Bear’s claws, dollar surge popping bubble in gold

It’s looking more and more like the only thing propping up the price of gold is speculators, and the 10%-plus plunge in its price this month could send them fleeing at a moment’s notice.

In just the last week, the bearish mood of gold investors has brought the price of bullion down 3.7%, to $1,092 an ounce. In that same period, however, SPDR Gold Shares (GLD) has bought 12.2 metric tonnes of the stuff. Absent that demand, the price would surely have tumbled much more. The gold spider is an exchange-traded fund that represents investment, rather than fundamental, demand for the metal.

And unlike central banks, the only other owners of huge amounts of gold, the spider has no restrictions on disposing of its holdings. It owns 1,132 tonnes of bullion, and if redemptions forced it to sell just 100 tonnes or so, that could slash as much as $150 an ounce from the metal’s price.

“I expect the (gold) price to decline next year, as we return to more-normal conditions that we’ve had in 2009,” says Jon Nadler, senior analyst with Kitco Metals Inc., a leading dealer in the gold market. His target price: $845 an ounce, down more than 20% from the current level.

I’ve been viewing December’s break in the price of gold as a potential buying opportunity, but a number of recent events are forcing me to reconsider.

The first of these is that the U.S. dollar has rallied hugely, after shedding a third of its value against other major currencies in this decade. For its owners, gold represents a store of value; i.e., a sort of universal currency. So it competes with dollars, as well as euros and pounds sterling and yen, as a store of savings. A weak dollar makes gold’s price go up. But what we’re seeing is a strong dollar.

Gold rally has been strictly a dollar affair

This chart shows how the price of gold has behaved over the last year. The red line is the dollar price of the metal. The blue line is the price in a basket of other major currencies. Since February gold has gone up substantially in dollar terms, but in other currencies it is actually lower. So the gold “rally” is really a dollar rout.

Why has the dollar strengthened lately? In December, the Federal Reserve publicly announced deadlines beginning as early as February for withdrawing some of its most extraordinary–and potentially inflationary–public spending intended to combat the recent recession. Fed-watchers are predicting it will begin to raise short-term interest rates in the second half of 2010, and possibly even earlier.

That would be very positive for the dollar because it would stanch fears of inflation. At present, inflation is utterly absent from the U.S., and much of the global, economy. It has been the fear of inflation, rather, which has prompted interest in gold, including my own. To the extent U.S. authorities can prevent inflation from becoming a serious problem, gold is dead money.

Nadler, whom I interviewed by telephone in his office in Montreal, says a genuine rally in gold would require “actual tangible inflation, manifest in the system, but people are positioning as if they expect the Weimar Republic.”

Yet another argument against a sustainable rally in gold is that fundamentals in that industry are lousy–”the worst I’ve seen in years,” says Nadler.

– Jewelry demand fell to a 21-year low this year, choked off by a price that briefly soared above $1,200 an ounce.

– Mine supply increased in 2009, and the market was flooded with 900 tonnes of gold scrap as people flocked to cash in on grandma’s jewelry. The scrap supply alone was twice the usual annual consumption of gold.

So dizzy did the market become in 2009 that India, which ordinarily is one of the world’s largest consumers of fabricated gold and produces very little, was briefly a net exporter. “That’s akin to Saudi Arabia importing sand,” Nadler quips.

Nadler estimates that in the five years since it was introduced, the gold spider has added $150 an ounce to the price of gold through the investment demand it was created to satisfy. It would probably have the same impact in the opposite direction if it began to shed a significant amount of its holdings, which it would be forced to do if shareholders redeem.

Yet another underpinning of a genuine gold rally is absent: a falling stock market. Gold is marketed, including by firms such as Kitco, as insurance against the collapse of paper assets. As gold went to more than $800 an ounce in the 1970s, it left behind the worst stock market since the Great Depression.

“If you are rooting for $2,000 gold,” Nadler says, “I’d ask you to think what happened to the rest of your assets. Theyd be smoldering.”

For all these reasons, I think gold is too dicey to think about–except as that insurance policy. In my own case, a 2% stake in the gold spider that I owned in my retirement account became 3% in the late bear market. At some point I might ratchet that up to the 6%-to-8% that has long been recommended by Swiss bankers as a wealth protector.

But it won’t be soon.