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Investing

Why Gold is Declining

Markets are crashing. So is gold. Wasn’t gold supposed to protect?

The number one question I’ve received this week: why is gold down with the stock market?

Fair question. Gold is sold as a form of protection against calamity. Were we really sold ‘fools gold’?

Probably not.

Gold has a tendency to decline during crises. One only has to look at 2008 for a recent example.

In 2008, gold prices declined along with everything else. However, after the immediate crisis ended gold prices started a dramatic rise, reaching a record high (around $1900) in 2011.

So why does gold fall during severe market stress? There are a few possibilities:

1. Forced selling to cover margin calls.

As markets collapse, anyone who bought stocks on margin (i.e. borrowed from their broker) will need to put up additional collateral or sell their holdings. Those who don’t want to sell need to add cash to their accounts. On way to do this is to sell holdings that have performed well. Up until last week, gold was performing exceptionally well.

2. Sell winners.

Investors sell their winners not only to fund margin calls. They might sell winners so they have cash to redeploy into cheaper stocks. Or they may simply want to increase their cash buffer. Investors tend to sell winners because it is psychologically easier to lock in a gain than a loss.

3. Rising dollar.

Most financial crises are accompanied by a dollar shortage. One reason is because investors are reallocating to US Treasuries (which require dollars to buy). The US dollar (and the dollar-denominated Treasury market) is viewed as a safe haven in times of crisis. This causes the value of the dollar to rise. When the value of the dollar rises, the number of dollars required to purchase any asset priced in dollars declines. Gold is priced in US dollars.

What’s next?

If this crisis plays out like the last one, central banks will eventually inject massive liquidity into the financial system, which is ultimately good for gold.

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