Diamonds, always a girl's best friend, in coming years may become the best friend of investors both male and female. Diamonds are quickly transforming from an individual investment to a commoditized asset.  What is happening to the diamond market now is eerily similar to what happened to gold 20 years ago.

Since the mid 1990’s diamond prices have been highly correlated to gold prices, but in recent years gold prices have been rising faster due to the acceleration in macro-economic uncertainty and inflationary risks surrounding the global economy. In the end, diamonds, unlike gold, are commodities which are not a part of the global monetary system.  Many would argue gold is not either, like Fed Chairman Ben Bernanke, but then why do central banks carry so much gold on their balance sheets and buying it at an accelerating rate?

As a commodity, diamond prices are mainly driven by supply and demand.   Prices have been increasing due to a significant supply shortfall that ranges in any given year between 2% and 5% of global demand. The demand for diamonds and gold in China (AMEX:$FXI)and India is a major contributor to the increased prices of both. 
The reports of physical buying by the Chinese of massive quantities of gold have been all over the headlines, 383 tons imported through Hong Kong (AMEX:$EWH) through the end of June, and China has made no bones about their desire to accumulate as much as they can get their hands on.  The internationalization of the Yuan is predicated on this. 

On the other hand India is at war with its people who see gold as the ultimate form of wealth while distrusting the Rupee.  In the face of a number of moves by the government to staunch the flow of gold into India, Indians are quickly shifting their buying into diamonds. 

Diamond jewelry demand has exploded in India, China and the rest of Asia.  Since 2000 India’s demand has grown nearly 400%, while China’s has surged 539%, while demand in the U.S. and Italy has fallen during that time.  The Indian diamond market is nearly 4 times the U.S. market.  And, as stated above, the gold market is becoming increasingly controlled.  This is also true in gold hungry countries like Vietnam and Turkey.

While the SPDR Gold Trust (AMEX:$GLD) has risen 365% since its inception in November 2004, the prices of diamonds not doubled. But the gold prices have risen mainly due to concerns over currency, poor investment alternatives, and the lack of stability in everything else. Polished prices are currently trading around levels seen in 2004-05. Historical price performance of polished diamonds since 1982 is strong relative to gold, yet in the last 10 years it has lagged behind gold and other commodities.
The primary use for both gold and diamonds is for jewelry. They both are tangible, portable and liquid investments.  Russia emerged in 2010 as the biggest producer of diamonds and it has grown to a $5.3 billion industry for them, growing steadily at a CAGR of 4% for the past 10 years.

From cutting tools to use use of nanometrics diamonds as adjuncts in high-tech composite coatings, Compared to Gold, Diamonds have a wider industrial use than Gold. Due to its hardness and heat connectivity, diamonds are used in saws, abrasives, construction, computer chip production, lasers, surgical equipment and mining.
The growing uncertainty in the global monetary system will eventually lead to a re-monetization of gold, in fact the process is well on its way.  This is why Russia and China are voraciously accumulating gold while Russia, as well, keeps a tight control on the diamond industry as both a source of governmental revenue but also as a store of national wealth.

Like all mining, diamond mining is risky, expensive and becoming more so every year.   This is part of the reason for the demand and supply imbalance.  And during time of high energy costs and weak money-substitute prices, like the current environment, miners find it tough to carry forward. Rio Tinto (NYSE:$RIO) and BHP Billiton (NYSE:$BHP) have recently announced their plans to shut some of the largest diamonds mines on the planet. Also, De Beers and Alrosa have stated their intentions to reduce production.  This will only serve to put a fire under diamond prices over the next few years.

This rising cost of production due to both energy costs and lower quality grades being mined on average, will actually put a firm bid under the price of gold.  The current industry average I’ve heard quoted is somewhere near $1300 per ounce, so, while this is bad for the mining stocks in the short-to-medium term it is bullish once Gold finishes its current consolidation.

So, while supply and demand have been out of balance, the issue then could be one of liquidity.  Opening up direct investment opportunities should be a means to facilitate better price discovery. We are already seeing various closed-end hedge funds for diamonds. In March, there were news reports that ETF provider IndexIQ had filed with the Securities and Exchange Commission to launch a physically backed diamond fund.

However, there are many challenges involved with diamond ETFs to overcome. Unlike gold, the gems are not standardized; there are different types of diamonds, based on size, quality and other factors. Several firms are trying to develop standardized indices of diamond prices. In 1980 Martin Rapaport, who founded a popular gauge of diamond pricing, submitted a proposal to the New York Commodities Exchange for the creation of a futures market for diamonds, but the proposal was rejected as the “diamond industry didn’t want price transparency.”  That dynamic is no longer valid.

In the next 12 to 18 months it is perfectly reasonable to believe gold reaching more than $2500 per ounce with silver tagging along at a 40:1 ratio.  For this reason silver (AMEX:$SLV)streaming companies like Silver Wheaton (NYSE:$SLW) are very good plays, as they will lock in years of silver production at dirt cheap prices while providing strong financing for early stage producers.  As gold becomes that much more expensive and governments begin to act more erratically in the face of monetary stress, the more people will turn to other investments to protect their wealth.  One natural substitute for gold will be diamonds.  It happened in 1980 and it will happen again.