Why Gold Could Drop $200

With gold hitting $1,000 per ounce today, many believe that the sky's the limit for the yellow metal. If you're thinking about buying gold now, though, you need to understand the risks involved.

Us vs. them
It's hard to find objective analysis on gold. Many die-hard "gold bugs" seem to feel vindicated whenever gold prices rise, while decrying the markets as irrational when prices fall. Meanwhile, market investors often mock gold bugs for putting so much faith in the metal, arguing that other investments give better potential for both income and growth. As one who understands both sides of the argument, I'm going to try to approach gold from an objective point of view.

Gold has traditionally been a hedge against inflation. In my opinion, though, we currently have stronger deflationary pressures in the economy. While deflation could result in a rally in Treasury bonds and the U.S. dollar, it would also likely bring a fall in commodity prices. Gold bullion could see its price fall substantially from current levels.

You cannot print demand
Much has been said lately that "printing" by the Federal Reserve and other central banks will result in above-average inflation. This is absolutely true, but the key is when. I don't believe that inflation will show up at any point in 2009, and it very well may not show up in 2010 either, given the collapse of securitization markets and the resulting decline in credit available in the U.S. economy.

At the same time, overall demand for gold hit a six-year low, according to the World Gold Council. In the second quarter, global consumption fell 8.6% to 719.5 metric tons compared to 2008, to the lowest level since the first quarter of 2003. Falling demand for jewelry (down 22%) and electronics manufacturers (down 26%) was partially offset by rising demand from gold investors (up 46%).

As you can see, even enthusiastic gold bulls cannot push the market higher if other sources of demand are falling. It is true that central banks were net buyers for the first time since 2000, which should be the main driver of gold bullion in the future. But if the current economic stabilization turns out to be just an inventory rebuilding cycle, and the economy weakens again in the fourth quarter or in early 2010, gold demand is likely to stay suppressed. The dollar will likely rally again and so will Treasury bonds -- no matter how much the investment public hates bonds at present.

Why $200?
To get a sense of how big a correction might be, let's take a look at gold's trading range in recent years.

Year

High

Low

Range $

Range as % of High Price

2009

1007.7

801.5

206.2

20.5%

2008

1033.9

681.0

352.9

34.1%

2007

848.0

603.0

245.0

28.9%

2006

730.4

503.8

226.6

31.0%

2005

541.0

410.4

130.6

24.1%

2004

456.9

371.3

85.6

18.7%

2003

418.0

322.1

95.9

22.9%

2002

350.5

276.7

73.8

21.1%

2001

294.0

255.0

39.0

13.3%

 

    Average

23.8%

Sources: Thomson Reuters, author calculations.

With the average drop between a yearly high and low of about 23.8%, a drop from current prices around $1,000 per ounce down to $800 would be well within historical norms. Such a $200 drop wouldn't necessarily spell the end of the longer-term bull market in gold, but rather would constitute a correction.

A $200 decline = a buying opportunity
If gold does decline by $200 per ounce, I believe it will present a buying opportunity -- but only for the right investments. In my years of investing, I've too frequently seen investors chase the worst kind of stocks: small, unprofitable miners with only a nebulous promise to produce gold some day. Such small mining stocks tend to decline at a much faster pace during corrections. I've seen many 70%-80% declines in small gold mining stocks over the years. High-profile examples in past years include Coeur d'Alene (NYSE: CDE  ) and DRDGOLD (Nasdaq: DROOY  ) , both of which failed to advance over long periods despite big run-ups in silver and gold, respectively. Both issued a lot of stock without producing the profits they promised and declined well under a dollar, before being forced to do reverse splits.

On a more positive note, Goldcorp (NYSE: GG  ) , Barrick Gold (NYSE: ABX  ) , and Royal Gold are more serious gold stocks that have benefited from the bull market in gold, and investors should look at their shares on any decline. Royal is not a mining stock but rather a royalty company with excellent margins in the precious-metals sector. It recently completed its largest royalty acquisition from Teck Resources (NYSE: TCK  ) , which resulted in the issuance of a lot of stock. The large issuance is not a problem as the acquisition is accretive over the long term, but in the next three to six months, it could cause pressure on the stock if the current price declines below the secondary offering price of $38.

Stocks vs. bullion
Gold bullion began rallying at the beginning of this decade and has not had a down year since. This is very different from gold stocks -- be careful not to confuse the two -- which had a big down year in 2008 and have been known to see prices diverge significantly from bullion. Gold stocks are financial assets; gold bullion is a real asset. In times of great financial stress, gold stocks can go down even when gold bullion goes up. In 2008, for instance, gold bullion, as measured by the SPDR Gold Trust (NYSE: GLD  ) , was up 5%, while the Market Vectors Gold Miners ETF (NYSE: GDX  ) of mining stocks fell 26%.

