The Impact of Synthetic Diamonds on the Market

SUMMARY:

| The impact of lab-grown (synthetic) diamonds on the market is disruptive.  Investors should consider these facts. |

Diamond prices have declined significantly since their high in February 2022.

“The plummeting prices follow two record-breaking years… In 2021 and 2022, demand for natural diamond jewelry was at an all-time high… There was a parabolic move up, and now there’s a correction on the other side.” —CNN Business 10/1/23

Diamonds have historically held their value consistently against inflation for tens, if not hundreds, of years. For example, according to the Natural Diamond Council, diamonds have increased in value on average over 3% per year, for the last fifty years. Furthermore, as we have written previously, there are unique advantages that diamonds can deliver, versus other assets like gold and silver, which have made them a valid diversification option for hard asset portfolios.

Is that now changing, given the significant dip in prices in the last eighteen months?

No one can predict the future, but we have some insights that may be helpful to hard-asset investors.

UNDERSTANDING WHAT HAPPENED TO DIAMOND PRICES OVER THE PAST SEVERAL YEARS

The diamond market is currently facing pressure from a few key factors.

First is the fact that trillions of dollars were pushed into the marketplace to relieve economic pressure from the onslaught of the COVID pandemic. People couldn’t travel, but they still had birthdays, anniversaries, Christmas/holiday giving, and other meaningful family gift-oriented occasions. Diamonds and jewelry were always a good option, but since travel has long been the jeweler’s number one competition, diamonds and jewelry became the best possible option to say I love you. Consequently, 2021 and 2022 were the two best years in jewelry industry history. Demand for diamonds rose significantly, and diamond prices rose with that demand.

Second, nothing lasts forever (except maybe diamonds), and the rise of travel in the second half of 2022 and continuing into 2023 is a major factor that has cooled diamond and jewelry demand. People were couped up for some two years and finally broke out of their shell. This diversion in spending from jewelry to travel, along with no more free government money and supply chain disruption, has caused economic uncertainly to the point of near-recession.

Third, while all this has happened in only three years, the tremendous production (even over-production) and dissemination of lab-grown diamonds has been an option never before seen in the jewelry industry. Demand for the man-made (synthetic) product is something few of us would have predicted to grow at such a rapid pace, and it is no doubt having an impact on the sale of natural diamonds, and their prices. In other words, while economic cycles will always impact diamonds and other consumer goods, lab-grown diamonds are a new factor causing disruption in the market.

ANALYSIS OF MARKET FROM TWO PERSPECTIVES

In trying to predict what is likely to happen with diamonds and diamond prices over the coming years, given the advent of the lab-grown product, two approaches are useful. We’ll call them herein: (1) the “Comparables Approach,” and the “Product Segmentation Approach.”

The Comparables Approach: What Happened To Colored Gemstones.

The diamond market is currently facing price pressure from the growing adoption and consumer acceptance of lab-grown diamonds, and it’s difficult to predict the ultimate outcome. We’re fortunate in that there is a market quite adjacent to diamonds where something nearly identical has happened: the colored gemstone market.

Synthetic colored stones first appeared early in the 20^th century but had no significant influence on the market until the technology reached a point where production costs made them commercially viable. As the technology improved, the costs of creating colored stones dropped, finally reaching a relatively stable level.

What happened, not surprisingly, is that the market segmented. Those who cared primarily about price chose the lab-grown route, and those who wanted the natural product continued to buy it. Today, a high quality, one carat ruby, for example, will be sold at retail for several thousand dollars, whereas a comparable quality ruby created by man will be sold for a small fraction of that.

The advent of the synthetic product, rather than ruining the value of natural colored gemstones over the long term, simply provided a less expensive alternative. Yet when synthetics were first introduced, they were disruptive and scary to the natural gemstone market. In fact, the advent of manmade colored gemstones at affordable prices to mainstream consumers actually increased the attention of people on the natural product. Hence, ultimately, they were additive to the popularity of natural colored gemstones.

The diamond industry is now going through a similar process, and is currently in the “disruptive” stage. Most agree that while today a lab-grown diamond is much cheaper than its natural counterpart, the disparity in pricing has grown exponentially and will continue to grow, with the price of the manmade product dropping to perhaps as low as a $100/carat. In fact, evidence already exists to show prices of some qualities and sizes to be that low.

As this happens, the market is likely to segment just as it did with colored stones. LG diamonds will have a price-point similar to fashion jewelry, and the natural product will be priced higher. But how much higher, we don’t know. Also, it’s not impossible that the very low-end segment of the market, where the diamond is visually not appealing, may be entirely crushed by the lab-grown product, which simply looks better. However, most of the gradations in diamond color and clarity—once set in jewelry—are not readily distinguishable to the naked eye.

In short, the colored stone market gives us a “comparables” model that can be studied in our attempt to understand what is happening in the diamond market today, and what’s likely to happen in the future.

