Top 5 Reasons Gold Prices Move

NEW YORK ( TheStreet ) -- Gold prices have risen more than 10% in 2010, closing Wednesday at $1,241 an ounce. Rising unemployment in the U.S., import slowdown in China, weak global economic data and a struggling eurozone have triggered gold's recent surge, but those issues don't tell the whole story.

Gold prices have regained speed in the past weeks as Cisco's CEO John Chambers hinted at a double-dip recession, and a slew of economic data including rising weekly initial jobless claims have brought into question the health of the U.S. economy, which has trumped any merger news and positive earnings. Gold prices have rallied 5% in August during a typically slow buying season while the Dow Jones Industrial Average fell 4%.

Gold prices are volatile, however. When equities plummet, investors are often forced to sell gold for cash, but any significant dip triggers a wave of buying as investors purchase gold at "discount" prices resulting in a strong tug-of-war for prices. Aside from recent market jitters, there are five other fundamental factors that contribute to gold's strong price moves.

5. Price Manipulation

Price manipulation is the most controversial theory that has circulated among gold bugs for 20 years. Some argue that gold prices have been illegally suppressed over the last two decades by central banks and governments. GATA or Gold Anti-Trust Action Committee is the biggest complainant.

Central banks reportedly have 32,000 tons gold, with the International Monetary Fund accounting for 2,800 tons. Under the Washington Agreement on Gold, its members can sell a maximum of 400 tons a year, thereby restricting the amount of gold in the open market place.

GATA argues that central banks in actuality have less than 15,000 tons of gold, and that the missing gold has been secretly sold or leased into the market to prevent gold prices from rising to their actual value, which should be between $3,000 to $5,000 an ounce.

"The reasoning for the suppression is governments/bankers look at gold to be a barometer of the health of economies and countries. These suppressors want to kill or at the very least, greatly slow the messenger," argues Peter Grandich, Editor of Grandich Publications. The suppression theory means that global economies are in worse financial shape than investors think and that gold should be bought as the ultimate safe haven. According to recent reports, Texas representative Ron Paul is planning to introduce a bill in Congress calling for an audit of U.S. gold reserves.

Another supporting theory is that traders short gold and silver when prices actually rise, meaning that they know something everyday investors don't. Grandich says, "We've witnessed a concentration of gold and silver shorts by JPMorgan and HSBC on the Comex."

The New York Post reported in May that the the Commodities Futures Trade Commission and the Department of Justice have launched criminal and civil probes into JPMorgan's trading in the silver market to determine if the investment bank depressed the silver price for their advantage. According to Grandich, a rumor is also circulating that a major New York law firm will also launch a similar lawsuit against the investment bank.

The belief is that as investors realize that the precious metals market is manipulated, gold prices will rise exponentially, but until then prices will suffer.

The opposition, however, believes that claims of price suppression are completely unfounded. "There's no vested interest on anybody's parts to suppress prices here," says Jon Nadler, senior analyst at Kitco.com. "The allegations remain at that level, simply allegations."

Nadler argues that despite the rumored price manipulation, prices have still quintupled in value over the 20 years. "If this is suppression, I think it's completely ineffectual, and let me have more of it."

4. Supply and Demand

The supply and demand factor is pivotal in determining the gold price.

Many analysts argue there is not enough gold being produced to satisfy rising demand. The above ground stock of gold is around 160,000 metric tons and grows about 2,400 tons a year, which is only 1.75% ,while demand keeps expanding.

In the World Gold Council's recent Gold Demand Trend report, gold supply rose 17% in the second quarter from a year ago compared to a 36% rise in total global gold demand. Mine production grew to 658.5 tons while demand popped to 1,050 tons.

From 2005-09, the gold industry received 59% of its supply from mining production, 31% from recycled or scrap gold and 10% from central bank sales.

Juan Carlos Artigas, investment research manager at the World Gold Council, says that as central banks become buyers instead of sellers, the supply picture loses 10% of its gold while simultaneously grappling with gold-producing countries that have exhausted their resources.

For example, South Africa produced 74% in the beginning of the decade but is now down to 19%. "What we've seen is that there's a strong demand going on at the same time that the supply picture is shifting," says Artigas.

One factor contributing to this supply and demand imbalance is the advent of physically backed gold ETFs. Along with the GLD, the iShares Comex Gold Trust ( IAU) and ETFS Physical Swiss Gold Shares ( SGOL) hold more than 1,400 tons of gold, over half of annual gold production.

Over the past three years, cumulative supply has grown 59% while demand has surged 62%. According to Artigas, this imbalance has "created a fundamental support in the development of the gold market and, consequently, an environment of rising gold prices." This upward trend is expected to continue as investors seek ways to diversify their portfolio. "While there are many factors that affect the price of gold at any given point, the overall trend has been underpinned by the dynamics of supply and demand."

3. Safe Haven and Peer Pressure Buying

Traditionally, gold investing was reserved for gold bugs -- those who thought global wealth would be eradicated and gold would be the only currency left standing.

However, as the financial crisis rocked global markets at the end of 2008, a trend started to develop of regular investors allocating a certain amount of their portfolio into gold. The recommended percentage is typically between 5%-20% depending on how aggressive the investor wants to be or just how much he/she needs to diversify against other assets.

This shift was underscored by gold purchases from big name investors who had profited off of the subprime crisis by betting against mortgage-backed securities.

