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Gold bars from melted gold jewellery and pure gold bars are seen at Express Gold in Toronto

Moe Doiron/The Globe and Mail

No doubt about it, gold is a hot investment these days. But its soaring popularity hasn't persuaded Tim McElvaine that now is a great time to join the bull market in bullion. Quite the opposite, in fact.

"Today's fad is tomorrow's flop," he said from Vancouver, where he runs McElvaine Investment Management, a money management firm. "I'm as confused as the next guy about what's going to happen with currencies and whether [Federal Reserve chairman]Ben Bernanke is right or wrong. But I'm not sure a whole bunch of yellow stuff in a warehouse is going to do much."

Mr. McElvaine is a lonely figure these days - a bear on gold. Driven by fears of inflation and potential currency devaluations, investors have propelled the yellow metal to $1,400 (U.S.) an ounce, a remarkable climb from under $300 near the start of the decade. Now, with the price of gold hovering near a record high in nominal terms - though still below its 1980 peak when adjusted for U.S. inflation - the bulls see plenty more gains ahead.

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In the middle of this market fever, it is easy to forget that gold still must obey the law of supply and demand - and that the underlying fundamentals are now looking distinctly negative for the metal's long-term prospects.

The jewellery factor

Unlike most commodities, gold isn't consumed in high quantities. Industrial uses account for only about 10 per cent of total demand, which is why jewellery makers have traditionally provided most of the market for the metal.

However, global demand for gold jewellery has been in steady decline, replaced only by demand from fickle investors - a shift that could have a disastrous impact on the price of gold if those buyers turn squeamish.

According to GFMS, the London-based precious metals consultancy, global jewellery purchases plunged to 1,759 tonnes last year from more than 3,000 tonnes at the start of the decade, as the rising price of gold turned off consumers and jewellery makers cut back on gold content.

"For many markets, we've seen jewellery demand suffer quite noticeably," said Neil Meader, research director at GFMS. While jewellery demand in China continues to increase, the Indian market is down. So is demand in the United States - the world's No. 3 market - where gold sales to jewellers have plummeted about 50 per cent over the past four years.

At the same time as demand is falling, gold supply is rising. Most central banks, for instance, are jettisoning their gold holdings. According to the World Gold Council, total gold holdings were about 30,600 tonnes in December, down nearly 2,900 tonnes since the start of the decade - and these overall declines take into account an increase in gold holdings by China's central bank.

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Adding to supply is ramped-up production from mines. This rose to a four-year high of 2,572 tonnes in 2009. In addition, consumers are now happily mailing in their "scrap" gold jewellery to the host of gold-dealing companies that have sprouted up in recent years. Add in this recycled gold and total world supply hit 4,034 tonnes last year, the highest level in at least a decade.

The fear factor

Of course, gold is still in high demand. But the source of this demand is now investors, who have become gold's biggest buyers for the first time in about 30 years. These buyers have no uses for gold, other than the hope of selling it to someone else at a higher price somewhere down the road.

"We talk about a secular upward shift in the investment demand for gold," said Jeffrey Christian, managing director of CPM Group, a New York-based commodities research and advisory firm. "More investors have been buying more gold at higher prices over the last 10 years than ever before in history."

The bullish argument for gold rests primarily upon fear - the fear that paper currencies are being devalued by governments and central banks; the fear that the world is awash in money, which will lead to problematic inflation; and the more general fear that the world is falling apart, and prudent doomsayers will need more than shotguns and tins of beans to survive.

There is nothing new about these fears. But in recent years, they have gained heft as terrorist attacks, stock market collapses, Wall Street implosions and creative monetary policies have rattled investors' confidence in paper currency.

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As investors grow more fearful, gold has become increasingly easy to buy. In Abu Dhabi, Berlin and Madrid, passersby can purchase the metal at vending machines, called Gold-To-Go.

The most profound impact on the market, though, has come from exchange-traded funds (ETFs) that hold gold. The SPDR Gold Trust, launched in 2004, now holds nearly 1,300 tonnes of gold worth about $58-billion - a considerably larger gold holding than Switzerland's central bank.

