Why Gold Is Collapsing And What Investors Need To Know

Gold is taking a pounding today. The yellow metal is down around 3 percent (at the time of writing) and still falling in pretty much a straight line this morning. Moves like that in most commodities, such as oil, copper or wheat, are pretty much irrelevant to the vast majority of investors, who tend to concentrate on stocks and bonds in their portfolios. Gold, however, is an exception. There are a lot of retail investors whose portfolios include gold, whether through physical holdings of coins or bullion, or through an ETF such as GLD. Many will be scratching their heads this morning, wondering why gold is collapsing on a day when everything else seems reasonably steady. An explanation of what affects the price of gold seems especially relevant today.

The first thing that has to be understood is that, while gold is a commodity, it is, in many ways, unlike any other. A while ago I described it in these pages as the Kardashian of commodities; pretty to look at and at times fascinating to follow, but fundamentally of no use to society. That description still holds true. Whereas the industrial and consumer uses of things like oil, wheat, cotton and copper are obvious, the biggest use of gold is for jewelry. It has a very limited use in industry.

The simple fact is that gold is not consumed like most commodities. Its demand is not driven directly by economic growth. From the supply side, gold behaves like any commoditized product. Higher prices lead to an increase in supply as mines that cost more than average to operate become profitable, and miners are encouraged to increase production. As the price falls, the opposite is true and supply is reduced. From the demand side, however, there are drivers that are in many cases almost entirely unique to gold.

The first is fear. Despite having very few practical applications, gold has been seen as a store of value for centuries. When people are afraid that the currency they hold will lose value, or that the whole international or domestic economic system under which they operate is in danger, they buy gold. They believe that, whatever happens, the metal will have an exchange value that increases over time due to limited supply. Gold, then, is a hedge against inflation and financial armageddon.

In many ways gold is more of a currency than a commodity. It cannot be spent as readily as U.S. Dollars, for example, but its value rests mainly on the belief that if push comes to shove it could be exchanged for goods and services. That role as a currency explains the other main influence on the price: the strength or weakness of other currencies. In particular, the relative strength of the dollar impacts gold’s value, as it is priced in dollars in theglobal market If the U.S. currency is deemed generally more valuable in the marketplace, then it will be more valuable relative to gold and the price will fall.

However, gold is also used for speculation and this is particularly relevant to today’s big move. Speculators are attempting to assess demand that is really based on nothing concrete and in doing so they rely heavily on previous price action. In most stock investing, chart points of major support and resistance have limited impact. They are useful to traders with a very short term outlook, but the majority of small investors hold stocks, bonds and other investments for periods measured in months and years, not minutes. Over that kind of time span fundamental factors such as the overall strength of the economy and, in the case of stocks, how the business actually performs are far more important. With gold, though, there are no fundamentals other than the strength of the Dollar, so points of support and resistance on the chart take on an exaggerated importance.

All of that brings us to what happened this morning. The dollar gained significant ground early today as the possible effects of Brexit weighed on the Pound and Euro and the prospect of a rate hike by the Fed came into focus. That forced gold low enough that it broke through several significant points of support around the $1300 level. Speculators who owned gold would have, in many cases, set stop loss orders to protect their positions against a break below those levels and, as those orders were triggered the selling pressure increased and the rout was on.

It can be seen, then, that this morning’s big drop in the price of gold didn’t come from nowhere. It is a function of the overdependence of the market on technical analysis in the absence of any real fundamental drivers. It could be that a large holder is liquidating their position, but that would still likely have been triggered by technical consideration. On that basis, now that these levels have been reached it could go lower still. If you own gold, though, and this drop tempts you to sell, you should pause for a moment and consider one thing. The reason you own it is probably as a hedge against inflation and as a diversification tool. Gold’s value to you in those respects is not dependent on its market price, so selling now really makes little sense. Think of any paper losses as an insurance payment and sit tight is the best advice for most retail investors in this situation.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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