Gold's Role Reversal

Gold has staged a spectacular rally over the past few days and there are a few important things to note:

1. The precious metal bounced after dipping below $700
2. On Thursday gold strengthened alongside the dollar. Friday then saw a massive jump with follow through buying today.
3. Gold's role has reversed from safehaven focus to dollar focus - it has been rallying along with the market.

Role Reversal

As the crisis unfolded, it was common to see gold strengthening alongside weakening equities - now we are seeing the opposite. Why? Well simply because we are not rallying on fundamentals but rather the prospect of government bailouts. In other words, the markets are only being supported through inflation. Another inflationary development over the weekend saw several OPEC members calling for massive production cuts to support the price of oil - another positive for gold. All of this has led to a massive rally in gold.

Gold Shares

Gold mining shares have significantly underperformed gold year-to-date. In my opinion this is largely a reflection of the massive run-up in energy prices - a major input in the mining process. With the gold/oil ratio back to a justifiable ratio, gold shares may have a lot of room to run here, should gold continue up.

click to enlarge images

However, there are a few things to take into account here. Firstly, should gold rise for the reason of a weakening dollar, global bailouts and currency debasement, then oil should rise as well for the same reasons. Oil also has another non-market force - OPEC. These guys are going to do whatever possible to support oil prices. Then there's the general theme of risk aversion and the pressure that it puts on equities and the fact that many gold miners are debt burdened. If you choose to pursue the gold miners, do your research.

Gold Miners Hedge Books

There has been a lot of de-hedging going on and the following chart, courtesy of timingcharts.com, shows what's been going on with the gold producers' (commercials) hedge books. The commercials (who are almost always short), are less short than they have been for a long time. In other words they are bullish.

At the height of the gold bull market, commercials were VERY short. When the World Gold Council released its last quarterly report, it was obvious why they were so short - Gold demand was down significantly. Obviously the gold producers have extra insights into demand patterns. When the World Gold Council released the most recent quarterly report, demand was back on the rise again (mostly due to retail investment demand) and the trend in global de-hedging over the past few months reflects this insight.

As you can see in the chart above, the past few times that the commercials held such small short positions, the market rallied.

Back to Inflation/Deflation

I have been arguing for gold to come down significantly as its purchasing power over other real assets had increased significantly. I first made this argument with gold in the high 800's and when the precious metal failed to break 700 I largely abandoned the position from a trading perspective. I am now more neutral - indecisive is a better word.

Bloomberg reports that the Fed has pledged $7.4 trillion thus far, that's enough to scare anyone shorting gold and should also be enough to avoid deflation. James Hamilton argues that the Fed doesn't need to worry about deflation because they can simply continue to inflate.

I have also been arguing about the existence of a liquidity trap where the Fed pumps money into the banking system but the banks don't lend it out. According to TradeTheNews, the Telegraph reported that the UK Treasury officials may be mulling draconian laws which could limit the interest rate charged by banks. That's one possible solution, but I don't see the U.S taking similar action. They will try to monetize the credit that they are pumping into the system but they are more likely to do so by monetizing government debt. By buying long term government bonds, the Fed is ultimately printing to cover the expense of the bailouts. Obama's proposed stimulus focusing on infrastructure, alternative energy and modernizing public schools will likely be the way that this credit makes it out to the markets and gets diluted in the pool of fiat money. They can continue giving money to banks, but anything short of the strategy suggested by the Telegraph will likely not result in the monetizing of that credit.

Conclusion

For now I will remain somewhat neutral but watching closely for year end swings. As Ashraf Laidi points out, we could expect to see seasonal reversals heading into the final stretch of the year. The prime candidate for such a reversal is the dollar and the catalyst could very well be the automakers. The story of the past few months has been the rest of the world weakening to catch up to the U.S. Now it may be America's turn to take the lead again as we head into what could be a disastrous holiday shopping season. How gold will respond to these events remains to be seen, but it will surely be a volatile ride.

Disclosures: Author holds OTM gold calls

Comments

[Smarty_Pants:]

Precious metals, the dollar, and US debt are pretty much the only bull markets in town and of those three only the precious metals have the fundamentals to continue upward in the long run. US debt and the dollar will head down eventually as soon as everyone realizes that the FED is going to keep printing until the ink runs out.

Get gold and silver. Buy the dips, trim down on the rallies and build a position. When all the newly created money eventually works its way into the economy you will be glad you did.

The fact that Adam is objective enough to reassess his previously held opinions and conclude he might have been in error speaks well for his approach. Soon enough he will realize that the gold bull market is still intact and about to resume in earnest.

I may be a bit early, but welcome aboard Adam.

