The Gold Emperor Has No Clothes

Apr.16.13 | About: SPDR Gold (GLD)

Gold (NYSEARCA:GLD) has become a staple in many investor portfolios. What are the reasons people want to own gold? As a real asset, gold is sometimes viewed as protection against inflation. However, since the 1970s, the price of gold has been a poor hedge against inflation - the correlation between the CPI and gold price is close to zero. The rally in gold of roughly 140% over five years from 2007 to 2011 had nothing to do with inflation, which was very low during this period.

Rather, being synonymous with stability, gold has seen investment demand as a hedge against "really bad things" happening. The debt bubble bursting in 2007 created a severe financial crisis in the U.S. and in Europe, and governments coped with the crisis by flooding their financial systems with unprecedented amounts of liquidity. Naturally, people were concerned that all this newly-created money might put fiat currencies themselves under pressure.

However, the currency system remains intact, and equities staged a solid performance in 2012 for the fourth year in a row. Economic fundamentals have been reasonably good in the U.S. since 2009, and even the stubborn employment situation is now improving. European austerity policies seem to have led to improved competitiveness in the peripheral economies, with their balances of payments now healthy and equities rallying. In Japan, Prime Minister Abe's new easing policy - which mimics the Fed - is viewed as the right thing to do, and Japanese equities are rallying. Suddenly, the chance of "really bad things" happening diminished. The gold emperor has lost some of his clothes.

Keep in mind that gold is owned these days primarily as a financial asset - through SPDR® Gold Trust , for example. The trust's creation in 2004 allowed vast pools of investment capital to get exposure to gold, which no doubt contributed to the price rise. GLD converts all demand into bullion, and the rise in demand from 2004 to 2010 propelled GLD to its place as the 6th-largest holder of gold in the world, behind France and ahead of China:

World Gold Holdings

Sources: World Gold Council, SPDR Gold Trust

The problem is not the fact itself that GLD is the world's 6th-largest holder of bullion. The real problem is that the price became driven by supply and demand from short-term investors, rather than long-term holders who want to store value (such as central banks). Gold became a short-term financial asset rather than a long-term real asset. So, the romantic "store of value" argument is obsolete; the emperor has no clothes.

This is aggravated by the fact that gold doesn't have self-correcting supply-demand mechanisms of other assets. Gold has no industrial use to speak of, so higher price does not necessarily result in reduced demand. So, we had a hard-to-value financial asset into which large pools of new capital were piling up. As with many financial assets, the price of gold tends to be self-reinforcing (higher prices beget more demand, and yet higher prices) rather than self-correcting. So, since 2004 we have had perfect conditions for a bubble.

The rise had to end, and gold price spent all of 2012 in a wide range. Then, in early 2013, sales by some prominent hedge funds became public. To keep the GLD pegged to bullion, SPDR Gold Trust had already sold about 170 tons of gold (roughly equal to 24th-largest holder Algeria) over four months. Then, last Friday, the price dropped below the important support at $1,550 ($150 on GLD). This will likely accelerate the selling. Large liquid pools of capital will sell, in order to preserve gains or to cut losses. Such is their business - you can't blame them.

As on the way up, the down-trend is self-reinforcing - lower price begets more selling. The new supply of bullion being offered in the market is so large (think 170 tons, more coming) that only long-term holders such as central banks are likely to be able to absorb. China, Russia, Japan or other countries with low percent of reserves in gold may consider acquiring some at a reasonable price. However, it may take months for them to make such decisions, and it's not clear what price they would consider attractive.

So, what are investors to do? Diversification is always key, and I hope that most investors followed this disciplined approach and did not put more than 10% of their portfolio into gold. So, a price drop of, say, 25% would mean a 2.5% hit - certainly disappointing, but not as large as to ruin a portfolio. If your exposure is tactical, and in liquid form (GLD, futures, etc.), I recommend reducing it quickly. Finally, in cases when the exposure cannot be reduced (if it is strategic or illiquid), but you can use derivatives, I would recommend buying out-of-the-money Put options, at the right price, to obtain protection just in case I am correct.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I do hold GLD Put options. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.