Don't Give Up on Gold Just Yet

If you were counting on gold to boost your returns this year, chances are you’ve been cruelly disappointed. In fact, when it comes to gold-related investments, virtually every category is down, making this one of the worst years in history for gold investors.

So, why is it that the largest of the large futures traders have some of the lowest net short positions in years? And what does this tell us about gold prices in the near future?

I’ll get to that in a minute. But first …

What Went Wrong?

In my analysis, I’ve identified the three missteps most investors made. First, investors did what they’d been told to do. But in their panic, they flocked to gold on the assumption that the yellow metal would perform as advertised. They forgot the “safety first” strategy that we’ve emphasized this year – one that included a safer, more-conservative way of buying gold.

Strike one.

Adding insult to injury, very few investors (Money Morning readers aside) understood that the massive “de-leveraging” process that’s been part and parcel of the global financial crisis would put downward pressure on virtually every asset class at the same time. And that includes gold. As we’ve seen in the last few months, during times of global panic, investors around the world want the safety of U.S. dollars – and a lot of them – even more than they want gold right now.

Strike two.

But above all else, most investors failed to realize that gold, just like any other asset, produces the best returns when it is attractively priced. So most investors made the classic mistake of piling in on the basis of performance. In other words, they bought in at the top.

Strike three.

What’s Changed?

During times of crisis, investors have been taught to latch onto those asset classes with the highest relative stability – including gold and precious metals. More often than not, investors who have followed these time-proven practices have been handsomely rewarded for doing so.

This time around, however, the parameters have changed, as the increased use of such “derivative” securities as “credit default swaps” has exacerbated the fallout from the global financial crisis, and touched off the aforementioned de-leveraging process. As asset markets have melted down, hedge funds, financial institutions worldwide, and even government-controlled sovereign wealth funds have taken heavy losses, forcing them to deal with unprecedented margin calls and redemption requests. Because this has never before been part of their crisis-management process, institutional investors have engaged in a massive, concerted effort to sell anything that’s at all liquid – including gold.

Making matters worse, the so-called “carry trade” unwound with a vengeance, forcing offshore investors to buy U.S. dollars in order to offset the sell-off of dollar-denominated assets. In contrast to what you’re hearing on the news, this really is not a sign that the dollar is any stronger than other currencies. Instead it signifies that the greenback is still the global currency of choice – much to the chagrin of Russia, Venezuela and others who begrudgingly tie themselves to it.

It also highlights something that most investors forget, or perhaps never knew in the first place. For better or worse, the dollar is the most liquid of the world’s reserve currencies. Part of that’s because many assets – especially oil – are still predominately traded in dollars.

The problem is that the dollar’s healthy appearance may be just that – an appearance that covers up an inner ill health. These still-hidden maladies have been worsened by the recent machinations of “Bailout Ben” – U.S. Federal Reserve Chairman Ben S. Bernanke – and U.S. Treasury Secretary Henry M. “Hank” Paulson Jr., whose fix-it programs have created a financial Frankenstein that will chase American taxpayers for years.

When the dollar was rallying back in May, and many experts were lauding the move as a turnaround in the making for the long-languishing U.S. currency, we warned investors not to be taken in by the market’s head fake. There were just too many underlying problems for the dollar’s rally to be sustainable. Ultimately, that rally sputtered, and the dollar reversed course and continued its decline.

This time, we again suspect that the dollar is rising too far too fast and that the spike we’ve seen in recent months may be nothing more than a flameout in the making.

However, given the relationship between the greenback and the yellow metal, this leads us to believe that gold could move higher next year if investors lose faith that the dollar merits their nearly exclusive attention right now.

Two pieces of closely related information appear to support this theory:

First, even though gold prices have tanked – a reality that under ordinary circumstances would mean more supply is available – dealers of gold bullion have experienced widespread physical shortages during the third quarter, according to the World Gold Council, a top trade association for the gold-mining industry. That, in turn, led dealers to both charge more and pay more than the spot price would indicate. Particularly strong demand was noted in China, India and the Middle East.

