If you’re considering buying gold into this selloff, please let me be the first to dissuade you. To explain why, though, we first need to look at the past — and discover why gold made its spectacular ascent in the first place.
Although gold started its uptrend as far back as 2006, it really kicked into gear during the financial crisis. As housing prices cratered, a chain reaction kicked off that roiled the markets. In times of crisis, people move into hard assets — things with real, tangible value associated with them. Real estate was no longer on the table as an option, however. So whereas lots of capital might have flooded into that sector, it instead had to find another home … thus, we saw a huge flood of capital into commodities, including all the precious metals.
Then the frenzy begins to feed on itself, fueled further by easy access via funds such as the SPDR Gold Shares (GLD). Once gold broke through the $1,000 mark, the average investor took notice. Hedge funds were piling in as well. The initial reason for the flood of capital into this perceived asset of safety was beginning to wane, but now momentum had taken over.
If that had been the end of the story, however, gold prices might have come back down.
Instead, two more things happened. First, the Federal Reserve started quantitative easing. The perception — not entirely true, by the way — was that by printing more money, inflation would inevitably occur and the value of the dollar would fall. Gold generally moves inversely to the dollar, because as the value of the dollar drops, things priced in dollars are worth more … thus hard, tangible assets denominated in dollars would be expected to increase in price, which gold did.
The consumer sector saw an explosion of places that would buy gold. Volatility in gold prices actually drives consumer demand to sell gold more than absolute price, so as gold continued to move in leaps and bounds, consumers sold their gold to scrappers, who paid far less than it was worth, then turned around and got huge payments for scrapping it near the spot price. The demand for trading gold kept the price sustainable.
What goes up, however, will come down.
I knew from the chart that gold was going to inevitably collapse. Not just fall, but collapse. I just didn’t know when … and having been burned on trying to short it before, I gave up trying to figure it out. But the fall began and it will continue because everything I’ve just discussed is in the process of reversing.
Once gold topped out, my sources told me that the finite supply of gold that people had to sell had more or less been exhausted. There’s always some replenishment going on, but for the most part, the people who wanted (or more likely, needed) to sell gold have sold. The economy was such a disaster and people were out of work for so long that a lot of gold was pawned and sold during the past few years. That removed one source of price sustainability.
Then the Fed announced it was considering tapering off QE. Just the fact that the word “consider” was used — it hasn’t even been tapered and might not be for a long time — was enough to cause gold to crater even further. At some point, QE will end and the inflation fears will subside … and the dollar will rise even further than it has been of late, pushing gold even lower.
Real estate is making a comeback, although most reports suggest these remain speculative purchases and sales. Still, it’s a hard asset that is now attracting capital where it wasn’t before. And again, as people sell out of gold, that capital needs to find a home.
The bottom line is that buying gold in the hope of seeing $1,700 an ounce again seems like a bet in the wrong direction. I think the path of least resistance is down. Despite having been burned in the past, I am considering going short the SPDR Gold Trust (GLD) on the next significant move up, using a tight 5%-7% stop.
There are other plays here if you want to be short, however. You could be very aggressive and go with the PowerShares DB Gold Double Short ETN (DZZ) or the VelocityShares 3x Inverse Gold ETN (DGLD), but be careful — these are leveraged, inverse funds that can double or triple your returns … but also your losses if you bet the wrong way.
Despite my bearishness on gold, I still think having a small percentage of a long-term portfolio in gold or precious metals is a good thing, for the sake of diversity. If you want to hedge that position, have a look at the Credit Suisse Gold Shares Covered Calls ETN (GLDI), which sells calls against various gold positions as a hedge and pays those out monthly.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets @ichabodscranium.