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Gold is a hot topic among investors these days. Some are arguing that the gold run is just getting started. Others argue that we are in a gold bubble that is poised to pop. Still others maintain that gold is a store of value -- a way to protect their wealth. I don't agree with any of these arguments, but I will put forth one of my own: Having a strong conviction about future gold prices is arrogant.

What exactly are you analyzing?
However dazzling, gold comes up short when it comes to:

  1. Cash flow analysis (no cash flows).
  2. Any kind of practical fundamental analysis (there are no bottom-up fundamentals).
  3. Any realistic absolute valuation technique.

What we do have is economic data about gold. The data tell us that total 2010 demand for gold amounted to 3,812 tonnes. On the supply side, mines pumped out 2,543 tonnes of gold in 2010. Adding in "recycled" gold (think Aunt Betty trading in her gold trinkets) coming back into circulation, the total supply entering the market last year was about 3,900 tonnes.

Demand of 3,812 tonnes, supply of 3,900 tonnes ... sounds like market equilibrium! Not exactly.

The real numbers
Those supply and demand numbers are annual figures. Unlike most commodities, very little gold is actually consumed each year (a fact that may preclude gold from being called a commodity). In other words, supply is in a sort of perpetual long run while demand, well, isn't.

World total supply of gold is currently about 162,000 tonnes. Mining output adds just 1%-2% to this supply. To put in context how little that is, consider this: If you were to buy all the gold that traded on the London bullion exchange on an average day, you could purchase an entire year's worth of new gold supply in just four days.

Pure industrial demand -- demand for gold that will actually be consumed in some value-creating activity -- accounts for just one-quarter of 1% of supply. That's essentially a rounding error, and it means three things: (1) gold can't be analyzed based on demand for it in business operations; (2) demand needs to increase about 1%-2% annually just to maintain gold prices; and, most importantly, (3) gold prices change based on investor sentiment, not the underlying industrial value of gold. This last point is key. If you are going to have an opinion on gold, you had better know who owns and trades it.

Where did all the gold go?
If there are 162,000 tonnes of gold out there, and just 420 tonnes or so are consumed each year, the obvious question is, "Who owns all that gold?" Let's divide the owners into three groups.

  1. Central banks. Central banks collectively hold about 30,000 tonnes of gold, accounting for 18% of supply. There seems to be a misconception that central banks have been aggressively acquiring more gold -- in fact, their sales and purchases just about broke even last year.
  2. Exchange-traded funds. Gold ETFs own surprisingly little actual gold. The largest, SPDR Gold Trust (NYSE: GLD), holds only 1,213 tonnes, or just 0.7% of supply. Other ETFs, such as the iShares Gold Trust (NYSE: IAU), own even less.
  3. Everybody else. After subtracting gold held by central banks and ETFs, we still have 80%, or about 130,000 tonnes, left to account for. The two remaining groups are institutional investors and retail investors. It's next to impossible to determine the split between these two, but it seems safe to say that a ton (pun somewhat intended) of gold is held by retail investors. This scares me, and it should scare you.

What's so scary?
All investors can be victims of their emotions, but none suffer worse than the average retail investor. Fund flow data from mutual funds show that investors routinely buy high and sell low, riding alternatively waves of emotion-driven greed and fear at precisely the wrong times.

Why does this make gold scary? Benjamin Graham, Warren Buffett's mentor, said that the market is a voting machine in the short term, but a weighing machine in the long term. What he means is that, in the short term, stock prices are influenced by emotions and popularity, but in the long term, the market will price stocks based on their fundamental value. Well, what happens when the asset not only has no fundamental value, but is primarily owned by the most emotional of investors?

Fear -- of inflation, depreciating currency, political unrest, economic stagnation, or recession -- is a primary driver of retail-level investment in gold. Combine that with the notoriously emotional, fear-and-greed-driven investments these investors make, and one thing is clear: If you are going to reach a conclusion about gold, that conclusion had better be based, at least in part, on your perception of the general investing community's perception of fear-inspiring macroeconomic variables. And if you think you have an edge at reading fuzzy macroeconomic data over millions of worldwide investors, you are undeniably arrogant.

Good luck with that.

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