Where Is The Next Gold Buyer?

Includes: GDX, GLD, SLV, SLW
by: Ananthan Thangavel
The following quote was posted in a Bloomberg news article about hedge funds that had performed well through August's market turmoil. Quality Capital's Karim said:

Long positions in flight-to-quality assets, mainly fixed income, have again showed their ability to hedge out uncertainty,” Quality Capital’s Karim said. “Gold has been a store of value for centuries. Its price reflects global anxiety, political and economic uncertainty, and even long-term implications of climate change.

While the comment about fixed-income investments is warranted, the attitude towards gold is striking. Karim's belief that gold can cure everything from global warming to male pattern baldness, while comical, is frighteningly similar to the chorus coming from gold bulls nowadays. While bulls continue to pound the table on currency printing, political instability, and a perceived under-investment in gold, these factors have not changed at all in the past year, yet the price of bullion has absolutely skyrocketed. While in a dream world buyers would pay any price for the perceived protection of bullion, we believe that the financials will still reflect reality at some point, and prices cannot continue in an uninterrupted upward fashion.

Our long-time readers are cognizant that we have been staunch supporters of precious metals for years, but the attitude of precious metals bulls that they are somehow investing in a magical asset class that can never fall is astounding, and will ultimately be proven incorrect. Even worse for precious metals is that they are a truly speculative asset class, throwing off no income and relying on a ready market for their price appreciation. If for some reason buyers for gold dry up, the price fall could be swift and furious.

Possible reasons for gold's depreciation could be a banking collapse in Europe or a simple change in trend among investors' preferences. While gold bulls believe full speed ahead that a banking collapse in Europe would reap untold profits, they are sorely mistaken. All investors need to do is look to 2008 for a parallel situation. After the collapse of Lehman Brothers, bullion took a steep dive, as margin liquidations and hedge fund redemptions forced gold to be sold off just like any other risk asset. Because of how widely held gold now has become, and the attention the market has received, gold is no longer being held as a hedge. It is being held by buyers hoping to make quick and riskless profits, just like house flippers in 2006, and tech stock day traders in 2000. As we have seen, this mentality always ends badly.

In addition, relatively tight monetary policy should also be a catalyst for precious metals to fall. As we approach the FOMC meeting on September 21st, we believe investors will begin to realize that QE3 is not nearly as forthcoming as they had believed. In fact, we believe the most aggressive move that the Fed could possibly take at this point would be an Operation Twist. An Operation Twist is somewhat likely given the market's obvious thirst for Fed action, but, as the Fed has noted numerous times, the Twist would not increase the size of the Fed's balance sheet while achieving the exact same result of a QE3, lower long-term interest rates. This ability to get stimulative effect essentially for "free" (not expanding the balance sheet) will most likely prove too tempting to the Fed over the next two to three meetings, as risk assets continue to suffer due to exogenous foreign factors. While precious metals may rally in between now and the Fed meeting in anticipation of easing, we will be watching the next Fed statement as a critical data point as to whether gold's rally can continue.
Trade Recommendation

We continue to recommend selling calls on silver to profit from its relatively unattractive position as compared to gold at this stage. The volatility of the gold market makes a short position tough to sustain at times, but aggressive investors could explore the possibility of buying put options or put spreads on 1-2 month expirations.

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