Chris Powell has written an article in reply to my blog post “Looking for (gold price) clues in all the wrong places“. Actually, that’s not strictly true. He has written an article that purports to be a reply to my blog post, but completely ignores my central point. Instead, he shifts the discussion back to his manipulation hobbyhorse. Was this deliberate misdirection to avoid addressing my argument? You might very well think that; but of course I couldn’t possibly comment.

Here’s a hypothetical situation that will hopefully further explain the main point I’m trying to get across. Assume that Fred is looking for an opportunity to buy 1 million Microsoft shares, that Jack is looking for an opportunity to sell 1M Microsoft shares, that the current share price is $40 and that there is temporarily no one else looking to do a trade in these shares. Initially Jack offers his shares for sale at $42 and Fred bids $38, so no trade takes place. Subsequently, Jack reduces his offer price to $38 and the sale is completed at that price. The fact that the price fell $2 indicates that Jack, the seller, was more motivated than Fred, the buyer, but what if you knew nothing except that 1M shares ‘flowed’ from Jack to Fred? What would this ‘flow’ tell you about the price? The answer is: precisely nothing.

In my hypothetical example, the only way to know whether the buyer or the seller was the more motivated is to look at the price change. It’s the same story in all the financial markets, including the gold market. The price of something could go up on rising volume or it could go up on falling volume or it could go down on rising volume or it could go down on falling volume. In fact, it is possible for the price of something to make a large move in either direction on NO volume.

My point, again, is that the price isn’t determined by the volume or the ‘flow’; it’s determined by the relative eagerness of buyers and sellers. Therefore, from a practical investing/speculating perspective the most useful information is that which provides clues about the likely future intensity of buying relative to selling. In the gold market, these clues will be indicators of confidence in central banks and confidence in the economy.

This point cannot be refuted by quoting Henry Kissinger or a Chinese newspaper. It’s based on logic and economic reality.

A recent article at Mineweb discusses the latest gold-market analysis of Gold Fields Mineral Services (GFMS). As far as past or likely future gold price movements are concerned, every sentence in this article is either completely wrong or completely irrelevant.

The GFMS analysis discussed in the article follows the typical, wrongheaded pattern of adding up the flows between different parts of the market and using these flows to estimate supply and demand. It’s the same mistake I’ve addressed many times in the past, most recently in a 26th January blog post. The mistake is largely based on the misconception that current mine production constitutes the supply side of the equation, rather than just a small increment to an existing aboveground inventory.

If you start with a totally wrong premise, you will probably end up with a ludicrous conclusion. In this case the ludicrous conclusion is that gold supply is currently greater than gold demand.

In a market that clears (such as the gold market), supply can never be greater than demand and demand can never be greater than supply. Supply and demand must always be equal, with the price constantly changing to whatever it needs to be to maintain the balance.

Claiming that the supply of gold exceeds the demand for gold would be like claiming that the supply of dollars exceeded the demand for dollars. Such claims create the impression that there is a pile of gold or dollars somewhere that nobody wants or owns, because current demand has already been fully satisfied by the rest of the supply. The reality is that all gold and all dollars are always held/owned by someone, with the price (or purchasing power) adjusting to keep the supply equal to the demand.

From a supply-demand perspective, the only significant difference between gold and the US$ is that the supply of dollars regularly changes a lot (by 8% or more) from one year to the next, whereas the annual rate of change in the total aboveground gold supply is always around 1.6%. The reason, of course, is that considerable real resources (labour, materials and energy) must be employed to increase the aboveground gold supply, whereas the supply of dollars can be increased at no cost at the whim of central and commercial bankers.

That’s why I care about changes in US$ supply and do not care about changes in gold-mine production.

This post is a slightly-modified excerpt from a recent TSI commentary.

Here is chart that compares the long-term inflation-adjusted (IA) performances of several markets. This chart makes some interesting points.

