Gold prices have been rising sharply over the last few months while the equity markets went into a sharp correction. Over a one year period, the popular Gold ETF (NYSEARCA:GLD) is up almost 40%. Compare that to the S&P 500 (NYSEARCA:SPY), which is down 10% during the same period.
The main reasons for the rise were basically inflation and the weak dollar. The explosive growth in emerging markets over the last few years has led to a huge commodities bull run and fueled global inflation, which in turn put pressure and weakened the USD against most of the major currencies.
And then to make things worse, a nasty credit crisis hit Wall Street last fall due to the collapse of the mortgage subprime market.
The Federal Reserve, in order to avert a complete collapse of the financial system, had to start slashing rates and add liquidity to the system. Interest rates went down from 5.25% to 3% in a few weeks. That's when gold prices had their steepest rise, going up 300 points since November.
So why do we think you should sell gold, and especially the mining stocks, if prices are so strong?
First, if you look at the mining stocks prices compared to the gold prices, while the GLD is up 40%, the mining stocks ETF (NYSEARCA:GDX) is up only 20% over a one year period. The reason for the underperformance is that it is getting harder and harder to extract the metal from the ground and also more expensive. The margins for mining companies are not as good as they used to be.
Second, and more importantly, the two main reasons behind gold's rise may not be valid anymore, at least in the short term. At the last Fed meeting, interest rates were cut by 75 basis points to 2.25%. When that happened gold prices unexpectedly collapsed 100 dollars in 3 days. The reason was that investors in the metal were disappointed and the markets were actually looking for a 100 basis points cut. The Fed's next meeting comes in April and this time traders are expecting a 50 basis point cut.
However, we think it is very likely that the Fed will only cut by 25 basis points and that might disappoint investors again. Even if the Fed cuts by 50 basis points, and rates go down to 1.75%, that might be the last time we even get a cut. Very few people are expecting rates to go lower than 1.75%. The ECB, on the other hand, is expected to just start cutting rates later this year when the EU economy shows more signs of weakness. All that could stabilize the dollar in the coming months.
As for inflation, the numbers are finally starting to moderate due to the weakness in the world economies led by the US housing crisis. The PCE inflation numbers just released show inflation for the last year at 2% which is still inside the Fed's comfort zone. Actually, the Fed has been predicting inflation to moderate for some time no,w but no one on Wall Street really believes them.
Finally, if you look closely at the GLD chart, you can see that the short term uptrend has been broken. For the first time since gold broke out last year, it has fell through its 10-week moving average and it has done so on high volume in the last week. This surely is another sign of weakness.
Gold might still be in a long term bull market, but for all the reasons mentioned above, it is now due for a correction in the short term.
Disclosure: No positions in any gold or gold mining stocks.