ETFs have given investors the opportunity to buy and sell gold at the touch of a button throughout the day, without having to worry about the inconvenience of storing and guarding the stuff. This democratizing development is lauded by some observers for bringing gold to the masses. Indeed, it is estimated that retail investors hold as much as 70 per cent of the outstanding units of the SPDR Gold Trust.

However, the popularity of these new investments raises a concern: If investors have piled into gold as the price has risen, what are these investors going to do if the price of gold declines or even stagnates? Some ETFs such as the SPDR Gold Trust, might be forced to sell their gold holdings to meet redemptions, creating a negative feedback loop that will pull down gold prices.

The market itself is expressing doubts about the long-term outlook for gold. Demand for gold stocks - that is, the companies that run the mines - is relatively weak next to gold itself.

The divergence factor

Pierre Lapointe, global macro strategist at Brockhouse Cooper, noted that the ratio of the gold price to the U.S. gold stock index is about 6.5, which is well above the ratio's historical average of 4.4 for data going back about 25 years. In other words, gold stocks haven't been keeping up with the price of gold, creating a confounding divergence.

"Such a divergence can be interpreted two ways. On the one hand, it could mean that gold stocks have yet to reflect the increase in the underlying commodity," Mr. Lapointe said. "On the other hand, it could mean that the commodity has overextended its rally and that stock investors do not believe the bullion rally has legs."

He leans toward the latter explanation, largely because gold stocks are nowhere near bargain levels. World gold stocks trade at nearly 20-times estimated earnings, compared to about 15-times earnings for the broader S&P Global 1200 composite index.

If gold stocks were to rise to the point where they closed the gap with the price of gold, then the P/E ratio for gold producers would come close to 29 times estimated earnings. Such lofty valuations are often followed by disappointment.

Addressing the long-term outlook for gold, Jeremy Grantham, the widely followed chairman of GMO LLC, the global asset management firm, recently offered a withering comparison.

"I would say that anything of which 75 per cent sits idly and expensively in bank vaults is, as a measure of value, only one step up from the Polynesian islands that attached value to certain well-known large rocks that were traded," he wrote in his monthly letter to clients.

Some fear that the gold market is repeating history. In 1980, gold shot up to $850 an ounce amid fears of war and inflation. Anyone who was late to the party, though, nursed losses for the next 28 years, as gold retreated to $500 an ounce just months after hitting its peak, and then fell to $300 by 1982.

It wouldn't take much to skewer the price of gold a second time. An improving global economy would send interest rates and bond yields higher, which would make the opportunity cost of holding gold - which pays no dividend - prohibitively expensive. Money would probably flow out of gold investments and into other assets, such as stocks and bonds.

"If you look at the Internet bubble or the housing bubble, it can go on longer than you think," Mr. McElvaine said. "But are the fundamentals for you or against you? With gold, they're against you. It doesn't mean it won't work out in the short run, but it will end badly."



1980: Gold peaks at $850 (U.S.) an ounce amid a surge in the price of oil following the 1979 Iranian revolution. At the same time, Federal Reserve chairman Paul Volcker confronts double-digit U.S. inflation by raising key interest rates as high as 20 per cent.

1999: Gold tumbles to a cyclical low of $252 an ounce during the height of the dot-com bubble and soon after the Nasdaq composite index peaks at more than 5,000. With low U.S. unemployment and a strong housing market, there was little for investors to fear.

2007: The price of oil rises above $80 a barrel for the first time amid concerns about rising Chinese energy demands. The gain feeds concerns that higher energy will translate into rising inflation, which sends the price of gold above $600 an ounce.

2008: The global financial crisis sends investors scurrying for shelter and into the U.S. dollar. The dollar's gains send gold down as low as $700 an ounce - down about 30 per cent from its high near the start of the year.

2009: The price of gold rises above $1,000 an ounce again to a new record high in nominal terms. Investors fret over the implications the Federal Reserve's monetary policy, which involves printing hundreds of billions of dollars to buy U.S. Treasury bonds.

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