Will Gold Drop Below $800?

NEW YORK (TheStreet) -- Last weekend I read an interesting article regarding the correlation between gold and inflation. The article, "Gold Could Still Have Further To Fall," by Mark Hulbert was published in the Wall Street Journal and calls for gold to fall into the $700 range.

The idea is based on research done by Campbell Harvey and Claude Erb, in a study called "The Golden Dilemma." According to the study, assuming that inflation doesn't change all that much, gold still has significant downside ahead. Essentially they tied the price of gold to the Consumer Price Index (CPI) and have assigned a long-term price ratio to it.

According to the research, over the long-term gold has a 3.4:1 price ratio to the CPI measurement. Right now, the measurement currently stand at 5.3:1, suggesting that gold would have to go to $780 for the ratio to work its way back down to 3.4.

During the peaks of the gold bull market, the ratio was as high as 11:1 in 1980 and, more recently, 8:1 in 2011.

Of course, gold doesn't necessarily need to decline another $500 per ounce. Inflation could rise as well, driving the ratio lower. Perhaps a combination of the two will eventually get the gold to CPI ratio back to its long-term average.

However, since the world has failed to end, the Federal Reserve has begun to discuss the tapering of its stimulus program and the global economy is still intact albeit rattled, the price of gold does have more than enough reasons to favor the downside.

Many people continue to say gold has likely bottomed at $1,179 per ounce. On June 28 there was a large intra-day rally after the commodity bounced hard off that mark and was able to close slightly above $1,200.

But it could just be a technical oversold bounce. Gold recently had its worst quarter, where it was down 22% in the second quarter of 2013. Off nearly 40% from its highs made just 18 months ago, the yellow metal has yet to see a long-term bottom.

While the CPI measurement does have its flaws and many investors point to it as understating the actual levels of inflation, the ratio does carry some meaning. Even if inflation were understated in the CPI, we still haven't seen the long-lasting implications of money printing -- at least not yet.

While I do acknowledge that gold serves its purposes in an investor's portfolio, its effectiveness has to be questioned at this point. After all, the key reasons to hold gold are for an inflation hedge, financial collapse, or when high levels of economic uncertainty are in the air. Right now, none of those circumstances have panned out or are in existence at the moment.

Although I wouldn't make a full position in gold at the time, I think if you're a long-term investor this selloff does offer a nice entry point. I would think that below $1,000, gold would be a great buy. However, even at that level, it would still leave the ratio elevated, at 4.3:1, assuming inflation remains about the same.

Those looking to play gold can do so in the futures market with contracts of physical gold, or can do so with smaller gold bars or coins. Those looking to participate via the equities market could look at the SPDR Gold ETF ( GLD) or the iShares Gold Trust ETF ( IAU).

Erb summed it up best when he wrote, "Our research doesn't provide a basis for predicting when gold will once again trade at fair value, however, only that it will eventually do so."

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Bret Kenwell currently writes, blogs and also contributes to Rocco Pendola's Weekly Options Newsletter. Focuses on short- to intermediate-term trading opportunities that can be exposed via options. He prefers to use debit trades on momentum setups and credit trades on support/resistance setups. He also focuses on building long-term wealth by searching for consistent, quality dividend paying companies and long-term growth companies. He considers himself the surfer, not the wave, in relation to the market and himself. He has no allegiance to either the bull side or the bear side.

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