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A final purge to $700? What gold bulls' surrender might look like

·Michael Santoli
Gold bars are stacked at a safe deposit room of the ProAurum gold house in Munich March 6, 2014. REUTERS/Michael Dalder/Files

To some, it’s the only true money; to others a near-useless mineral. Which means that gold is always carried along currents of investor emotion. 

So when - at what price – might gold’s fans feel sufficiently demoralized by its relentless decline to surrender in a climactic selling purge?

With gold near $1,160 and down around 40% from its 2011 high above $1,900 per troy ounce, the gold bulls’ most ardent arguments have dissipated or even been discredited: Inflation is dormant, the U.S. dollar on the rise, the federal government is solvent and modern civilization abides.

At this point in a bear market, attention turns toward anticipating what “capitulation” might look like – that phase when remaining loyalists surrender hope and liquidate in disgust.

This is the kind of climactic market washout that is only ever clear in retrospect. But while there are inklings that gold has fallen far from favor among traders, if a comprehensive capitulation is to finish this move it hasn’t nearly happened yet.

Bank of America Merrill Lynch investment strategist Michael Hartnett, who has been correctly bullish on stocks and other risky assets in recent years, last week expressed some alarm at the overconfidence of equity bulls (at the expense of gold partisans) in the face of copious global liquidity. He’s on the lookout for a near-term reversal, but only after these markets get to further extremes.

“The big hubristic 'tell,’ will be gold,” he says. “A sudden gap lower in the gold price to below $1,000/oz. should coincide with the final thrust higher in stocks, both indicating capitulation of the ‘stubborn bears,’ the end of the ‘melt- up’ and the next opportunity to get tactically bearish. We increasingly fear next year’s highs in stocks come early.”

Of course, a rapid move below $1,000 for gold would mean serious additional pain and a further loss of at least another 15%.

Mark Dow, a hedge-fund manager who blogs at Behavioral Macro, has been a vocal bear on precious metals since around the time they peaked in 2011, believing gold bugs were using a deeply flawed understanding of the Federal Reserve’s quantitative easing program and its impact.

This week, Dow wrote a piece suggesting “the second wave of the [gold] bubble unwind is upon us.” Pointing out that the central-bank money-printing storyhas lost its psychological punch, emerging markets have tepid income growth, the dollar is trending stronger, and [higher U.S. interest rates] can only be a headwind.

He ultimately expects the entire 2007-2011 manic advance in gold will ultimately be undone, which implies gold would return to around $700 per ounce.

One reason Dow figures the market hasn’t yet been cleansed of all hope is that retail-investor flows into the precious metal jumped in recent weeks. And, as the Wall Street Journal describes, small investors are hustling to buy up silver, often known as “poor man’s gold,” as silver prices plumb four-year lows. That’s far from the kind of tossing-in-the-towel action a contrarian bargain hunter would want to see in an asset.

As it happens, this week marks the tenth anniversary of the SPDR Gold Shares exchange-traded trust (GLD), the pioneering vehicle that allowed a broad class of small investors to own an interest in a trove of physical gold. As the following chart shows, outflows have dropped the number of ounces of the yellow metal held in the GLD by 46% since the end of 2012.

While a big drop, this is still more than the trust held on the eve of Lehman Brothers’ failure in September 2008, when gold traded at less than $800. So the public hasn’t nearly reversed its crisis-motivated bet in dollar terms.

On a shorter-term basis, there is evidence that speculator sentiment toward gold is near negative extremes, which could set up a trading bounce in the price.

Speculative funds last week cut their long bets on gold by the greatest amount in two years, just as the Daily Sentiment Index of professional traders hit rock bottom at zero percent bulls on gold-mining stocks. The Central Fund of Canada Ltd. (CEF), a long-tenured portfolio of physical gold and silver, now trades at an 11% discount to its net asset value – the widest shortfall to the dollar value of the metals held since 2001.

Rumors that Russia has been liquidating gold were rife, and - true or not – this is often the kind of scary headline that hit a market when it’s stretched to extremes.

This has some tactical traders playing for a bounce or more, and shares of gold miners (which are heavily exposed to now-declining energy costs) popped by nearly 5% Tuesday.

Yet the problem with handicapping a potential low in gold is that there are no real fundamentals to fall back on. Unlike shares of companies, there is no dividend yield or book value to act as cushion. There is no management to lobby for a restructuring or sale of assets. Gold’s price is reliant not on any intrinsic or accounting value, but on the faith the public places in it, or the lack of faith it has in paper assets.

Nick Colas, chief market strategist at brokerage firm Convergex, this week calculated gold’s price relative to the Standard & Poor’s 500 over the span of decades to place it in some long-run context.

Over the past 30 years, the ratio of the S&P 500 index level to the price of an ounce of gold has averaged 1.86. Currently it stands at 1.57 – so gold isn’t even “cheap” yet relative to U.S. stocks, which trade at an all-time high.

This ratio peaked in 2000 at more than five, with the S&P above 1500 and gold beneath $300, and in the years leading up to the great 2007 “buying opportunity” in gold versus stocks, the ratio was consistently above two.

If Harnett gets his violent spasm of selling that sends gold cracking below $1,000, that ratio would return to that range. Be careful what you wish for, gold bugs.