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Massive Redemptions, Strong Dollar Squash Goldbugs

Gold is considered a “safe haven” asset of choice, particularly among those worried about loose central bank policies and the decline of the U.S. dollar.

I personally agree with Cullen Roche and Howard Marks — that there is nothing intelligent to be said about gold, and that the metal is a hard asset hedge and little more.

That case was very hard to argue a few years ago as prices for the precious metal tripled from the low $600s in 2007 to a peak of over $1,900 in mid-2001.

Unfortunately, that speculative bubble didn’t last, and gold has run out of gas. Gold prices are down about 12% since the metal was trading at around $1,800 in October.

Why? Well, the doom and gloom narrative of hyperinflation and the death of the dollar didn’t hold up. As the economy has slowly stabilized and the world hasn’t ended because of political shenanigans at home and abroad, the momentum has turned decidedly against gold.

Here’s why gold is still in store for trouble going forward, too:

Strong Dollar

The U.S. dollar has been on a tear lately as investors put faith in Americas consumers, businesses and (perish the thought!) the government.

That means lights out for goldbugs.

Check out this chart from the Wall Street Journal. The paper’s dollar index — a measure of the greenback vs. a basket of currencies, similar to the DXY — is up about 6% this year and has been steadily on the rise since September.

GoingUpChart

That is naturally a curb on dollar-denominated commodities like gold, since the dollar and commodity prices have an inverse relationship. Goods priced in U.S. dollars are cheaper when the currency is strong, since a stronger greenback buys more gold, oil, corn or what have you on global markets than a weaker greenback does.

The strong dollar baffles some market watchers who continue to insist that the U.S. currency has to crash thanks to high federal spending and a stagnant economy. But consider that since the financial crisis, the rest of the world has been just as troubled — if not more so when you consider the continued threat of a crash in China and constant debt mayhem in Europe that has threatened to break up the eurozone.

Currency Wars

Another important fact: Other nations are actively lowering the value of their money, which makes the dollar more attractive by comparison.

In addition to China’s historically aggressive currency devaluation, you have Japan and the U.K. both getting in on the act with active debasement of their currencies to boost exports. It’s hard for the dollar not to look good when the rest of the world is sabotaging their currency’s value.

Gold bugs insist that an era where paper money can be manipulated so brazenly is a more bullish case than ever for gold. Well, complain all you want about fiat money and currency manipulation, but you can’t fight the tape.

Risk On as Stocks Rise

Additionally, the asset of choice in times of trouble has become particularly less attractive as it has grossly underperformed a red-hot stock market.

In the past 24 months, the S&P 500 is up 20% vs. 10% for gold prices as measured by the bullion-backed funds SPDR Gold Trust ETF (NYSE:GLD) and iShares Gold Trust ETF (NYSE:IAU). In the past 12 months it’s even worse, with 12% returns for the S&P vs. a loss of about 8% for gold funds. Nearer-term, gold’s still the loser, off 7% while the S&P 500 is up in double digits.

It’s hard to keep hanging on when you’re back to mid-2011 pricing for gold while stocks have left you way behind and the recovery appears more and more likely to hold.

Cascading Risk of Redemptions

This is the most interesting point of all: That the easy access into gold via these ETFs and other exchange-traded products allows much greater volatility.

Now, anyone with a brokerage account can buy a half ton of gold if they so choose. Or alternately, sell it. That means the supply-and-demand equations are amplified.

Consider that the recent market surge and downturn in gold resulted in massive redemptions from gold funds as investors moved their money — a record 110 tons in February pulled out, according to Barclays estimates, with 74 tons pulled out of the GLD fund alone.

You see, when assets are pulled out of a stock fund or a bond fund, the money is wound down across a host of investments — and frequently, other funds of different flavors can also share exposure to those assets.

But when a pure gold fund suffers a redemption, it has to sell gold. That results in the fund dropping further, since the underlying asset is in less demand. This in turn results in more redemptions — and a vicious cycle of negativity that might be hard to break.

I remain convinced the tripling of gold had a lot to do with an influx of capital into funds like GLD, and that asset reallocation will be brutal for the precious metal.

That’s not to say gold will collapse, since there will always be baseline demand. But don’t underestimate the power of speculators running for the exit.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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