Can Gold Plummet To $400/Ounce?

by: Jason Schwarz

This gold slaughter is a good reminder to beware of the momentum trap. Momentum is good if it's built upon strong fundamentals. Momentum is dangerous if it's built upon a house of cards. No matter how badly some investors want gold to be a currency it's not a currency. It only acted as a safe haven because hedge funds said it was a safe haven in the midst of the financial crisis. Monday's market meltdown (Dow -200) is happening because of the $200 2-day gold sell-off that is causing an overall commodity drag that includes the market-moving asset of oil. The direct catalyst for gold's drop is linked to Cyprus being forced to sell reserves in order to finance its bailout; analysts fear other eurozone nations will have to do the same. Now that gold has lost its momentum, when will the drop end? From a historic perspective, gold prices averaged $280/ounce in 2000, $450/ounce in 2005, $975 in 2009, and $1500 in 2011. Today's price of $1370 is still very high when put in a historical context. If we're truly on the verge of a gold bubble burst, it means this market is susceptible to a continued commodity drag.

Back in 2010 I wrote the following: 'Gold at $1400 is eerily similar to the oil bubble at $140. Remember all the credible firms extrapolating the speculative action into $200 oil forecasts? Those same bubble builders are now calling for $2000 gold. What does a bursting bubble look like? The Nasdaq dropped 78.29% when the dot-coms burst, the S&P 1500 Homebuilders dropped 67% on the housing burst and oil dropped 76.1% in 2008-2009. A typical bubble burst of 70% from today's $1346 closing price would put gold at $400/ounce; strikingly close to its pre-crisis norm. If you don't believe me, then believe the architect of fear himself, Mr. George Soros. Last month Soros told investors that gold is the ultimate bubble and it's "certainly not safe and it's not going to go up forever."

Since I wrote that piece in 2010, we've been waiting for gold to come back down to the $1350 level as a signal that the bubble was bursting. Today it's happened. Option LEAPS are a great way to take advantage of bursting bubbles. Buying an out-of-the-money put at a strike price 70 percent down from the peak of the Nasdaq, housing, or oil bubbles would have cost you relatively nothing at the time. An oil LEAPS put at the $40 strike price could have been purchased for 0.50 in July 2008. By December 2008, those options were trading 20X higher at 10.00. GLD is ripe for put buying.

Disclosure: I am short GLD. 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.

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