I still believe both the bullion and mining ETFs have more upside, so despite the possibility of a correction, now's not the time to think about selling. In fact, you'd do well to hope for a correction and look for buying opportunities in the next three to six months. The key, though, is not to buy low-quality miners that won't participate in a gold rally. Stick with high-quality names and you'll get the gold exposure you want.

More on gold issues:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


Read/Post Comments (18) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 08, 2009, at 4:25 PM, uttergld wrote:

    Nearly every year gold makes a new high. It still has yet to make a new high in 2009. Sure a gold correction will occur in 2010. It will pull back 20% AFTER it hits 1200 plus. It will pullback to the 1000 range where we are now. So why not stay long until it hits 1200, we have already had the 2009 pull back. Don't understand the timing of your article? There is still room to blow off to the upside for sure!

  • Report this Comment On September 08, 2009, at 4:29 PM, paultaut wrote:

    Is this the same person who wanted people to get out of CDE? Who said reverse splits don't work?

    The Person I dared to short it when it was below $15? Is this the same person?

    If so, Since, you have decided to pick on Gold this time, Why don't you short it Now.

    Gold has a Possibility to Drop to $400, Anything is Possible. With a Falling USD, What is the Probability? Since you are into "Scare Tactics" to peddle a view. Why don't you Short It Now.

  • Report this Comment On September 08, 2009, at 4:31 PM, oliversudden wrote:

    This article is a balanced look at gold. I do believe that gold has the wind at its back because people are losing faith in the U.S. dollar as well as the other fiat currencies. When countries receive the dollars we export ( and support our standard of living ) they do not convert them into their currency because they want their currency to stay low in relation to the U.S. dollar, instead they create more of their currency and have been buying U.S. treasuries which is why long bond rates are low. However there is evidence they are seeing the folly in that and may instead buy commodities including gold.

  • Report this Comment On September 08, 2009, at 5:17 PM, ivanmartchev wrote:

    Paultaut, no not the same person, I am actually long term bullish, but people do chase the worst stocks in the sector at the worst possible time

  • Report this Comment On September 08, 2009, at 7:42 PM, XMFSinchiruna wrote:

    Ivan,

    In my humble opinion, a return to $800 gold is now off the table.

    I think $900 is now extremely likely to hold as a long-term floor, and depending upon how we proceed towards / through the old high ($1,032), the likelihood of ever seeing $900 again before much higher levels are achieved could be waning fast. Given the fundamental factors at play, it is entirely possible that $1,000 -- once effectively breached -- will itself become a quick-drying floor.

    Gold is well-positioned for a breach of this 18-month-long correction ... I agree with a prior reader's comment that the timing of this article seems a bit off. The time for this article was during a prior attempt at the $1,000 mark ... when an $800 floor did remain very much in play. (February 2009, for i.e.:) http://www.fool.com/investing/general/2009/02/26/tomorrows-m...

    http://www.fool.com/investing/general/2009/09/04/the-untold-...

    http://www.fool.com/investing/general/2009/09/02/the-next-mo...

    http://www.fool.com/investing/general/2009/06/02/the-top-10-...

    I won't say anything is impossible short-term in a market this heavily manipulated (for which supporting evidence is reaching a new stratus), but $800 gold is extremely unlikely from either a technical or fundamental perspective. The course for USD stagflation has now been etched in stone. China is calling the shots to a large degree. I believe Treasuries won't look as attractive next time around when rumblings from abroad further erode confidence in the greenback and demand for U.S. debt while renewed stress forces additional measures like a re-capitalization of the FDIC.

    I agree with Ivan that people can easily get ahead of themselves jumping into heavily-hyped explorers they may know little about, or arriving too late to a precious metal feeding frenzy, but I do not advocate holding out for a lower entry point at this late stage in the 18-month correction. The bias for gold after last week's move is bullish. A small correction before finally trouncing $1,000 is within the realm of possibility, but I believe that anyone awaiting $800 gold to move in will be left out in the cold with nothing to burn but fiat. Some exposure at this stage is prudent for any investor that sees merit in the fundamental outlook.

    Ultimately, the short-term trajectory is always something of a crap-shoot .. it's the long-term picture that matters.

  • Report this Comment On September 08, 2009, at 7:47 PM, oliversudden wrote:

    What would you do if you had trillions of U.S. dollars that you didn't want ? 2.8 trillion last count. You can't convert them into another currency because you've got too many and the other currencies are lousy too. Luckily the commodities are priced in dollars which could change so the obvious thing to do is buy commodities hand over fist now. This is why our "leaders" beg the holders of these dollars to keep buying treasury bonds. What I think is happening is China and others are shortening the maturity of the treasuries they hold which is why the yield curve is steepening. If these holders of dollars stop buying treasuries or cut back gold and other hard commodities could go up a lot more than anyone thinks.

