Sep 27, 2011
What Happened to Gold?
By Dan Steinhart
Precious metals are experiencing a correction that may spook even the staunchest gold bug. Gold has fallen 16% in under one month, which already bests its average correction since 2001 of 12.8%. Even so, gold has quite a way to go to match its largest decline during this period, a 27.7% plummet in the latter half of 2008. A decline of that magnitude this time around would send gold down to $1,370, where it last was on February 16 of this year.
Silver, gold's more volatile kin, has been nearly chopped in half since its peak, registering a 48% decline. It would only need to fall another 6% to reach its largest decline since 2001 of -53.9%.
All of this begs the question: What the heck happened? Let's take a look at some of the more popular reasons, real and imagined, being discussed in the media.
1. Margin Hikes
On Friday September 23, the Chicago Mercantile Exchange announced a 21% margin hike for gold and a 16% margin hike for silver. On Monday, the Shanghai Gold Exchange followed up with a 20% silver margin hike of its own. Margin hikes effectively require that any traders leveraged past the new limit must liquidate enough of their positions to meet the stricter requirement. They equally affect longs and shorts, but with the amazing runs gold and silver have had over the past decade, it's safe to assume there were more leveraged longs than shorts in precious metals, meaning the margin hikes applied downward price pressure.
Conclusion: It's likely that margin hikes played a part in gold's rapid decent.
2. Disappointment with Bernanke's Announcement
When the Fed announced on September 21 that it will purchase $400 billion of long-dated Treasuries by selling the same amount of short-dated Treasuries, the markets were largely disappointed. We can hardly blame them; by now, we're all used to "Helicopter Ben" stepping up to the podium and promising to shower us with new money. Not so this time around. Instead, he gave us "Operation Twist," which by itself is balance-sheet neutral, meaning the Fed isn't pumping in any extra liquidity.
So speculators who were long precious metals and expecting to Bernanke to announce QE3 were left wanting. Prior to the announcement, buyers bid up the price of precious metals and "baked in" money growth to precious metals prices. When the money growth didn't come, the premature appreciation unwound, sending silver and gold spiraling downward.
Conclusion: Bernanke's temporary restraint definitely contributed to gold's sharp correction.
3. Hedge Funds
September 30 marks the end of the third quarter for hedge funds reporting on a calendar year basis. Funds often liquidate positions prior to quarter-end for various reasons, including raising cash and upping performance fees. Combine this normal quarter-end activity with the rampant market fear toward the end of September, and we have a solid rationale for the move out of investments and into cash.
But why would this disproportionately affect precious metals? Well, when fear hits and margin requirements come knocking at the door, investors will often first sell their biggest winners to realize a profit. Silver and gold have been two of the biggest winners of late, and so were natural candidates for profit-taking during this latest market meltdown.
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Conclusion: Hedge fund activity likely played a significant role in gold's pullback.
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4. The Bubble Finally Popped
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A bubble means prices of an asset class are unsustainably high for speculative reasons. The reasons why gold is high are neither unsustainable nor speculative: The world's developed economies are still crushed by debt; central banks the world over continue to print money; and numerous regulations continue to be a serious drag on economic expansion. None of that has changed over the past month, and the political will needed to fix these dire conditions remains nonexistent.
Any conclusion that gold is in a bubble is entirely superficial and likely doesn't involve much more thought than looking at a gold chart and observing that it's gone up for a long time, so it must be in a bubble. Anyone with a serious understanding of gold's monetary properties and the world's economic woes shouldn't lend any credence to the bubble theory. Gold may well yet reach a bubble stage, but we are certainly not there yet.
Conclusion: Gold is not in a bubble.
5. The Dollar Is a Safe Haven
Despite the inescapable reality that the dollar is being systematically debased, investors the world over continue to flock to it as a safe haven in times of uncertainty. The dollar is still the world's reserve currency, and as long as the perception remains that it is a stable store of wealth, it will continue to function as a beacon of safety.
Consequently, when investors rush back into the dollar, the price of gold in dollar terms is pushed down. So even though we here at Casey Research view gold as the ultimate insurance policy, most other investors still bestow this status on the undeserving dollar. Until that perception changes, flights to dollar safety will produce gold price drops.
Conclusion: The dollar's reputation for safety absolutely dragged down the price of gold in late September.
Overall, the recent sharp correction in gold was undoubtedly caused by several factors, including the ones above. Fortunately for us gold investors, all of those factors have one common characteristic: They have nothing to do with underlying fundamentals. Debt is still crushing the developed world, and money printing is still the favored solution; as long as this dismal reality remains true, gold will continue to rise.
While short-term gold prices can swing because of such factors as margin calls and quarter ends, in the long run these factors are inconsequential. The secular bull market we've been experiencing in precious metals for a decade remains firmly intact.
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