The price of gold has dropped below $700 an ounce, and that has a lot of people in the precious metals community puzzled.

After all, isn’t gold supposed to be a safe haven in times of financial depression and panic?  And if these aren’t times of financial depression and panic, what are?

After all, every country in the world is busy running their printing presses to fund bailouts and fight deflationary forces.  Gold should be on its way up, not down.

If you want to see a good article on the topic, there is some nice coverage here on Marketwatch

Gold futures hit a historic high above $1,000 an ounce a few days after Bear Stearns was taken over by J.P. Morgan Chase & Co. on March 14. But in the recent round of crises triggered by the collapse of Lehman Brothers Holdings Inc. gold has fallen to below $700 for the first time in 13 months. The metal has so far lost nearly $170 this month.

The reason, according to analysts at the World Gold Council, is that the latest bout of the credit crisis has been deeper and more far reaching. Funds were forced to sell desired assets such as gold to meet margin calls, while weakness in European economies lifted the U.S. dollar, which then pushed dollar-denominated gold prices lower.

This decade has seen an amazing boom in investment tolerance for non-traditonal asset classes.  People freely talk about how different new investment assets have a “low correlation” to the stock market.  Real estate, commodities, rare coins, art, collectibles, long/short funds, you name it.   As a result, across the world, trillions of dollars are now factored into different asset classes, prudently distributed to minimize risk and maximize reward.

This would all be fine except for one thing.  And it’s the one thing that more than anything led to LTCM’s demise.

That one thing is that all of these great measures of risk are based on historical records.  And as all mutual fund prospectus readers know, “past history is not necessarily indicative of future performance.”

You see, you can take two things that historically have not been correlated.  Asset A & Asset B.  But the minute that an investor owns both A & B, there is now a correlation that didn’t exist historically.  The investor is that correlation.

If Asset A goes down, and the investor needs to sell something, they may now turn to Asset B for liquidity.  And that means selling pressure for Asset B, based on nothing but the asset price of Asset A.  Voila, correlation.

Gold didn’t used to trade like a stock in an ETF that anyone could buy.  It was expensive, hard to store, and was distributed through inefficient, clumsy channels.  It was diversified from other investment classes because it couldn’t be bought & sold easily like stocks or bonds.

Now, buying a Gold ETF is trivial, and can be done for less that $10 a trade with very little spread.  In fact, many commodities can.

All of a sudden, in this market, people are realizing that the investors are the correlation.  And that correlation is much stronger than historical analysis would suggest.

Not to get to gloomy, but re-reading my August 2007 post, I caught this somber realization:

What’s worse, those historical models lead investors to believe that they have less risk on their books than they do have, which leads rational investors to introduce leverage into their portfolios.  That means when the risk shows it’s ugly head, the results get magnified by the leverage of loans.

That’s what happened to LTCM.  Their models were excellent, but they were based on historical correlation.  The minute some of their investments turned the wrong way, their incredible leverage forced pressure in previously uncorrelated investments.  What’s worse, other investors, smelling the “blood in the water”, discovered this new-found correlation, and pressed trades against them.

So, this scares me a lot, at least intellectually.  There are very good reasons why major investors like hedge funds and other asset managers can’t share their up-to-the-minute holdings.  That means, however, that no one really understands this type of “co-investment risk” that is building in mass across the markets.  Unfortunately, the only way I can imagine to properly handle this risk would be to have a universal monitoring set up to accurately reflect this new type of correlation from mass “co-investment” across assets.

Ugh.