A selloff? A capitulation? An “epic dump-fest”? Pundits scrambled to find precisely the right word to describe the bloodshed in the gold market Monday, the grand finale to six months of downward pressure that scraped away all of gold’s luster and culminated in the biggest two-day selloff in the metal price recorded in the last 30 years.
That frenzied selling left gold futures so cheap – at around $1,360 an ounce – compared to their highs of last year that it brought bargain-hunters into the market Tuesday morning, bidding up the price of bullion and briefly pushing it above $1,400 an ounce. But gold investors, traders and speculators shouldn’t pay nearly as much attention to this kind of bottom fishing as they do to the months of trading that preceded it, which drove gold inexorably lower, one step at a time, from its highs of $1,900 an ounce. That’s the real trend, and it’s one that isn’t likely to reverse any time soon. Certainly, Bank of America Merrill Lynch cautioned investors that its own investment strategists saw “no compelling reason” to recommend adding to gold positions.
There are as many hypotheses about the reasons for this massive decline as there are attempts at capturing the frenzied atmosphere at gold-trading desks worldwide Monday. At the core, however, is the simple fact that there isn’t enough fear among investors worldwide. Anxiety, yes. Uncertainty, absolutely. But blind panic? Nope. And it’s panic that pushes investors into gold as a “safe haven” and a store of value. It’s what people buy when they think they’ll need portable wealth, or when they believe a currency’s value can’t be sustained, or when they think that other assets are about to lose all their value. (Remember the autumn of 2008?)
The rest of the time, unless you’re a gold bug, the metal isn’t a logical investment. Most investments provide some kind of potential gain, whether in the form of yield or capital appreciation. Gold, on the other hand, actually costs the investor money to own, at least in its traditional forms. If you own futures contracts, you need to keep rolling them over, incurring trading costs; if you own the physical metal, there are small issues like storage costs. (And gold ETFs don’t offer a perfect or sometimes even an easily managed proxy for gold itself.)
That’s the backdrop to the meltdown. Throw into the mix the widespread fear that Cyprus has been or soon will be selling off some of its stocks of gold reserves, and the growing chatter that the Fed won’t persist in keeping interest rates at today’s ultra-low levels for all that much longer, and you’ve got more fuel for the fire. The former is a simple matter of supply and demand: In a thinly traded market like that for gold (in normal market environments) an influx of new supply that isn’t very carefully handled over a long period of time can destabilize prizing. Basic economics rules. Adding to the supply/demand picture is the prospect that Chinese demand is likely to falter as the country’s economy grows at a comparatively very modest rate, below the level many had expected.
The Fed argument? Well, as long as the central bank has been so ultra-accommodative, gold bugs could argue that investors should keep gold in their portfolios to hedge against inflation caused by so much liquidity. Sadly, gold hasn’t worked as a hedge (there hasn’t been very much inflation, at least so far), but as speculators dove into the precious metals markets, the perception that there were rich rewards to be mined there fueled even more speculative activity.
Now those chickens are coming home to roost. Gold has always been one of the trickiest commodity markets to navigate. In contrast to the energy commodities, or metals like copper, there is relatively little in the way of what commodities geeks refer to as “physical” demand. In other words, while most of us rely on gasoline to power our cars and natural gas to heat our homes, and global manufacturers couldn’t get by for long without copper, gold is an optional extra. (Even silver has more practical uses.) There is physical demand by jewelers, of course, but even then, a significant part of that gold jewelry is treated as a different kind of investment in areas like India and the Middle East, where it is a form of portable wealth.
Once investors viewed their gold investments as being less critical in their portfolio – or involving more risk – then the ground was prepared for the kind of rout that we have just witnessed. Adding to the downward pressure was the fact that, as the market slid and more and more sellers emerged from the shadows, the odds of gold’s price falling below $1,540 an ounce increased. That, says Anthony Valeri, a strategist at LPL Financial, had been “a fairly firm floor” for gold for some months; on many occasions, gold had touched that level only to bounce higher once more. As with many technical market indicators, once it had broken below this level, gold lacked support: investors’ models screamed “sell.”
The broader transformation that has taken place over the last quarter century or so in financial markets also has reshaped the gold market and contributed to Monday’s drama. Open outcry in commodity trading pits has been replaced by computerized trading, which means faster and more dramatic moves are possible and even likely. When I began writing about commodity markets nearly twenty years ago, there were very, very few hedge funds that were interested in this arena, although the number of commodity trading firms treating commodities as short-term investments was beginning to take off. But since then, gold has become another asset class in which traders and short-term speculators can place bets designed to last a few minutes, hours or a few days. And yet, in contrast to the stock market, gold is thinly traded. All it takes to push this market around is a few news stories on the margins – Cyprus, China, the Fed meeting minutes – that individually aren’t all that surprising but that collectively affect the decisions of a handful of critical players.
Indeed, the gold market is so thinly traded that there were rumors swirling throughout the commodities arena Tuesday that at least one hedge fund has been left sitting on immense losses because its traders didn’t hit the sell button fast enough.
Among the other big losers are gold mining stocks. Mining companies sell their output at levels close to world prices – unless they have established long-term contracts or have hedged the risk of just the kind of move we have seen by using futures to sell forward future production. But most of the miners -- already scaling back their capital spending plans and output -- are now in even more of a perilous position. Barrick Gold (NYSE: ABX), the world’s largest mining company, has rarely ever hedged against the risk of a price downturn, preferring to offer its shareholders an indirect way to invest in gold via its mining operations.
On one of the rare occasions when Barrick Gold changed that policy, it didn’t last long. For instance, it paid $5 billion or so to unwind gold hedges back in 2009, as the commodity’s price was rising in the post-financial crisis environment. “We now have full leverage for the gold price,” Aaron Regent, the company’s CEO, trumpeted. Whoops. As the price began to wobble, Regent lost his job last year. But the company didn’t go back to hedging.
That’s something gold mining companies now are likely to regret very bitterly, as they prepare for a period in which they will have no way to sell their gold production at a high enough price to cover their operating costs. In other words: losses, not profits, lie in their future.
Gold has definitely lost what was left of its glitter for the remainder of this cycle.