Gold’s Drop Begs the Question: When Is it Time to Buy?

Gold grabbed the attention of investors, speculators and average Americans as prices doubled from the start of the financial meltdown in late 2008 to a record high three years later.

As a safe-haven investment, gold outperformed all of its rivals, including U.S. Treasuries and the Swiss franc. But the yellow metal has melted down since Federal Reserve Chairman Ben Bernanke said last week that policy makers will end their stimulus program when the economy gains full strength, with the consensus of central-bank watchers saying that could be as early as a year from now.

For investors, that’s created a conundrum. An ounce of gold costs less than $1,300 today, down from a record of more than $1,900 in September 2011, as hedge funds and other speculators dump their holdings. Laszlo Birinyi, the president of Birinyi Associates, says gold is his biggest short investment, and investment banks including Goldman Sachs are predicting more losses. The trading model I developed with Sir John Templeton, founder of the Templeton Funds, has been pointing to lower gold prices all year.

But to others, gold may once again represent one of the biggest buying opportunities once prices bottom in the months ahead.

When there’s such a disparity in the investment community, it’s important to take a step back and look at the fundamentals and longer-term trends to put the most recent gold moves in context.

The Fundamental Case for Bulls and Bears

Traditionally, gold plays three roles in the global market. The precious metal is:

1. Considered a safe-haven asset

2. Bought as a hedge against inflation

3. Used as an alternative store of wealth to paper currencies and fiat assets

Gold bulls cite those reasons as to why the precious metal should be much more highly valued than it is now. But those roles have been greatly diminished over the past two years.

First, traditional safe havens must have two critical qualities: They must be liquid and maintain low volatility. Gold fails both of those tests. While it is more liquid than many assets, it doesn’t come close to rival safe havens such as U.S. Treasuries. And as evidenced by last Thursday’s sell-off, volatility in gold trading has exploded, delivering sudden losses for investors holding gold for safety.

Second, as a hedge against inflation, gold simply doesn’t have the rapid price growth to offset the rising prices of goods. To gold bulls, that doesn’t make any sense. They say the massive stimulus programs instituted by global central banks should inflate gold along with other assets. That argument may make rational sense, but as John Maynard Keynes famously said, “The market can stay irrational longer than you can stay solvent.”

Finally, we have gold’s role as an alternative to “manipulated” currencies. Here, too, we’ve seen currency traders ignore the distorting effects of quantitative easing. Central banks’ efforts to boost economic growth and end deflation have led to unprecedented increases in their balance sheets, which should also have the side effect of devaluing currencies. But the U.S. dollar has remained relatively strong and may get even stronger as the Fed slowly winds down its $3 trillion-plus bond-buying program. That doesn’t bode well for the price of gold.

Gold will likely face even more downside pressure in the weeks and months ahead.

In addition to the underlying fundamentals, we must also look at gold’s historical performance. Gold has been in a bear market for almost two years, falling by a third during that time.

Where Will Gold Go From Here?

Based on fundamental analysis and technical indicators that my trading model relies upon, gold will face even more downside pressure in the weeks and months ahead.

Gold bulls, of course, have laid out a different argument. For many, the main point is: The global economy is under greater threat now than it’s ever been. Individual economies are slowing or shrinking, high unemployment and widening income disparities are causing rioting in the streets, and central-bank money printing has produced bubbles in stocks and bonds.

Marc Faber, author of the Gloom, Boom & Doom Report and one of the world’s best predictors of the securities markets, said Friday that bonds and gold have “incredibly negative” sentiment, and the yellow metal may rally — he said he’s recently been buying gold.

That’s a sentiment shared by Larry Edelson at the Gold and Silver Trader newsletter. Edelson, who’s correctly forecast gold’s moves for more than a decade now, sees a renewed bull market in gold unfolding over the next several years. Like others, Edelson acknowledges gold may decline further before a run-up in prices.

Schroder Investment Management, standing apart from other money-management firms, has suffered “very few redemptions” since the sell-off in gold began, commodities product manager Christopher Wyke told Bloomberg yesterday. That’s because “the fundamental reasons why people are buying gold are still there. We have economic risk, [and] political and market risks.”

From a long-term perspective, I think that may be true. But, for now, the trend for gold is undeniably bearish. The yellow metal will remain in this bear market until it regains its fundamental value as a safe haven, inflation hedge and alternative store of wealth, just as it always has.

Best wishes,

Douglas