HERE´S WHY GOLD PRICES HAVE BEEN DECLINING / SEEKING ALPHA

Here's Why Gold Prices Have Been Declining
             

Nov. 5, 2014 4:39 PM ET

 

by: The Financial Lexicon

           

Summary

• There is an abundance of commentaries on gold's price declines.
• I generally find that commentary to be lacking in terms of identifying the underlying causes of gold's price declines.
• In addition to poor sentiment and poor technicals, there are five other things currently contributing to gold's declines.

The relentless decline in the dollar price of gold has brought with it a multitude of commentaries on the subject. Despite abundant commentaries, it is challenging for investors to find accurate descriptions of what is ailing gold. I've read a lot about poor sentiment and poor technicals, both of which are true, but both of which don't explain the underlying problem gold is having. In order to better understand why it is that gold valued in U.S. dollars has been declining, let's begin by reviewing why it was that gold rose in the first place.

In the world of finance, high-level, big-picture themes are often touted by investment professionals, in order to drum up excitement for a particular asset or asset class. Around the turn of the century, the big-picture theme of a commodity "super cycle" driven by growth in the emerging markets was starting to take hold. In the years that followed, that theme gained strength and momentum, pulling commodities across the board higher in price. This included precious metals.

During the same time, the exchange-traded-fund revolution was taking hold and commodities-related ETFs began popping up. This included the SPDR Gold Shares (NYSEARCA:GLD) and the iShares Gold Trust (NYSEARCA:IAU). As it became easier for investors to plow money into commodities, new investment demand added fuel to the fire and prices continued to march higher. Also adding fuel to the fire that pushed commodities (and gold) higher was a weakening dollar, with the U.S. dollar index falling from over 120 in January 2002 to right around 80 in August 2007.

Then came the next piece of the puzzle. On August 17, 2007, the Federal Reserve jump-started the easy-money world we still live in today, when it cut the discount rate 50 basis points. That triggered more U.S. dollar selling and added further confidence to believers in the emerging-markets-can-decouple-from-the-U.S. story. Commodities soared. The PowerShares DB Commodity Index Tracking Fund (NYSEARCA:DBC), for example, rose 97% from its low in August 2007 to its July 2008 peak. That abruptly came to an end in the summer of 2008 as the financial crisis kicked into full gear and a stronger U.S. dollar, falling demand, and global deleveraging crushed commodities across the board, including gold.

The tide would again turn in 2009 as the Federal Reserve's quantitative easing started a cyclical bull market in commodities that lasted a bit over two years and took gold close to $2,000 an ounce. In late 2010, QE 2 only added to the demand for commodities-related assets, as fears of money printing leading to high inflation tightened its grip on the investing community. Emerging markets stocks also performed quite well during that time and many investors thought we were heading back to the commodities and emerging markets pre-financial-crisis heydays. Alas, it was not to be. And gold has fallen ever since. But why?

Gold has been falling for many of the same reasons the commodities complex in general has been falling for over three years. The pieces of the puzzle that made up the pre-financial crisis bull market and the post-financial crisis cyclical rally in commodities have been falling apart.

First, emerging markets growth has been slowing.

Second, just as inflows into ETFs tracking physical commodities can help to push prices higher, so too can the process act in reverse. And it has.

Third, after QE 2, investors realized that the high levels of consumer price inflation so many thought would occur as a result of money printing wasn't actually occurring to the extent thought. Investors had been wrong to funnel money into commodities in anticipation of money printing causing extremely high levels of consumer price inflation. Instead, the inflation was occurring in certain financial assets, including stocks. It therefore made sense to shift one's allocation out of commodities.

Fourth, the U.S. dollar (NYSEARCA:UUP) has performed strongly since the spring of 2011. As I noted in "Commodities And The Dollar: This Chart Says It All," there is a strong inverse correlation between commodities (gold included) and the U.S. dollar. Investors have long known this to be true, and the stronger dollar of recent years has therefore put downward pressure on the commodities complex.

Fifth, now that the Fed has ended QE, investors are looking ahead to potential rate hikes. From an interest rate differential standpoint, and from an opportunity cost standpoint, a Fed rate-hike cycle would make it less favorable for certain investors to own precious metals. That puts downward pressure on the prices of gold and silver (NYSEARCA:SLV).

Despite the shellacking gold has received in recent years, I'd like to reemphasize something I noted in "Putting The Gold Selloff Into Perspective."

"If you own gold as a store of value, rather than as an asset whose success or failure is judged by its price movements in fiat-currency terms, the recent selloff is largely irrelevant to you. In fact, it may actually be a benefit, as a drop in the U.S. dollar price of gold will bring with it a drop in storage fees and give you the opportunity to accumulate more of the world's ultimate store of value. 

To put into perspective how meaningless the recent selloff in gold is to someone who owns gold for its historical role as a store of value, let me use myself as an example. I own some gold in my portfolio as a hedge against the current fiat-money system not outliving me. I couldn't care less whether the price goes up or down in dollar terms. If the current fiat-money system outlives me, my gold holdings will simply pass on to my heirs. That's the perspective owners of gold have historically had. And that's the perspective current owners of gold should remember when watching fluctuating gold prices in dollar terms."