Investors Beware: Gold Glut Could Lead to Crashing Prices

There is no shortage of paranoid cable TV personalities like Glenn Beck with underhanded endorsements from the gold industry pushing the precious metal. But a hefty oversupply of gold leading to a sharp drop in prices could now be on the horizon as well.Last week, analysts at Credit Suisse calculated that there will be an excess of 420 tons of gold hitting the market in 2010 if buying by exchange traded funds (ETFs) goes back to levels prior to the credit crises last year. They estimate that gold prices would have to drop to $722 an ounce -- a fall of about 36% from current levels north of $1100 -- before supply and demand were in sync again.

While the analysts "can see signs of institutional investor divestment in ETFs, "smaller investors have been rushing into gold leading to shortages of gold coins, for example and "institutional sales have been offset by non-institutional purchases," propping up prices thus far.

But the big players on Wall Street are now expecting an economic recovery to take shape -- Goldman Sachs (GS) just raised its estimate of fourth quarter GDP growth to 5.8% from 4% -- and demand for gold ETFs, which soared 84% to 590 tons in 2009, is likely to turn down as a result.

Run Up In Gold Could Turn

Credit Suisse notes that last year's run up in gold prices had an "accelerating and reinforcing effect on market sentiment and the safe haven status of gold" and that things could turn quickly in the other direction. But even the firm's startling outlook is based on assumptions that may prove too rosy.

Central banks are likely to continue buying gold, the firm assumes. But despite paltry sums picked up by relatively small central banks last year, major central banks in countries like China and South Korea have indicated they see gold as a potential bubble and have little interest in the precious metal. While offering little meaningful diversification, a move into gold would likely hammer the piles of dollars the countries have already amassed.

The firm also assumes that the dollar, which has demonstrated a sharp inverse correlation with gold prices lately, will remain week amid a brisk recovery. But investors are growing increasingly concerned about the prospect of sovereign debt crises. Any likely panic would likely lead to a pile-on into the dollar and sharp selling of gold much as it did when concerns recently surfaced about Dubai.

The surprisingly strong signs of inflation that just emerged in the United Kingdom, meanwhile, could also take hold in the United States. If the Federal Reserve is forced to raise interest rates sooner than expected, the dollar could rally though the prospect of inflation is likely to help gold as well.

As the Senate race in Massachusetts plays out, investors may believe that less government spending and smaller deficits than previously anticipated are now in the cards. Perceptions that Republicans are better positioned to block a Democratic agenda are also likely to strengthen the dollar.

If gold's volatile history is any guide, the considerable oversupply already expected could quickly turn into a glut as investors race for the door.
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