its gold holdings by 29%, Brazil made its first gold purchase since 2005 and Paraguay reported a tenfold increase in its (admittedly small) gold holdings. Brazil followed up with a 17-tonne purchase in October, while Kazakhstan was also a significant buyer.

All of this suggests to me that the world's emerging markets are losing confidence in the dollar and are serious about diversifying their foreign reserve holdings. This means that central bank buying could help support the price of gold for some time to come.

There is a risk
Gold ETF investors should remember that while jewelry and industrial demand for gold is fairly stable (albeit falling), investment demand and central bank buying can be very volatile.

So far this year, central banks' quarterly gold purchases have ranged between 98 tonnes and 161 tonnes, while investment demand has varied between 294 tonnes and 430 tonnes.

This volatility has a direct effect on the price of gold, which ultimately depends on physical supply and demand for its direction. If central banks decided to stop buying gold, the bottom could fall out of the market.

An additional risk for new gold investors is that gold prices are pretty high already -- and there is no guarantee that recent gains will be repeated unless physical demand rises further.

An alternative?
If you are new to investing in gold, an alternative way to benefit from current high prices and any future gains could be to invest in smaller mining companies with growing gold production, rather than directly in gold itself.

The share prices of gold producers can rise, even when the price of gold is flat -- and some of the larger companies even pay dividends.

Your first million
In fact, identifying successful mining companies while they are still growing could be a very good way to make big profits from shares. Investors who bought shares in FTSE 100 (UKX) success story Randgold Resources  (LSE: RRS  ) 10 years ago have seen the value of their shares rise by 14 times since then -- a gain that would really have transformed your wealth.

If learning to identify fast-growing small resource stocks is something that interests you, I would strongly recommend you take a look at this free Motley Fool report, "Ten Steps To Making A Million In The Markets."

It explains how you can beat a flat market and shows how a million-pound dream portfolio could be well within your reach.

If you'd like learn more about how you could transform your wealth by identifying small companies with big growth potential, then the "Millionaire" report is essential reading. To get your copy, click here to download this report now, as availability is strictly limited.

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  • Report this Comment On November 29, 2012, at 6:10 PM, EGTalbot wrote:

    There is one other concrete supply and demand item preventing "the bottom from falling out": the cost of producing gold. Although you'll often see average costs touted in the three figures, most new gold is reported to cost between $1200 and $1500 per ounce to produce. If the price of gold stayed below $1500 for a significant period of time, supply would drop.

    Now if both investment demand and central bank demand were to drop off a cliff, all bets would be off - tens of thousands of tonnes of already mined gold could flood the market. It's a risk, but it is tempered by the massive money taking place in pretty much every developed economy.

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