Recently, I shared my research on the current valuation of gold companies. My primary aim was to show how gold stocks are immensely correlated with gold prices. Readers' interest was high, and extremely defensive. Therefore, after performing due diligence on the spread between gold futures and spot prices, I decided to short gold futures (x10) in European capital markets. While this is an extremely risky move for a long-term investor, I believe it was the right time to do so. Here are 10 reasons why I decided to take this risk:
1) The P/E ratios of gold companies have gone way beyond the fundamentals. The average P/E ratio of gold companies in the NYSE is 72.9, whereas S&P 500 (SPY) companies have an average P/E of 13.61. That reminds me of Cisco (CSCO) shares trading with a P/E ratio of 100 right before the techno-bubble exploded. The world-famous Irving Fisher was also a victim of going beyond fundamentals. Right before the stock market crash of 1929 he stated, "Stock prices have reached what looks like a permanently high plateau." A few days after this statement stock market collapsed, triggering the worst depression in US history.
2) Gold miners reduced, and even in most cases stopped, hedging themselves against an implosion of gold prices. That is an extreme gamble: In case of a collapse, not only will their future profits diminish, but their asset base will also be destroyed.
3) There is an enormous volatility among the ytd returns of gold stocks. While Allied Nevada (ANV) gained 53.21%, Banro Corporation (BAA) lost 35%. The variability in ytd returns gives us another strong sign that the gold stocks became subject to massive speculative movements.
4) Recently Barclays conducted a well-respected survey among several prominent institutional investors. The survey results suggested that gold is expected to be the looser commodity of the year, whereas oil will reach new highs. So far the survey has been right about oil prices as well as gold.
5) The "gold expert" I saw on TV last night claimed that SPDR gold (GLD) was up by 1.5% because of impending demand from Indian bachelors. It is true that India is the largest consumer (32%) of physical gold. It is also true that gold is an integral part of Indian society. However, the claim that the gold price will be driven to insanely higher levels due to young Indian couples to be married this summer is also insane. They have been getting married for decades. Fundamental rules of economics suggest the demand will be lower when the price is higher, whereas those bullish on gold think the opposite.
6) The largest holders of SPDR Gold shares have already started to reduce their gold holdings. John Paulson is the largest owner of SPDR Gold trust ($4.4 billion), followed by Northern Trust (NTRS) at $2.04 billion, JPMorgan (JPM) at $1.28 billion and Bank of America (BAC) at $1.16 billion. Both JPMorgan and Bank of America significantly reduced their holdings, whereas Paulson is cautiously waiting for the overall market sentiment. The legendary investor George Soros, who owned 6.178 million shares in 2009, had reduced his gold holdings by 23% to 4.72 million gold shares by 2011.
7) The debt problem of European Union, particularly the PIIGS, is official. The spread between German bonds and PIIGS is eye-opening. In case of a default threat, the European countries' last resort will be their gold reserves. According to IMF, EU member states have a total of 10,792 tons of gold. Portugal, Italy, Greece, and Spain have 382.5, 2451.8, 111.7, and 281 tons of gold reserves, respectively. The same super supplier status possibility applies to large institutions as well. In 2009, IMF sold 400 tons to India. There could be other massive gold sales in the future, triggering the expected collapse of gold prices.
8) Gold investors' last stronghold is growing demand from India and China. Sure, these countries are growing fast, but there is a growing demand for energy, not for some piece of metal with limited industrial use.
9) Speculative connections between future markets and spot markets: Many speculators used to speculate in highly leveraged gold futures by betting on higher prices. At the same time, arbitragers shorted the futures while going long on physical gold, uplifting spot prices to converge into future prices. How long can this artificial demand last? Forever?
Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.
Going leveraged short in any bull market can cost huge losses in remarkably short periods. I do not suggest anyone going short in any market. I have done in the past for many things, and made significant losses. Statistical analysis shows that going short in any market is extremely risky, particularly for small investors.
Additional disclosure: I am leveraged (x10) short in gold futures. I am also leveraged (x10) short on USD and EUR. I might close, decrease or increase my positions in the next 72 hours.