by Roger Conrad, Investing Daily
Last year about this time, the price of gold was pushing toward $1,800 an ounce. I was a guest speaker on a well-produced Caribbean cruise, where the consensus was that gold $6,000 was inevitable if not imminent.
Given that the yellow metal has since declined by more than $400 an ounce, I suspect many former enthusiasts now feel differently. SPDR Gold Holdings has fallen from the second to the third largest exchange-traded fund (ETF), as many have given up on gold entirely.
That’s certainly understandable. Just as every argument and news development seemed to push gold higher last year, this year we’ve seen the metal head lower on almost any rumor.
Last year, for example, an event of the magnitude of last month’s Cyprus crisis would have sent gold higher for several days. This year there was barely a ripple. In fact, this week’s decision by Cypriot authorities to sell some $522 million of gold reserves for cash was blamed for the massive declines we saw in the metal.
Cyprus, of course, remains very much in crisis, due to the austerity imposed by European central bankers. And unless economic growth does pick up, governments there will be under rising pressure from citizens to buck the euro and start inflating. That’s also the case in other euro zone countries, including major ones like France.
This week, France’s Socialist government announced it would attempt to roll back deficit reduction targets to revive economic growth. That joins similar calls from two other major countries, Italy and Spain.
To date, Germany has resisted such calls for relaxing deficit reduction targets, and has used its superior financial position to keep them in force. But the longer Europe contracts, the greater the pressure will be for looser monetary and fiscal policies to ease the pain.
To the extent there is easing, it can’t help but be bullish for gold, but this year’s effect is negligible.
In this country, the US Federal Reserve continues to back a policy of quantitative easing until unemployment falls to at least 6.5 percent. Last year, that policy drove people to gold in droves as a hedge against supposedly inevitable inflation.
This year, it’s done nothing to stem gold’s decline. In fact, judging from traders’ comments, the buzz is about what will happen when quantitative easing ends, and removes a supposed spur for inflation.
Behind the Fall
Every ounce of gold ever mined is still in circulation today. That makes discussions about supply basically meaningless, other than as spurs for near-term events. Rather, it’s all about demand, which is driven by investor psychology alone.
Last year, the psychology was crazy positive for the yellow metal. This year, it’s quite negative, and prices have fallen as a result.
Interestingly, gold’s decline corresponds closely to a protracted drop in the VIX Index to its lowest levels since the 2007-09 bear market in stocks. VIX — the Chicago Board Options Exchange Volatility Index — is basically a fear gauge, based on options prices.
When VIX is at a high level as it was in late 2008, it indicates investor anxiety is elevated. At such times, only investments considered the absolute safest do well.
In contrast, a low VIX indicates greed is outweighing fear as the primary market emotion. It’s risk-on now as far as investors are concerned. And it’s stocks, not gold, that are drawing the buyers.
Ironically, at the height of the 2008 panic, gold prices were tracking stocks very closely, sliding to $660 an ounce in late October 2008. Rather, US Treasury bonds were the safe haven of choice during that crisis, surging even as everything else burned.
Treasurys have retained that exalted status since, rallying during the 2010 Flash Crash and the wake of the US government’s credit rating downgrade in late 2011. Today, the 10-year Treasury note yield is just 1.7 percent. That’s just 30 basis points above its all-time low reached last July.
In other words, gold’s current decline also corresponds to an historic rally in US Treasury bonds. And it’s in opposition to a rally in the stock market.
At the same time the VIX is at rock bottom levels indicating little fear of stocks, investors have been buying US Treasurys, the ultimate safe investment during the worst financial crisis since the Great Depression. Meanwhile, they’ve been selling gold, historically viewed as the ultimate hedge against growth igniting inflation, as fast as they were buying it last year.
Limits of Rotation
What’s going on here is basic asset rotation, with a lot of buying and selling momentum behind it. Gold was in favor last year because of inflation worries. Conversely, the metal is out of favor now as investors are simultaneously worried about slowing economic growth but afraid not to participate in a stock market where the big cap averages continue to make new highs.
Obviously at least in retrospect, last year’s psychological high in gold signaled a top for prices. The question now is whether today’s bearish sentiment is giving off a similar signal, in which case the recent selloff would be a buying opportunity in a continuing bull market.
That question is particularly important for gold mining stocks. These have long lagged the metal’s climb. Now during the selloff, even the largest and most secure have been harder hit than the metal itself.
My view is economic growth will be the most important factor affecting gold prices the rest of this year, and by extension gold stocks. The key question is how much impact austerity — i.e., higher taxes and reduced federal spending — will have on the broad economy, particularly at a time when Chinese growth is moderating and Europe is still contracting.
Thus far, there appears to be some impact on growth, though not enough to tilt the economy into an official recession. Some sectors like housing remain strong. Others, particularly those involving production of natural resources, have been visibly weakening. The labor market seems to take a step back for every one it takes forward. And of course, money continues to flow into stocks.
Given that, it’s no wonder many investors are giving up on gold, and trying to buy what appears to be working. And no one should expect anything better for the metal, at least until austerity’s ultimate impact is known.
On the other hand, gold and even gold stocks march to a different drummer than other markets. Mainly, this is a market that does nothing at best for long stretches of time, and then blasts off as excitement suddenly flares up.
That means if you’re going to play gold, you’ve got to follow a different set of rules. Number one is you’ve got to be patient and stick with positions if you’re still holding on after prices drop. I prefer mining stocks because you can earn a dividend while you wait.
Rule number two is to sell when investor euphoria reaches a peak. That was the case a year ago. It’s not the case now by any stretch.
If you were one of those people who put their whole nest egg in physical gold last year, you may have to wait a while to make your money back. In fact, it’s not a bad idea to consider other investments, particularly those that pay dividends.
But if you’re like me, you’ve owned gold in a small part of your portfolio as a disaster hedge. And for us, this is the time to be patient and ride out the turmoil. Gold’s day will come again.