Watch out for that shiny pendulum because it’s swinging back fast. Investors are chasing stocks and real estate and fleeing gold. The two former asset classes have experienced solid returns since 2012 while gold has suffered double-digit declines.
Large cracks in the “go-long-gold” strategy are evident. Economic weaknesses in Europe remain but no financial Armageddon has emerged. Keynesian economics remain the drug of choice, Japan being the latest user, yet inflation is non-existent. The strength of the dollar and the increased willingness of the Fed to taper quantitative easing undermine higher gold prices. Investor support is crumbling and gold bugs, those believing it is a stable investment, should be nervous.
Since the historic highs of 2011, gold has dropped by over 30 percent. In 2013 alone, investors have begun to give back several years of gains. Recent paper losses for hedge funder John Paulson have topped $1 billion. In just the last six months, gold has dropped by 22 percent, the worst fall since modern trading commenced in early 1970s. Gold is locked in a bear strangle and prices have plenty of room to fall still further.
It has taken over a decade but the bubble has finally been pricked. The pin that popped this most recent asset swelling is not complicated. It’s a stock market that has reached new highs, falling unemployment and rebounding investor confidence in central banking policy. In the last year, gold investors have lost over 18 percent while those in S&P 500 stocks have enjoyed a 23 percent return. Real estate in the largest U.S. cities has also climbed 10 percent or more since last year and historically low interest rates are forcing investors to find new places for capital. Even junk bonds are back in vogue. Investors are starting to ask the right question: Why lose money on gold when you can gain big on stocks, real estate or new alternative investments?
Other commodities also point to a bust in gold. Silver, the poor man’s gold, has dropped in the last six months by 37 percent. Platinum, a metal that is 15 times scarcer than gold, up to recently, sold at a steep discount to gold. Today, platinum trading at $1,450 per ounce is moving back towards to its historical premium — another powerful sign that lower gold is in the offing.
Caveat emptor: The last gold bust was not kind to investors. From 1980 to 2000, investing in gold was dead money. When that bubble burst in 1980, gold plummeted by 60 percent in less than a year. Using history as a guide, the current pop could push gold down to $700 per ounce — a mind-numbing drop of over $1,100 per ounce from September 2011 historic highs. Taking into account the physical cost of extracting gold from the ground, it is under $600 per ounce. Selling at $700, would still generate modest mining profit. In recent months even gold mining companies have started to hedge against the fall of gold, attempting to lock in profit before it is too late.
This time the gold bubble pop is even more hazardous to financial health. The great unknown is the effect of exchange-traded funds (ETFs) on gold prices as the global economy moves steadily back toward prosperity. Exchange traded funds are derivative instruments used by investors to quickly trade equities, bonds and other commodities like gold. Through the financial support of the World Gold Council, a London-based trade organization charged with stimulating market demand, the first gold ETF was launched in 2004. In less than a decade this ETF called the SPDR GLD and copycat funds have experienced hyper growth. At their peak they had a market capitalization of over $80 billion or 40 percent of the overall physical market. Armed with ETF’s, and a low barrier to entry, even small investors have jumped in to own a piece of gold.
But gold ETFs were created in a gold bull market and these same derivatives that played an important role in the price run up are now morphing into a giant wrecking ball. In 2013, gold ETFs are being bear-market tested. A single gold ETF like the SPDR GLD and how its investors think can dramatically move the price of gold up or down in a nanosecond.
As speculators continue to switch horses and move to stocks, real estate and other higher yielding investments, how far and how fast will gold prices fall? History suggests $700 gold is not out of the question (and that was before the advent of multi-billion dollar, rapidly traded ETFs). The silver lining to all of this is that falling gold prices are a strong sign that market confidence is returning and a long-awaited global economic recovery is finally taking hold.