2 reasons gold crash is scary

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There seem to be no easy answers in the investing world to explain why the price of gold tumbled Friday and kept falling Monday. Since September 2012, the price of gold has been on a downward trajectory. It hit $1,800 and then meandered down to about $1,600 until Friday. At around noon Tuesday, gold was at $1,377.40 per troy ounce.

“What happened on Friday was the equivalent of 15 percent of the world’s entire mined supply of gold being dumped in a single three-hour window. That was an extraordinary hammering,” says Chris Martenson, CEO and co-founder of Peak Prosperity. “There is no market in the world that can sustain elevated prices under that environment.”

Stocks weren’t unscathed by the trouncing, but that’s not surprising. “Generally speaking, when you get a sell-off in one market, particularly a highly levered market, you tend to see sell-offs in other markets,” Martenson says.

Scary reason No. 1: Fall in commodities can signal deflation

As we all know, the Federal Reserve has been throwing money into the economy by the bucketful, to the tune of $85 billion per month in its third quantitative easing program, or QE3, since January 2013.

“Commodities are usually a sensitive indicator on whether you are in an inflationary or deflationary environment,” Martenson says. “From a signaling standpoint, markets might look at that and say, ‘Oops, liquidity is drying up, deflation is here.'”

Combine that signal with the less-than-great economic data seen over the past two months, and it could mean not-great things — specifically that investors are doubtful the Fed is inflating anything but the stock market.

“The thesis all along is that the Fed is going to force reflation. The problem with that is that price is not believing it, price meaning that which should be sensitive to reflation is not actually doing well,” says Micheal Gayed, CFA, co-portfolio manager of the ATAC Inflation Rotation Fund.

Reflation refers to monetary and fiscal policies designed to fight deflation — for instance, the Federal Reserve’s quantitative easing programs. Deflation is the opposite of inflation. Rather than going up, prices fall, and consumers stop spending.

Typically, when investors are nervous about economic conditions, investments that are less sensitive to the economic cycle do well — consumer staples, utilities, health care and bonds. Investments that are more sensitive to inflation do poorly during those times.

“One would think that $85 billion is a lot of money and would be inflationary and would cause gold to do well and commodities to do well — but it’s not,” Gayed says.

If the economy picks up steam, consumers continue to spend and unemployment decreases, the sudden fall in the price of gold will eventually be nothing more than a memory. On the other hand, if the price of commodities is a barometer for broadly shifting expectations on inflation and the economy lags, that could bode ill for the stock market.

“If suddenly the cyclical trade returns, jobs pick up, growth picks up, maybe this gets resolved positively and favorably for inflation. But as of the end of January, this has been a prolonged period of expectations for deflation. Gold, like every other asset class, is going to react off of that,” says Gayed.

Scary reason No. 2: Computers run markets and crash them

That gold’s crash is a signal of deflation that could lead to a market downturn, and a return to economic gloom is squarely in the worst-case-scenario realm. The reality may very well be more banal.

“This is the bullion banks doing what they do, which is making obscene amounts of money by manipulating markets. I’m using that word carefully and mean it,” says Martenson.

Back in January, giant bullion banks began building big short positions. That means they were betting that the price of gold would go down

“Then in February, they started warning clients that the gold market might be topping. I’d been watching little, tiny test bear raids in the overnight markets where they blast a few thousand contracts into these tiny, thin markets at 12 at night just to see what is happening,” Martenson says.

After introducing a little uncertainty into the market with the overnight rates, they blasted the market and cleaned up with short positions at the bottom.

“That is unfortunately how markets work now. We have completely ineffective regulators on the scene, and even if they were going to try to be effective, what I saw on Friday and Sunday was being driven by (high-frequency trading) computers,” says Martenson.

“When you have these computers ruining these markets, you get these extraordinary swings. Where in the past I think the bullion banks would have shaved $40, $60 or $80 off of the price of gold, it took more than $200 off the price. This is the kind of exacerbated market dynamic when we have these computers,” he says.

Of the two implications, high-frequency trading is the more unsettling to me at the moment. Regulators are outgunned, essentially with a knife at a gun fight, while markets are taken for a ride.