A Bullish Case For Gold: Let The Facts Speak

Feb.18.13 | About: SPDR Gold (GLD)

Gold (NYSEARCA:GLD) is now very attractively positioned for traders (and investors) with bullish and bearish positions alike.

Technically, the bulls see a strong long-term uptrend, which is still intact, and view the recent price action (since the peak of September 2011) as a healthy consolidation before the uptrend continues. On the other hand, the bears see the potential bubble in gold with significant downside once the technical support is broken. Thus, technically speaking, both the bulls and the bears are playing a classical bubble-game, which can be notoriously volatile.

Fundamentally, the bearish case for gold is based on a prediction that the global economy has survived the financial crisis, and thus buying gold to insure against the doomsday-scenario makes no sense. The bulls, on the other hand, don't really agree that "we are out of the woods yet," frequently referring to the global currency wars, and the continuing QE by the Fed.

Our research shows more support for the bullish case for gold based on the two facts, one fundamental and one technical. First, fundamentally, the Federal Funds futures are currently predicting that the Fed will increase the interest rates to 50 basis points in May of 2015! (Figure 1) As early as December 2012, the prediction for the Federal Funds rate in May 2015 was only 30 basis points (Figure 2), which is not meaningfully higher from the current level of 14 basis points. Essentially, the Federal Funds futures imply no real end in sight for the current crisis over the next 2-3 years, and that's a fact. Yes, the chart in Figure 1 looks steep, but selling gold now, based on the possibility of "baby-step" increases in interest rates 2-3 years from now, does not make much sense. Technically speaking (ignoring the fundamentals), the long-term chart of gold futures resembles a rising bubble, which has not peaked yet. History shows that bubbles usually end in panic buying and exhaustion, followed by a bubble bust. The price of gold has been consolidating for last 18 months since the peak, and that's also a fact (Figure 3). Thus, we did not have a classical bubble top in gold, which will likely occur at much higher prices.

In summary, fundamentally the bull market in gold still has room to run, strictly based on the current economic forecast embedded in the Federal Funds futures. Technically, the gold bubble has not peaked yet. As a result, we believe that gold is about to enter the last stage of a long term bull market, possibly characterized by a parabolic rise. The return to risk-on strategies will have negative consequences for the broad stock market (NYSEARCA:SPY) as well.

Our specific recommendations:

We suggest that traders buy longer-term call options on gold futures or GLD. Specifically, we are looking at Dec 2013 call options on gold futures, strike prices 2200 and 2300. These options cost $610 and $320 per contract, respectively (as of Feb 15th). This is not only a directional bet on rising gold prices, but also a bet on the rise in volatility, which is at near record low levels, based on the gold VIX index. Thus, even a bounce of gold prices to the resistance level at around 1800 would likely triple the prices of these call options as the volatility increases. We are looking specifically at Dec call options to minimize the risk of premium decay due to time expiration. This strategy also has a predetermined maximum loss in case we are wrong, which is desirable in a bubble-like environment.

Figure 1. Federal Funds rate implied from Federal Funds futures (source CME).

Price Rate
February 2013 99,86 0,14
March 2013 99,86 0,14
April 2013 99,86 0,14
May 2013 99,86 0,14
June 2013 99,86 0,14
July 2013 99,86 0,14
August 2013 99,86 0,14
September 2013 99,86 0,14
October 2013 99,855 0,145
November 2013 99,85 0,15
December 2013 99,845 0,155
January 2014 99,84 0,16
February 2014 99,83 0,17
March 2014 99,82 0,18
April 2014 99,81 0,19
May 2014 99,795 0,205
June 2014 99,785 0,215
July 2014 99,77 0,23
August 2014 99,745 0,255
September 2014 99,725 0,275
October 2014 99,705 0,295
November 2014 99,675 0,325
December 2014 99,66 0,34
January 2015 99,635 0,365
February 2015 99,59 0,41
March 2015 99,56 0,44
April 2015 99,535 0,465
May 2015 99,505 0,495
June 2015 99,475 0,525
July 2015 99,45 0,55
August 2015 99,4 0,6
September 2015 99,365 0,635
October 2015 99,33 0,67
November 2015 99,275 0,725
December 2015 99,235 0,765
January 2015 99,19 0,81
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Figure 2. Federal funds futures - the Fed rate equals 100 minus the price (source CME)

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Figure 3. Gold futures prices (source CME)

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.