Why Be Bearish On Gold?

How Do Gold Prices Generally Work?

With a peak price of around $1,900 an ounce in September, 2011, gold prices have been on the rise almost every year since 2006. But why has gold continued to rise? Why do we see workers on street corners flipping their signs to buy our gold jewelry?

In general, gold moves in the opposite direction of the dollar; this is because gold, similar to oil contracts, is denominated in USD. So while the value of the dollar decreases, the price of gold generally increases; a relationship shown in Graphs 1 & 2. Although the graphs are not well-aligned, both demonstrate that, over the years, relative to the Euro, the USD has decreased in value, while gold prices have sky rocketed.

Price Per Ounce of Gold Since 2000 (Graph 1)

 

Price EUR/USD Since 2000 (Graph 2)

The example of the USD decreasing in value against the Euro is just an example of how the value of the dollar can affect gold prices. But why has the value of the USD decreased in value relative to the Euro?  

 QE1 & QE2 - The Increase in Money Supply Decreases Value of Currency

We can partly attribute the decreases in the value of the dollar versus other currencies over the past few years to QE1 & QE2, the buying of Treasuries from the Fed, which increased our money supply, and has been keeping our interest rates artificially low. This monetary control was "Helicopter Ben's" attempt to spur growth and keep us out of a full-blown depression, and so far it has seems to have worked.

However, the increase in money supply is a primary cause of currency devaluation; whenever you see a country increase its money supply, you can assume that the value of its currency will decrease in value - the same amount of goods, but more money, means things will cost more (inflation). The decrease in value is also caused by less demand for our currency; a simple supply/demand graph can explain the relationship. Basically, since rates are so low, investors look elsewhere to place their money for a higher return.

Also contributing to the low value of the dollar is the fact we run large trade deficits with the EU, which means we have more dollars to exchange for Euros than the Europeans have Euros to exchange for dollars. 

Overall, the devaluation of the dollar makes gold more expensive because gold is denominated in dollars.

Gold: Inflation Hedge and Fear

There are a few, but major, traditional concerns that leads investors fleeing to buy gold: inflation and fear. If investors believe there will be high inflation (sometimes caused by the devaluation of currency or high demand for goods), they will feel the need to buy gold. Ironically, if you look back at which asset classes have outperformed inflation over 18 year periods, gold has not been a good hedge against inflation. In fact, equities almost always outperform inflation. Those who make the claim that gold is a good inflation hedge have never looked at the data.

Fear is another reason investors buy gold. With many EU countries potentially defaulting, and with the US budget/deficit issue becoming more politically complicated, gold may seem appealing to those who fear a global default. Although gold has no real value, other than being used in jewelry and in a few other industrial applications, investors still flock to it in times of crisis.

Why I'm Short Gold

The fear of European default, the US deficit issues, QE1 & QE2 increasing the money supply, and the fears of inflation in the US, have all helped to prop up the price of gold. Still, I believe that gold is overvalued and that it will fall in value over the coming months. Why?

The first reason is that trade deficit gaps with Europe have been slowly closing, leading to a small relative increase in the value of the dollar to the Euro. Furthermore, as the European sovereign debt crisis continues to worsen, there may be a flight to quality out of European denominated securities and into securities such as Treasuries, which are considered among the safest assets in the world, backed by the US government. This flight to quality, because of the fear of default, would require Europeans to exchange their Euros for dollars, further increasing the value of the dollar.

Another reason why I believe gold will decline in value is that there has been no significant inflation in the US or Europe, mainly because there has been a slowdown in economic activity. I believe the European sovereign debt crisis will also slow down the Asian markets, eliminating the fear of inflation there as well. Moreover, the QE2 ended in June, and the Fed has signaled that there won't be more quantitative easing, plus the US economy has been signaling signs of slow recovery.

Finally, I believe that those who invested in gold years ago will now dump gold to take their gains before the end of the year. While there seems to be no real reason to buy gold at its current elevated price, I think that there will be a large sell-off because investors will want to dump gold as the dollar increases in value, the trade gaps narrows, and as Europe leans towards a potential recession.

Follow this link to an article that came out this morning on CNBC:
http://finance.yahoo.com/news/gold-sheds-cant-lose-status-165243054.html