After the gold crash: What to do now?

The gold price dropped like a stone this week … now it’s a waiting game.

Summary: The warning bells on gold have been sounding for some time. Now, with the spot price having plummeted over just a few days, gold is not the safe haven it was during the height of the GFC. For now, investors should see what happens in the aftermath of this week’s price meltdown.

Key take-out: Shares in goldminers should be avoided until a clearer picture emerges of the damage inflicted on gold forward selling and hedging programs.

Key beneficiaries: General investors. Category: Commodities.

Gold has been an accident waiting to happen since late last year, which is why the biggest gold-price crash of 30 years was not a surprise, especially to regular readers of Eureka Report, who were warned in December in my article “Gold warning bells chime”.

The question now is whether the $US200 an ounce (13.7%) fall in less than two days of hectic-trading will satisfy the “bears” who have been waiting impatiently to savage gold, a currency and commodity which sits outside most rational concepts of investment.

Source: World Gold Council

“Perhaps” is the only safe answer to the “what next” question, because while the sharp price fall from around $US1565/oz last Thursday to a two-year low of $US1350/oz on Monday has damaged gold’s reputation as an investment safe haven, it has not destroyed that status for a very simple reason – the world today is not a safer or more financially stable place than it was last week.

But while gold remains attractive from the perspective of it being an insurance policy in an uncertain world (see Sleep easier on gold’s currency cushion), a sudden movement in any market creates a period of instability. The big fall in gold could have triggered debt covenants and margin calls, which will force more gold onto the market, adding to the amount on offer, and further depressing the price in the short term.

If for no other reason than waiting to see who went broke in the biggest gold price crash (in dollar terms) for decades, it is probably best to sit on the sidelines until a clearer picture emerges – but with a notional bias towards buying at current levels because of the ongoing global economic volatility.

What just happened with gold over the last few days is precisely what was predicted here on December 10 last year after I returned from attending the Mines and Money conference in London. At that time, interviews and discussions with heavyweight investors exposed the fragile support for gold, which had risen too far and stayed high for too long.

Worse still, investors had grown weary of holding gold in its purest metallic form or as an exchange-traded certificate, because it generates no recurrent income, such as dividends. In other words, in the ‘hunt for yield’, it has no role.

Gold is an investment that only rewards its holders via capital gain, or from the psychological comfort of being in a class of its own and therefore beyond the reach of any government manipulation or inflation created by excess government spending.

For much of the 10 years from April 2003, gold was a one-way bet, rising from $US327/oz to an all-time peak of $US1920/oz in August 2011, a world-beating gain of 487%.

Since hitting its high, gold had been in retreat, with the latest price equating to a fall of 27%, taking it back to price levels last seen in 2010. However, gold recovered some of its losses today, with the spot price reaching around $US1574 at the time of publication.

Source: World Gold Council

The reasons behind the weaker gold price are a mix of long and short-term factors, such as:

  • Profit-taking by people who bought in at a lower level, something I did with half the gold in my personal portfolio about two years ago, missing the peak in the market but happy to have taken a profit on something acquired in 2007 at around $US780/oz. (see Gold: To buy or not buy).
  • Concern that the ongoing poor outlook for some European countries could force a wholesale liquidation of gold holdings by private investors and possibly by the hardest-hit governments.
  • The pursuit of higher yields by investment funds suffering near-zero returns on portfolios heavy with government bonds and gold.
  • Gold being caught in a more widespread sell-off of all commodities amid concern that China’s rate of growth, which slipped to 7.7% in the first quarter of 2013, signals an era of slower growth.
  • No evidence of a feared outbreak of inflation, an event widely expected because of the massive volumes of liquidity created (out of thin air) by governments around the world with Japan the latest major economy to resort to the printing press as a means of stimulating growth.
  • An emerging view, which contradicts uncertainty about the world’s major economies, that there is greater stability in the global economy. This means a return to more normal conditions might not be far away, and that means a period of rising interest rates which, in turn, means now might be a good time to quit low-yield (zero yield) gold and bonds.
  • Influential investment banks, such as Goldman Sachs, advising clients that it’s time to sell gold and rotate funds into conventional stocks, which offer reasonable yield. This is a move encouraged by the lack of inflation in any major economy.

All of the reasons listed are plausible explanations for what’s happened with gold, but there is a problem. If analysed point-by-point, they are inconsistent.

Profit-taking is a perfectly logical reason for the price to fall, but it is impossible to reconcile the other views, such as a return to more normal conditions making it safe to rotate out of safe haven assets into conventional stocks (Goldman Sachs).

What is certain is that prudent investors will never over-expose themselves to a single asset class in the same way they would never liquidate their portfolio and put it all on red on a roulette wheel, though remarkably this is what one of the world’s smartest investors appears to have done.

John Paulsen, a man who made a fortune for himself and clients of the hedge funds he runs in the sub-prime crash of 2008, is reported to have incurred a loss on gold over the past few weeks of around $US1.5 billion.

According to reports emerging in Paulsen’s home town of New York (from where I am filing this story), Paulsen & Co has been advising clients to denominate their funds in gold rather than US dollars. Paulsen is said to have about 85% of his personal capital in the firm tied to gold.

If the reports are correct, then what Paulsen & Co has done cannot be described as a balanced investment strategy. It is more a bet against another financial crisis, or the monetary Armageddon predicted by people who believe governments are destroying the value of all paper currencies by printing too much of them.

Paulsen is not alone in fearing a global meltdown. I am also aware of a number of wealthy Australians who have made similar moves because they want to preserve their capital and keep it out of the reach of government.

An explanation for the Armageddon view of the world was provided by a Paulsen & Co director, John Reade, who told the Financial Times newspaper this week that: “Federal governments have been printing money at an unprecedented rate, creating demand for gold as an alternative currency,” he said.

“It is this expectation of global paper currency debasement which makes gold an attractive long-term investment,” Reade said.

He’s right, but to bet heavily on a single asset class is not wise investing. Even if a high-risk approach can sometimes yield spectacular returns such as Paulsen’s massive sub-prime wins, it is a strategy which has more in common with speculation than investing.

Another near-certainty in the broader gold market that embraces the metal itself and goldmining companies is that the big price fall will have knock-on consequences. (I recently wrote on the challenges facing Newcrest. (True believers stick by hapless Newcrest).

Some investors lacking the balance-sheet strength of Paulsen & Co will be struggling with their gold exposure, especially anyone who has used debt to accumulate gold – perhaps the most foolish of all investment strategies.

Some goldmining companies will have developed or expanded mines on the assumption of a gold price higher than it is today – they too will be struggling to survive in a lower-price environment.

The best way to treat gold is as an asset in an investment class of its own, worthy of a place in all balanced portfolios if only to act as an insurance policy against the sort of “paper currency debasement” seen by Paulsen & Co.

It is possible that Paulsen’s view of the future is correct and that excess paper money in circulation will generate an outbreak of inflation, debasing conventional forms of money.

But, so far, there is no evidence to support that theory and, until the evidence starts to emerge, gold should retain no more than a 5%-to-10% position in a balanced portfolio, preferably as bullion (physical gold), but with exchange-traded certificates as an acceptable alternative.

Shares in goldminers, given the dramatic events of the past few days, should be avoided until a clearer picture emerges of the damage inflicted on forward selling and hedging programs. You can be sure that someone has been wiped out by placing incorrect bets; we just don’t know who, yet.