Bullion as an Investment, Part 1

Investors are curious to know whether bullion will provide them only with wealth preservation, or whether they can expect real gains in bullion price.
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Editor's note: This is part 1 of a three-part series on Bullion as an Investment. Here are part 2 and part 3.

Valuing Bullion

When most precious metals commentators (including myself) recommend gold and silver to investors, we label it as a means of wealth preservation, or simply as insurance. Few (serious) commentators talk about bullion as a means of making money (above and beyond the rate of inflation).

The reason for this is clear. When one is strongly encouraging people to play defense and focus on wealth preservation and insuring that wealth, then it is simply inappropriate to advertise precious metals as some sort of get-rich-quick scheme. Nonetheless, investors are naturally curious to know if bullion will only provide them with wealth preservation, or whether they can actually expect real gains in the price of bullion -- in other words, does it offer a rate of return above the real rate of inflation?

The best/easiest way to answer that question is to compare the rate of change in global wealth levels with the rate of change in global bullion stockpiles. However, such a direct analysis is not practical, for two reasons. First, with humanity having mined-and-refined precious metals for close to 5,000 years, we can only make a crude guess at the total amounts of bullion which have been refined.

Secondly, in the case of gold, much of these global stockpiles would simply never come onto the market -- at any price. Many of the world's most treasured religious/cultural icons contain lavish amounts of gold, and all of that gold could never come onto the market unless/until those religions were to die-out. There is also vast quantities of antique jewelry, and irrespective of the price of bullion, such bullion will always command an additional premium as an antiquity -- meaning that such items will forever remain a part of the antiques market, not the gold market.

In the case of silver, global stockpiles must be much more radically revised -- to reflect the fact that most of the world's silver has (literally) been consumed by industrial applications. Compounding this, as I reported in

a recent commentary, inventory and stockpile numbers for silver have been grossly distorted by "lapses" in record-keeping which are so absurd and glaring that they strongly suggest a deliberate attempt to deceive.

Deprived of using the most direct means of assessing the increase (or decrease) in the absolute value of bullion, we can fortunately rely upon a "proxy" for this measurement -- using data which is readily available, and relatively reliable.

While we can't measure the absolute change in bullion stockpiles, we can measure the rate of change in those stockpiles, or (in other words) the acceleration or deceleration in the change of those stockpiles. Similarly, we can measure the acceleration or deceleration in global incomes. By comparing the two rates of change, we can come up with a clear measurement as to whether bullion is becoming "absolutely" more valuable (i.e. its value is increasing faster than inflation) or only "relatively" more valuable (that is, bullion only tracks the rate of inflation, but produces no real gains).

Because of the dramatic differences in the fundamentals for the gold and silver markets, and because the gold market is, by far, the larger of the two markets (at the moment), I will restrict my analysis to the gold market, with the obvious implication that whatever conclusion is produced for the gold market will be applicable (in approximate terms) to the silver market.

With respect to the rate of change in gold stockpiles, the principal variable is mine-supply. Roughly nine years into this gold bull market, and after a quintupling in the price of gold, mine supply is "flat" (at best) with a clear trend toward lower production over the long-term.

Because increases in the price of a good (especially large increases) are supposed to lead to increased supply, the actual data is not what we would have expected. Mining experts will tell you that it takes five to 10 years to start bringing new supply on-stream: the time it takes to develop a gold deposit from scratch.

With year-after-year of strong price growth, we should have seen some clear evidence of rising mine supply by now. The fact that this supply growth is absent is leading myself (and a growing number of other precious metals commentators) to suggest -- if not embrace -- the concept of "peak gold."

In this respect, I'm influenced by the superb research into commodities markets which was undertaken by Chris Martenson, and reflected in his ground-breaking presentation:

The Crash Course. Martenson constructs many eloquent and powerful arguments that "peak supply" is a concept which is applicable (to greater or lesser degrees) to many of our most "precious" non-renewable resources. I encourage all doubters to take the time to view this presentation -- with the expectation that there will be far fewer doubters once they view Martenson's analysis.

In the second part of this series, I will complete my analysis of the supply side, and have a look at the peculiar behavior of central banks.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.