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.

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:

• Whence the Windfall Profits From Gold?
• The Incredible Irony of Paltry Gold Profits
• The Fourth Way to Invest in Gold