2 Reasons the Gold Bubble Burst in 2013

There's little dispute that the gold bubble has officially burst. What's not as well understood, however, is what caused this to happen.

Feb 22, 2014 at 12:36PM

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In hindsight, I think we can all agree that the gold bubble has officially burst.

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After peaking in September of 2012, the precious metal's price dropped nearly 30% by the end of last year, extracting a commiserate amount of value from the largest gold exchange-traded funds, the SPDR Gold Shares (NYSEMKT:GLD) and the iShares Gold Trust (NYSEMKT:IAU).

What's less obvious is: Why? What was the catalyst for the precipitous decline? Did consumers stop purchasing gold? Was it the result of monetary policy? Or are speculators to blame?

The answers to these questions are laid out in a report released this week by the World Gold Council, a global authority on gold and its uses. As the authors note (emphasis added):

The gold market became polarized in 2013 as 21% growth in demand from consumers and value-seeking investors contrasted with large-scale outflows from ETFs. The net result was a 15% decline in full-year gold demand in a year where jewelry, bar, and coin demand reached an all-time high.

The fact that speculators were behind the drop -- as evidenced by the cited "large-scale outflows from ETFs" -- is borne out in the numbers. In 2012, ETFs were net buyers of gold, purchasing an estimated 279.1 tons of the precious metal. In 2013, they transformed into net sellers, offloading a staggering 880.8 tons onto the market.

What, in turn, triggered the change in investor sentiment?

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Beyond profit-taking, the outlook for interest rates changed dramatically in 2013, with analysts and commentators predicting the Federal Reserve would begin reversing course on its third round of quantitative easing. And because real gold prices and real interest rates are inversely correlated -- when real interest rates are low, real gold prices are high -- it seems reasonable to conclude that this served as the ignition switch.

With this in mind, the outlook for the future of gold prices seems dismal. Just last week, the newly appointed Fed chief, Janet Yellen, made it clear she intends to continue the central bank's current policy of tapering. Over the long run, this should continue to push interest rates up, and, if the historical relationship holds true, gold prices down.

With gold prices plummeting, it's time to switch into stocks
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John Maxfield has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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