Gold’s hangover from hell

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A cyclical correction or a structural shift? Gold’s aggressive recent sell-off has revived the debate about whether the commodity is a legitimate hedge against Armageddon financial forces, while the jury is out on whether fundamental or technical forces are driving the bullion’s price.

After its party in 2011, gold is suffering the mother of all hangovers. The price of gold peaked in August 2011 at $1,883 per ounce, a level some would call irrational exuberance, and even its admirers acknowledged was probably too expensive.

“The $1,800 level was not justified,” says Andrew Schneider, CEO of Global HFA, a hedge fund consultancy firm. “Every action has a reaction.”

By contrast, the price of gold fell to $1,255 per ounce at the beginning of the month, a level last seen in August 2010, amid slowing emerging market growth and speculation the Fed might ease its quantitative easing (QE) policy.

Last week, gold notched gains as hopes of Fed stimulus sparked short-covering and reinforced the traditional investment pitch for the bullion: as a hedge against perceived inflation and currency debasement. Investors are now licking their wounds, mulling the outlook for the commodity.

“It is only the third time in its history gold has ever witnessed such an extreme sell-off,” says Adrian Ash, head of research at BullionVault.

The appeal of gold in 2011 was obvious. It was a time when currencies worldwide were coming under pressure. The euro looked doomed, a scenario that would be “like a thousand Lehman’s”, says Daniel Masters, founder of Global Advisors, a systematic commodity-trading hedge fund.

Sterling was under pressure from spiralling debts and faltering growth, while in the US the dollar was undermined by acrimonious haggling over the budget and its fiscal cliff.

Although inflation had yet to rear its head, QE convinced many it was coming with a vengeance. Fear was high and there was nowhere obvious to hide except for the oldest currency of them all.

Yet the currency crises never materialized and inflation never came, and as these concerns dissipated so did the case for gold. A correction was inevitable. Safe havens – 10-year treasuries, Bunds and gold – all sold off. But while bonds corrected by 5%, gold’s drop was more like 30%.

“The magnitude of gold’s decline was a function of liquidity,” says Masters. It was a victim of its own success.

The majority of gold positions were held in ETFs, bought by pension funds and retail funds around the world – a new constituency of gold owners.

“ETFs looked like a giant pyramid scheme,” says Masters. “People were selling but the buyers were mainly like-minded investors, and the pool was shrinking.”

The jewellery market and retail buyers are a drop in the ocean against the ETFs, he says, adding: “It was a full room with only one exit. Then there were the momentum traders like us, the high-frequency traders and the discretionary managers, most of which were shorting the market as well.”

Even the biggest gold bugs such as hedge fund Paulson were forced to sell to meet redemptions. “It had nothing to do with fundamentals,” says Global HFA’s Schneider.

Others see it differently. “Negative real interest rates are theoretically good for gold but what is most important is not where you are but your direction of travel,” says Ash at BullionVault. “Since gold peaked in 2011, 10-year yields have been rising and have delivered positive real returns.” That has sucked money out of gold.

What is less clear is what comes next. When gold traded at a similar level to this in 2010, that was the culmination of a rally that had seen it trade up gradually from below $300 around the turn of the century, when Gordon Brown infamously sold off the UK’s gold stash. Clearly, it cannot be assumed gold is at the bottom.

This is a buying opportunity,” says Schneider. “But we are only 10% to 15% invested at this point. I can see a small bounce back but then another drop before it rises again to some middle ground.”

Interestingly, western retail investors have not lost all confidence in gold – while Asian households are in full-on buying mode – though they have only come in on the drop, says Ash.

“One ounce in two is now bought by Indian and Chinese households,” he says. Gold ownership is a relatively new phenomenon in Asia, where it had previously been restricted, so this again is new territory and it is hard to predict how robust their appetite will prove.

BullionVault saw a record 3% net liquidation between April and June (inclusive), a sell-off of one ton from total client holdings of 33 tons. Yet there are more buyers than sellers of gold, even if the sellers are big players and the buyers are small ones, says Ash.

“People still believe in gold as insurance,” he says. “When gold was at $1,900, people felt they missed it. But many people still think it is sensible to have 5% to 10% of their assets in gold.”

And then there are the remaining die-hard gold bugs, who spy bank conspiracies to drive down the price of gold to support the dollar, and believe inflation, still nowhere in sight, to appear like a jack-in-the-box, supercharged by years of QE.

“I normally say to the Apocalypse-next-mongers, ‘Every single one of your predecessors throughout history have failed – go home and do your homework,’” says Frank Jensen, CIO at Origo Asset Management. “The gold bugs have clearly stayed anchored in their conviction and are now looking for excuses for not adapting to an ever-changing world.”

Jensen is scathing about the outlook for gold, saying it is “history as an established bear-market”, and yet another example of “the fallacy of human nature in investing”.

The more mainstream view is gold has oversold and will eventually bounce back. “It is there to be played, and that is what we are seeing on BullionVault,” says Ash. “There are good reasons to believe the long-term bull market is not done yet.”

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