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Three Reasons Why Gold Continues To Fall And How It Will Recover

January 29, 2014

You have gold in your investment portfolio, but you've been watching the price tumble down, down, down. Is now the time to sell? According to some people, yes it is. But, before you ditch the pretty yellow metal, you should understand why gold is falling and what will ultimately save it.

It's The Fed's Fault

Precious metal company reviews often talk trash about the Fed and other central banks. They're an easy target. The Fed prints money through its magical monetary powers, floods the economy with more dollars, and everyone suffers the effects of inflation. When they do, gold shoots "to the moon."

This is a very cool fairytale and it fits nicely on the side of a cereal box, but it's a little oversimplified. For starters, it's not automatic that gold will protect you against inflation. Sometimes, it provides no protection at all. Other times, gold is much more of a signal of bad times to come, politically or economically than it is a sign that the dollar is weakening.

Secondly, while the Fed influences interest rates, this doesn't necessarily mean that investors always jump ship and run to gold when the Fed holds down those rates. Post 2008, the Fed made banks rather liquid, and capable of lending, but banks retracted and refused to lend more than they needed to. Because long-term rates were being held down, the prospect for profits in the banking industry began to shrink.

There are two sides to inflation - monetary inflation and price inflation. But, price inflation won't happen if the money from the monetary inflation never makes its way into the economy (i.e. if banks refuse to lend or tighten lending requirements). Additionally, if production keeps pace with inflation, the effects will be barely noticeable.

Everyone Is Selling Except Goldbugs

It's almost heretical to sell gold in some circles. But, if you're not in the goldbug camp, take a look around. Your peers are all selling gold right now. Exchange traded funds, for example, have sold more than 500 tons of gold in 2013. That about 20 percent of their total holdings, according to David Wilson, Director of Metals Research and Strategy at CitiGroup.

Even the infamous SPDR Gold Trust has fallen to their lowest level since 2009. That's a 17.8 billion withdrawal. Ouch. At least it's not as bad as hedge fund manager John Paulson - he tied up 85 percent of his personal capital in his firm in gold.

Institutional Investors Are Bailing

Firms like Morgan Stanley and Goldman Sachs are lowering their price targets on the pretty yellow metal. Even UBS, who is traditionally a perma-bull on gold - in as far as banks are concerned - is changing its tune. All signs point downward.

Over the past year, the Swiss bank has lowered its estimate of gold, moving from an optimistic $1,750 to $1,050 an oz. At those prices, gold will be a steal.

The Chinese and Indians Have Given Up

The last time gold took a skinny dip, the Chinese and Indians were there to rescue all of the goldbugs. Mostly, the foreign investors were interested in coins and jewelry. This time around, however, Asian interest just isn't there.

Maybe they already have all the gold they want or can afford. Maybe they're following the trends of larger institutional investors. Whatever the case, there's no foreign savior to bail the rest of us out.

What Will Save Gold?

Ultimately, what will save gold is partially what is killing it right now. As the price declines, it becomes more attractive. Right now, the metal is seen as overbought and overpriced. When the bottom hits, expect investors to start buying it up by the kilo.

The Federal Reserve may or may not keep rates low for the foreseeable future. But, at some point, banks will start lending again. If that excess liquidity isn't mopped up by then, this might be a buying signal from inflation-minded investors who are afraid of their 401(k) or other investments being wiped out.

Finally, gold won't ever go away as a store of value. It's been with us for over 5,000 years. Bitcoin is a flash in the pan and already seeing cracks in its dike. Right now gold is soft, no pun intended. But, it's also resilient.

Long-term buyers are rarely interested in its current price, and that's the attitude you have to take with it. Gold is the replacement for the dollar (and all other fiat currencies when they fail), and its dollar-denominated value shouldn't concern you. At some point, an unbacked currency falls to its intrinsic value - zero. Until then, you just have to hold tight onto the reigns and ride out the storm - or, know when to duck and weave in and out of the commodities market.


Paul Shaefer has extensive insights in trading. His articles mainly appear on commodities and trading blogs.

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