What is the behavior of gold price telling us?

I’ am no gold analyst but it has always interested & perplexed me. It is supposed be a hedge against inflation as also a savior in bad times – depression/deflation scenarios.

A Business Week report explains:

“It can be argued that gold's price spike to a record high of almost $1,030 an ounce last March had more to do with a surge of strength in commodities as a whole than anything specific to the yellow metal. Unable to buck the general sell-off in commodities since the summer, gold sank to a low of $680 in November before rebounding above $800 as the end of the year approached. Now that a new era for commodities seems to have begun—one likely to be characterized by greater price stability—any future gains by gold will have to come on its merits as a perceived safe-haven store of wealth, a hedge against inflation, and as a desirable component of jewelry.

…. cited questions he has received as to whether gold is still a safe haven asset—and if so, why the metal hasn't performed better during the recent economic tumult. Meger believes gold remains a safe haven asset and says it has weathered much smaller percentage decreases in price than have other commodities while avoiding the extreme volatility seen in other financial instruments. In fact, some of the selling pressure has been the direct result of gold's function as a store of wealth with easy liquidity, he points out.

...The true inflection point for gold, however, will come when concerns about deflation give way to inflation worries, Meger predicts.

…..Much like the stock market, which is way ahead of the economy, the price of gold is reflecting the market's belief that the worst of the recession is over, he says.” (all emphasis added)

So the import to me is that gold can be sold in times of chaos & disorder and hence one should invest in it if you expect a major deflation/unemployment/depression scenario. Also in case of expectations of inflation or high-inflation when the value of currency is falling rapidly gold can be a proxy as it is real as against a fiat money (fiat or order by the government that it should be accepted as a means of payment) where it is created out of thin air without any real asset backing it. As the trust in a given currency bursts gold increases in value as it is anticipated that gold can be used as currency for payment of goods & services if the currency fails.

Further this distrust on the fiat currency makes the governments and central banks jittery and more so in the case of US dollar which is a reserve currency for many countries/institutions. The fear that this reserve currency may now change to gold because of the lack of faith in US dollar has lead to manipulation theories where various central banks are supposed to have sold gold in a coordinated fashion to strengthen the US dollar and the spike from July in USD was as a result of this effort which also squeezed the dollar shorts. Gold in other words is an inverted dollar.

Source: gold-eagle.com

What I understand is that the current move up above $800 is due to the weakening of the dollar due to the Fed ratecut to zero levels. However it is expected that ECB and BOE will also follow with their own ZIRP (Zero interest policy) and it would be interesting to watch how US dollar and gold behave thereafter. Also the current geo-political situation in the Gaza-strip and Indo-Pak situation is supposed to have given it a further fillip.

Another point made by the Business Week article referred above is:

“Not everyone favors gold, even as a mere hedge against inflation. Historically, the returns on the physical commodity are miserable, although commodity futures are "somewhat more favorable as a diversifier,"….Those looking to gold as a store of wealth as part of a doomsday portfolio are better off holding gold coins, which they can keep in their physical possession,… "If the worst happens and you want gold because nothing else is worth anything, being able to say 'I have shares in this gold ETF' and going to the vault of a bank to get it out is unlikely to cut much ice…

…Prices of gold coins have spiked in the last six to seven weeks due to a shortage of supply and a jump in demand, even as gold futures prices have come down on the Comex division of the New York Mercantile Exchange. The American gold eagle, one of the three most popular gold coins, is now selling for the spot price of $845 plus a premium of $80 to $100, compared with the usual premium of 4.5% to 6.0%—or $38 to $51…

…That indicates small investors are moving more and more into gold because they're worried about the economy…" (all emphasis added)

So while physical demand has been strong the question that arises is why did gold fall to $680? Manipulation theory explained above has been given by many. It is a fact that paper gold market is 40 times the physical one and the former sets the price. The other reason is the deleveraging or forced selling due to the credit crisis.

So if gold prices are leading indicator what is it behavior telling us about the possible future economic conditions? It appears to be a ‘heads you win-tails you win’ asset class both in a potential inflationary (or hyperinflationary as some think) situation and deflationary or depression conditions – desire to hold gold should be pre-dominant in both situations. In such a situation should not gold prices be already at the levels they are projected to be - $2000+? Why this hesitancy? Is the behavior giving some other signal? Or am I missing something? I look forward to readers’ views and comments.

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