Yellow fever: End of the road or just a big bump?

Growth is stalling, the euro zone is failing, the Fed is spent and risk markets are melting down -yet gold, the one asset that has consistently rallied in similar circumstances over the past year, is in a tailspin.

After a month of unprecedented volatility that has rattled some investors’ confidence in gold’s decade-long winning streak, the question is obvious: Is this what the popping of a gold bubble looks like?

The answer, of course, isn’t obvious. The bursting of asset bubbles is best seen in retrospect, and gold’s 10 percent decline from a record high just three weeks ago is far from its worst tumble; it last suffered such a setback in late 2009, and multiple times in 2008. It is only halfway to the 20 percent mark that separates a correction from a bear market.

While a survey of the best minds of the bullion market predicted this week that gold would continue to power higher over the next year, topping $2,000 an ounce, there are undeniable warning signs flashing along the way, threatening to undermine one of this year’s top-performing assets.

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Spot gold prices tumbled more than 3 percent to a one-month low of $1,721 an ounce on Thursday, falling further out of favor as a global round of risk aversion triggered by weak Chinese manufacturing data and grim comments from the Federal Reserve hit commodity markets especially hard.

[caption id=“attachment_90464” align=“alignleft” width=“380” caption=“The 25-day correlation between gold and U.S. 10-year Treasuries had strengthened to the highest since at least 2005 at 0.7 by a week ago, but has since collapsed. Reuters”]  [/caption]

The US dollar index rose 1.25 percent and US stock indices fell nearly 4 percent. Brent crude dived by $5 a barrel, copper logged its biggest loss since October 2008 while sugar and grains slumped 5 percent.

Without calling a top in a market that has consistently proven all but the most intrepid gold bugs wrong, below are several factors to consider when weighing whether this is the end of the road or just a big bump in it.

RISK CORRELATIONS IN TATTERS, DOLLAR DRIVER RETURNS

The most alarming shift in the gold market in recent weeks has been the abrupt collapse in what had become a predictable risk-off trade. The 25-day correlation between gold and U.S. 10-year Treasuries had strengthened to the highest since at least 2005 at 0.7 by a week ago, but has since collapsed. The inverse link with the S&P hit its lowest in early September since the financial crisis, but has now bounced.

The dislocation has been increasingly evident this week, with gold falling in tandem with oil, stocks and copper, while the safe money rushed instead for Treasuries and the dollar.

The apparent cause? Possibly the rise of another popular correlation, one that had been largely set aside - the dollar. On Thursday, the correlation returned negative for the first time in two weeks. It has averaged -0.4 for five years.

If that correlation holds strong, gold may be hostage to the greenback for some time. While the euro’s woes and ultra-risk-averse investors may continue to help pull the dollar index up from near its 2008 record lows, few expect a sustained recovery that could drag down gold.

INFLATION BEGONE

Along with the loss of its safe-haven status, for the moment at least, gold’s long-standing favor as a hedge against inflation hasn’t been evident for months, with Western economies closer than ever to another recession.

Even so, with the Fed pledging to keep interest rates at near zero for the next two years, gold’s lack of yield is less of a penalty than in normal times.

VOLATILITY BITES

On top of the disrupted correlations, gold has extended a period of unprecedented volatility, with day-to-day price movements in excess of 2 percent during 15 of the last 37 trading sessions – a run unrivaled except for in 2008. On an absolute basis, intraday swings of more than $50 an ounce have not been regularly witnessed since 1980.

“When something can move 3, or 5 or 6 percent in the course of two days, that’s not a safe haven. Safe havens should be quiet and stable … not violent,” said Dennis Gartman, a longtime professional commodities investor who has regularly traded in and out of the bullion market.

OPTIONS FLASH AMBER

The extraordinary whipsaw trade has bled into the options market, where implied volatility - a measure of the cost of buying options either to bet on prices rising or to protect against prices falling - has surged lately.

The CBOE’s gold volatility index based on COMEX futures prices spiked in August to its highest in two years, and surged anew on Thursday as prices crashed.

