The Fear Premium of Gold

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 |  Includes: DGL, GLD, IAU
by: EconMatters

Gold prices were hitting record highs as gold's appeal as a safe haven asset exploded. June gold was down 1.1% to settle at $1,229.20 an ounce on Thursday after hitting a record high of $1,250 in the previous session.

The metal’s surge was driven primarily by concern that an almost $1 trillion loan package in Europe will slow the region’s growth and debase its currency. Adjusted for inflation, gold is near its highest since April 1981, based on data at Bloomberg.

Record Investment Boosted by ETFs

Global investors, led by the US, last year bought a record 228.5 tons of gold in the form of bullion coins, up from 77.4 tons in 2000, according to GFMS, the London-based precious metals consultancy.

Exchange-traded funds [ETFs] also have made it convenient for retail investors to get in on gold. Holdings in physically backed gold exchange traded funds are at record highs after some ETFs last week experienced their biggest inflows in over a year.

The largest gold ETF--the SPDR Gold Trust (NYSEARCA:GLD)--recorded its highest daily inflow since early 2009 last week, with total holdings hitting a record 1,185.78 tons.

Pattern Change – Gold & Stocks

Gold tends to rise when investors are uneasy about risky investments, so gold often gains as stocks fall. However, stocks continued to recover from last week's big drop, while gold also broke new highs. (Chart 1)

Meanwhile, the euro broke through the 14-month low reached against the dollar last week touching $1.2516. Some analysts say a test of the euro's 2008 low of $1.2330 looks likely in coming sessions. These are clear signals that investors' anxiety is with the euro.

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Pattern Change – Gold, Dollar & Euro

Furthermore, gold prices usually go down when the dollar strengthens. But that inverse relationship gold previously has with the dollar has now been switched to the euro since late last year due to the sovereign debt crisis in Greece and Europe (Chart 1).

The lack of faith in the sustainability of the euro has been driving investors to flee the euro and go into gold, stocks and the U.S. dollar. Nevertheless, this is not indicative of any fundamental strength in the U.S. currency. Rather, it's “relatively stronger” against the embattled euro.

Similar to Crude - Gold Has a High “P/E Ratio”

Many analysts expect gold prices to fall back near $800 an ounce over the next ten or twelve months, according to Jon Nadler at Kitco Bullion Dealers. Nadler thinks the economic fundamentals for gold are "completely upside down." Demand from jewelry has been weak, and that much of gold's recent strength has been speculative in nature.

However, similar to crude oil, gold also has become an asset class in itself, and trades beyond market fundamentals. Gold has long been a safe haven when world markets are gripped by fear. Those fear factors -- outlined below -- if prolonged, will most likely drive investors to gold and send gold’s P/E ratio soaring far beyond the demand/supply fundamentals.

Fear Factor #1 – Inflation

Analysts say there’s a lot of fear on the part of the Europeans that moves to mitigate the debt crisis will only lead to more problems. FT.com reported that traders and coin dealers said buying was exceptionally strong from German and Swiss investors.

The spike appears to reflect concerns in Germany about the potential inflationary impact of the European Central Bank’s decision to buy up eurozone government bonds in the wake of the Greek debt crisis. Outside the eurozone, dealers said that demand was also strong in North America.

Fear Factor #2 - Fiat Currencies Debase

The potential for other countries to be overwhelmed by debt also has investors rethinking paper currencies in general. Gold is vastly appealing as it has become the only reserve currency not backed by debt.

It is this fear that has fueled the price of gold rising against every major currency, not just the thrashed euro. (Chart 2)

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Fear Factor #3 – Mountainous Sovereign Debt


The European Monetary Union [EMU] collectively is facing €965 billion of debt redemption this year. Among them, three of the most heavily indebted PIIGS countries, Spain has to redeem €81 billion of debt this year, Italy at €267 billion, and Portugal with €19 billion. (Chart 3)

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The Greek contagion may seem to be partially contained at the moment, but investors are still concerned widespread fiscal tightening could derail the already weak European economic recovery. Continued fears over the stability of the eurozone should further depress the euro and buoy gold prices.

The sheer scale of fiscal deficits facing numerous countries, including the United States, will likely prompt further diversification from fiat currencies and could ultimately propel gold to fresh highs.

Dissimilar to Crude – Not a Real Commodity

As noted earlier, gold is similar to crude oil with a built-in premium due to psychological factors. However, unlike crude oil, which is an essential energy source that the world cannot function without, gold has no real fundamental demand except for the use in jewelry.

Indeed, much of gold's recent run-up has been driven by speculators, which means the correction[s] could be just as ferocious as the climb-up once investors' fear subsides.

Short to Medium Term - Hinges on The Euro

Gold has risen 40% since the beginning of 2009, which suggests the market could be due for a correction. A dip in gold prices within the next 10 to 20 months is certainly possible as European and U.S. markets stabilize.

For now, the general trend over the short term basis is still to the upside. But at this juncture, gold looks over-priced from a risk/reward standpoint. Retail/individual investors looking to invest in gold are best to stay on the sideline until a significant pullback, possibly at round $1,130. (Chart 4)

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In the mean time, the 1,000-point drop in the Dow on May 6, although still under investigation, is a grim reminder that markets will likely be volatile going forward. Volatility breeds chaos and fear, and gold certainly has a proven record of thriving on both.

Disclosure: No positions