On April 12 and 15, the price of gold dropped dramatically — from above $1,560/oz. to as low as $1,332/oz. before rebounding slightly. It was the largest two-day plunge in more than 30 years. The roughly 14% drop in just those two days belies the idea that gold is a "safe" investment.
Many investors are attracted to gold primarily because they believe it will protect them from an economic catastrophe, and this tends to foster the idea of safety. But gold has always been a speculative investment — it has no underlying fundamental value, unlike a stock whose value can be tied, at least in part, to the value of the issuing business. As a result, gold's history is one of booms and busts, spikes and sell-offs.
Since peaking in September of 2011 at roughly $1,900, gold is off more than 25%, well into bear-market territory. There's no single explanation for this plunge, but rather a confluence of events. Here are a few of the factors involved in gold's slide.
- Unwinding of Fear
It's important to remember that gold had already advanced from roughly $300 to $700 before the first winds of the subprime crisis began blowing in 2007. But it was the massive expansion of the Federal Reserve's balance sheet in the aftermath of the 2008 financial crisis that sent gold soaring — from roughly $750 at the height of the crisis to $1,900 three years later.
Much of that move was driven by the fear that the Fed's policies would lead to higher inflation, if not outright hyperinflation. Many still harbor that concern. But the dire inflation outcomes haven't materialized, and with the minutes of the Fed's latest meeting indicating it could soon be winding down its quantitative-easing programs, the fear of those dire outcomes has been dissipating.
- Central Banks and Cyprus
Over the past three years, central banks have been net buyers of gold, helping push gold's price higher. This could be changing, and Cyprus could be the catalyst. Part of Cyprus' recent bailout deal with the European Union involves selling a chunk of their gold reserves. While Cyprus' gold reserves are tiny, the concern is it sets a precedent for other Euro nations that need help. If Greece, Portugal, Spain, France, etc. were to become net sellers of gold in the future, it would represent a significant switch by central banks from gold buyers to net sellers. China also has been a big buyer of gold, but growing suspicion of its economic weakness throws that continuing role into question.
- Supply and Demand
No big surprise here, but since gold prices started shooting higher, production has risen. It's a lot more lucrative to mine gold when the price more than doubles. Gold mining output is up about 20% since 2008.
- Competition from other Investment Types
Many people were scared to death of equities after 2008. As that fear has receded and gold's rise has faltered (indeed its price has actually started to fall), some of the same money that rotated out of equities and into gold has rotated back. (That's speculative on my part, but it's hard to believe that hasn't been a contributing factor.)
- Ease of Trading
The massively popular gold exchange-traded funds (ETFs), led by GLD, which was briefly the largest ETF in the world, have greatly facilitated the rotation by smaller investors from other asset classes to gold, and now back again. On April 12 alone, GLD saw outflows of $1.2 billion. So far this year, GLD has seen its assets shrink 28% due to outflows of more than $15 billion. It used to be inconvenient to buy or sell physical gold, so few tended to do it. Now it's exceptionally easy to add or remove gold from one's portfolio via the ETFs.
That leads me to the two approaches to investing in gold we've stressed in the past — that of the long-term accumulator and that of the opportunistic trader. For the long-term accumulation path, our suggestion has been to buy physical gold in the form of non-numismatic bullion coins. (We also have suggested Goldmoney.com as a "digital gold" option.) Readers who have scaled into those types of positions since we started writing more about gold in 2009 probably have not been affected by the recent price declines too much. In fact, the recent price declines may provide accumulators with a buying opportunity.
On the other hand, the recent meltdown in gold prices has dramatically affected the shorter-term trader. For those desiring an occasional exposure to gold, I suggest you investigate our Dynamic Asset Allocation strategy, where gold can represent as much as one-third of the portfolio, or none at all, depending on DAA's well-defined timing system. Our back-tested model shows that strategy would not have owned gold since a year ago. Gold was above $1,650 at the time.