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Gold is now in a bear market – is it time to sell?

With its price now more than 20% below its 2011 peak, gold is now in a bear market. Does this spell the end of the long-term bull run? John Stepek investigates.

It's been a terrible few days for gold.

On Friday, the yellow metal collapsed down through the $1,500 an ounce mark. And in this morning's trading, it fell as far as $1,425 at one point.

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The price has now fallen by more than 20% from its September 2011 peak of around $1,920. That means that gold is now in a bear market.

For a while, we've been saying that you should hold around 10% of your portfolio in gold as insurance against a wobbly financial system.

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So has gold outlived its usefulness? Is it time to ditch your insurance policy?

I don't think so. Here's why

Are Japanese government bonds behind the collapse in gold?

When gold suffers a brutal collapse, the conspiracy theorists rush out of the woodwork, muttering darkly about "price suppression". Ignore them. It's not good for the blood pressure and it doesn't help matters.

A number of factors have hit gold in recent days. For one, sentiment among investment banks has started turning bearish. Socit Gnrale issued a sell' note on gold recently, while Goldman Sachs went as far as to recommend shorting it. Good timing on their part as ever.

But it's not just gold. Commodities as a whole have been suffering. The oil price has taken a dive over the last couple of sessions. Copper is at an eight-month low. One slightly technical theory, cited by the Zero Hedge website, is that this general plunge is linked to the Japanese government's money-printing plans.

Since the new central bank governor, Helicopter' Haruhiko Kuroda promised to re-inflate the Japanese economy, Japanese government bonds (JGBs) have been on a wild ride.

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If Kuroda is true to his word, then the current miniscule yield on JGBs (around 0.6%) is unjustified. It has to rise (and so bond prices have to fall).

At the same time however, if the central bank is planning to snap up JGBs, then why would you sell them? You've got a guaranteed buyer willing to chase prices higher (as has happened in the US and the UK).

So, even as some flee JGBs, others are keen to buy in. And as a result, JGBs have become much more volatile in other words, the price has fluctuated a lot more than normal.

When the price of an asset becomes more volatile, anyone using borrowed money to invest in them, has to put a bigger deposit (also known as margin') down. If you've ever used spread betting, you'll know how this works.

If you haven't, the margin' is there so that if your bet moves into a losing position, the person who loaned you the money to speculate won't be out of pocket. It's just like a bank asking you to put a 20% deposit down on a property. The deposit protects the bank if prices fall.

So, anyone holding JGBs is being asked to put up a bigger margin to do so. That means they need to raise the money from somewhere. That somewhere' includes taking profits on gold and other commodity holdings.

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It's a theory at least. And if you're looking for something to explain the last couple of days' sell off, it's one of the more interesting ones.

Gold as a measure of faith

But I think there's a better way to explain gold's recent lacklustre performance.

It's no coincidence that gold has sold off in the wake of Japan's promise to "do what it takes" to revive its deflating economy. But it's not really about the margin calls'. It's about faith in central banks.

We've always seen gold as a form of insurance against financial calamity. At the start of this century, that insurance was cheap, because everyone believed that nothing could go wrong. After all, Alan Greenspan, the Maestro', was in charge of the Federal Reserve, and by extension, global investment markets.

Gold's rise coincided with investors gradually losing faith in the ability of central banks to keep a lid on inflation and the credit bubble. And when the financial system froze up in 2008, gold was among the first assets to bounce back.

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But since then, investors have been well-trained by the Federal Reserve, and to a lesser extent, the Bank of England. When a central bank prints money, the price of stocks goes up. You don't need to worry about anything else. Just buy shares and the central banks will take care of the rest.

So what's really hurt gold is the return of faith in central bankers. Think about it. When gold hit a peak in September 2011, that was just before Mario Draghi took charge at the European Central Bank.

He was taking over from Jean-Claude Trichet, a man who had entirely lost the confidence of investors. Since then, Draghi has promised to "do what it takes" to save the euro. He's seen as a safe, market-friendly pair of hands.

And now even the Bank of Japan has seen the light. So why would you hold on to gold? The central bankers have it covered. Everything's going to be fine. So get out of boring, old gold and go buy some riskier assets.

Why you should still be insuring against financial disaster

We've been saying for some time that you should treat gold as insurance, and have no more than 10% of your portfolio invested in the metal. So is it still worth hanging on to this insurance?

I can see gold going lower from here. I'm no technical analyst, but you don't have to be to look at the gold price chart and say: "That's ugly."

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However, the answer has to be "yes I'm holding on to gold". Here's why.

I'm happy to have money invested in equity markets just now. In terms of exposure to general markets, I'd hold Japanese and eurozone funds or trackers. I think they're cheap, and they'll keep going up.

In developed markets like the US and UK, I feel the overall indices are expensive (in the US) or imbalanced (the UK). I'd prefer a portfolio of individual stocks that pay an income and give exposure to the US dollar.

In any case, I think it's a good idea to have your money invested in markets rather than sitting under your bed.

But would I feel comfortable having a portfolio without any gold in it? No.

Central bankers might have won back the confidence of investors for now. The central bank put' - where investors bet that central banks will bail them out, no matter what is being wedged back in place. Central banks may even have won the war on deflation.

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But make no mistake, current monetary conditions are unprecedented. Interest rates have never been this low. The Bank of England owns about a third of all outstanding UK government debt. The Federal Reserve holds about 10% of US debt.

How does all of this unwind? I don't know. No one does. But I can imagine it might get messy. Just look at the JGB market: despite Bank of Japan assurances, it's acting like a bucking bronco just now, which just shows that central banks can't control everything.

In short, I'm happy to ride markets higher via the stocks and indices we've been endlessly suggesting over the past few years. But I also want to be holding some gold, just to be on the safe side. We'll be looking at the yellow metal in more detail in the next issue of MoneyWeek magazine, out on Friday.

Follow John on Twitter || Google+ John Stepek

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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