One of the most interesting points is that market volatility increased dramatically in the early-1970s when the current monetary system was ushered in. This shows that the generally higher levels of monetary inflation and the larger variations in the rate of monetary inflation that occurred after the official link to gold was abandoned didn’t only affect nominal prices. Real prices were affected in a big way and boom-bust oscillations were hugely amplified. As an aside, economists of the Keynesian School are oblivious to the swings in relative ‘real’ prices caused by monetary inflation and the depressing effects that these policy-induced price swings have on economic progress.

A second point is that commodities in general (the green line on the chart) have experienced much smaller performance oscillations than the two monetary commodities (gold and silver). This is consistent with my view that there aren’t really any long-term broad-based commodity bull markets, just gold bull markets in which most commodities end up participating.

A third point is that apart from the CRB Index, the markets and indices included in the chart have taken turns in leading the real performance comparison. The chart shows that gold is the current leader, closely followed by the Dow Industrials Index (since January-1959, the percentage gain in gold’s real price is slightly greater than the percentage gain in the Dow’s real price). However, if dividends were included, that is, if total returns were considered, the Dow would currently be in the lead. This will change.

    Chart Notes:

1) I use a method of adjusting for the effects of US$ inflation that was first described in a 2010 article. This method isn’t reliable over periods of two years or less, but it should come close to reflecting reality over the long term.

2) To make it easier to compare relative performance, the January-1959 starting value of each of the markets included in the above chart was set to 100. In other words, the chart shows performance assuming that each market started at 100.

3) The monthly performance of the scaled IA silver price peaked at more than 2600 in early-1980, but for the sake of clarity the chart’s maximum Y-axis value was set to 1500. In other words, the chart doesn’t show the full extent of the early-1980 upward spike in the IA silver price.

Every transaction in a market involves an increase in demand for the traded item on the part of the buyer and an exactly offsetting decrease in the demand for the traded item on the part of the seller, which means that neither a purchase nor a sale implies a market-wide change in demand or price. This is obvious, so why does so much gold-market analysis focus on the quantities of gold shifting from one geographical area to another or from one part of the market to another?

I don’t know the answer to the above question, but I do know that focusing on the changes in gold location is pointless if your goal is to find clues regarding gold’s prospects. For example, while there could be a reason for wanting to know the amount of gold being transferred to China (I can’t think of a reason, but maybe there is one), the information will tell you nothing about the past or the likely future performance of the gold price. For another example, the amount of gold shifting into or out of ETF inventories could be of interest, but the shift in location from an ETF inventory to somewhere else or from somewhere else to an ETF inventory is not a driver of the gold price (as I explained in a previous blog post, changes in ETF inventory are effects, not causes, of the price trend).

Over recent years many gold bulls have cited the net-buying of gold by the geographical region known as China as a reason to expect higher prices. Prior to that it was often the net buying of gold by India that was cited as a reason to be bullish. The point that is being missed in such arguments is that regardless of whether gold’s price trend is bullish or bearish, some parts of the world will always be net buyers and other parts of the world will always be net sellers of gold, with the two exactly offsetting each other. At some future time it is possible that China will become a net seller and the US will become a net buyer. If so, will the same pundits that have wrongly cited the buying of China as a reason to be bullish then start wrongly citing the buying of the US as a reason to be bullish? Unfortunately, they probably will.

What determines gold’s price trend isn’t the amount of gold bought, since the amount bought will always equal the amount sold. Instead, the price trend is determined by the general urgency to sell relative to the general urgency to buy (with the relative urgency to buy/sell being strongly influenced by confidence in the two senior central banks). To put it another way, if the average buyer is more motivated than the average seller, the price will rise, and if the average seller is more motivated than the average buyer, the price will fall. So, how do we know whether the buyers or the sellers are the more motivated group?

The only reliable indication is the price itself. If the price is rising we know, with 100% certainty, that buyers are generally more motivated than sellers. In other words, we know that demand is trying to increase relative to supply. And if the price is falling we know, with 100% certainty, that sellers are generally more motivated than buyers. In other words, we know that demand is trying to decrease relative to supply.

That’s why statements along the lines of “demand is rising even though the price is falling” are just plain silly.