What happened to Gold?

The recent plunge in the price of gold has caused shell-shocked investors to second guess their previous outlook for the metal. However, in the midst of a roller coaster market it can be very easy to lose touch with the broader perspective. With that in mind, gold's prospects are as bright as ever, and the sharp fall likely created one of the best buying opportunities of the current bull market.

First and foremost, the recent decline was not a gold decline, it was not a metals' decline or even a commodities decline. It was an across-the-board pullback among asset classes, from commodities, to emerging markets, to the Dow Jones, regardless of their individual investment merits. The commonality was that the drops seemed to be proportionate to prior advances, and that the assets were widely held by leveraged speculators. (The lone exception seems to have been oil, where its surprising resilience likely indicates that a significant rally is about to begin.) To me, this was a liquidity event, with the decline in the price of gold having little to do with its underlying fundamentals.

For years, leveraged speculators performed their financial high wire acts secure in the knowledge that Greenspan and the boys at the Fed were manning the nets below. The protection became know as the "Greenspan Put." The fear now is that the "put" may have expired with Greenspan's term, and that Bernanke has neither the intent nor the credibility to write another one.

With his anti-inflation rhetoric seemingly taking any interest rate cuts or added liquidity off the table, leveraged speculators suddenly found themselves out on those wires with nothing but concrete below. In Wile E. Coyote fashion, a glimpse below caused reality to set in. As a result, many opted to climb down, requiring assets to be sold to pay down debts. The result was a reversal of momentum, causing additional selling, short-selling, stop-related selling, margin liquidations, and redemptions.

However, my guess is that the markets are misinterpreting the Fed's resolve or even its ability to fight inflation. Bernanke really wants to pause, but he is fearful of causing a run on the dollar by doing so. Therefore he must first lay the ground work for a pause by convincing the markets of his commitment not to. His strategy may work for a while, but once investors call his bluff, he will fold like a cheap suit.

With so many speculators stampeding for the exits at the same time, it is only natural that prices would collapse. However, once such selling pressure is exhausted, gold's fundamentals will re-assert themselves, likely resulting in a spectacular rise. Having been badly burned, speculators will likely stay clear of the market until gold forms another base above $700 per ounce.

The biggest trade yet to be unwound is the massive long position in the U.S. dollar. The fact that a broad-based pullback has already begun in other asset classes means the dollar could be next. Such an event would be extremely bullish for gold, meaning the recent decline in its price could ironically lay the foundation for its biggest advance.

One anecdotal indication that gold's recent rise may have been a bit too steep was that my traditionally anti-gold opponents in a "bull and bear" debate at last month's Las Vegas Money Show were both bullish on gold. Of course, they were bullish for the wrong reasons; claiming gold's rise was a result of the strengthening global economy pushing up jewelry demand. With these misguided bulls likely to have now been flushed out of the market, a more orderly rally can resume free from all that excess baggage.

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