Going for the gold? Be alert

Demand has spiked so much that many dealers are low on stock. If you're an investor in the metal, pay attention, because some unusual crosscurrents are at work.

By Bill Fleckenstein

Gold recently hogged the limelight in my daily column on my Web site. My editor is a wordsmith, not a goldsmith. She would sooner walk on hot coals than dabble in commodities, a reaction entirely appropriate to this riskiest aspect of investing.

Nevertheless, the topic intrigued her from an academic standpoint. She suggested that other people who are wisely on the sidelines as she is might also view it that way. Thus, in the spirit of education, let me proceed, beginning with an explanation of the recent carnage in precious metals.

The quants take control

There are huge amounts of money being managed according to mechanical or mathematical trend-following systems. (See the second section of "The Fed embraces inflation" for more on this.) When those systems kick in, gold and silver can drop in price even on days when inflation is reported to be high, as happened Aug. 14.

That's because when a major liquidation is under way, the economic fundamentals have no bearing on market action. The quantitative systems take control.

(Liquidation sometimes works on the upside as well, when folks are short -- betting a commodity will drop in price -- and are forced to buy to cover their positions. That's probably what drove the oil market from $120 to $140 and change recently.)

Except for the dollar's huge rally, virtually nothing has changed in the case for owning gold, though the price recently tanked by more than 20%. However, in the short run, fundamentals do not make any difference when powerful tailwinds or headwinds push prices around.

In the stock market, price action often reflects underlying events in businesses, industries and the economy. With commodities, price is just a reflection of the market's attempt to help balance supply and demand, as the cost of production and other variables have only long-term relevance.

A closer look at the gold market reveals shortages driven by price declines and a subsequent explosion in retail demand, and many dealers have run out of assorted forms of gold coins, bars, etc. If you click here, for example, you can see that Tulving is out of gobs of products. Kitco.com has been warning about delivery delays.

These shortages likely have something to do with the fact that last week the U.S. Mint suspended sales of gold coins -- a reflection of the surging demand. The fall in price also triggered an outpouring of buying in India and the Middle East. In addition, the exchange-traded funds, or ETFs, that hold gold and silver showed an amazing resilience in the face of plunging prices.

Thus we witnessed an unusual dichotomy: Physical buying (and here I'm kind of including the ETFs, though they aren't purely physical) was ratcheting up even as the selling of futures contracts was driving the market lower. When the price was rallying, the futures market had a big hand in that, so we can't ignore it when it seems to be at the epicenter of lower prices.

In any case, if we saw (as it appeared) heavy selling or short-selling in the futures market while demand for gold in the physical world was rising, that historically would be a very bullish development.

What does seem quite clear is that some portion of gold's weakness has been a function of the dollar's strength. The dollar's violent rally owes to folks' beliefs that the economy is improving in the U.S., that the Federal Reserve intends to raise interest rates and that the rest of the world economy is slowing down.

The rest of the world may in fact be slowing down. But our economy is not about to get better, and the Fed is not about to tighten rates. Just the thought of the Fed increasing rates is laughable.

Taking the measure of one's metals

As I survey the macro landscape, it looks friendly to gold. However, the folks who are betting on a rise in gold prices must be alert to the possibility that some very serious technical damage has been done.

Someone I respect a great deal pointed out to me that the technical aspect of gold -- i.e., the chart -- has turned quite negative. The difference between the 2006 price break and the 2008 price break is that this time the 200-day moving average has turned down. He feels that's potentially a fairly bearish development.

My reason for bringing up this caveat is to get folks who own gold, as I do, to think about their position, in case it has grown larger than what previously appeared suitable.

If it has, consider whether you need to find a spot (a price) at which to lighten up on gold during the next rally, just in case it turns out that the gold futures market faces a prolonged large trading range.

I'm not saying that will be the case, as I believe gold will eventually trade much higher still.

But I think the most important point is that you need to have a plan -- regarding any investment, not just gold. Because when the gold price rises, as it has for the past five or six years, it's easy to wind up with too much of your portfolio in one investment -- an unfortunate circumstance that you realize only when prices sink.