Gold Analysis

How to analyze the gold market? Oh boy, this is not a piece of cake. There are many factors the analyst should take into account. But the most important thing is to have an appropriate theory of the gold market. As the saying goes, there is nothing more practical than a good theory!

Nature of Gold

You need to know what is gold and what is its nature. Otherwise, you can play with data and use sophisticated techniques that ultimately make no sense. You can analyze the birds as if they were mammals, but it would be quite unwise, wouldn’t it? Similarly, you can analyze gold as if it was a commodity, but it won’t lead you anywhere.

The starting point, the core of each serious gold analysis, must be viewing gold as a currency, not a commodity. Forget about annual demand and supply numbers published by the World Gold Council. Don’t be fascinated by mining production. Gold has very high stock-to-flow ratio, so the freshly mined gold is a tiny part of the whole gold holdings. Remember: gold was chosen as money because it was practically indestructible. When something is indestructible, while its added each year, it is accumulated over time. Indeed, gold reserves are mammoth. So why should one take care about the annual flows?

Gold Demand and Supply Analysis

The next step is to understand and analyze the demand for gold and the supply of gold. As the old joke goes, it is very easy to make economic analyses – just teach a parrot to say ‘supply and demand’! Indeed, as in every market, the price of gold is determined by supply and demand. But it does not tell us anything unless we understand what constitutes supply and demand in the gold market.

And this is when we need to know what is gold’s nature. Gold behaves as a currency, so, just as with other currencies, the demand for gold comes from the marginal buyers of gold. For instance, if the demand of gold increases, it means that buyers of gold value gold more highly and thus are willing to pay a higher price.

Similarly, the supply of gold comes from the holders of gold who decide to bring it into the market. The supply side of the gold market is dominated by the owners of the world’s existing stockpile of gold. In a way, every ounce of gold is for sale at some price. It is just a matter of price and people’s preferences. For example, if the supply of gold increases it means that sellers value their gold less intensely and are willing to sell it at a lower price.

Key Factors in Gold Market to Analyze

OK, we can enter the next level of analysis now and answer what factors do influence the demand and supply side of gold? There are many drivers, but three of them are the most important: the U.S. dollar exchange rate, the level of real interest rates, and the level of confidence in the global economy and its monetary/financial system, but in particular in the States. For instance, when people think that the U.S. dollar will appreciate, they could bring their gold into market more willingly, increasing the available supply of bullion and exerting a downward pressure on the price of gold. Meanwhile, when people lose confidence in the U.S. economy, they could buy gold more willingly.

Key Factors That Drive Key Factors in Gold Market

Now, the crucial question is what drives these key determinants. This is where things begin to get complicated, as there are myriads of drivers that influence the value of U.S. dollar, real interest rates, risk aversion, and, in consequence, the price of gold. And to make the whole case even more complicated: all these variables are interconnected, not to mention that their impact on the gold market may vary over time.

This is why we do not focus merely on one factor, but always thoroughly analyze the broad macroeconomic picture. After all, to analyze currencies, you have to examine the whole macroeconomics! For example, we carefully examine the monetary policy, the stock market, the fiscal policy, the pace of GDP growth, the strength of the labor market, the inflationary pressure, etc. We also look at possible global risks, although the impact of the geopolitical factors on the gold market is usually temporary and limited.

Fundamentals Are Important, but Gold Analysis Is a Pricing, Not a Value Game

One might notice now that the price of gold does not always behave in line with its fundamentals. This is true. Market sentiment is also an important factor in the gold market. You see, gold fundamentals are important, but they play a different role than the fundamentals of copper or equities or other cash-generating assets. It means that gold cannot be valued as assets which generate cash flows or even as commodities whose value can be at least estimated looking at the balance of demand and supply.

As gold behaves like currency, it has no intrinsic value, but only a relative one. Hence, investing in gold is more of a pricing game, not a value game. There are no cash flows, while industrial use is minuscule – so, we cannot determine the intrinsic value of gold, but we can try to guesstimate the future price direction, which is affected by the market sentiment. We are not saying that fundamentals don’t matter for the precious metals market. After all, the shifts in the market sentiment are not ‘deus ex machina’. People do not formulate their opinions in void, but based on the observation of the changes in objective reality and fundamental drivers.

What we are saying is that gold market fundamentals are substantially different than in the cash-flow-yielding assets or commodity markets. As gold is a currency (or anti-fiat currency), the influence of these factors on gold prices occurs via investor’s perceptions and moods. This is why technical analysis is perfectly justified from the fundamental point of view and why our Gold & Silver Trading Alerts are so relevant.

In other words, the fundamentals affect the gold market through market sentiment, or the narratives. People cope with real world uncertainties by creating and following narratives. The chart below presents the history of the gold market shaped by four such powerful narratives.

Chart 1: Gold prices (London P.M. Fix, in $) and four narratives in the gold market from 1971 to 2019.

Gold analysis

The narratives explain why gold – although it is generally negatively correlated with the greenback and real rates – sometimes moves in tandem with the dollar and yields, or, why some developments (such as quantitative easing) are sometimes positive and sometimes negative for the gold prices. The question is how traders and investors interpret the particular event and react to it.

But do not become nihilistic, for it’s not the case that gold just moves erratically driven by animal spirits. After all, the market sentiment doesn’t change out of the blue, but it depends eventually on the changes in objective reality and fundamental drivers. The precious metals investors should include all these factors into their gold analyses.