What's Happening to Gold?

Gold had the biggest monthly drop since 1983, last month. It dropped 18% in that month to about $700/ounce (1 troy ounce approximately equals 31 grams). It seems counterintuitive given the fact that crisis generally increases the price of gold, and October is the month of peak credit crisis.

One of the biggest factors causing this is the fading of inflation fears from the mind of investors. Inflation always pushes people to look for hard assets and after a year of inflation worries, the central banks are breathing easy that the oil drop has taken at least one of the worries from their backs. 

Performance of GLD - one of the main ETF’s for gold, in October.

Another factor is because of the drop in interest from speculators who have been selling all profitable assets to make good for their losses elsewhere. Suppose you are an institutional investor who wants to maintain a constant allocation of 80% in stocks, 20% in gold, you would have lost 40% of the value in stocks since the start of the year, while your gold worth would have increased, skewing your portfolio heavily towards gold in the process. This will force you to sell gold at this time and re-balance your portfolio.  Marketwatch writes that:

Speculators reduced their buy positions by 8,313 contracts on the Comex while increasing their sell positions by 12,574 in the week ended Oct. 28, according to latest data from the Commodity Futures Trading Commission. One contract represents 100 ounces of gold.

The Gold report gives another reason for this drop:

It has been central bank gold loans, even more so than official gold sales, that have really pulled the rug out from under gold. Gold loans by central banks are an alternative, and invisible, means of injecting liquidity into the banking system. These gold loans to banks and bullion dealers by the leading central banks are probably a significant multiple of outright official sales.

In simple terms, a central bank may lend or deposit gold with a banker or bullion dealer who simultaneously sells forward. Even with the recent substantial increase in gold-lending rates, at the end of the day the dealer receives cash in the transaction at a cost that may be advantageous to short-term money-market borrowing costs. Central banks have great freedom to lend gold outside their government-mandated rescue programs and these lending activities are typically hidden by their accounting practices…

Why is gold a good buy right now?

1. Gold is very good hedge given its low/negative correlation with stocks and bonds as you can see from the chart below from World Gold Council. More likely, gold will stay neutral or move slightly opposite to your rest of the portfolio giving you a good risk balance.
2. Gold is a bet against all currencies - and a good inflation hedge. As nations the world over keep turning on their money spigots, all the currencies get weaker. By the end of this crisis, there is a good probability that the central banks would have pumped in far more money than the money supply contraction caused by deleveraging, and that could cause a severe inflation. Gold is historically good with inflation. 
3. People in developing nations like India and China traditionally turn over to gold in times of trouble - as they don't have too much trust in their equivalent of Treasury bills. Given the performance of their stock markets (loss > 50-60%) and asset classes, it is expected that they might turn toward the asset class known to them for 1000s of years instead of the stock or bond markets that are still nascent by Western standards.
4. The thawing of credit markets is pretty superficial. There are still deep problems down there and they will take years to solve. So, even if the current situation looks calm and serene, turmoil and volatility might turn any time. Whenever people lose trust in banking system they tend to fall back towards gold.

However, take note that gold over the long term under performs other asset classes like equities and bonds and you should not weigh too much of your assets in gold. If you are a long term investor think gold more like an insurance, and you could keep a small amount of it to give better risk tolerance to your portfolio and don’t assume it to take care of your retirement. The best gold investments come over the short term to medium term, in times like these. Here is the 15 year gold price chart from the WGC. Gold has significantly outperformed most other asset classes in the last 6 years.

Read More:

Gold Council report for Quarter 2, 2008

Disclosure: Long position in GLD.

Comments

[Robert Cassidy:]

This is a superb assessment !
There is indeed widespread unawareness about the level of clandestine intervention by central banks in the form of gold loans and "swaps"
My compliments to Balaji !
[e-mail]

2008 Nov 06 07:37 AM

[User 30121:]

Gold (and silver) prices are incredibly lower than they should be at this time given the turmoil in the markets/world. Why that is is due to precious metal manipulation by US Bank. To NOT identify this fact as a contributiong factor SHOULD BEG a response from the author. Otherwise, a fine article.

2008 Nov 06 09:44 AM

[ussmls7:]

The real name to call the Banks Swaps is Maniputation & Price Surpression,JP Morgan & GS where named in many articles on many sites. The MS Media will not talk about it,they are never mention by the business Channels,but on the Web you can read about it daily.Jsmineset.com,Goldseek.com have plenty of info for you! The SEC could have read these sites & cut the Chase of looking into Price Manipulation,Naked Short Selling & Insider Info Being Used by the illuminists to reap Billions and, now as these same illumina have got Bailed Out by Paulson & Ben useing the Bailout Package! They continue at price surpression,even while under supposed investagations?The talk abuzz on the coming weeks ahead on both Silver & Gold Markets about Contracts? Many "How To" take Delievery of Physical Bullion, Smooth & Easy, are posted on web sites for some time now! Will this be the End of the Paper Markets Ablity to keep Prices of Physical & Paper so out of wack? Will these Bankers get away with what many say they where able to Pull Off by Naked Short Selling & after hours OTC trading,forceing many investors to take big losses,when Market Conditions Should Show Gold/Silver should be going up,not Down?Many are saying watch Nov. 27th for the Events to Start to unfold,As a outsider,looking in,this will be interesting to watch! It should be called, 'The War Against Illuminist Crooks of Wall Street" by Mad as Hell Investers not Waiting on A Spineless Bunch in Congress"! BALIJA,THIS WAS GREAT!

2008 Nov 06 10:06 AM

[nmelendez:]

Not to worry. You do not think China knows this and is buying up gold dirt cheap? Wait till the IMF and world banks figure this out. That's when gold will sparkle.

2008 Nov 06 10:34 AM

[bowman711:]

A couple of weeks ago I surmised (in previous SeekingAlpha posts) that this new 'Bretton Woods' summit starting next weekend was going to start the process to back a new world currency with gold. Now, more and more articles are saying much the same thing. If so, where is that gold going to come from?

Then, Joe Biden came out with his statement that early in the Obama administration there would be a huge crisis, and the actions they take would be unpopular with the people, but that they should bear with the administration. I contended that what this crisis would be a default of the American dollar and the switch to a new, gold-backed world 'dollar.'

The longer gold behaves contrary to all laws of economics, due to heavy manipulation by the mega-bullion bankers backed by the government, the more I believe it precedes the outlawing of privately held gold. Governments know that they would have an instant revolution if the just confiscated privately held gold, so they are artificially reducing the spot price of gold to be able to 'buy' yours, mine, and everyone else's gold for $500 (or whatever) instead of its true worth of $1,200, $1,500, $2,000 or whatever it really would be within the laws of economics.

What GATA, gold dealers, and anyone with an interest is gold need to be doing now is demanding to know every holder of GLD, IAU, and other large holdings of gold - their name, address, phone number and any other information needed to organize a massive protest against such action; enough to bring down any government that goes along with such an action as a government theft (by paying lower than its economic price) of gold.

Keep watching . . .

2008 Nov 06 12:24 PM