By Louis Golino for Coin Week
During the week that ended September 23, gold and silver saw their biggest declines in decades.
Gold suffered its largest one day drop (5.9%) in five years, and for the week it lost 10%, the most since the early 1980's.
Silver dropped even more, declining by 18% on September 23, its biggest one-day decline since the 1980's, and it was down almost 24% for the week.
Silver is still viewed primarily as an industrial metal, and thus as an indicator of future economic activity, like copper. As the prospects of a U.S. and global recession increase, silver is coming under more pressure.
It fell more sharply than gold did because it lacks gold’s status as a safe haven asset and alternative currency. It also normally trades in a more volatile way than gold does.
This was clearly a major sell-off and it continued into early trading on Monday, although it is interesting than after new lows were set during Asian trading, both metals rebounded to roughly the same levels where they closed last week.
While it is impossible to predict what will happen next, it is possible to analyze the reasons for the dramatic decline and to try to understand the implications for future precious metal prices.
First of all, global financial turmoil reached the highest point this past week since the height of the financial crisis in September 2008, when lending began to freeze up between banks and there was a real risk of a global financial meltdown.
The European sovereign debt and banking crisis is clearly the principal factor, with the prospect of some kind of Greek debt default looming larger all the time.
Although Greece is not a major player in the world economy, many large European, and to a lesser extent American, financial institutions are heavily invested in Greek debt.
The European crisis is likely to continue to weigh heavily on investor confidence and could have major contagion effects on the U.S. economy.
A Greek default could trigger a collapse of the euro, and a run on European banks, which would probably make the crisis that began with the collapse of Lehman Brothers seem mild in comparison.
That is not to say that it is certain these events will take place, and this week there will be a number of important developments that will affect the crisis.
For example, there will be a key vote in the German parliament on Thursday on whether or not to approve the next tranche of financial support for Greece.
At the same time, the recent move by the Federal Reserve to reduce long-term interest rates by selling short-term treasuries and using the proceeds to buy long-term ones, coupled with greater emphasis in the Fed statement on the negative outlook for the U.S. economy, helped roil the U.S. and global equity markets.
Stocks declined almost as much as gold and silver did last week, as investors fled riskier assets and chose the perceived safety of U.S. Treasuries. That helped cause a rally in the dollar, which played a role in the sell-off of precious metals.
In a financial crisis the dollar is always the go-to asset, though that may not be the case years from now. The Fed’s recent “Operation Twist,” as explained above, helped make the dollar a more attractive asset in part because it apparently did not involve the printing of more money.
Probably the key factor in the massive metal sell-off was the simple fact that, as was the case in the 2008 crisis, large hedge funds and other investors needed to cover their large equity losses. So they sold the assets that were most liquid and on which they had made the greatest returns, namely, gold and silver.
In 2008, the need for cash led major metal holders to sell so much that gold and platinum both declined to $800 an ounce, with gold even going below that level briefly, before beginning an upward trend that has been quite amazing. That can not be said of other asset classes.
Another important consideration is that gold in particular has risen too far too fast since the summer and was due for a major correction. Silver already started to correct during the spring.
Jeffrey Nichols, a precious metals analyst and columnist for Coin World, said in August that “At some point, however, we will see a correction, perhaps a sizeable one. After all, even the strong bull markets never move up in straight lines. I would not be surprised to see gold stumble - falling back $100, $200, or even $300 - before prices begin working their way higher once again.”
In addition, as was the case with silver this past spring, which also rose too quickly to be sustainable, gold’s rise was driven partly by speculators, rather than just longer-term investors.
As it began to stumble recently, those speculators quickly headed for the hills, creating a self-fulfilling dynamic of selling that produces more selling.
Some people also believe that a leaked decision on September 23 that the Chicago Mercantile Exchange would raise margin requirements once again, effective on September 26, may help explain the violence of the sell-off. Gold’s margin is to be increased by 21.5% and silver’s by 15.6% in an effort to reduce volatility.
It is also worth bearing in mind that even with this dramatic sell-off, gold is still up substantially for the year, while virtually every other investment class, especially stocks, is down significantly for the year.
Moreover, as most metals experts agree, the fundamentals driving gold and silver have not changed.
Looking ahead, there are three factors that could drive prices lower, as identified by participants at a recent conference of the London Bullion Market Association.
These are rising interest rates, a resolution of the sovereign debt crisis, and reduced investment demand because of increased price volatility. Only the third of these strikes me as something that investors need to worry about any time soon.
I would not be surprised to see at least some kind of rebound and stabilization of prices in the after such a major sell-off.
Physical supplies of both metals are tightening, as buyers take advantage of the fire sale, the traditional Asian and Indian buying season is about to begin, and retail premiums are running high.
Quoted spot prices mean little when no one can actually buy at anywhere near those levels.
As Mr. Nichols explains, violent equity sells-offs, like that of the past week, “typically spill over into the gold market.” But following a first wave of extreme selling of the metal, “gold tends to disassociate itself from and act independently of other asset markets.”
It could be days, weeks, or longer before that happens, but I think the fundamentals that support rising prices will reassert themselves eventually.
Louis Golino is a coin collector and numismatic writer, whose articles on coins have appeared in Coin World, Numismatic News, and a number of different coin web sites. His column for Coin Week, “The Coin Analyst,” covers U.S. and world coins and precious metals. He collects U.S. and European coins and is a member of the ANA, PCGS, NGC, and CAC. He has also worked for the U.S. Library of Congress and has been a syndicated columnist and news analyst on international affairs for a wide variety of newspapers and web sites.