  • Report this Comment On September 08, 2009, at 8:12 PM, ivanmartchev wrote:

    The reaction is always predictable (and I am a bull)---funny

  • Report this Comment On September 08, 2009, at 10:07 PM, oliversudden wrote:

    With all due respect to the author, you didn't even touch on the real issues. Why is gold over $1,000 in a deflationary environment ? Why are other commodities up too ? Is the reason people think inflation is coming or is it the reasons I stated in my previous posts ? The truth is we could have a depression and gold go up and treasury bonds go down because there has never been a time in our history when our future depends on foreigners buying our worthless treasury bonds.

  • Report this Comment On September 08, 2009, at 10:45 PM, ivanmartchev wrote:

    Oliver, there is an 800 word limit on the article, otherwise, you have great points

  • Report this Comment On September 09, 2009, at 2:57 AM, paultaut wrote:

    Go Oliver go, sorry about the rant.

    Gold has a good possibility of dropping $200 but I think it will do so after it has punched through $1,100. You have to emember that Goldman's target is $1,500. Barrick is raising Capital to buy back around $2.9 Billion worth of hedges. This will not hurt the market in the short run.

  • Report this Comment On September 09, 2009, at 11:45 AM, menefer wrote:

    Author doesn't mention that inflation is almost certain to take place and it could happen sooner rather than later. The time to buy was the end of 2008 but if you didn't buy then I wouldn't wait for a $200 correction that may or may not come. I'd start buying now and buy more on a correction. Chances are that prices will be much higher within the next two years. Keeping inflation low while exiting the recession will be near impossible.

  • Report this Comment On September 09, 2009, at 2:05 PM, ivanmartchev wrote:

    Author mentions clearly that in his opinion inflation will not happen in 2009 or even 2010:

    "You cannot print demand

    Much has been said lately that "printing" by the Federal Reserve and other central banks will result in above-average inflation. This is absolutely true, but the key is when. I don't believe that inflation will show up at any point in 2009, and it very well may not show up in 2010 either, given the collapse of securitization markets and the resulting decline in credit available in the U.S. economy."

  • Report this Comment On September 10, 2009, at 7:21 PM, xetn wrote:

    Just consider a comment by a highly placed Chinese official that the Chinese government has begun investing in Yen and Euro based securities (away from US treasuries) and GOLD. Although he stated that their gold purchases were in relatively small quantities because they did not want to "influence the price". If this is true, I don't see a large drop in the dollar-denominated price of gold.

    What could hurt gold is if the FED decided to do a 180 and start raising interest rates. (That will be the day).

  • Report this Comment On September 11, 2009, at 5:27 PM, Retirefunds wrote:

    I don't know why, but you seem to have left out in your article some observations from the past 12 months.

    Several large hedge funds are buying gold. China is buying gold. China is telling it's own citizens to buy gold as an investment (Aug)

    I am no gold bug, but these seem like obvious omissions.

  • Report this Comment On September 13, 2009, at 6:40 PM, ivanmartchev wrote:

    no, I have not left that out, it's linked in the article:

    http://www.fool.com/investing/international/2009/05/29/he-ma...

    and I wrote it originally

  • Report this Comment On September 13, 2009, at 10:36 PM, tmsiguy wrote:

    Ivan,

    Thanks for the article. While Gold may fall, and you make a case, I would take issue with your interpretation on the Gold Trading Range Table. It shows Highs and Lows for the Year and you interpreted the range as being a drop by your own quote..."With the average DROP between a yearly high and low of about 23.8%, a drop from current prices around $1,000 per ounce down to $800 would be well within historical norms...." A Range isn't any more a drop than it is a rise. It is simply a Range. I could easily interpret that the Low Preceded the High as opposed to you implying the Low came after the High. I believe that to be an error of interpretation Sir.

  • Report this Comment On October 15, 2009, at 8:31 PM, drax009 wrote:

    Gold's rise over the last 8 years has a direct correlation to the Federal Reserve's policy of easing credit to the point of setting discount rates to levels at or near 0 and leaving them low and even after recovery. There's a migration of wealth from the dollar because there is little or nothing to be earned in interest. If you think the Fed will reverse course and raise rates for the foreseeable future, by all means sell your gold. I think we all know that ain't happening.

    When is the Motley Fool going to get some balls and start making predictions instead of telling people maybe something is going to happen. This is the biggest bunch of wishy-washy financial journalism out there.

  • Report this Comment On June 18, 2010, at 1:23 AM, Jahnavipat wrote:

    The mention that inflation is almost certain to take place and it could happen sooner rather than later. The time to buy was the end of 2008 but if you didn't buy then I wouldn't wait for a $200 correction that may or may not come. I'd start buying now and buy more on a correction. Chances are that prices will be much higher within the next two years. Keeping inflation low while exiting the recession will be near impossible.

    http://www.financeandmarkets.net/why-you-should-invest-in-go...

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