Don't Give Up on Gold Just Yet

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 |  Includes: GLD, IAU
by: Keith Fitz-Gerald

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 (NYSEARCA: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.”

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