From the July 2012 issue of Research Magazine • Subscribe!

Is Gold in Trouble?

Goldbugs are nervous, and rightly so. Their beloved metal—the “currency of last resort”—has been acting more like a basket case than a bastion of safety. During the second quarter, gold fell in value right alongside global stocks (AWCI) and the euro (FXE). What’s going on?

Even commodities permabull Jim Rogers admitted to the Business Insider that gold could fall 40 to 50% in value if India ceased gold imports or if Europeans began liquidating their holdings.

The early warning signs behind gold’s fall beneath key trading levels have been months in the making. Gold flirted with falling 20% from its peak multiple times during the second quarter and has already forfeited the gains from its strong start earlier in the year.

In the three months up through the May 24 market close, the SPDR Gold Shares (GLD) lost 12.09% in value. From a technical perspective, GLD is trading below both its 50 ($158.57) and 200 ($164.63) simple day moving averages, which means the trend is still down.

The ETFS Physical Precious Metals Basket Shares (GLTR), which is a broader measure of the precious metals group and includes gold, silver, platinum and palladium in one package, was down 15.76% over the same period.

“While gold is a safe haven in general, this is not true during a credit crisis,” said Daryl Montgomery, author of Inflation Investing: a Guide for the 2010s. “When the financial system is severely stressed, it is difficult to sell paper assets. Banks and hedge funds instead lease gold from central banks for a small sum and then sell it on the open market. This provides them with some quick cash that they desperately need and is what causes gold to drop when it seems like it should be going up.”

Could 2012 turn out to be the first time in 11 long years that gold has a loss?

For more than a decade, gold performed well despite the 9/11 attack, the bursting of the dotcom and housing bubbles and the 2008-09 financial crisis. But past performance, as investors keep forgetting, is not prologue for the future.

It’s been a long time since gold has had a major correction and those corrections have tended to be infrequent. From 1999 to 2011, gold experienced three declines greater than 20%, but snapped back each time. But this time around might be different.

Huge budget deficits, bankrupt governments and political instability aren’t necessarily a slam dunk for gold investors, as 2012 is already proving.

Interestingly, the Dollar Index—also known by goldbugs as the Grande Fiat of Fiats—rose on consecutive days during May, posting its longest winning streak since 1973.

The median estimate of 11 analysts tracked by Bloomberg project gold to average $1,740 per ounce in 2012 compared to its current trading range of $1,500.

ABN Amro cut its forecast on gold from $1,600 in January to $1,550 in May. Barclays reduced its outlook by 8% to $1,716 and RBS cut its forecast by $25 to $1,725.

Falling estimates for gold haven’t dissuaded large hedge funds from staying in accumulation mode.

John Paulson, who made a fortune in 2007 betting against the U.S. subprime mortgage market, said to clients that gold is the best protection against currency debasement and a good long-term bet against rising inflation and a euro breakup. Paulson also added that gold mining stocks are historically inexpensive. The Market Vectors Gold Miners ETF (GDX) has fallen 20.93% over the past year.

Another gold bull has been billionaire investor George Soros, who increased his stake in GLD during the first quarter.

Demand for gold grew 16% over the past 12 months to 1,098 tonnes, or metric tons, according to the World Gold Council’s Q1 2012 Gold Demands Trend Report. Globally speaking, that translates into a tidy sum of $59.7 billion in gold.             

Also, central banks are buying bullion at the fastest pace in five decades, adding 439.7 tonnes in 2011.

In the consumer market, gold has long relied on India for consumer buying, but the threat of bans on imported gold could stop that. Also, India’s gold market got jolted with a national strike by jewelers protesting an excise tax on gold.

China figures to become a bigger player in the gold market, despite its sagging stock market and property bubble. Jewelry demand in China now makes it the largest jewelry market for the third consecutive quarter. Altogether, China increased its gold holdings in Q1 to a record 98.6 tonnes, up 13% from Q1 2011.

Europe’s sovereign debt crisis adds another monkey wrench into the gold demand/price equation. Will Europeans start liquidating their gold to raise cash? How would worldwide gold prices be impacted by panic selling?               

Looking Ahead

For gold traders, being short has been the right move thus far in 2012. Inverse ETFs like the ProShares UltraShort Gold (GLL) have spiked more than 25 percent over the past three months. If gold continues to slide, funds like GLL will likely have more gains ahead. GLL aims for two times the daily opposite performance of gold.

Keep an eye on the Federal Reserve. More monetary stimulus from the Fed could reverse gold’s recent weakness. Would gold react to further quantitative easing with a price hike?

Financial advisors with clients holding positions in gold ETFs can smartly hedge those positions with defensive put options or by writing covered calls. This is one big advantage of investing in gold ETFs that can’t be obtained by investing in gold related mutual funds.

While gold has recorded an impressive 11 consecutive years of gains, at some point, the streak must end. If there’s any time gold should be shining, it’s during turbulent economic and political times like this. And given that gold’s recent performance has been spotty, this year looks like it might be the first in many, where gold does the unthinkable by posting a loss.

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