3 Reasons Why Gold Could Drop Another 30%

| About: SPDR Gold (GLD)

Seems like years ago gold (NYSEARCA:GLD) was the biggest story in the market. With volatility at all-time lows, Europe relatively calm, and U.S. markets on pace for their biggest seasonal gains in the market's history; gold has been all but forgotten. The return for individuals who have allocated capital to gold, silver, and other hard commodities has been pretty forgettable as well. Interestingly though, despite gold's poor relative performance for really five months now, gold is still at the high end of its trading range.

The primary reason why gold has appreciated over any ten year period since the post-World War II era is because of inflation. While gold has risen for brief periods of time because of rising levels of fear from issues like the latest European debt crisis, gold's best performing periods over any extended time-frame has been when inflation was rising.

The problem here for gold is that Europe is now beginning to pursue new and more aggressive forms of monetary and fiscal stimulus while the Fed is on hold. Although certainly no one would argue that the Fed is likely to raise interest rates anytime soon, the Fed is also unlikely to pursue new and more aggressive forms of quantitative easing during an election year.

Congress has also signaled an unwillingness to extend existing stimulus measures like unemployment benefits longer term, and has likewise refused to pursue new fiscal measures to stimulate the economy. With the U.S. in an election year, the ECB likely to continue easing for some time, and with food and oil prices still high, new fiscal or monetary stimulus from the Fed or congress seem highly unlikely this year.

While the Fed is not likely to raise rates anytime soon and congress has extended temporary assistance like unemployment benefits, the ECB's latest LTRO program is far more robust than what the Fed or congress are doing right now. Europe's economy is also much weaker than the U.S. economy right now. In this environment, it is hard to see the euro appreciating significantly against the dollar, and 60% of the dollar index is tied to the euro-dollar cross.

However, while the euro continues to be weak against the dollar, volatility and fear levels have come down considerably. No one believes the European economy is likely to take-off anytime soon, but the LTRO program initiated by the ECB in mid-December, combined with renewed support from the U.S. and IMF for ECB bond purchases and other liquidity pushes, have taken the worst case scenario off the table. Looking at the chart we see the gold peaked in late September when the VIX topped out as well.

The chart also shows that gold has consistently made lower high and lower lows over the last five months.

Indeed, while fear levels in the West likely peaked in the fourth quarter of 2011, China remains weak. While food and oil prices have risen significantly this year, China's economy remains weak. As the most levered large global economy to the eurozone, China is facing significantly weaker demand for its exports this year. China is also dealing with a housing and real estate bubble as well.

The Chinese central bank and Chinese central government have continued to cut rates for several quarters now, but the reality is becoming increasingly clear: The country's heavy ties to Europe as well as its heavily overbuilt real estate and construction industry make short-term stimulus unlikely to do much good. Also, while China is continuing to cut rates, it is also weary of food and energy costs for the country.

So, where does this information leave us. I think gold traders and investors have to reassess their positions in gold. If people want to hold gold as a long-term play on inflation and currency devaluation, I think this kind of asset allocation strategy makes sense. If gold is a short-term play on inflation and fear, it is probably time to exit this position.

Gold is not just at the historically high end of its trading range, it will still be near all-time highs even if this shiny metal were to drop significantly from current levels. The S&P 500 (NYSEARCA:SPY) has now rallied around 30% since September, and the best performing stocks like Apple (NASDAQ:AAPL) have rallied even more.

While gold may be a new currency, gold investors are not likely to get any dividends anytime soon. Gold has declined in a pretty orderly fashion up to this point, but with its support levels continually being tested and the metal failing break new highs. If inflation expectations don't pick up and the rally in the equity markets continue, some of the new and less seasoned traders and investors who only recently entered the gold market may want to exit fairly quickly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.