In our last update on gold in October 2010, we said that gold prices might start to enter a period of consolidation and that the market would start to look for new catalysts to support the next upward move in gold. Now, three months after we made that statement, gold prices have moved down to around $1,330, which is about 6% lower than when we wrote our last report and almost 10% lower than the highs seen in November.
Given the correction in gold, it is important to review the investment case for gold and decide whether the current price correction is indeed just a consolidation or whether a larger correction is in the cards. What is obvious right now is that there is lower demand for gold, and volumes have been relatively thin. We saw a first wave of profit-taking in late December and, since the start of this year, we have been seeing lower buying interest and lower volumes.
We believe there are a number of factors responsible for the current price consolidation. The main reason is that gold had an incredible bull run the past two years, and an increasing number of investors want to lock in the gains. Also, buying activity in Asia has been very low and will probably not increase until after the Chinese New Year (early February) when market participants are finally back at work.
Another reason, in our view, is that the general fear about future inflation and possibly hyper-inflation caused by money printing worldwide has diminished somewhat. Don’t get me wrong; we still believe we have laid the groundwork for future inflationary pressure, but it might take longer for it to materialize. Since this is not a new topic, people have gotten used to it and, when things become old news, people usually don’t show much reaction anymore; that’s just how the mind of the market is working.
Another factor that needs to be kept in mind is the recent increase in longer-term interest rates that has made it more costly for investors to hold gold relative to other assets, since it is not paying any interest. However, as long as the short-end of the yield curve remains at very low levels, the impact on gold prices should be moderate. The recent downward move in prices to levels around $1,310 is nothing more than a reversion to mean, or a reversion to the long-term upward trend. After unsuccessfully testing the upper limits a couple of times, the prices are now moving to the lower end of the trading band in the absence of larger buying interest.
In our view, gold will only be able to move to fresh highs once the market receives real news that is currently not priced in. This could come in the form of a sudden spike in inflation, announcements of further measures to provide liquidity (QE3?) or a sudden market sell-off caused by external factors, such as a worsening of the sovereign debt crises or a military conflict (Korea, Iran).
In our view, the recent consolidation is not the start of a larger correction in gold prices, but we might see gold in range trading for another couple of months. The longer the price can stay above important support levels and therefore form a new base, the better the downside is protected. In any case, gold remains an important part of our core holdings for the time being.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.