2008 Nov 25 09:13 AM

[leh:]

Agree with pants that gold is looking better by the day, especially the mining stocks. Go look at charts of CDE and SIL to see how badly beaten the silver miners have been. CDE printed .30 a share last week, so a half dozen shares cost less than a medium cappacino at Starbucks. Anyone not at least nibbling hard here is insane IMO, especially give the Fed's admission that the only solution they see is a massive injection of liquidity.

2008 Nov 25 09:26 AM

[Adam Katz:]

Smarty Pants,

I was expecting a quick response from you!

The truth is I am sincerely neutral. If I was living in the U.S I would convert a lot of my cash into gold, but as a Canadian I still find gold expensive in CDN dollars. I'm definitely not looking to go long with leverage like I did last time gold was at $700.

What I can tell you is that in my time working as a trader I have learned to put aside my personal beliefs and to not try to fight the market. There may very well be gold buying hysteria down the road (whether I think it's fundamentally just or not) and as a trader I hope to catch on to a piece of that. Mark my words though, at some point gold will have a 50% drop as the frenzy comes to an abrupt halt and the bubble bursts - but that may very well be from $2000 down to $1000.

As Jeremy Grantham calls it, it is the curse of the value manager. You get in too early and out too early as market swings will usually swing past fair value. I do think gold is overvalued relative to other real assets at the present time, but that doesn't mean that it won't be higher in the future.

2008 Nov 25 09:35 AM

[moonbat1775:]

"the Telegraph reported that the UK Treasury officials may be mulling draconian laws which could limit the interest rate charged by banks."

Who says it's the interest rates that are deterring borrowing by the credit worthy? Now would seem the time to ramp reserve requirements to a permanent 100% and let the market set the interest rate.

2008 Nov 25 09:41 AM

[Smarty_Pants:]

Sadly I am forced to keep score in US dollars. I believe gold will hold value better than dollars over the long run given the huge increases in the monetary base of late. Even ink and paper are no longer limits on creating money these days.

In the near term, the current rally may only last a few weeks before fizzling out. I'll be watching the price action to see what I can deduce in that regard. I will be surprised to see a huge upside move before a higher low is put in above the recent bottom. The market has yet to gather itself for a really big run even if it is firming up a bit.

My approach is still mainly to trade the swings and use portions of profits to add to my pile of physical. I added to my GLD call position around $730 and am approaching strike levels now. I will likely 'lighten up' when the current rally shows signs of stalling. If gold surprises and runs up to $2000/oz I will be able to afford an immediate retirement.

So far, so good.

2008 Nov 25 09:52 AM

[Dean Plassaras:]

One postive aspect for gold lately is that many money managers recommend a small, albeit higher than past, gold allocation in their investment portfolios. John Hathaway of Tocqueville Funds said that if the current 2% institutional investment allocation increases to 6% there will be a sea change for gold price. Very reputable investment firms in Asia have been recommending up to 30% gold allocation for their institutional clients and most investment advisors in the US think at least a 10% allocation to be reasonable.

2008 Nov 25 11:00 AM

[ZurichGnome:]

Check also GOFO rates, negative on some short term maturities. A good sign of demand for the metal.

2008 Nov 25 02:02 PM

[nevket240:]

$$ lovers should ask why Merrill & Morgan are shorting Gold mining stocks and becoming substantial shareholders after driving the stock prices into the ground. Maybe they are closet "bugs"?? Or are they looking to throw away some of Paulsens Largesse??

regards

2008 Nov 26 11:31 PM

[DollarTalk:]

I am very thankful for the blessings that I have in my life. Now, regarding the market, the power of optimism never ceases to amaze me. In fact, we are missing a very large component of our view on the market and the economy in larger view when we discount the role of perception. Most of this market volatility was brought on by increased uncertainty and the perception that our credit crisis and financial difficulties were beyond our ability to solve as a free market. This, of course, was exacerbated by the media and capitalized on by the media in order to accomplish the election of now President-elect Obama. Now, the media has their man and would do well to continue to promote positive, uplifting views on the future direction of the economy and the solutions and people proposed by President-elect Obama. Otherwise, they will find themselves in the company of the Republican party when the public develops a pessimistic or negative perception of the new President and his leadership team. That's all for now. More on my blog.

2008 Nov 27 01:52 AM

[Natalie Le:]

Go buy Superfund gold funds. They're up 17-20% ONLY IN NOVEMBER. Their other funds are up 33-70% YTD.
The MD said gold is gonna double to $2000 coz of hyperinflation.
www.youtube.com/watch?...

2008 Dec 03 02:58 AM