As gold flirts with all-time (non inflation-adjusted) highs, many investors wonder whether gold can surge yet higher, or if we’re merely in a bubble. Although we lack a crystal ball on that question, we do know some basic facts that help to explain just how far from a baseline value that yellow metal has come.

Gold serves four main purposes:

1. As a key ingredient in a range of industrial processes
2. Jewelry
3. As a key asset held by governments that can be used in trade when they want to take steps to fund their budget deficits or provide confidence in their currencies
4. As a hedge by investors that fear eventual high inflation.

It’s that last factor that has caused gold to nearly triple in the past five years to around $1,400 an ounce.

It’s hard to get a true read of how much gold is bought and sold between countries. Some countries have sold off major gold reserves, while others have loaded up on it. Assume that major governments do not impact gold, and supply and demand are balanced by their activity. In terms of the other three factors, 50% of annual mined gold is used as jewelry, 40% of it as investments/hedges by individuals and financial institutions, and the remaining 10% is used in applications such as dentistry, medicine and a range of electronic devices such as electricity conductors, industrial connectors and others. 

Never-ending increase in supply
According to the world gold council, 165,000 tons (or 3.3 billion pounds) of gold have already been mined from the earth in human history. Since gold does not oxidize, evaporate or dissolve, much of that gold still exists. How much is anyone’s guess, but we can at least assume that the vast majority of gold mined in the 20th century has been preserved, whether it’s in depositories like Fort Knox or in private safe-deposit boxes. Gold that went into industrial applications is often salvaged, but in many instances, an industrial piece of equipment with gold in it now sits in the junkyard. (And bodies with gold teeth lie six feet under.)

Yet with much of the mined gold still in existence, and more gold being produced very year, there never has been and never will be a shortage of gold. To be sure, the easiest gold mines have played out, so the cost of mining new untapped sources of gold becomes ever-more expensive. 

Substitution effect
As gold prices rise ever higher, it becomes less attractive to central banks, jewelry buyers and industrial users, some of which can substitute other metals with similar properties. Using jewelry as an example, rising gold prices mean that existing jewelry is being turned in and melted down, providing ample supply to the manufacturing of new gold jewelry. So that 40% factor — as an inflation hedge — is now an ever more important part of the demand equation.

The inflation argument
Why has gold become so popular among some investors? Because they fear that current government policies are awfully risky. They note that there are two ways a government with massive budget deficits can meet future obligations: by defaulting on their bonds, or subtly encouraging rising inflation so assets can rise in value while debts stay constant. Either way, gold would become more valuable. [“If States Start Defaulting, This Company is in Trouble”]

Their fears have a degree of logic. Germany in the 1920s or Zimbabwe in the last decade have shown that a sharply-expanded money supply and crushing foreign debts can lead to runaway inflation. But the odds of such an event happening in the United States or elsewhere is extremely remote. The simple fact remains that there is already too much idle money sitting around earning low bond yields because so many investors see risk in stocks, housing or other assets that would often be bought. In the 1990s, that money chased tech stocks. In the last decade, that money chased housing. And in this decade, it’s chasing gold. Those first two manias ended badly, and gold may be set up for a similar fall. Here’s why…

Rising prices of any asset creates an environment for its own downfall. As gold has risen in value, demand for non-investment purposes has begun to fall (as noted above). Rising gold prices also tend to stimulate supply. The 1990s tech boom led to the appearance of hundreds of new dot-com IPOs. The housing bubble led to the construction of far too many homes, many of which are now empty. And the gold price spike is leading many gold mining firms to re-open mines that were no longer cost-effective when gold was worth $500 an ounce. As those re-opened mines crank up, the output of gold will follow suit (after notable output declines in recent years). Rising supply that lacks a commensurate rise in demand sets the stage for falling prices. Investors are playing a game of musical chairs, pushing gold higher and higher — until the music stops.

Can gold climb yet higher? Sure. Nasdaq stocks were sharply overvalued in the summer of 1999, yet they rose much higher at the end of that year, in what’s known as a “melt-up.” I don’t foresee that happening with gold, where we would go from $1,400 to, say, $2,000 very quickly. But that Nasdaq melt-up set the stage for an eventual profound meltdown when the music finally stopped.

Action to Take–> Even if the inflation hawks are correct and inflation re-emerges, it’s unlikely to be the sky-high inflation like we saw in the 1970s. In the context of a reasonable rise in inflation, gold bugs are bound to be disappointed. If you hold any gold stocks, you don’t want to be stuck without a chair when the music stops.