Why Gold Has Fallen & Why It Will Rise Again

The price of gold in US dollars is down 17% since hitting its peak of $1,923.70 back in September 2011, however the long-term outlook for gold (& gold stocks) remains very bullish. This article looks at why gold has fallen and why it will rise again.

Why has gold fallen?

The simple fact is that last summer gold rose too far, too fast, and as is the case with any market, its huge run up had to be followed by a correction and a period of consolidation.

Gold rose from $1,478.30 in early July to $1,918 in less than two months. This type of parabolic price spike tends to lead to extreme volatility, and this was the case with gold in August and September last year.

As the price of gold rose those bullish on the metal tried to stay with the trend till the last moment while bearish traders began shorting it. Often the final stage of a parabolic rise is fuelled by bearish traders who went short too early and were forced to cover their positions.

A 1 Year Chart Of GoldChart courtesy of Stockcharts.com

Major turning points in any market are almost always accompanied by extreme sentiment and this was the case with gold last summer. Now however, investor sentiment towards gold has gone from being extremely bullish to being extremely bearish – a sign that we are likely approaching a major bottom.

Recent weakness in gold has in large part been due to a rally in the US dollar which has been the beneficiary of the troubles in the Eurozone. A rising dollar is typically negative for gold since gold, as with all commodities, is denominated in US dollars. However, while gold in dollar terms has fallen by 17% since its peak last summer, in euro terms it is only down by around 9%.

Buying from India, historically the largest buyer of gold has also dipped recently thanks to an excise tax which the Indian government imposed on both gold imports and gold jewellery. The tax has now been rescinded and buying is expected to pick up once more.

Another important factor in gold’s recent decline has to do with the way the gold market is structured. The fact is that there are actually two gold markets, the paper market and the physical market:

  1. The paper market where gold is traded as futures contracts (and players are typically leveraged 10:1 or more) and where rarely, if ever, do holders take actual delivery of the metal.
  2. The physical market where investors, central banks and industrial users (such as jewellery makers) take delivery of actual metal.

What’s significant about this is that around one hundred times more gold is traded in the paper futures markets than exists in the physical market. Therefore the paper price can sometimes control the physical price, and that is the case today.

This latest selloff in gold (and silver) was driven by liquidations in the paper futures markets controlled by mechanical/ algorithmic, computer trading which makes up as much as 70-80% of all trading today. It had nothing to do with the fundamentals.

It’s also possible that distressed Eurozone countries were selling gold to help meet their debt obligations – though this is purely speculation on my part.

Why gold will rise again

I’ve talked before about currency debasement and negative real interest rates, which are both important drivers for gold, but the bottom line is that gold is slowly resuming its historical role as money.

There are a number of reasons for this, but chief among them is that gold has been used as money for thousands of years and today’s fiat (paper) money is being debased (destroyed) by the actions of profligate governments who are printing more of it through Quantitative Easing and other such schemes, and thus deliberately creating inflation.

“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” John Maynard Keynes, chief architect of today’s monetary system.

Since 1970, when President Nixon removed gold backing from the US dollar, the currency has lost more than 83% of its value, or purchasing power.

History teaches us that paper currencies do not stand the test of time. They have been tried many times before but every fiat currency since the time of the Romans has ended in devaluation, hyperinflation and eventually, collapse.

There have been 34 instances of hyperinflation in the last 100 years alone, the majority of which took place in the 20th century with fiat currencies.

The problem is that there is no mechanism inherent within a paper currency that prevents it from being over issued (printed) by governments in order to pay for unaffordable legislation or social programs. Crucially this is the first time in history that no currency on the planet is backed by anything tangible, they are all fiat.

Ultimately I believe that sooner or later one or more of the world’s major currencies will once again be backed by gold, or a basket of commodities including gold. China understands the significance of gold and is therefore using its vast foreign exchange reserves (left over from the goods it sells to the rest of the world) to buy large amounts of gold in the physical market.

In the first quarter of 2012 China increased its gold purchases seven fold, buying 136 tons, up from just 20 tones in Q1 2011. If their gold buying continues at this pace (and there is every reason to think that it will), they will buy the equivalent of almost 30% of total mine output this year. China is soon likely to replace India as the world’s number one buyer of gold – it is already the largest producer.

China is not the only nation buying gold, in fact central banks around the world are taking advantage of the lower prices and in March 2012 alone they purchased 57.9 tons of gold bullion, that’s up from an average of 37 tons a month in 2011.

Those who understand the big picture are using this pullback in the gold price to add to their holdings of both physical gold, and the shares of gold mining companies.

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