Gold Bugs Beware: John Paulson's Gold Fund Stumbles as Sentiment Sours

As gold surged past $1,200 an ounce amid record deficits and a weakening dollar in November, gold bugs got another massive vote of confidence. John Paulson, the high-profile, billionaire hedge fund manager who had just made a killing betting against the sub prime meltdown, launched a fund dedicated to the precious metal.Analysts raced to outdo themselves at the time predicting potential price tags of $3,000 or even $6,000 an ounce for gold. But Paulson's fund has taken a bruising since its launch and even lower prices could be in order as Wall Street's once exuberant sentiment for the precious metal shows signs of turning. Investors, meanwhile, should be reminded not only of gold's famous volatility but also of the dangers of following even luminary investors blindly.

Since it launched operations in January, Paulson's gold fund has tumbled 14% according to reports. And while many expected the superstar to bring in billions into the hot offering, the fund has raised only a meager $90 million to date from outside investors – barely more than a third of the $250 million he personally put into the investment vehicle.

The Ultimate Asset Bubble

But bigger trouble may lie ahead. Bullish gold investors had argued that piling into bullion was a hedge against inflation and that the world's major central banks -- such as China's -- would eventually allocate much higher fractions of their enormous reserves into gold amid a diving dollar.

Instead, the dollar has rallied sharply in recent months, few signs of inflation have materialized and the trend right now favors tightening of monetary policy around the world. China, on Friday, announced that it would again take measures to curb bank lending as its economy regained blistering 10% growth and the U.S. Federal Reserve is also telegraphing that the record amounts of liquidity swishing through the markets could be reigned in.

And some at Wall Street's most influential firms are now reasoning the high inflation expectations baked in will be needed just to support current prices.

"Yet if inflation expectations are merely missed (maybe inflation picks up, but by not as much as markets expect), then gold prices could be in for a tumble," Citi (C) analyst Alan Heap wrote recently. "Worse yet, if inflation remains benign for too long, thus causing inflationary expectations to collapse, then gold could be in for a complete rout."

But core inflation is currently declining and has little chance of resurging because of massive unemployment, Brian Nick at Barclay's Wealth recently told Hard Asset Investor. Moreover, other key markets such as Treasuries do not anticipate inflation in the near term either, all of which leads gold to be "significantly overvalued relative to fundamentals."

The souring sentiment comes amid calculations that a glut of gold may be hitting the market in the near future and that institutional investors have been selling even as smaller individual investors have been snapping up the precious metal.

Legendary hedge fund manager George Soros recently called gold "the ultimate asset bubble" leading to a burst of speculation about its value.

A Prudent Way to Bet on Gold

Of course, investors should not simply latch onto Soros' pronouncements any more than Paulson's.

But a prudent way to bet on gold prices declining for investors who are also concerned about nonexistent inflation and its impact on gold, would be to buy long dated put options -- the right to sell shares at a predetermined price within a defined time frame – on a range of gold ETFs, as Barclay's has advised.

That would limit the exposure if gold was to burst higher -- the options could simply be allowed to expire -- while locking in big gains if a slide did materialize.

Given the passion and perseverance of many gold bugs, a move higher can never completely be ruled out even if inflation doesn't materialize.
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