What's Wrong With Gold?

While the stock market has been a loser on a buy and hold basis over the last 12 years (the S&P 500 is still 14% below its peak in 1999), gold surged up 625% over the same period, from $255 an ounce in 1999 to its recent high of $1,850 in March. As with each of its previous record highs there was much excitement and widespread forecasts of $2,500 gold by year end, $5,000 gold in the not too distant future.

But this time instead of still higher highs, gold has dropped $300 an ounce.

What's wrong?

The driving forces that were driving it higher have gone away, at least for a while.

For instance, gold is the historical hedge against rising inflation, and the theory has been that the global easy money policies of recent years couldn't help but create an inflationary spiral. But it hasn't happened. Inflation in the U.S., the world's largest economy, remains tame at around 2%. Inflation did pick up in other regions over the last two years, notably China and India, which helped extend gold's bull market. But those countries fought back aggressively against inflation with interest rate hikes and other tightening measures that brought their inflation fears under control. The concerns now are that they went too far and have slowed the inflationary pressures of their strong economies too much, and now face serious deflationary economic slowdowns.

Perhaps surprisingly, gold has also not been perceived as a safe haven in the current time of uncertainty as has often been its history. With the return of the eurozone crisis over the last three months, gold has actually declined, and the perceived safe havens seem to be the U.S. dollar and Treasury bonds.

Demand for gold also depends to a significant degree on the jewelry trade. According to Thomson Reuters and the World Gold Council, over the last five years 12% of gold demand was for use in the manufacture of tech products, 33% from investors, and 55% for jewelry.

And that important demand from jewelry producers is taking a hit. The World Gold Council reports that jewelry market demand for gold fell 2.7% last year, but was more than offset by investor and public buying. Jewelry demand fell 6% year-over-year in the 1st quarter this year. But will investors and the public continue to offset that worsening demand? The All India Gems & Jewelry Federation reports that gold consumers in India, the world's largest importer of gold, are now selling gold "aggressively".

Anecdotally, the stories over the last two years have been about public demand for gold being so high that ATM-like machines dispensing gold coins and bars were becoming a growth industry. However, over the last few months, with people strapped for cash in the newly stumbling global economy, the stories are of people flooding jewelry stores, street-side gold 'dealers', and pawn shops, looking to sell gold coins and jewelry items to raise cash.

Meanwhile, there are two basic types of gold; that which is above ground and in circulation, and that which is still in the ground owned by gold mining companies.

An interesting phenomenon of the last two years has been the divergence between the price of gold bullion and the stocks of gold mining companies. Mining company stocks normally rise and fall in tandem with the price of the product they produce, the bullion, and the un-mined reserves of that product they still have in the ground.

Yet, while the price of gold bullion surged up 31% from $1,415 an ounce in December 2010 to its high of $1,850 in March, the gold mining stocks, as measured by the XAU Index of Mining Stocks, plunged 38% over the same period.

Traders and a number of large hedge funds bet heavily on gold mining stocks over the last year, on expectation that the divergence could not last and the mining stocks would rally sharply to catch up with the spike-up in gold prices. But the mining stocks continued to decline. It's still a popular theory that the mining stocks will eventually have to rise to match the increased price of bullion.

Apparently not being considered is that perhaps the mining stocks, not the bullion, have the value picture right, and the divergence will be resolved instead by the price of gold dropping down significantly to return the relationship between bullion and the gold stocks to normal. That's not a prediction, but is certainly a possibility to consider. My technical indicators remain on a sell signal for gold and I will simply stand aside until they reverse to a buy signal again.

Meanwhile, gold has been very volatile as it has declined from its March high, short-term traders repeatedly jumping in to try to catch the bottom, creating brief rallies. But brief demand from short-term traders is not the type of demand that gold needs for a sustainable rally that would put it back in its previous bull market.

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