More tellingly, traders say there is growing demand for buying put options, which protect an investor if prices fall. In the past, they say, far more investors wanted call options to benefit from gold’s seemingly unyielding rise.

TEMPORARY LIQUIDITY RUSH?

Over the past few years, gold has occasionally tumbled in tandem with stocks and other “riskier” assets simply because investors in those other markets were desperate to raise cash in order to cover margin calls or offset losses. This had little to do with any safe-haven issues or correlations and everything to do with the need for immediate liquidity.

That occurred most recently in June, with several days of in-sync losses. But the impact tends to ebb quickly, and few analysts see that as a compelling factor at the moment, suggesting the bounce-back may not be as swift.

HISTORICALLY SPEAKING…

While gold in notional terms has been notching record highs since Nov. 7, 2007, when it first topped the long-standing January 1980 peak of $835 an ounce, bullion is one of the few commodities that has not set new peaks when adjusted for inflation.

Based on current prices, gold’s inflation-adjusted peak would sit somewhere just short of $2,500, and has been mooted by some analysts as a possible target for the medium term.

Some analysts have also looked at the relationship between gold prices and equity markets as a historical guide.

At this week’s annual gold trading conference, Franco-Nevada’s chairman set the pace for bullish predictions by suggesting gold would reach parity with the Dow Jones Industrial Average in the next four to six years. Currently gold is trading at less than one-sixth of the index, at 10,835, but it did reach parity briefly in 1980.

ETF INVESTORS HOLD TIGHT…FOR NOW

One of the biggest factors behind gold’s recent rally has been the advent of exchange-traded funds (ETFs), which buy physical bullion on behalf of investors. This has opened the market to smaller retail and institutional investors who want more liquidity and possibly smaller deals than a full gold bar.

The biggest fund now holds more gold than Switzerland.

So far this year, holdings of gold in exchange-traded funds have risen by 4.25 percent or a net 2.765 million ounces to some 68 billion ounces – equivalent to some nine months of global production.

So far in September, holdings of gold have risen by 0.4 percent or 275,000 ounces after nearly two straight weeks of outflows in the early part of the month – suggesting that most of those investors are sticking with it, for now.

Some analysts have cautioned that the influx of some $120 billion of investor money into the market over the past decade could leave gold more exposed to a sudden collapse - but most believe such a move is unlikely given the uncertainties and instability in the world.

CHARTS SAY…HANG IN THERE

Because of its liquidity, its links to financial markets and unusual independence from fundamental factors, gold tends to be a favorite with technical analysts and computer-driven traders, those who study chart patterns in search of clues on when to buy and when to sell.

While gold’s downturn has clearly broken down the accelerated rally in prices since the end of June, the much longer-term trends look intact – for now.

However, some analysts warn that the market’s failure twice to hold onto gains in excess of $1,900 an ounce may be setting it up for a much deeper correction.

“Gold is forming a large, ominous double-top pattern. There is a neckline at $1,705.40 … that’s an important area to watch,” said Adam Sarhan, chief executive of Sarhan Capital in New York. “We’re either going to have a light-volume pull back toward that support and bounce or it’s going to slice through this neckline like a hot knife through butter.”

WHEN ALL ELSE FAILS….

Go back to fundamentals. The commodity laws of supply and demand rarely apply to gold given the huge role of investors, and the fact that most of the world’s gold has never been “consumed” - merely “stockpiled” by central banks, funds, investors and bejeweled citizens of the world.

But at least one fund manager has argued that the market should eventually be forced to return to the marginal cost of production, which sets a floor. That cost has doubled since 2006 to around $850 an ounce, according to Thomson Reuters GFMS Gold Mine Economics Service.

“From a strategic long-term perspective, you don’t want to be investing in precious metals,” Christoph Eibl, CEO and founding partner of the $2 billion Swiss commodity hedge fund Tiberius Group, told Reuters this week on the sidelines of the London Bullion Market Association conference in Montreal.

Reuters