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Why Gold Price Has Fallen Despite Record Demand

Commodities / Gold & Silver Nov 21, 2008 - 10:31 AM GMT

By: Money_Morning

Commodities

Best Financial Markets Analysis ArticleMike Caggeso writes: Having spawned the worst market for stocks since the Great Depression, the global financial crisis is forcing investors to re-examine a number of long-held beliefs. Gold bugs, for instance, have been left to wonder just how gold prices could backpedal in the face of all-time-record demand.

Gold demand did increase – in fact, by a record 45% from the second quarter to the third.


Retail demand was the primary catalyst , spiking 121% to 232 tons. And because of it, bullion dealers reported shortages in bars and coins, according to the World Gold Council , a gold-mining-industry association. 

“Gold's universal role as a store of value has shone through during this quarter helping attract investors and consumers to all forms of gold ownership,” James E. Burton, chief executive officer of the World Gold Council .

However, if you'd just looked at gold's performance alone, you'd never be able to tell demand was so strong. Indeed, in the third quarter alone, gold prices tumbled almost 6% – and were actually down as much as 20%, until a mid-September rebound narrowed that loss.

Then came “Black October.”

The worldwide financial crisis continued to punish stocks, slashing the Dow Jones Industrial Average by 14%. At the same time, however, in a disconcerting surprise for gold investors, yellow-metal prices plummeted 17%.

Why? The financial crisis is apparently once again taking long-held market truisms – and forcing investors to question the validity of their beliefs, namely:

  • That gold should act as a safe haven against the global recession most economists believe has just begun.
  • And that when demand for gold moves up, prices should do the same.

“Gold is not a safe haven against recession,” said Money Morning's Martin Hutchinson, an investment banker with more than 25 years' experience on Wall Street and a leading expert on the international financial markets. “It's a safe haven against inflation .”

And it just so happens that, in October, consumer prices dropped at the fastest rate in the 61 years that the Labor Department has been keeping records.

And as far as gold prices go, demand for gold isn't as widespread as the World Gold Council would have you think.

Overall demand was a record; that's no fluke. And most of that came from the retail side. But like common tradable stocks, institutional demand exerts much more influence on the market than consumer-led retail demand.

As markets collapsed, institutions and hedge funds were forced to liquidate assets across the board. This so-called “ de-leveraging ” is taking place for a number of reasons, but one is due simply to asset allocation issues.

Simply put, institutional investors typically employ an asset-allocation model that's designed to manage risk and maximize returns by setting a percentage for each category of assets. Those ratios can change over time as some assets surge in value, while others hold steady or even decline. Thus, assets that performed well while others tanked could now comprise 20% of the portfolio's value, instead of once accounting for 15%.

And these multi-billion-dollar portfolios are often controlled by precise asset allocation guidelines that set strict maximums and minimums for each asset category.

For example, Harvard's endowment aims to have 13% of its portfolio to be composed of “private equity” investments. But private equity now accounts for more than its assigned allocation. So, to get back to that 13% target, it's selling $1.5 billion in private equity assets , according to Fortune .

One purpose of such asset-allocation models is to prevent a massive loss in case one class of assets takes a big hit.

But in this case, institutions are selling gold because, in the third quarter, it only fell 6%, while the rest of the stock market skidded 14%.

The logic is confounding, but the bottom line gold's value is incredibly suppressed considering demand has moved at an all-time high.

Two Catalysts For Gold's 2009 Climb

The U.S. Department of Agriculture's Oct. 10 Crop Production Report said acreage for a handful of staple food commodities has shrunk:

  • Corn acreage fell 1.2%.
  • Soybean acreage dropped 1.4%.
  • Canola acreage dropped 1.9%.
  • Sunflower acreage shrank 0.8%.
  • And acreage of dry edible beans fell 0.7%.

That naturally translates into higher prices because it squeezes the supply of the particular commodity. And it does so at a time when demand continues to escalate from populations in China, India and Latin America.

And higher prices equal inflation.

But Hutchinson – who correctly predicted this last run-up in gold prices – says there's another catalyst that's right now inherent in the U.S. economy that could help vault gold prices to $1,500 an ounce by the end of 2009. And it has to do with the much-ballyhooed $700 billion rescue plan.

“The government is pumping money in so many banks, and that money has to come out somewhere,” Hutchinson said.

The philosophy behind the rescue plan is elegantly simple: By providing a portion of the $700 billion to foundering U.S banks, the Treasury Department believed it could provide banks with badly needed capital, and get them to start lending money once again – jump-starting the economy in the process.

Since September 2007, U.S. Federal Reserve policymakers have cut the benchmark Federal Funds target rate nine times – from 5.25% down to the current 1.0% rate – to increase bank-to-bank lending and bank-to-consumer lending.

Right now, banks aren't boosting lending. Instead, as a Money Morning investigative article demonstrated , they are using the cash – essentially taxpayer-provided money – to finance buyouts of other banks .

Even so, that money will “come out” into the economy in the form of higher stock prices for banks. That will make consumer/investors wealthier, and could make them more confident in the economy. If they're more confident, they will spend. As that happens, food prices should begin ticking upward, adding another set of thrusters to gold prices.

“Everybody thinks that because we're having a horrible recession, we're not to going have inflation. I think that's probably wrong,” Hutchinson said. “I think gold has quite good hidden-store value.”

As gold prices increase, count on more investors leaving the sidelines to invest, too, causing the surge in gold prices to accelerate and then steepen.

“As gold goes up, it gets more popular and investors start piling into it,” Hutchinson said.  

And if gold gets anywhere near the $1,500 mark, it will probably be smart to sell. At that level, the price of gold could likely stall and remain in place for a long stretch. Or, in an even more likely scenario, the yellow metal could see its price careen downward – once the economy starts to show some life, forcing the central bank to boost interest rates, an act that should also cause the dollar to rise in value.

[ Editor's Note : Money Morning 's just-published 2009 Gold Outlook report , written by in-house gold expert Mike Caggeso, is part of our just-underway “ Outlook 2009 ” economic forecast series. So far, we've published six installments, and have provided outlooks for the stock market , the overall economy , and even the housing market . Many more stories are to come. Next up: Look for our outlook for Latin America and for the U.S. retail market. Like all the reports, the gold report is a must read – whether you're a true gold bug, or simply an individual investors looking for new ideas in a market that's already called into question many long-held market maxims.]

By Mike Caggeso
Associate Editor

Money Morning/The Money Map Report

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