Gold’s One Certainty: Its Decline Has Been Swift

GOLD and trouble go together, because the metal is often seen as a haven in times of economic distress.

But the relationship is complicated. Prices can rise or fall for seemingly contradictory reasons.

Investment advisers these days are trying to make sense of a 25 percent plunge in gold prices in the second quarter, to roughly $1,200 an ounce, its lowest level in three years. The reasons for the dip may not be clear, but the results certainly are.

Mutual funds specializing in mining stocks lost 34.5 percent, on average. Mine operators often encounter exaggerated reactions to gold-price moves because their profits depend on the difference between the metal’s price and their production costs, which tend to be inflexible.

Many investment advisers who attribute gold’s sharp drop to an improving economic outlook say they expect the price to fall further, but even some who are less optimistic about the economy recommend shunning it.

Investors expected “rampant inflation, but it’s not happening,” said Rebecca H. Patterson, chief investment officer of Bessemer Trust, a firm that advises wealthy families. “The stronger dollar is also hurting gold, and there is less demand from emerging markets,” she added. “Given these factors, it seems reasonable that gold is going down.”

Doug Ramsey, chief investment officer of the Leuthold Group, also finds gold’s decline reasonable because so many small investors find the decline unreasonable. He pointed out in a note to clients that demand for small gold coins rose sharply after the plunge. Because small coins are typically bought by small investors who often get their timing wrong, he takes that as a sign of investor complacency that heralds continued weakness.

“Analysts looking for a durable low in gold would much prefer to see panicked liquidation by these odd-lot buyers,” Mr. Ramsey wrote. But such a panic, which might signal an end to the decline, may not set in “for months or even years,” he said.

Returning to economic fundamentals, Mike Ryan, chief investment strategist for wealth management in the Americas at UBS, notes that gold tends to perform worse when inflation-adjusted interest rates rise. They have done so this year as concerns about the sustainability of the economic recovery have subsided.

“If rates are high, you can capture better returns in other asset classes,” Mr. Ryan said. “Gold has no return at all. If the economy gets significantly better from here and interest rates move significantly higher, gold could drop further.”

But he raises one of the standing complaints about gold as a long-term investment: it produces no profit, pays no dividend and, apart from jewelry and some industrial applications, has no practical value. It is worth only what people are willing to pay for it.

Another reason that investors have been willing to pay less lately is that worries of many sorts have subsided — not just ones about economic growth. The Federal Reserve, too, apparently has joined the public in a more carefree spirit.

“The decline reflects an abatement of tail risks and fears of the wheels coming off the bus,” Mr. Ryan said. “We’re getting closer to a normalization of policy, especially by the Fed. A lot of what’s happening is a sign of healing, a recognition that the more acute risks have dissipated.”

But John Hathaway, a manager of the Tocqueville Gold fund, sees the economy as suffering from chronic weakness — and he isn’t ready to discharge the patient yet. In a note to investors after gold plummeted, he made the case that stimulus measures worldwide, especially very lax credit policies, have controlled the condition but can’t cure it.

The “consensus belief in global economic growth seems misplaced,” he said. “It seems quite likely that extreme monetary policies are not a passing phase, but a thing of permanence.” The likely result, he predicted, will be a run of inflation and a recovery in gold.

Pete Kendall, co-editor of the Elliott Wave Financial Forecast newsletter, also questions how robustly the global economy is recovering, but he concludes that the weakness is bearish for gold. He contends that gold is foretelling fully-fledged deflation — a contraction in the economy and asset prices — just as it did in 2008, when the metal dropped from about $1,000 an ounce to roughly $700 between March and November.

“Contrary to popular belief, gold has done a lot better in times of expansion than recession,” Mr. Kendall said. As signs of global sluggishness become clearer, he warned, “gold should weaken further.”

So does that mean investors should avoid owning it? Maybe. The main drawback of gold — its lack of intrinsic cash flow or practical utility — makes speculation unsuitable for conservative or unsophisticated investors, some investment advisers say. But a case is also made by bulls and bears alike for allocating a small amount of a large, broadly diversified portfolio to gold, either in physical form or in an exchange-traded fund that holds bullion, like SPDR Gold Shares. The aim is not to generate long-term returns, but to hedge against some unlikely yet costly and unfortunate event.

“We recommend that folks have some of their holdings in gold,” Mr. Ryan said. “It’s a special niche within a portfolio. You just hold some portion adequate for providing diversification and a hedge against extreme outcomes.”

FOR him, that portion is slightly less than 1 percent. Ms. Patterson encourages the same weighting through a mix of bullion and the SPDR E.T.F., although at other times, she said, the allocation could range between 1 and 5 percent.

One extreme outcome that investors feared until recently was a bout of inflation. The bigger dangers, warned Ms. Patterson at Bessemer Trust, are bolts from the blue, sources of trouble that investors are not even considering.

“The risk is that people are not prepared for whatever that next unknown unknown is,” she said. “If it happens, you’re going to be glad you held on.”

Article source: http://www.nytimes.com/2013/07/07/business/mutfund/golds-one-certainty-its-decline-has-been-swift.html?partner=rss&emc=rss