In the fourth-quarter of 2009, legendary investor George Soros almost tripled his gold holdings in the gold ETF, the GLD, from 2.5 million to 6.2 million shares as gold prices hit a then-record high of $1,227 an ounce. Sorossold over 340,000 shares in the second-quarter of 2010 but is still the seventh largest holder of the GLD.

The largest holder remains Paulson & Co., run by legendary investor John Paulson. Paulson'ss fund currently owns 31.5 million shares, which it has for more than a year.

During the second quarter, large investment banks like Bank of America ( BAC), Morgan Stanley ( MS) and JPMorgan ( JPM) loaded up on gold ETFs. JPMorgan is now the largest holder of the smallest gold ETF, the ETFS Physical Gold Shares ( SGOL).

Big name buyers like Soros and Paulson are significant as they can trigger peer pressure buying. Typically, when gold prices pop double digits on high volume, retail investors will jump into the trade for fear of missing the opportunity.

Scott Carter, executive vice president of Goldline International, a seller of precious metals, says that "when there's a spike in the price of gold, it's somewhat counterintuitive, but you see buyers increase into the markets. So it's almost like the train is leaving the station ... if gold goes up 1%, 2% in a day we'll see a dramatic increase in the interest."

On the flip side, when profit-takers sell gold for cash or the crisis premium decreases, momentum buying also slows.

The advent of physically backed gold ETFs over the past six years has given investors an easy way of speculating on gold. One share of the GLD is equal to 1/10 an ounce of gold. If investors start piling into the ETFs, the funds must add more gold, taking more gold out of the open market and triggering higher prices. But the reverse is also true. If investors sell gold ETF shares en masse and there are no buyers, there will be inflows of gold into the market, which will weigh on prices.

2. Currency Debasement

The most popular reason to own gold is as a hedge against inflation. The theory is as paper currency loses value, gold will retain its purchasing power, making it a safe place to preserve one's wealth.

Historically, gold has traded in opposition to the dollar. A stronger dollar makes dollar-backed commodities like gold more expensive to buy in other currencies, which weakens demand.

Times of real market panic have altered the dollar/gold inverse relationship as both are bought as safe havens, an alternative to stocks and "riskier" currencies like the euro. But the Federal Reserve might change all that.

The Fed's recent decision to use money from maturing bonds to lend more money to the U.S. government has many analysts speculating that the Fed will ramp up monetary easing if the U.S. economy continues to deep-end. As of now, the Fed is not altering the size of its balance sheet, meaning that it doesn't need extra money to buy government bonds. But if a decision is made to increase liquidity in the market even more, then the Fed will have one last resort: printing money.

Although inflation is currently low, the core consumer price index rose just 0.1% in July, future money printing will debase the U.S. dollar and make gold even more appealing as a form of currency.

The more pressing currency issue is deflation, however, as high unemployment is forcing consumers to save more, spend less and wait for prices to fall. Some experts say that gold will perform well even in a deflationary environment.

"If we have a severe bout of deflation, gold might actually, while falling, become a very decent reverse hedge," says Nadler. " That is it could fall less than other asset classes would in such a situation. Let's say stocks, and bonds and real estate."

Whether deflation or inflation, the U.S. is currently more than $13 trillion in debt with $224 billion in interest payments due in fiscal year 2010 fueling rumors among doomsayers that the dollar will eventually be worth zero.

"Intrinsically, the dollar is worth nothing. It's a dream painted on a piece of paper," says Rick Rule founder of Global Resource Investments. Rule predicts higher gold prices in the future because the U.S. dollar will eventually depreciate in value. "There's no particular reason why you, despite the fact that you live in the U.S., need to be a prisoner of the dollar ... use gold money, export your capital."

Investors' lack of faith in currencies is expected to support higher gold prices over the long term.

1. Central Bank Buying

Huge double-digit price movements in gold could mean that there are big buyers and sellers in the market like central banks.

"There has been a fundamental shift in the behavior of central banks over the past few quarters," says Natalie Dempster, head of investment for the World Gold Council. "Central banks on the whole have been net sellers of gold for the past two decades."

Since the second quarter of 2009, however, central banks from emerging market countries have transitioned into net buyers. The Reserve Bank of India has been actively buying gold from the IMF . India now holds 7.5% in gold reserves, which is still considerably lower than the 20% of gold reserves it held in 1994.

One of the biggest buyers is China. Over the past five years, the country secretly increased its gold holdings from 600 tons to 1,054 tons. China currently holds only 1.6% of its reserves in gold. Dempster says that if the continent were to reallocate its holdings to 3%, it would need to buy 1,000 tons of gold. Compare this with the U.S. and Portugal, which hold 70% and 80% of their reserves in gold, respectively.

"Some banks like India, says Dempster, "have been rebalancing as the percentage of gold in total reserves has fallen over time. Others are looking to diversify away from dollar-based assets, and with sovereign debt concerns continuing to grow around the world, gold's attractiveness as a reserve asset that bears no credit risk continues to grow."

Central banks in general regard reserve allocation as an ongoing government policy. Although the governments consider fundamentals like dollar weakness and the sustainability of gold as money, they don't trade gold; they buy it as an investment. They will buy gold when they feel ... gold reserves are too low when compared to its other holdings.

Central banks tend to be price agnostic but are heavy buyers and sellers.
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-- Written by Alix Steel in New York.

Alix joined TheStreet.com TV in February 2007. Previously, she held positions in film and theater production, management, and legal administration. Alix has a degree in communications and theater from Northwestern University.

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