October 3, 2011 9:06 pm

Gold bugs beware – the bubble is finally bursting

By Mark Williams

Gold is losing its glimmer. Last month, gold prices dropped more than $300 an ounce – the largest short-term fall in more than 20 years. This suggests that a decade-long bull market is ending. Gold’s recent volatility is spooking investors and destroying demand.

The last bull market for gold ended in 1980, when prices fell by 60 per cent.

For 20 years after, owning gold was dead money. In 2011, the bubble is popping again. This time, gold could drop to $700 an ounce, more than $1,000 below its peak.

The difference from the current gold bubble and the previous one is that investors are now armed with exchange traded funds (ETFs), derivatives that increase their ability to run from gold if necessary. Several hedge funds have become dominant holders of ETFs. Investors now are responding to uncertainty in the eurozone by selling gold and other commodities and buying less volatile US dollars. ETFs, the vehicles that helped push gold to stratospheric levels, are now pulling it down to earth.

The current gold bubble has lasted nearly three times as long as the previous one. Over the past decade, gold prices quadrupled, rising by 17 per cent per year on average.

For many investors, gold seemed to defy basic investment logic – year-on-year double-digit returns without the fear of double-digit losses. By 2005, more and more investors tried to rationalise why gold was no longer a fringe investment. It was a hedge against a weak dollar, global turmoil, incompetent central bankers and inflation. As trust in the financial system declined, gold would naturally rise, they reasoned.

Gold ETFs were created to meet this growing investor interest, and allowed about $70bn in new capital to flood the market. ETFs opened the door for a new class of short-term investors, including hedge funds and other speculators that could sell gold like stocks, getting in and out of positions at a moment’s notice.

In 2004, a new ETF was launched: SPDR Gold Shares (known as the GLD). One share of the GLD equates to one-tenth of the price of an ounce of gold, less a management fee. This lower cost point appealed to investors: the GLD and its copycats grew rapidly. In mid-August, when gold peaked at more than $1,900 an ounce (above the value of much rarer platinum), the GLD became the highest valued ETF in the market, even eclipsing the S&P 500. The upstart was now market king.

Today, at $65bn the GLD is one of the world’s largest holders of gold and, for the first time, private investors own more gold than is held by all central banks. In London, the GLD stores more than 1,200 metric tons at HSBC Bank.

But ETFs have not been around long. In a bear market, derivatives that attracted billions of dollars could easily turn into a huge wrecking ball, as ETF investors run for the door. Since August, the volume of ETF trading has gained pace, signalling shifting investor sentiment. Many ETF speculators still hold large positions, but recent price drops erode the belief that gold is a “safe havenâ€