Gold witnesses sharp sell off; Is it time to invest?

ICICIdirect.com has come out with its report on gold update. The research firm expects, the current decline to stabilise in the Rs 24000-23000 price range. Prices will witness time wise correction while the base formation takes place. Investors should be patient and should not expect new highs in the near term.

Sharp sell off after multi year dream run

After generating unprecedented positive returns for 12 consecutive calendar years, gold has surprised everyone by declining sharply by around 20 percent from its high of Rs 32800 per 10 gram in November 2012 in a span of five months. The domestic price of gold has been buoyed by a steady depreciation of the rupee against the dollar in the last couple of years. In dollar terms, gold has not generated meaningful returns in the past two years.

Reason for recent correction

One of the main reasons for the recent correction in global gold prices is the confidence in the US economy that has led to investors shifting money from safe havens like gold to riskier assets like stocks. The US stock markets are currently trading at all-time high levels. At the same time, the holdings of the SPDR Gold Shares, the largest gold ETF in the world, have fallen 15 percent from their peak levels. At 1,154 tonne, SPDR's gold holdings are at their lowest level since April 2010
The rise of the dollar due to the economic crisis in Europe also resulted in prices being adjusted as it is denominated in US dollar terms. The dollar has also moved up on hopes that the US economy is emerging from its crises
Expectations of the US Fed withdrawing the stimulus soon, which would results in sussing of easy money that is currently available
News flow of Cyprus selling its gold reserve. Cyprus holds just 13.9 tonnes of gold. Speculation that Portugal and Italy may follow Cyprus in selling gold added to the negative sentiments. However, it is unlikely that Portugal and Italy will resort to gold selling to meet the fiscal deficit
The sell-off was seen across commodities including metals and crude oil prices as weak Chinese GDP raised concerns over demand
The news flows, as mentioned above, led to panic selling and speculative or hot money, which was chasing the rising metal got reversed

Technical View: May consolidate for long period around current levels

International gold prices witnessed a sharp sell off after violating the lower band of past 18 month's consolidation range below USD 1530. After recording an all-time high of USD 1920 levels during September 2011 gold prices have remained in a broad trading band between USD 1800 and USD 1530 levels in the last 18 months

Meanwhile, domestic gold prices continued to remain in a rising trajectory till November 2012 and scaled an all-time high of Rs 32464 levels. The most dominant pattern on the price charts is the Double top formation at around Rs 32400 levels being two distinct peaks recorded in September 2012 and November 2012.

The recent violation of major horizontal trend line support placed at Rs 29200 levels triggered a major sell-off and took prices to their two year lows of Rs 25270 levels. In the process, prices have also breached the long term rising trend line in place since 2008.

The intensity of the current fall makes us believe that the four year bullrun from 2008 lows of 11290 has culminated at the 2012 peak and gold prices are subject to a multi year consolidation, going ahead. Within this larger consolidation phase, oscillations of 8-10 percent are possible. However, that should not be construed as the beginning of a new bull run.

Domestic gold prices have major support in the range of Rs 24000-23000 levels being the confluence of the following

The 200 week moving average is currently placed at Rs 24180 levels
The 38.2 percent Fibonacci retracement of major rally from July 2007 low of Rs 8542 to the all-time high of Rs 32464 is placed at Rs 23300 levels
The trigger point of the last major rally, which started in August 2011 from where domestic gold prices started outperforming international prices is also placed around Rs 23000 levels

We expect the current decline to stabilise in the Rs 24000-23000 price range. Prices will witness time wise correction while the base formation takes place. Investors should be patient and should not expect new highs in the near term.

Investment Strategy

Even as the market figures out when the US Fed will terminate the stimulus package, other central bankers are coming out with their own versions of quantitative easing. The Bank of Japan has promised to inject a massive USD 1.4 trillion into the economy over the next two years. This intense burst of monetary easing is meant to offer a shock therapy and pull the economy out of two decades of stagnation. Other world economies, especially the struggling eurozone, may also be forced to come up with more stimuli in the near future. The next major move may be from the European Central Bank in the form of a reduction in interest rates.

Inflation is another reason investors should hold on to gold. Central bankers across the globe are going for competitive devaluation to stimulate their economies. This means global inflation is likely to rise in the coming months. The inflation-adjusted price of gold in the international market has not yet reached the previous peak. It is an indication that the price of gold may move up again once the current weakness is over. In other words, gold remains a good investment bet, at least till the world economy is beset with the problems that it is facing today.

The demand for gold has also not seen a significant reduction. In India, it came down due to high prices in the recent past. The demand was robust in January and February but slumped in March. It is expected to pick up now due to the upcoming Akshay Tritiya and wedding season. The demand from China, the next biggest gold consumer, is increasing faster. According to estimates of the World Gold Council, the country could soon overtake India as the largest gold consuming nation in the world.

Gold prices have come up from USD 260 to the current level in a decade. Therefore, a lot of the factors that are positive for gold are already priced in.

However, Indian investors need not be worried about a steep fall in prices. The 1980 crash in gold was not felt in India because the appreciation of the dollar against the rupee buoyed domestic prices. The situation right now is similar, with the rupee having fallen against major global currencies. In the past two years, it has dropped more than 20 percent against the US dollar.

Another factor that impacts domestic gold prices is the import duty on the metal. It did not perform well between 1991 and 1998 despite the rupee depreciation because of the duty cuts. Now that the import duty has been hiked, domestic gold prices may not come down in a hurry All said and done, gold is a good diversification tool. Irrespective of the outlook on gold, a small portion of your portfolio should be allocated to the metal to give it some stability. Since the factors that affect gold and other asset classes are different, the metal offers a good diversification potential. Due to this, the portfolio with gold offers better risk adjusted returns. Since Indians do not have too many international investments, gold can be a proxy for global diversification and protect the portfolio from a sudden depreciation of the rupee.

Instead of a fixed percentage, allocate 5-15 percent of your portfolio to gold. Hit the lower end of the band when the outlook is bearish, keep it at 10 percent when the outlook is neutral (as it is right now), and raise it to 15 percent when the going gets better. You can invest either in physical gold or paper gold. While the former offers greater psychological satisfaction to the investor, the latter provides better returns and is more tax-efficient. However, both options carry more or less the same risks and rewards.

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