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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. 

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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. image
  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.

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Read More:

Gold Council report for Quarter 2, 2008

Disclosure: Long position in GLD.

Source: What's Happening to Gold?