The glee was palpable in the air as financial commentators pointed to gold’s 9% drop last week. The sub-text of their observations was: didn’t we tell you that gold has no inherent value and that its price has only been catapulting higher because of a coterie of momentum chasers and central bank hating doomsters?
Before rashly concluding that a bubble has been popped, let’s see if we can put gold’s move into context and determine why its price plunged. Over its current twelve year bull run, gold has suffered three significant corrections: the spring of 2006, mid-2008 to early 2009, and Dec.2009-Feb. 2010. Respectively, gold fell 25%, 34%, and 15% from prior highs during these three periods. Currently, gold is off 15% from the September 5 high of $1920. So the latest price action is well in line with previous counter-trend movements. From a technical analysis perspective — that is, from a standpoint that focuses on price patterns alone — there’s nothing here to necessitate the conclusion thatÂ gold’s upward trajectory is finished.
Which brings us to the fundamental drivers of the gold price, to wit, the complex of financial, economic, and political factors affecting demand and supply. One explanation that’s being put forward is that hedge funds having to make up for losses on stocks and commodities were compelled to take profits in their gold positions. This makes some sense, for we also saw this dynamic at work during the height of the financial crisis in 2008. Back then, higher quality shares and bonds were being hit hard as fund managers sold them to meet margin calls precipitated by their losing sub-prime mortgage trades.
Still, given the rapidity and extent of the drop, such portfolio adjustments can only partly explain what happened to gold. A more complete account must take into consideration that gold has been a play on both deflation and inflation. To use the language of options trading, gold is a straddleÂ — which is to say, it’s become a wager on the ultimate realization of one of two opposing, extreme scenarios. The value of this type of bet depends on the likelihood that either of the extremes, rather than a more normal condition, will occur.
Last week, the probability of the inflationary outcome declined as the prospects of an economic slowdown grew. The latter was reflectedÂ in the drop of commodity prices. At the same time, the chances of a deflationary spiral that brings down Europe’s financial system lessened somewhat, especially towards the end of the week when signs emerged that the EU was going to augment its rescue fund. Together, these portend a world in which Europe’s banks continue to hold up on life support, but lend little. The money supply neither implodes nor explodes.
One can justly doubt whether this kind ofÂ middling scenario is a tenable foundation out of which an enduring fix to our economic ills can be achieved.Â For this reason, it’s too early to write off gold.