According to a Nov. 19 press release, the World Gold Council also noted that identifiable investment demand for gold in the third quarter was up $10.7 billion to 382 tons – double the levels of a year ago. At the same time, retail investment demand rose 121% to 232 tons, especially for gold bars and gold coins as reported in the Swiss, German and U.S. markets.

At the same time, the SPDR Gold Trust (GLD) – the largest exchange-traded fund (ETF) that invests in the yellow metal – noted that it now holds 755.06 tons of gold in trust, up 6.12 tons from the prior week. This is significant because authorized market participants like GLD have to add metal and increase their trading float when buying pressure is higher than selling pressure. This suggests that gold may be reaching the end of its downside run and that it may behave more like investors expect it to in the months ahead.

Second, we find it especially interesting that the largest of the commercial futures traders now hold the smallest net short positions they have held in several years. According to the U.S. Commodities Futures Trading Commission (CFTC), large commercial traders' combined net short positions reflect only 71,116 contracts net short, one of the lowest net short positions the CFTC has reported since January 2006.

Historically, low net short positions have proven to be bullish influences. And net short levels of less than 30% total open interest have proven to be especially bullish.

The wildcard here, of course, is that the markets are working through a de-leveraging process that’s far from over, meaning that normal supply and demand relationships are out of whack. Longer-term, however, everything we know about those relationships still appears to be intact.

That’s why we suggest that investors make gold a part of their investment program – if for no other reason than we are approaching levels typically associated with higher, rather than lower, returns.

But we can’t just pile in.

Short-term market conditions will transform anything other than a measured approach into a hazardous foray.

That’s why, when it comes to gold, we’ve repeatedly recited the market mantra: “Gold works over time, but not all the time.”

Original post

Comments

[JudeJin:]

gold corrected 30% from its top in march. what's the big fuss about this?
isn't this a very normal and healthy correction or not? the correction offered investors a once in a generation opportunity to load up the gold mines.

the irony in the depressed gold price lies in that one of the poorest countries in the world, a former british colony, a third-world country, india, is the biggest consumer of this sparkling precious metal!

2008 Dec 02 09:28 AM

[BrunoT:]

One of the worst years on record? You sure about that?

The YTD return shown for GLD at yahoo.com was positive 3.17% until yesterday's drop off.

Then compare that to how much oil an ounce of gold will buy you. Nearly twice as much! By that metric gold is way way up.

Then compare an oz of gold to the dow. The ratio went from something like 15-1 to 10-1. So again, way way up. The Dow is down over 40%. Gold isn't.

An oz of gold also buys more house, more pickup truck, and even more agricultural commodities than it did a year ago.

Sounds to me like it's serving its role as a true store of value. Unless one went "all in" at $1,000/oz it wasn't a bad year at all.

2008 Dec 02 09:44 AM

[GMiki1:]

I haven't lost money in gold. Gold has performed admirably in a horrible environment.

Even if you bought at $1,000, you'll be very happy with gold over the next few years.

And, by the way, I'd be surprised if the author actually understood the impact of deleveraging before it occurred. Hindsight is 20/20.

2008 Dec 02 01:57 PM

[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 coz of hyperinflation.
www.youtube.com/watch?...

2008 Dec 03 02:52 AM

[sorgmot:]

Gold is a pysical store of value.
It is the best at what it dose.

The United States Dollar (US$) is experiencing a short squese as 2008 progresses. Investors started 2008 believing that all their bets on owning phsical assets with borrowed US$ were going to pay off big. They were wrong. Those investors are now scrambling to sell their physical assets to get US$'s to pay off their debts. Banks are not lending because Physical asset prices are falling.

Lots and lots of individuals and businesses are going out of business and into default.

