After a dismal 2013, both gold and silver gave metal investors some hope with their optimistic bounce at the turn of the New Year. As of this writing, both the SPDR Gold Shares (NYSEARCA:GLD) and iShares Silver Trust (NYSEARCA:SLV) are up over 2%. Not a bad start to the year. But will this continue or is this just a dead cat bounce?
Let's first discuss how horrible of a year 2013 was for those who were long gold and silver. The returns were dismal; gold fell 28.83% in 2013 and silver fell 35.90%. Respectively, for those invested in related ETFs, SPDR Gold Shares fell 28.83% in 2013 and iShares Silver Trust fell a whopping 37.47%. This horrendous annual return is only matched by gold's 32.76% plummet in 1981 (source).
I'm an optimist and, though I trade both gold and silver on both the long and short sides of the trade, I truly am hopeful that gold and silver will spike in 2014, washing out their 2013 plummets.
Based on historical data, however, this is unlikely for gold. As we look at the annual returns of the yellow metal throughout the last century, after a significantly poor year, gold doesn't snap back the following year as some might assume. In fact, historically, after an annual return of -20% or more, gold returns an average of only about 2.75% the following year. To offer some examples, after gold's 1975 return of -24.20% the metal returned -3.96% the following year (1976), after gold's 1981 return of -32.76% the metal returned 11.75% the following year (1982), and after gold's 1997 return of -22.21% the metal returned 0.57% the following year (1998) (source).
So, not to take the wind out of gold bugs' sails, including myself, but historical statistics suggest we may see a lackluster year in 2014. Silver may be a different story, as the metal could rise not only on stabilizing precious metal demand but industrial demand as well, but we're going to need to see some serious economic growth for that to happen, and I don't think we're there quite yet.
So why have we seen such a strong bounce in gold and silver the first couple trading sessions? My answer: taxes.
If you sold gold or silver in late 2013 and repurchased at the turn of the year, nice work; welcome to the club of investors who know that often times reducing your effective tax rate is, in fact, your best investment.
Here's a little more detail for the non-tax pros out there: Investors who were long gold or silver throughout 2013 lost money. But selling that losing position before the end of the year allows them to write off that loss on their 2013 taxes. Alternatively, holding that losing position and selling any time after January 1st, 2014 means they do not get to write off that loss until the following year. So, though these investors missed out on the small overnight climb prior to the market open on January 2nd, 2014, they will surely end up with a far better financial gain having sold before the year's end. And, in turn, the tax benefit of writing off this loss on their 2013 taxes and reducing their effective tax rate will far outweigh that small percentage bounce we saw at the turn of the year.
Similarly, and though the full discussion is beyond the scope of this article, it is worth noting that, opposite of gold and silver, the S&P 500 has seen a bit of selling pressure in the first couple trading sessions of the year. In my opinion, like the metals, this is due in part to similar potential tax advantages. It is likely that some investors who were long S&P 500 equities in 2013 decided to hold off on selling until the turn of the year in order to avoid reporting that gain until the following tax year. More on the 2013 S&P 500 return and what I anticipate in 2014 can be found in a previous article of mine, My Portfolio Returned 38.29% This Year, Here's What I'm Doing For 2014.
So, again, though I would be ecstatic if gold continued its climb, it's likely that the turn of the year bounce was largely due to those who sold and repurchased for tax purposes. And as much as I want gold to reclaim its lost ground, bearing some unforeseen monumental event, I expect we will end 2014 with a modest, 1% to 4% return. Silver, on the other hand, could see a continuation of this climb if, as mentioned, industrial demand for the metal increases as a result of economic growth throughout the year.
The good news for both metals is that investors did, in fact, choose to repurchase after selling at the end of 2013, and this could be a sign of regained confidence in the metals. Again, this repurchasing effect is shown by the bounce we experienced in the first couple of sessions.
We actually saw a bit of a hammer candlestick pattern for both gold and silver on the last trading day of 2013 (highlighted in yellow on the graphs below) as well. A hammer candlestick pattern along with strong volume is often seen by technical traders as a short term bullish indicator and generally shows us that, though significant selling pressure existed throughout the session, at the end of the day, there were more investors willing to buy than willing to sell.
As such, what the December 31, 2013 trading pattern of gold and silver suggests to me is that, as mentioned, investors were liquidating their positions for tax purposes but there was enough buying interest at those low levels to bring the metals back up and keep them from closing beneath key support levels.
So what do we do? Investors may have sold for tax purposes but then possibly repurchased their positions at the turn of the year. So what?
Well, I believe, if nothing else, this shows us that the bottom is probably in for both metals. The level that was tested for each metal on December 31st, 2013 was the same level that was tested after the six month landslide that ended this past June. This, in turn, means that gold and silver may have established a double bottom trading pattern, generally a sign of strong support.
The daily charts below, of SPDR Gold Shares and iShares Silver Trust, offer us an illustration of this support.
At these levels, both metals are offering an enticing "reward" for an all but insignificant amount of "risk".
As such, here's how I would trade it:
Buy gold and/or silver with a stop loss at their respective support levels. If the trade turn on us and the respective metal falls back below its support level ($115.00 for GLD and $18 for SLV), sell and walk away with a small loss.
If we look at the potential "reward" being the previous, 2011 high of each metal, our risk to reward ratios are as follows (illustrated by GLD and SLV):
SPDR Gold Shares: Our downside risk (from its current value to our stop loss at the $115 support level) is about a 3.60% loss while our upside potential (from its current level to its previous high at $180) is about a 50.89% gain. That's a risk to reward ratio of about 1:14.
iShares Silver Trust: Our downside risk (from its current value to our stop loss at the $18 support level) is about a 7.31% loss while our upside potential (from its current level to its previous high at $47.5) is about a 144.59% gain. That's a risk to reward ratio of about 1:20.
And if you consider leveraged ETFs, these risk / reward ratios can get even more interesting.
In summary, history suggests we may see a flat year for gold in 2014 and possibly the same for silver. But if 2013 has proven anything, it has proven that no person or statistic really knows where gold and silver will head tomorrow. So we just have to trade the metals with our risk to reward ratios in mind; with exit strategies on both sides of the trade. As such, I think both metals are offering a very enticing entry point at their current levels.
Disclosure: I am long AGQ, . 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.