The aftermath of the gold crash – what happens next?

They say that bull markets end with a bang, not with a whimper.

We got our bang. The problem is, it was in the wrong direction. In just two days, the gold price fell by more than $200, from $1,560 an ounce to an intra-day low of somewhere near $1,330.

The analysts at Goldman Sachs who last week put out a bearish forecast on gold must be sipping champagne, eating caviar and demanding a pay-rise. Yours truly, meanwhile, has been dining on crow.

The question we must now ask ourselves is: is it time to get out?

What drove the gold crash?

Almost everything fell on Monday – commodities across the board, stock markets, US Treasury bond yields. This signals that another bout of deflation may lie ahead. But all eyes have been on gold.

It’s estimated that some 400 tonnes of gold – almost 13 million ounces – were sold on Friday alone. That’s about $20bn worth.

To put that in some kind of perspective, that is more than the entire holdings of the Bank of England, which are just shy of ten million ounces. (Even after the debacle of the sales under Gordon Brown, we are the world’s 18th largest holder). It’s more than the holdings of Spain, Austria, Saudi Arabia, Portugal or Turkey.

Of course, most of the gold sold on Friday was in derivative or paper form, and the same ounces may have been bought and sold many times over throughout the day, but the numbers are still extraordinary.

Over the past three or four days I must have read more commentary than I would normally consume in several months. One thing that stands out is just how striking the size of this move was.

Russell Rhoads, CFA of the CBOE Option Institute notes that a move of Friday’s scale would statistically only be expected “once every 4,776 years”. Throw in Monday’s follow up on top of that, and “let’s just say the sun is expected to burn out” before it ever happens again. Similarly, John Kemp of Reuters calculates that, based on a normal distribution, movements like this can be expected once in every 500 million trading days, or two million years.

Of course, we all know that statistical models of markets are horribly flawed – the 2008 crash taught us that, if nothing else – but they do go some way to showing just how exceptional the action has been.

Newsletter writer Dennis Gartman commented: “We shall confidently say that we will never, ever see a day such as we saw yesterday in the gold market in our lifetime again… [The day’s] price action will go down in history as an aberration of truly historic proportions”.

It seems the entire gold investing world was watching the $1,520 area that I’ve been harping on about for over a year and, as soon as it broke, we got a waterfall of selling. But nobody yet seems to have found a satisfactory answer as to why.

Last week’s news that Cyprus might be forced to sell its gold (a mere 13 tonnes) into the market certainly contributed to the nerves. Would Portugal, Greece, Italy or Spain be forced to do the same? What effect would that have? The gold price started to slide. The slide – as slides can do – accelerated. That $1,500 area was highly significant psychologically and, as it broke, the herd stampeded. This snowballed as a chain reaction of stop-losses was triggered. 

That’s one explanation. There are other more conspiratorial offerings, which we won’t go into here.

In any case, the question I’m sure many of you will be asking is: did I sell my gold? The answer is no. The market moved too fast for me and by the time it settled, I was not happy with the price. I’m going to wait, watch and re-assess.

Gold is in a bear market now. We must ask: ‘how much further will it fall?’ and ‘for how much longer will it fall?’

How mining costs could prop up the gold price

It’s possible we have already seen the low. Some heavyweights think so. Gartman – who is never shy to be negative about gold, if he sees fit, has “a very, very strong belief that the low in spot gold at or near to $1,338 shall not be seen again in a very, very long while … it appears … that the bear market that began in gold nearly two years ago when gold in US dollar terms traded very near to $1,950 an ounce has run its course.”

Perhaps he’s right. It’s hard to see how gold sentiment can deteriorate any further. Should gold fall further, I see some support at $1,225-$1,250 and very strong support just above $1,000.

If we do go that low, I don’t see how it can be for long. Here’s why.

The average all-in cost to produce gold – ie the cost per ounce of finding, developing and building a mine as well as actual production – is widely believed to be somewhere in the $1,200-$1,400 range. On this basis, TD Securities’ David Bouckhout points out that “some 15% of gold producers would now be underwater on an all-in cost basis”.

But if you look at the 2012 numbers for the senior producers, a worrying picture emerges. All-in costs are higher. In 2012, the average price for the sale of mined gold was $1,650. At $1,650 gold, as Mark Mahaffey of Hinde Capital notes on his blog, Barrick was left with free cash flow of minus $930m (yes, minus!), Newmont with minus $838m, Goldcorp minus $511m, Kinross minus $623m, and Yamana minus $379m.

If costs really were $1,200 to $1,400 per ounce, as is widely believed, those companies would, at $1,650 per ounce, Mahaffey notes, see free cash flow. They don’t. What kind of cash flow will they have with gold now below $1,400?

Miners dealt with previous downdraughts, where price fell below productions costs, by hedging. Hedging, of course, depressed the gold price – but the option is not available to them as it once was, because the same credit is not available in the commercial banking sector. The mining industry is going to have to deal with this by halting operations – which will shrink supply.

I know that the gold price is not as sensitive to new supply as other commodities, because it is hoarded not consumed. But there is only so long it can trade at a price below its annual cost of production.

That said, I suspect it will be some time before the market gets over this event. Too many people will have lost too much money. The reverse avalanche of short-covering that you might have expected has hardly happened.

Yes, gold was up by $35 yesterday, but that is nothing in the context of the bigger move. Eventually, I would expect any recovery rally to at least re-test that $1,520 area.

This may be a period like 1975-6 when gold lost 50% of its value over two years, then resumed its bull market and zoomed to all-time highs in 1980. Or this may be gold’s 1987 moment – just as the Dow and FTSE were almost inexplicably washed out before resuming their multi-year bull market, so might the same apply to gold. We shall see.

I have held my gold too long to be panicked out of it just yet. Sell rallies, if you see fit, but selling below $1,400 makes no sense to me.

Finally, I had the great pleasure of speaking at the Investor’s Show on Saturday with Nigel Farage of UKIP, who, I discovered, was a metals trader for 20 years. I was very interested to learn that Farage is convinced that gold will have a role to play in our systems of money in the future. If it does, it will have to be at a much higher price than we’ve yet seen.

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