Gold is one of the oldest and most interesting asset classes due to the variables that affect its price. The pricing variables range from the economic laws of supply & demand to the real belief by some people that western governments could or will collapse in the future. To be sure no one person knows with one hundred percent certainty what variable holds the most sway over the price of gold today. Recently, the price of gold just broke $1400 USD and we hear screams that say it could go to $2,000 USD an ounce or perhaps even as high as $5000 USD down the line. Hearing such statements causes us to take pause and become very interested in finding a gold trade but not the one you might think about or the one that anyone wants to talk about publicly.
This asset now holds more than a few red warning flags. From a spectator standpoint watching the price of gold appreciate to $2,000 USD an ounce or higher would be an amazing sight. Still, entering into a “buy and hold” strategy with the gold ETF (GLD) now just doesn’t seem to be worth the risk for various reasons. We actually believe that the better and more interesting gold trade moving forward is to short the GLD via put options once the gold bubble starts to implode.
Geo-political Instability has failed to Deliver Results
Hearing initial rumors about a revolution in Egypt and then actually watching the Egyptian government dissolve should have made every gold investor grin with joy and the price of gold sky rocket. Why you ask? Theoretically when there are justified geo-political concerns investors around the world will start moving money into “safer” assets like gold. The price of gold didn’t really “pop” though after this recent event and gold bug investor grins turned into frowns.
The Egyptian Revolution got started on Jan. 25th, 2011, and ended with the government being dissolved by Feb. 11th, 2011. Over this time period the gold proxy GLD disappointed investors by only adding 1.5% to their bottom line despite the substantial event that took place. This should have been a slam-dunk scenario for gold investors; after all we saw one of the few democratic governments in the Middle East collapse, which also happened to be one of the US’s strongest allies in the region.
The take away point here is that the fear variable relative to geo-political instability now has less influence on the price of gold. Even the idea of Iranian military vessels passing through the Suez Canal barely caught investor attention. Now watching gold prices on the other hand spike because of similar civil unrest in a place like Libya is laughable. Libya, a small member of OPEC, is still a country best remembered for its public sponsorship of state sanctioned terrorism and is still viewed by the international community as a pariah. We feel that it would now take much more than the collapse of the Libyan government to make gold prices spike substantially higher.
The 10-Year Gold Trade
A profit on an investment is never real until you exit the position; otherwise its just paper profits. At this point savvy gold investors who got in 10 years ago are roughly sitting on a return of +435% in paper profits! That is an impressive return but we know that at some point they have to cash out to gain access to their profits. Taking paper profits to the grave isn’t a real strategy nor a pleasurable experience so this is a foregone conclusion on the topic. This is strike two against buying gold exposure with GLD since it is backed by gold bullion, which is where many of the big gold-investing profiteers are. This means investors of GLD are inherently less tenured in the gold trade and at a greater risk to panic at gold price volatility.
When this trade starts to unravel down the road it's likely going to look like the max exodus we saw at the end of the Tech Bubble. Someone somewhere made a lot of money shorting the Tech Bubble and someone somewhere will make a lot of money shorting this bubble. Perhaps that someone might even be you. In our opinion history has the tendency to repeat itself conceptually and to just use different names with different asset classes when it comes to investing.
Attempting to Outsmart Hedge Funds:
Hedge fund legends like George Soros and John Paulson have entered the gold trade through GLD and taken on substantial positions. Professional investors like this have become legendary by successfully staking their careers on such trades and outsmarting 99.99% of the human population no matter what the outcome. It doesn’t take a rocket scientist to understand that trying to outsmart or out trade top hedge fund managers has a high probability of failure. George Soros himself has said the gold trade is a bubble and chances are he’ll be out and swimming in profits before the retail investor ever smells a hint of trouble. We prefer to avoid investment situations where it has less to do with fundamentals and more to do with outsmarting hedge fund managers.
Signs of a Bubbly Future
Often asset classes that turn into bubbles start giving tell tale signs to the investment community long before they ever get close to popping. One indicator of how mature a bubble currently is deals with the amount of media publicity it is receiving. Today all we see and hear are gold ads on the radio, on the TV, Internet, and other forms of media communication. This isn’t a good sign for gold or GLD investors long term. Watching this is the equivalent of seeing a warning "danger" light come on in the gold airplane cockpit in our opinion. Further, when “everyone” is literally in on the same investment and making money that's just another positive “bubble indictor.” It was like this in the last commodity bubble, US real estate bubble, and the tech bubble so we see little reason for it to be different now.
The Call to Action to Make a Profit
Given all the mounting negative variables against gold the trade is to short it via GLD. In our opinion the best way to do this is with put option contracts. We prefer to use GLD put contracts against gold because we realize this an extremely risky trade that involves a lot of variables and want to limit the amount capital at risk.
The key to getting this trade right is timing, which is often the most difficult and treacherous of tasks. No one wants to come early to the GLD shorting party. After all, gold could theoretically reach $2000 USD an ounce or higher in this existing frenzy. We are waiting to see two key indicators that illustrate the gold rally is standing on its last leg and ready to collapse before we take action.
The first indictor is seeing the trade become “exhausted” and failing to capitalize on large bullish events that should take the price of gold higher under normal circumstances. An example of this is seeing the Egyptian Revolution of 2011 fail to take GLD substantially higher in that period. Even with all the political unrest abroad gold prices still haven’t broken the high of $1426 USD an ounce back in December 2010 either. This means that the first indicator to us is green for go right now.
Our second and more important indicator is waiting to see hedge funds like that of George Soros report a meaningful position decrease in GLD through the quarterly position disclosure requirement with the SEC. Due to the size that investors like him have taken there is no option to quickly unload their exposure over a very short period of time. When we see this combined with the other bearish indicator only then is it time to take action and buy GLD put contracts. Hedge fund selling activity in GLD is a crucial aspect to this trade because they are the ones who will get the ball rolling down the hill.
It doesn’t matter how intelligent “smart money” is because it doesn’t change the fact that they can’t just drop their huge positions overnight. This is where the profit potential in this trade starts to really rack up. The big money on the short side of this trade will be made when hedge funds are exiting and non-professional investors are delaying to take action. Instead, they will be like a deer frozen in front of headlights. It’s just a sad reality one always sees at the end of any bubble in any asset class. Investments always involve risk though and at the end there always has to be a loser in order to have a winner.