Gold plunges, should you panic?

Gold prices have crashed, should we panic and sell all our holdings? Is this the beginning of the end of the great bull run that gold has enjoyed so far?

Not really, even though gold has taken it on the chin again with prices falling heavily; in what we would term as a speculative sell-off. With the lack of immediate triggers, gold has become a breeding ground for short sellers. As selling started weighing on gold, prices seemed relatively unresponsive to even fundamental news which used to spark a rally in gold. And as the sell-off ensued, it became a sell fulfilling prophecy triggering stop losses with each technical level broken. So no, don`t panic and do not give up on the yellow metal just yet. Let me explain why:

The long sightedness based on fundamental factors was indeed looking compelling and the sell-off doesn`t change that outlook. The speculative supremacy has once again caused a huge sell-off in gold. And as they say, there`s no smoke without fire. This bout of selling is also caused by a deflation scare leading to a slide in the entire commodity complex including gold.

Why do we think that a deflation scare is the reason for this dramatic fall in gold prices?

Firstly we need to understand what we term as a risk-on, risk-off approach. When investors feel confident enough to invest in high risk assets, its termed as a `risk-on` scenario and when people feel their savings etc are threatened and do not wish to invest in any security then its termed as a risk-off situation.

At the current juncture, different markets are sending mixed signals. Strengthening in bonds and the commodities sell-off would seem to indicating a deflation scenario and so-called `risk off`. But stocks are still at or near record highs in most markets, which indicates `risk-on`. To explain further:

U.S economic recovery is nothing really sustainable yet. The real economy is not out of the woods. The number of people living on food stamps is at a record high. What`s clear is that even the economic data is showing signs of deteriorating off late. In the U.S., poor retail sales and empire manufacturing numbers are just another indication of caution. And with such scenario unfolding and Fed restraining from further stimulus; increases the probability of deflation holding. The decision of holding back on more Quantitative Easing (QE) is not on account of enlightenment that QE is bad but realization that costs of QE outweigh the benefits received.

Stocks are the odd man out and that`s largely on account of printed money flowing through them. What we see right now is deflation appearing to defeating the central banks` best efforts to produce inflation to reduce their debt loads. The prices of gold and copper indicate that inflation isn`t on the horizon and until we see more action from central banks (although harmful), gold may be sold. However, with the first signs of monetary debasement, gold will start moving up again.

Another reason that the speculators might be using to sell gold is the Cyprus over hang. Cyprus is likely to sell gold to partly fund its financing requirement. Given that the gold holdings of Cyprus are small, it shouldn`t be worrying. The issue here is that the Cyprus template may be extended to other countries seeking bailout, this means that these countries would be forced to sell their gold holdings to partly fund their bailout. This assumption brings a potential supply overhang and thus a reason to sell gold. However, if many countries come for a bailout implies a scenario where economic conditions would have deteriorated significantly and the current policy making attitude would ensure more monetary intervention; thus increasing the appeal to hold gold.

The price action

The Gold price was smashed over the last 2 days. It wasn`t alone as silver finished lower and other commodities were also sharply lower. Gold`s fall was largely technical. It breached May 2011 lows of US$1,536/oz. This triggered stop losses. Then the psychological US$1,500/oz was breached and further selling kicked in.

Past Performance may or may not be sustained in the future.

At these levels, gold has fallen 25% from its peak. Remember that during the 1970s bull market, gold fell more than 40%, before rising 700% to peak in 1980.

How much further could gold fall?

The truth is that no-one knows.
All bull markets have sharp corrections. You should expect them and that way there`s not much to panic about when they do happen. Even in the current bull run in gold, there were many corrections to the tune of 20 -30%. Then why is this correction worrying?

There could be a likelihood that the bull market isn`t over. Finally, history suggests that global currency devaluations favour precious metals. The current expansion of central bank balance sheets is unprecedented and there are no indications that its over yet and so is the bull run in gold. The monetary authorities are convinced that they can revive sluggish economies by printing money and so they will continue printing their way out. Then, when the fiat currencies are debased at will and eventually loose most of their value; gold will be the last man standing tall.

Positive gold price environment is just an icing on the cake. The main reason to own gold is just the sheer fact that it is good portfolio diversification tool.