Gold Sways on High Volatility

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Many investors liquidated their positions in physical and paper gold in the first six months of the year as economic data supported a growing U.S economy. Hedge funds and speculative investors shifted into U.S equities where corporate profits have flourished and beaten expectations. Gold rebounded in the month of August on rising geopolitical tensions in Syria, and the approaching U.S debt ceiling. Recent news of Syria forfeiting their chemical weapons has reverted investors back to shorting the yellow metal. Gold-backed ETFs such as SPDR Gold Shares (NYSEMKT: GLD  ) face further pressure from the Federal Reserve's decision to curb debt buying.

Rising consumer demand for gold
In early June, short sellers dominated the physical and paper gold market. Gold prices fell below $1,200/oz, which prompted a strong response from institutions and retail investors to rebuild their positions in gold investments. The pullback in gold prices raised consumer demand by 53% year over year from foreign national buying, particularly in China and India. Gold consumption in China, the world's largest importer of gold after India, soared 54% compared to a year ago. India posted an increase of 51%. Central banks remained net buyers of gold for the tenth consecutive quarter, adding gold to protect their reserves. What does this all mean for gold and gold investors? Demand heavily influences gold prices. As long as global demand remains strong, long-term traditional gold investors should see favorable price action, despite recent declines.

Regional investment gold demand in 2Q 2013. Source: World Gold Council

Syria tensions benefit gold investors
Geopolitical headwinds in the Middle East bolstered net long positions in physical and paper gold on safe-haven buying. Gold prices rallied above $1,430/oz in late August, the highest level since May, on news that the U.S looked to launch a missile strike on Syria. Investors naturally opened long positions as a hedge rather than short-selling into these political events. Short covering added further upward momentum.

Safe-haven buying consolidated when a U.S military strike looked less likely as Syria agreed with Russia's proposal to surrender and hand their chemical weapons over to the United Nations. There is still uncertainty on whether or not U.S Congress will vote in favor of military intervention. If U.S Congress approves a military strike, investors could drive net inflows into physical and paper gold, ballooning returns on their gold investments. 

Strong equities threaten gold
Economists believe the Federal Reserve's $85 billion monthly bond purchasing program has helped stimulate 2.5% GDP growth in the second quarter. The S&P 500 Index (NYSEMKT: SPY  ) , which represents 500 large-cap U.S stocks, is a leading indicator that reflects the aggregate performance of U.S equities across various industries. U.S equity markets have flourished from stimulus spending and lower interest rates.

The Federal Open Market Committee (FOMC) will meet on Sept. 17–18 to weigh in on tapering their bond buying program. The Fed has closely monitored domestic growth, particularly in the labor market, to examine if consumer confidence and spending is strong enough to support easing. The U.S economy generated 169,000 jobs in August, dropping the jobless rate to 7.3%, its lowest level since 2008. As the U.S strengthens, tapering looks more likely.

Source: Bloomberg TV

Economists project a reduction of $10 billion to $35 billion from monthly Treasury purchases, while keeping mortgage debt buying at $40 billion. Fed Chairman Ben Bernanke said asset purchases could end next year, but low inflation rates could decelerate the weight of tapering. Inflation sits at 1.7%, below the Fed's target of 2%. The Fed expects an unemployment rate of 7% when quantitative easing ends. How does tapering affect gold and equities?

If the Fed scales its easing program back $10 billion, economists expect gold prices to fade. Tapering should prove positive for U.S equity markets as tapering signals a stronger economy. But not all equities are poised to benefit. Gold mining equity indexes such as Market Vectors Gold Miners (NYSEMKT: GDX  ) may dwindle as downward pressure in bullion prices deflate miners' free cash flows and profits.

GDX provides exposure to small-, mid- and large-cap gold miners, including Barrick Gold, Goldcorp, Yamana Gold, Kinross Gold and 25 other miners. GDX accumulates net outflows when gold miners underperform the market. Gold could potentially retest June lows of $1,200/oz if the Fed is more aggressive than expected because the market has not priced in tapering beyond $10 billion.

This chart illustrates performances year-to-date. SPDR S&P 500 ETF (+18.90%), SPDR Gold Shares ETF (-21.11%), Market Vectors Gold Miners ETF (-44.75%). Source: Bloomberg

Gold miners have initiated strong cost controls, cutting all-in sustaining costs to generate higher profits and cash flows in a cheap gold environment. Investors should take the opportunity to search for undervalued mining stocks with effective management and strong balance sheets that could potentially generate high returns if gold recovers. Gold could surge if the Fed chooses not to taper right away based on recent economic data that does not support their long-term objectives. Bearish sentiment toward U.S equities and the greenback would propel physical and paper gold prices.

Bottom Line
U.S. equities have yielded higher returns on investment as opposed to the unwinding gold and bond markets. Cheap gold prices have prompted foreign nations and central banks to increase their gold holdings. Gold recovered near the end of the summer because investors recognized upside risks presented in the second half of the year, including Syria, the U.S debt ceiling, and budget debate. Ben Bernanke's comments at the FOMC meeting may determine bullish or bearish trends in U.S equities and physical and paper gold markets. With investors seeking to limit their exposure to market risks, adding perhaps 5%–10% of physical and paper gold holdings to your portfolio could protect you from market uncertainty. 

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