Is This the Start of a Bear Market in Gold?

Famed investing legends are dumping their gold holdings. George Soros dropped his stash of gold (held in the popular SPDR Gold Trust (GLD)) while Louis Moore Bacon sold all of his gold holdings in his Moore Capital Management fund with the exception of a modest position in a physical gold ETF, Sprott Physical Gold Trust (PHYS). Note that given the discount/premium nature of PHYS, the occasional pairs trade arbitrage creeps up for easy money by pairing it against GLD.

If that weren’t enough, PIMCO also cut its exposure to gold while recently under-performing hedge fund manager John Paulson was one of the few heavyweights to keep his gold position steady through a quarter of trading. How’s that for a vote of confidence?

So what’s wrong with gold? Why are well-known asset managers with long-term track records turning bearish?

The case for bullion

Generally speaking, bullion moves for two reasons:

1. Inflation or the threat of inflation – Under the assumption that gold is a long-term storage of wealth, gold prices should follow inflation over the very long term. Gold does this well over periods lasting a generation or more, but not so well with shorter periods. Despite the data, there are many who believe it is the best way to play inflation or the threat of inflation.
2. Fear – Gold performs excellently during periods of fear and widespread panic. As a universally valued commodity, it is in some form a global currency. Those who fear financial crisis or, in years gone by, Y2K calamity, gold is an excellent way to store wealth in a form that transcends national boundaries outside financial institutions.

These two factors give gold intrinsic value. Gold is worth what industry, jewelery users, and investors are ultimately willing to pay. Over time, these prices are generally higher during periods of inflation and fear. One need only look to gold’s peak in 1979 and subsequent 21-year bear market to see how quickly gold prices can change with expectations.

Gold and the greater fool

Now that the economy shows some signs of improvement – housing starts are up, buyouts are back, consumer staples stocks are on a tear – the case for holding a huge part of an investment portfolio in gold is materially weaker than it was just a few years ago.

Remember, gold does not produce economic earnings. It does not pay a dividend. Investors who own gold never see their ounces of gold become pounds, and certainly not tons. Gold merely sits there while productive resources are used to secure it from people who might want to take it.

Gold’s value, then, is primarily a function of what investors are willing to pay for it. And if investors are ditching it for the greener grass on the other side, then there’s no reason to believe gold prices can continue to march up, up, and away.

Perhaps most important is the fact that there are other ways to play rising rates (short bonds) and inflation (buy companies that can increase prices.) Investors are realizing that gold is just a messy way to play fear and inflation. Unlike a business, there’s no way to ascribe value to gold based on cash flows. One ounce of gold is worth whatever someone else is willing to pay for one ounce of gold, nothing more, nothing less.

Mean reversion coming soon?

Gold investors’ biggest fear should be that it is the gold investor that is driving prices. A chart from the World Gold Council shows just how important investors are to higher or lower gold prices:

Notice how quickly investment demand has grown in the past 10 years, and then consider what would happen if investment demand were to revert to the mean, or, even worse, if investment demand were to turn negative, dumping it faster than other investors could buy it.

When gold investors turn sour on gold, the correction will be quick, painful, and large. Gold needs a consistent inflow of more and more investment demand to keep rising, something that seems impossible given the exit of notable investors.

Disclosure: No position in any tickers mentioned here.