Over the years, several attempts have been made at evaluating the true worth of gold. For the most part, though, that effort has been futile. However, to put it as it is, the perceived worth of the precious metal is what determines the price of the commodity.
For instance, as shown by the chart above, from 2005 spanning through the global financial crises, the price of gold skyrocketed. That is as a result of the change in the perceived worth of the yellow metal. During that period, investors thought it would help keep the value of their wealth, which made its perceived worth grow. To makes things simple, in the gold market, the demand for gold for investment is a measure of its perceived worth. So, in other words, gold’s demand for investment has, historically, been the biggest mover of gold prices.
If you look at the above chart closely, you’d find that upward changes in the price of gold coincide with periods of improved demand for investment. In the period around 1970, when net investment demand dropped, you’d notice that the percentage change in gold prices was negative.
In addition, if you compare the net investment demand during the period between 2004 and 2008 with gold prices during the same period, you’d find that the high investment demand during that time drove gold prices high. So savvy investors, who want to profit from gold, might want to set their sights on gold’s demand for investment data. Here is another proof.
The World Gold council released a report earlier in 2014, reporting that China accounted for 26% of global private sector gold demand in 2013. It explained that Chinese consumers and investors are taking advantage of the lower prices of the metal. The increasing demand in China is a fundamental reason for the price surge that gold has seen in 2014.
The only thing that is yet to be said is that there are some events (factors) that drive the demand for gold for investment. However, no matter how serious these factors could be, if they do not alter the investment demand fundamental of gold, they can hardly affect the price of gold. So in other words, for these factors (below) to influence the price of gold, they must, first, influence the investment demand dynamics of gold. Many analysts simply conclude that it’s these factors that move gold prices. But that logic is flawed. With a definite background already set, let’s now look into these secondary factors/events.
Many analysts regard inflation as the biggest mover of the price of gold. There is a belief that gold, in itself doesn’t have a practical business or personal use, but to retain value and wealth. Therefore, during inflationary cycles, when the value of the dollar drops, investors put their money in gold to help preserve value. To link to our foundation, this then increases the demand for gold investment, which ends up driving gold prices. However, because of the sensitive nature of the market, inflation fears – and not the actual inflation – also drive the price of gold high. To understand this effect, you can think of it that the fear of inflation makes people suddenly think gold is worth more, which is the prerequisite for a price increase.
Price of dollar
Historically, the price of gold has also moved counter to the dollar. One reason for that is that during a 40-year stretch between 1931 and 1971, the dollar was the only currency that was backed by gold. This made the dollar become the most favored reserve currency. You might want to note that about 85% of central bank reserves are in dollars. This, in many ways and for many reasons, made the dollar become a substitute for gold. In other words, the dollar became a kind of “safe haven asset.”One of the reasons is that the dollar is more abundant than gold. As a result, a strong dollar means that people would not need gold to sustain their wealth and hence, lower price of gold. On the other hand, a weak dollar means that the demand for gold to store wealth would be high, which drives price high.
Simply put, during the period leading to the financial crises, the most prominent factor that drove gold’s demand for investment high was the state of the economy. Analyst warned about bubbles, and investors were keen to preserve their wealth, a luxury that gold offered. So, in general, fears of economic instability is likely to drive investment demands high and hence, the price of gold. On the other hand, predictions of a strong economy are likely to keep investment demands low and hence, the price of gold.
Historically, US equities trade inversely with gold. In other words, a strong equity market may translate to an under-performing gold market. While, on the other hand, a weak equity market may translate to higher gold prices. Here is why. Let’s note that the equity market is a paper-based market. We should also note that paper-based market markets are sensitive to the state of the economy and the dollar value. Again, we should note that investing in gold is a substitute for investing in stocks. All of these put together mean that, when the equity market is volatile, investors seek to protect their wealth, which ends up improving gold’s demand for investment and hence, the price of gold.
Some analysts would rather classify investment demand as just another factor influencing the price of gold – and not a prerequisite as we’ve done here. They may be right. But if you’d take time to compare these factors diligently with the price movement of gold, you’d find that the price movement correlates most closely to investment demands.
In fact, if you consider inflation in particular, which is considered the biggest mover of gold price, you’d find that, on some occasions, high inflation rate didn’t always translate to higher gold prices. Consider the chart above as a reference. Over the past decade, the price of gold has skyrocketed significantly. While the chart shows some correlations between the inflation rate and the price of gold, it’s easier to see that no conclusion can be drawn from it.
Therefore, the best, and possibly the safest way, to understand the price movement of gold is to look at investment demand metrics.