GOLD – END OF CYCLE

Over the last few days I have become more and more convinced that the up cycle for gold is now coming to an end and we will see a significant correction in this commodity before prices stabilize and move up again. My conviction has become greater after I talked to a vast variety of Investment Advisors/Fund Managers/Investors in general and took their view on Gold and other Asset Classes. Not to my surprise the only commodity that everyone had a buy on was GOLD. Gold today has become the most overowned and oversold ( in terms of it being sold as an investment idea) commodity. Infact the data coming out of Indian Mutual funds is also reflective of the sentiment where the inflows into gold funds have been higher than that of Equity Funds for a number of months over the last six months. This is despite the fact that the total assets under equity funds are more than 20-30 times that of gold funds.

I was frankly waiting for the technicals to become supportive of the fundamental view before putting out this piece. This now seems to be happening with Gold breaking down from a Symmetrical Triangle reversal pattern ( which is normally a continuation pattern and is rarely a reversal pattern which makes it stronger). As the chart reflects, there is now a breakdown which should see Gold moving down sharply over the next few weeks.

 The biggest consumer of gold in the world has traditionally been India. It is likely that this will be the case going forward also, despite their being talk of China becoming the biggest consumer. The traditional jewellery demand in India is not  a fad or fashion but something that is ingrained in the Indian system. This is very different from buying into an asset class that is fancied and where the prices are continuously going up. The significant increase in gold prices over the last few months have bought physical gold demand in India to a virtual standstill. 

As per the data coming out of the World Gold Council Gold demand in the third quarter of 2011 reached 1,053.9 tonnes, an increase of 6% compared to the same period last year. This equates to US$57.7bn, an all-time high in value terms.

According to the World Gold Council’s Gold Demand Trends report for Q3 2011 this increase was driven by investment demand which rose by 33% year-on-year to 468.1 tonnes, The demand for physical demand for the traditional purposes fell by 15% in this quarter. Gold supply was 1,034.4 tonnes in the third quarter of 2011

Overall, Indian jewellery demand in Q3 saw a 26% decline in tonnage, when compared to the same quarter in 2010, to 125.3 tonnes.

The question then is, for how long can investment demand hold up the price of a commodity in light of falling end user demand. The most drastic example of this was the way in which oil prices fell in the year 2008 from levels of USD 150 to USD 30 in a period of just six months. That is not to say that such a thing is possible and likely in the case of gold However the truth of the matter also is that lot of investment demand  is trend following demand  and also exists because of the fear phycohsis that prevails globally today. Investment Advisors and asset allocators find it easy to sell Gold ETF’s to investors who are running scared of investing elsewhere. In a number of European countries investors are running scared to putting deposits in the banks of their own countries. Similarly, given the way global equity markets have performed and the kind of volatility that we have seen investors are unwilling to allocate much to equities at this stage. As a result deposits of banks perceived to be safe, bonds or Germany, UK and the US have become save haven investment plays. Besides this gold is perceived to be the reservoir of value (and not without reason). However investors investing into gold need to be clear of their expectations from this asset class. The probability that gold will yield much below what investors can earn via fixed deposits of banks in a country like India where 5 year deposits of the safest of banks yield near 10% is extremely high at this stage.

As gold prices start to first stagnate and then fall, there will not only be low incremental flows into gold linked investment products but there will also be outflows. A large number of Hedge funds that have built up significant long positions in gold might also go short as the trend reverses. Given the fact that the supply of gold continues to be strong this will ultimately lead to a period where there could be a sharp sell off in gold. The only saviours for gold at this stage are the Central Banks that continue to buy with the trend. As price correct even they will move out and further accelerate the correction.

Contrary to views of gold prices moving to USD 2500 etc. my view at this stage would be for a correction in prices by atleast 20-25% over the next one year.