In the past several months, many investors thought they had discovered a way of beating the low returns gained from their financial assets by investing in gold. Many Western governments are still struggling with huge debt mountains, slow economic growth, as well as rising inflationary pressures. So many investors believe that gold is the ultimate safe haven. They buy gold bullion or shares of gold mining companies, or even exchange-traded funds (ETFs) that track the gold markets.

Italy is the fourth largest gold holder

But the fall in gold prices in recent weeks can only be described as dramatic. In October 2012, gold prices reached their all-time peak of $1,795 an ounce. A few days ago the price of gold fell by almost 20 per cent from this peak. So why is gold losing its glitter? Is this a normal ‘correction’ or a more serious and prolonged decline in gold prices?

As the financial journalist Emma Simon writing in the Sunday Telegraph says: “What is certain is that no one can blithely assume that gold remains the ultimate safe-haven asset. It isn’t. Its price is determined by a complex web of economic factors, market sentiment and supply and demand. As a result it is as vulnerable to sudden price swings as equities and bonds.”

The way people invest in gold has changed over the years. We all know how our grandparents would buy gold jewellery whenever they could afford to do so. They believed in the intrinsic value of gold as a store for value, even if it had very little practical use except for personal decoration.

Today’s investors wanting to dabble in the gold market are more likely to buy ETFs that track gold-mining shares or physical gold prices. But even professional investors, traders, hedge fund managers and other speculators use ETFs to diversify their portfolios. Since all these professional investors usually have active strategies they can often cause shocks in the markets when they unwind positions as prices move against them.

Jason Hollands, the managing director of Bestinvest, said: “In our view the explosive growth of ETF products has been a contributing factor to the recent volatility in this (gold) market.”

Small investors are increasingly moving away from buying bullion and gold-mining shares and are opting for ETFs which are so much easier to manage. The turmoil in the gold mining industry in some countries like South Africa has added pressure from investors to opt for ETFs that track gold prices.

As usual, conspiracy theories abound in financial markets. With increased automation in the trading of ETFs it is not inconceivable that some market manipulation by major players could happen. In fact some analysts who believe in conspiracy theories speculate that the recent fall in gold prices was the result of market manipulators wanting “to support the dollar or to prevent a major bank going bust”.

If conspiracy theories did not exist, the work of financial journalists would be that much more boring. There is, of course, little evidence that the gold market is rigged. The gold market is one of the oldest and most mature markets in the world. But it is also one of the most complex and opaque.

The dynamics of supply and demand in the gold market are not always easy to understand. Supply is sometime artificially influenced by politicians in gold producing countries. Demand can come from a little old lady buying gold trinkets for her dear grand-daughter to central banks diversifying their reserves not to depend too much on dollar or euro holdings.

What are even more baffling are the contradictions that one often sees in the gold market. For instance, recently more people were selling their interests in gold in the form of ETFs, but at the same time more gold bullion was being bought. Political tensions in the euro area are also likely to affect the price of gold.

With the Cyprus bail-in affecting thousands of bank account holders, one would have expected a rush to buy gold as the only real safe haven for investors. But this did not quite happen. Instead the Cypriot Central Bank sold part of its gold reserves to cover the bailout costs.

Some analysts are now predicting that the same thing may happen in Italy. Italy is the fourth largest gold holder. Despite the fact that they now have what seems like a stable government, their economic problems are overwhelming.

Will the Italian Central Bank need to sell gold to finance their economic restructuring?

johncassarwhite@yahoo.com

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