Diamonds, Jewelry, the economy and gold

An article in Mineweb earlier this month said that the International Diamond Exchange (IDEX) reported diamond prices are softening. I have not seen any hard data for a long time, but I do recall seeing a study about ten years ago that indicated a very high correlation between higher-end diamond prices and stock market indices. Diamonds are the ultimate luxury item and during times of prosperity (usually when stock prices are rising), demand for diamonds is strong. Conversely, when times are tough, less people buy expensive diamonds.  

By: Paul van Eeden

According to IDEX, the prices of 1.5 and 2 carat diamonds fell below their prices of a year ago for the first time in recent history. In my way of thinking that is probably because the bull market in stocks, bonds and real estate that started in 1982 might finally be coming to an end. IDEX apparently found that US jewelers are concerned that softening jewelry demand is a leading indicator for US economic growth.

I would not hang my hat on diamond prices as a leading economic indicator but in conjunction with everything else that’s going on I would look at it as confirmation that US economic woes are deepening.

Last week I reported on the Federal Reserve Bank of Boston ’s comments that weakness in the housing market poses a risk to the US economy. This week the Federal Reserve Bank of Philadelphia said its business conditions index, a gauge of manufacturing activity in the Mid-Atlantic region, fell into negative territory for the first time since 2003. A negative reading implies economic contraction and thus the index is not merely indicating a slowdown in economic growth, but an actual contraction of economic activity.

The Conference Board, a nonprofit business research group, issued a separate report of composite leading economic indicators that also signaled weakness ahead. Their index of leading indicators has declined for five out of the eight most recent months. The biggest contributors to the decline were waning consumer expectations and declining building permits.

During the past month, short selling on the New York Stock Exchange hit a new record -- a clear indication that there is a strong belief out there that the current rally in stocks is not going to last.

Not surprisingly the Federal Open Market Committee decided to leave US interest rates unchanged this week for the second month in a row. In the accompanying statement the Fed said: “ The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market.” The Fed continues to talk about the threat of inflation but weakness in the economy is, thus far, prohibiting them from raising interest rates.

The dollar softened up this week due to all this talk about negative economic conditions and that gave a boost to both gold and base metals prices. As the US economy weakens the demand for base metals will eventually drop off. China , India , Russia , Brazil , and the rest of the developing and developed world will not be able to replace falling US demand for goods and services. A lot of hope is pinned on China, but to believe that Chinese demand for base metals and other raw materials is going to offset falling US demand is ludicrous (see “Will China really save the world?” www.paulvaneeden.com/displayArticle.php?articleId=169).

Unlike base metals, Gold is purely a monetary asset. So while falling economic activity will have a negative impact on base metals demand and, consequently, base metals prices, the same is not true for gold. Falling economic activity has no impact on the gold price. Because gold is a monetary asset the gold price is determined predominantly by the inflation rates of fiat paper money and currency exchange rates. Therefore, a slowdown in US economic growth coupled with a declining US dollar exchange will have a positive impact on the gold price even if base metals prices fall.

A large amount of capital was invested in metals during the past year as investors looking for a hedge against the US dollar bought all sorts of “hard assets”, including base metals, precious metals and gold. Those investors did not differentiate between base metals, which are commodities, and gold, which is money. So while declining economic activity should not have a negative impact on the gold price, falling base metals prices might cause those same investors, who indiscriminately bought gold and base metals, to sell those assets, including gold. This could cause the gold price to fall in sympathy with base metals in the short term; however, any such decline in the gold price should be viewed as an opportunity. At some point the gold price will decouple from base metals and rise due to rising fiat currency inflation and a falling US dollar exchange rate.

My own target for the gold price remains somewhere between $900 and $1,300 an ounce so with gold now under $600 an ounce I am once again a buyer. I don’t buy physical gold; instead I invest in mineral exploration companies. I sold aggressively during May and have been waiting for good buying opportunities to arise. Now I am starting to see some attractive stock prices once again. If you are interested in what I buy and sell with my own money you could subscribe to my paid weekly newsletter, in which I discuss the stocks I buy and sell. For more information please visit www.paulvaneeden.com/publications.php.