The Product Segmentation Approach: Breaking Down The Market By Value Drivers

Unlike ounces of gold, which are fungible, diamonds are diverse. The GIA grading scale (the 4C’s) does a good job of classifying diamonds by quality and size, but one thing it does not do is show rarity. When people say diamonds are very rare, they’re correct. But when others say that diamonds are actually not that rare, they’re also correct. The difference is in which diamonds are truly rare, and which diamonds are not. The higher the quality and size of the diamond, the more rare it is. The lower the quality and size, the more common it is.

Here, we’re going to create two new terms, to help expand on this concept. While this is a vast oversimplification, and we’re dealing with a continuum not a binary split, let’s divide diamonds into these two groups.

Adornment-Class Diamonds. These are diamonds whose value is primarily driven by their value as adornment. In short, the buyer intends to wear them, and values them for their visual beauty and meaning (i.e. love, commitment, status).

Asset-Class Diamonds. These are diamonds whose much higher values are not based on an improved visual appearance, but rather on scarcity. We know their values are based on scarcity because—to the naked eye—these very high-quality diamonds are almost identical to most of the Adornment Class diamonds. More precisely, once set in jewelry, the top ten grades of color and clarity are largely indistinguishable to anyone without specialized training and equipment. Yet their price difference is significant—up to five times higher.

This is an important concept to those considering diamonds as part of a financial hard-asset portfolio, and eyeing the impact of the lab-grown product on future valuations.

Competition From Synthetics On The Two Classes

In our opinion, lab-grown diamonds are direct competitors to natural diamonds in the adornment class, yet are likely to provide much less—if any—competition to asset class stones. Price trends to date bear this out.

The reason comes back to why those asset-class diamonds have such values in the first place: their scarcity. It’s the same thing that gives value to other tangible assets like collectible stamps, baseball cards, and original art. The premium one pays for asset-class diamonds, over adornment diamonds, is based almost completely on the scarcity of such diamonds.

Adornment diamonds, on the other hand, are valued primarily for their physical appearance, and the fact that they are actual diamonds. Given that LG diamonds are also actual diamonds, and have the same appearance, if LGs are available at a lower cost they will disrupt the adornment-class diamond market—which obviously they’re doing. But they have little if any ability to disrupt the asset-class diamond market, which is driven by rarity. LG diamonds are the opposite of rare. Over-production and improved technology will continue to drive the price down to meaningless levels. It’s a race to the bottom.

From the top of the market in February 2022 to today, diamonds in the under 3 carat range have dropped in value by percentages that represent the tremendous increase that came in 2020 and 2021 Those in the 3-5 carat range have dropped very little. And those above 5 carats haven’t dropped at all.

The reason is not that lab grown diamonds don’t exist in those sizes. They absolutely do. The reason is that natural diamonds in those sizes are extremely rare. Whereas natural diamonds in the lesser size and quality ranges are not as rare.

Again, to be very clear, the distinction between the two classes is not binary, it’s a continuum. The higher the quality and larger the diamond, the more we can consider it “asset class,” and vice versa. Note: Icecap has always sold diamonds of both asset-class, and the higher-end of the adornment class (as we’re defining those terms herein.)

RECOMMENDATIONS FOR FINANCIAL BUYERS OF DIAMONDS

Based on the above analysis, and again acknowledging that past trends do not guarantee future outcomes, these recommendations seem reasonable based on what we know today, for buyers of diamonds to go into hard-asset portfolios.

1. Don’t buy the cheap stuff. Avoid, entirely, those diamonds whose color and clarity make them visually undesirable. These diamonds will be the most vulnerable to competition from the LG product. While only a very rough guide, we might define this category as K or below in color, and I1 or below in clarity.
   
   
2. Consider nice-looking “adornment class” diamonds as a more speculative choice. Diamonds that are, visually to the naked eye (and especially when set in jewelry), pragmatically indistinguishable from the highest colors and clarities, but are not those highest colors and clarities, should be purchased with an understanding that while the lower price point yields advantages and flexibilities to the investor, it is difficult to predict what will happen to the valuation of these stones. Judging by the colored stone market, they will likely come to rest at a significant premium over lab grown, and—given current drops—might be poised to rebound to earlier levels, once the LG product ends up at a price-point similar to costume jewelry. So there is probably higher risk with these types of diamonds, but possibly higher upside potential based on current valuations. We might define these diamonds as G-J color, VS2 to SI2 clarity, and perhaps 2-3 carats and below.
   
   
3. For best preservation of long-term value, concentrate on “asset-class” diamonds. These are the stones that are the most rare, and almost certain to stay that way. Their vulnerability to competition from things like synthetic diamonds (which are not rare) is probably very little. Let’s define these as D-F colors, FL-VS1 clarities, and 3 carats and above.

BOTTOM LINE: Buyers of diamonds for portfolio inclusion should focus on asset-class diamonds. Good quality “adornment class” diamonds can be included as well, to provide diversification, but these likely offer both higher risk, and potentially higher reward (upside) at today’s market levels.