Is The Gold Pain Over?

By Tim Parker | August 09, 2014 AAA
Is The Gold Pain Over?

The behavior of gold over the past decade might be compared to a moody co-worker. When he's happy, he's really happy. When he's down in the dumps, look out. A five-year chart reveals that the precious metal has traded in a range from $707 to $1,901 - an increase of 169%.

If that isn't enough to make even most risk-averse traders nervous, on April 15, gold plunged more than 9% which followed an April 12 fall of 4.1%. By the end of the day, April 15, the closing price was $1,360.60 - 28% off its all-time high of $1,901.

Commodities and volatility go hand-in-hand but the recent price action has investors wondering what's happening in the metals market.

The Hedge Theory Doesn't Appear to be True
The traditional wisdom among strategists is that gold is a hedge against inflation but history doesn't support that claim. According to MarketWatch, from 1980-2001, the inflation rate was 3.9%. In 1980, gold hit a then-record level of $850 but plunged by the end of the year. If an investor had held gold until 2001, they would have experienced a loss of 85% despite the high rate of inflation. If it's not investor response to inflation that moves the gold market, what is it?

Factors that Affect Gold
Supply and Demand
Jewelry is the primary use for gold, comprising 66% of annual gold production. India leads gold demand but in 2012, its consumption fell 12%. According to the World Gold Council, the average annual price of gold in Rupees, the Indian currency, rose 21% in 2012, which could account for the soft demand. But soft Indian demand doesn't reflect world demand. According to the Gold Demand Trends report, the demand for gold hit an all-time record high of $236.4 billion or 4,405 tons.

Speaking on CNBC's Fast Money on May 7, Lear Capital CEO Scott Carter said that the low price of gold stemming from the recent April plunge has created soaring demand for the physical product and that has helped to drive the price up more than 8% since its recent bottom. "Demand at the mint level for coins [and] demand at the retail level in our business is at an all-time high right now," he said.

World Events
Wars, natural disasters and other world events may decrease consumer and even industrial demand but as a nation destabilizes due to these events, the demand for gold, seen as a safe store of value, might increase.

Central Banks
In 2012, central bank net purchases accounted for 12% of demand. When gold plunged in April, some experts believed that Cyprus' announcement that it would sell a portion of its gold reserves contributed to the plunge. Cyprus is said to only have 40 metric tons but investors worried that this would set a precedent for other countries.

Investors and Speculators
Only 6% of 2012 demand was from ETFs like the SPDR Gold Shares (NYSE:GLD) but speculators are responsible for large amounts of the trading volume. Reuters reported that on April 15, the day of the plunge, a record 689,000 lots traded. (That's 68.9 million tons if the contracts were exercised.)

Recent Legislation
Despite the disappointing performance of gold recently, Bloomberg reports that lawmakers in seven states (Arizona, Missouri, South Carolina, Kansas, Indiana, Oklahoma and Louisiana), are considering legislation that would recognize gold and silver coins as legal tender.

Arizona was set to adopt such a law but Governor Jan Brewer vetoed the bill. This leaves Utah as the only state to recognize the metal as a currency but it has no infrastructure in which to enact the law. The movement's popularity stems from a general distrust in U.S. monetary policy as interest rates remain low and the value of the dollar remains under pressure.

Where's It Going?
If we look at the five factors above, what do they tell us about future prices? Supply and demand is high; CNBC reported that the U.S. Mint sold nearly 200,000 ounces worth of American Eagle gold coins in April, forcing it to suspend sales of the entry-level item. A relatively quiet eurozone, along with countries like Iran and Syria not making headline news, should give investors confidence that, at least for now, markets are trading on fundamental economic factors rather than news driven events.

On April 24, the Financial Post reported the Cypriot sale of its gold reserves was not a priority. This calmed international worries but U.S. investors remain concerned that as the United States economy continues to improve, the Fed will end QE, setting the stage for inflation. How that will affect the markets is a concern, especially as people like Warren Buffett go on record as saying an end to QE could result in a "very inflationary" economy. Although research may show that gold doesn't function well as an inflation hedge, many investors still trade under that assumption.

Finally, investors remain skittish. Even as nearly half of the plunge is erased, equities are still the growth asset of choice. In a stock market that continues to print new highs, why take the chance on gold, a commodity that has been in a downtrend since October. These, and many other factors, affect the direction of the metal but among investors, there's a "don't fight the trend" mentality.

Take Action
Investors trade gold through futures, ETFs and pure-play stocks. The gold mining stocks have seen disappointing returns even when gold was in demand. Far too many investors have spent the past few years pouring money into miners thinking that they can't continue to weaken. Unfortunately, most of those long positions have turned out to be a disappointment.  

For those who don't participate in the futures market, the most popular gold ETF is the SPDR Gold Shares. Its expense ratio of 0.40% is acceptable and because it owns physical gold, investors are immune to the problems that come with an ETF levered to futures contracts.

The traditional wisdom still remains that every longer-term portfolio should have gold as a prominent position. Although gold certainly hasn't been the most attractive of investments of late, when the bull market eventually comes to an end, investors will watch closely to see if gold offers the hedge that it's known for.

At the time of writing, Tim Parker did not own any shares in any company mentioned in this article.

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