Gold: Yes, It Will Drop. No, Don't Short It.

Includes: GLD, SGOL
by: Nicholas Jacobs

I agree with my Seeking Alpha colleague (writing under the name "Macro Investor") that gold prices should move down in 2013, though I do not find all of the five reasons in that article compelling. For example, the increase in expected supply from mining, while real, is tiny compared with the amount of gold trading. Gold mine supply is forecast to rise by 3.4 million ounces in 2013 compared with 2012, whereas the average daily volume of gold traded in London alone was 19.3 million ounces in November 2012.

And the "falling" gold demand in China seems to have been a statistical blip. It's true that imports were down in October 2012, to 47 tons, but they shot back up in November, to over 90 tons (chart from

Source: Zero Hedge

On the other hand, I would add a sixth reason to expect a correction in the gold price: it has moved up every year for the last 11 years (chart from

To my knowledge, this is unprecedented. We have seen bull markets that lasted for more than 11 years, but not without a correction that brought at least one down year. There has never been a bull market in any commodity that went up for 12 years with not a single down year. Now, it's always possible that "this time is different." But people who believed that "this time it's different" in the financial world generally ended up broke. I do not think this time will be different. I expect the gold price to correct in 2013, simply because it has moved up so far and for so long without a break.

However, profiting from a correction in a long-term bull market is a very tricky business, involving several difficult decisions. As I write, gold for February delivery is trading at $1675/oz, having risen from $1652 in the last few days. If you open a short position, at what level do you set your profit target? What would be your stop loss? Do you trade without a profit target, using a trailing stop? How long are you prepared to leave the position open? Without good answers to these questions, you cannot rationally short gold. If you're using futures contracts, you have roll costs every couple of months, and if you borrow gold to sell it, you have interest costs. Either way, it costs you to leave the position open. You can short stock in a gold mine as a proxy for the gold price, but mining companies are not good proxies for the gold price.

Because of these issues, shorting gold is not advisable for the individual investor. It is difficult to select promising parameters for the trade, and the risk is that the long-term trend will resume while the short position is still open. A better way of profiting from the correction is to use it to establish, or increase, a long position.

Why The Long-Term Trend Will Continue

In the long term, the gold price is driven by strong underlying factors that cannot easily be reversed, and the bull market will resume. Readers of Seeking Alpha will be familiar with the statistics on government debt -- the only recent change in the picture was the agreement by the U.S. Congress to reduce the annual deficit by a tax increase expected to bring in $62 billion/year. The deficit is over $1 trillion/year. The euphoria that swept through stock markets was mostly irrational: the tax increase has negligible effect on the budget deficit. It's literally smaller than the rounding error -- the deficit is actually $1.089 trillion, not exactly $1 trillion. European countries are mostly in even worse shape, and Japan is a lot worse. The accumulated debt of the U.S. government exceeds $14 trillion, and when interest rates rise again, the interest on the debt will increase the deficit further, in a vicious circle that could end in financial collapse.

To avoid financial collapse, the U.S. and other governments have only one course open to them: printing money. This solves the deficit problem, and is not immediately inflationary because deleveraging in the private sector has reduced the velocity of money. The increase in the supply of dollars will reduce the value of the dollar, and this, in turn, will make U.S. exports cheaper, damaging industries in other countries. Those other countries will, therefore, have to play the same game with their yen or pounds, so all paper currencies will fall in value. No country will want to preserve the value of its currency. Even Switzerland, for decades a sound-money country and a refuge from inflation, has been forcing down the value of the Swiss franc to prevent it rising against the euro. In such a world, you cannot preserve your savings by holding money in a bank account, CDs, or T-bonds, in any national currency -- they lose value faster than they earn interest. You must convert your savings into non-money assets. Land and precious metals are possibilities, but land gets taxed in most parts of the world. That leaves precious metals. The conclusion is that at some point in the not-too-distant future, everybody in the world who has some savings will want to convert them from politicians' paper promises to some tangible form, probably gold or silver. When this happens, prices of the metals will rise because most of those people currently own little or none of them compared with their net worth.

Establishing a long position during the correction, using money you will not need for the next 3 to 4 years, keeps you on the right side of the long-term trend. This is one of the situations in which dollar-cost averaging is a good strategy: decide what fraction of your net worth you wish to have in gold, then make equal dollar value purchases at (say) monthly intervals over the next year. You can use an ETF like the SPDR Gold Trust ETF (NYSEARCA:GLD) or ETFS Physical Swiss Gold Shares (NYSEARCA:SGOL). This enables you to build your position at less than the average price of gold, because by converting the same dollar amount into gold each time you buy, you acquire more gold at lower prices than at higher prices. At some point in 2013 or 2014, or possibly both, your gold may well be worth less than you paid for it. But as long as the trend resumes well before you have to sell -- which it will, because of politicians' need to print money -- your wealth will be safe.

Disclosure: I am long SGOL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.