Huge cutbacks in buying of physical assets are taking place. The USA Government's monetary authorities have engineered the biggest (by thousnads of times) financial collapse in world history. Millions and millions of humans now have no salable assets and no jobs. They face homelessness and joblessness.

Around the world governments are all now cartel owned and operated. Governments are the problem and not the solution. Government desigh is the socialist failure and not the paradise promised. Layoffs are spiraling upward. This is not a time when pretty or hansom pitch persons have any hope of future employment.

So, can any thinking person be suprised that gold has wavered slightly in its upward takoff from 2002?

Politician will stall the adjustments needed by USA businesses and their work forces and by the USA academic institutions and by USA governments and etc..

Now one thinks in decades and not in years. It is now 1938. If we repeat the 1940's with nukes in order to end foreign compotition, we will all be sorry we used taxpayers money to advance science.

Gook Luck.

2008 Dec 03 11:08 AM

[User 30121:]

Damn fine article, Keith! Thanks for enlightening posters. Maybe some will be SMART and buy some gold...and don't forget SILVER! Buy it too!

I

2008 Dec 03 04:13 PM

[jt:]

Strikes one, two, and even three are what happen in somewhat "normal" markets. But that's only ONE out. The second and third outs weren't even allowed in this market. That's b/c the Fed's (and therefore the thing we mistakenly call "our govt"...mistakenly b/c its the banksters who have finally had the curtain thrown back to show that THEY are truly the ones running the govt, just as our Founding Fathers warned) entire "strong dollar" policy, starting with Rubin, was and has been nothing more than suppressing the price of gold (and silver) to prevent most of the public and most of the market from seeing how worthless the little piece of green paper was becoming and to allow them to do what we have just seen them do.

The manipulation of gold and silver on the COMEX, as well as in London to a lesser degree, has gotten to such a blatant level that the only way one does not see it DAILY is to either refuse to look at it, or if one looks at it, to refuse to see the obvious, or if one sees it, refuse to believe what his eyes tell him is happening.

But hyperinflation is on the way, and one way or other, and really, there are multiple roads that will lead to it, the dollar is toast, and gold will fly in dollars ALSO!! Don't forget that gold has been reaching new highs in just about all currencies except the dollar and the yen...the dollar b/c of short covering and the unwinding of / redemption of many investment vehicles denominated in the dollar, and the yen b/c of the unwinding of the yen carry trade. Once those are done, the dollar will plunge and gold will fly also in dollars, if it hasn't already. One possibility of the "already" would be the potential for a delivery default on the COMEX within the next few months.

Buy silver and gold...take possession. There's really no use in trying to convince anyone...the proof will be in the pudding, as they say. But those of you who do understand don't want to be the object of an "I told you so" in the (perhaps not too distant) future. Better to be mocked now and safe later. At worst, you can sell your gold and silver for somewhere near what you paid for it. Now consider the worst that could happen to your paper money--you're not sure?? Well just Google "Weimar Republic" or Argentina hyperinflation. Recession / depression now...followed by hyperinflation...gold is a safe place in both scenarios.

jt

2008 Dec 03 08:11 PM

[Louis Paquette:]

Gold has held up relatively well. It's basically flat over the past 12 months in a market when most everything has been smashed.

This bigcharts.com 12 month chart shows the zero gain. It's the gold stocks which have performed miserably. Look at the ETF overlay - HGU - down over 60%....ouch.

bigcharts.marketwatch....

Hopefully when gold does finally start moving north again the stocks will outperform to the upside as they have done to the downside.

The question is when will this begin to happen. How long do we have to wait. It feels like an eternity right now..

2008 Dec 03 10:53 PM

[Louis Paquette:]

Re: the chart above - the overlay I referred to did not work! Trust me though, both the Bull and Bear ETFs HGU AND HGD are down big time. Which adds insult to injury. The bear ETF should be up.

2008 Dec 03 11:16 PM