Play Your Short Game in Gold

Editor's note: This article originally appeared in the June 2008 issue of Registered Rep. magazine.

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Sports and financial markets have more than a little in common. Just as a sports contest takes innings or quarters to develop, bulls and bears tug and pull upon an asset’s price over time to create a trend.

And just as an appearance on the cover of Sports Illustrated fairly well predicts an athlete’s or a team’s peak and ensuing decline, media saturation usually presages a market turn. When otherwise staid publications finally give in and plaster headlines on their front pages announcing gold’s new price high, the selling begins in earnest.

So it came to pass for gold. “Spot gold sets historic high above $1,000-mark” screamed headlines all over the English-speaking world on March 14.

With that, fortunes turned quickly—and badly—for gold bugs. By the beginning of May, the yellow metal’s luster was dulled by a nearly 13% loss.

The game sets up

What happened? Did the conditions that gave gold its dramatic buoyancy suddenly change once the $1,000 threshold was crossed?

Gold’s constantly touted as a bellwether of inflation. “Too many dollars chasing too few goods,” say the gold bugs, drives up prices. The broadest measure of the number of goods-chasing dollars has historically been the M3 monetary aggregate, published by the US Federal Reserve until March 2006. Though now discontinued, M3’s additive components, such as institutional money market funds, short-term repurchase agreements and other large liquid assets, are still published separately; they’re just not aggregated into a single statistic by the Fed.

Did the supply of greenbacks dry up? Clearly, no (see Figure 1). The easy credit years were plainly very inflationary. Gauged by the narrowest monetary aggregate, M1, we now appear to have moved to a tight money market. Keeping track of a reconstituted M3, however, tells a vastly different story. The M3 growth trend line has greatly diverged from M1’s and, in fact, parallels that of gold’s price appreciation.

That M3 includes large institutional investors’ money is telling, because large speculators have become the dominant force in the gold futures market, usurping the role typically played by commercial entities using futures as hedges (see Figure 2).  Setting up the run to March’s price peak was a changing of the guard in the COMEX trading ring as net long positions held by institutions outgrew commercials’ net short exposure. Even after the sell-off began, though, long speculators were still in the ascendancy as commercials’ interest in short selling waned.   

All this, along with other indicators, points to a bear cycle within a secular bull market. This isn’t anything new for gold.  Gold most recently worked through two bearish cycles in the previous secular bull market that peaked in 1980.  The first, from May 1969 through 1970,  saw gold give up more than 20%. The second wrought a 45% decline from December 1974 until August 1976.

From a technical standpoint, gold could have very likely entered a bear cycle in March that will shake out some weaker hands. Some chartists are looking for a downside objective of  $500 to $550, before the long-term uptrend that began in April 2001 resumes.

There are, of course, no guarantees in any forecast, be it technical or fundamental. Still, there’s  no denying that investors with gold investments are feeling nervous now. There are,  as well, investors bristling with bearish inclinations looking at a gold sell-off as an opportunity for speculative profit. If gold’s downward cycle continues toward $500, what should these investors do?

What to do?

The simplest thing would be to stand pat. That might work for those invested in gold or gold mining shares, but does nothing for prospective shorts. Doing nothing definitely saves commissions, not necessarily heartache or heartburn.

Alternatively, investors could sell their gold investments and await a bottom. Taxes and timing a re-buy have to be considered here as does reinvestment risk. Where does one hold the proceeds ‘til repurchase?

New investors looking to ride the market down might consider short sales, but of what? Futures? Gold grantor trusts? Mining shares? Is the prospect of being margined in an extremely volatile market offputting?

New players

Luckily, there’s a way to play the short side of the gold market without using margin. A suite of gold-tracking exchange-traded notes was launched by Deutsche Bank just before the metal’s March peak. Half of the new instruments offer inverse or short exposure to gold futures, a first for retail investors.

The DB Gold Short Exchange Traded Note (NYSE Arca:DGZ) and the DB Double Short Exchange Traded Note (NYSE Arca:DZZ) were launched on February 27 along with the DB Gold Double Long Exchange Traded Note (NYSE Arca:DGP) to complement the existing PowerShares DB Gold Fund (AMEX:DGL). The Deutsche Bank offer added length and depth to the roster of gold trackers dominated by the streetTRACKS Gold Shares (NYSE Arca:GLD) and the iShares COMEX Gold Trust (AMEX:IAU) grantor trusts. Both GLD and IAU hold physical bullion rather than gold futures.

All four DB products are based upon the Deutsche Bank Liquid Commodity Index – Optimum Yield Gold, though DGL holds COMEX gold futures, collateralized by Treasury securities, while the DB Gold ETNs are unsecured debt obligations of Deutsche Bank AG’s London branch. DGP earns twice the monthly return of the underlying index plus the monthly yield of an associated Treasury bill index. DZZ offers complementary exposure: twice the benchmark’s inverse monthly return, together with an unlevered T-bill yield. DGZ’s return is derived from a single-slug inverse exposure. 

The distinction between the ETN and ETF format is not trivial.  ETFs are grounded in a real-life portfolio dedicated to tracking a benchmark index. One of the essential risks for an exchange-traded fund investor is tracking error. An ETF manager that misses the benchmark return by more than the fund’s expense ratio introduces unanticipated—and mostly unwanted—error, an error largely due or exacerbated by frictional transaction costs.

Because there’s no portfolio underlying an ETN, however, there are no frictional transaction costs.. ETNs are structured products whose ultimate payout is derived through the adjustment of the notes’ principal value for variations in the underlying index. The accounting’s done in a ledger, not in an actual portfolio. The payout represents an unsecured obligation of the issuer and therefore conveys credit risk to the investor.

The scorecard

Short gold ETNs tracked the yellow metal’s downward spiral to profitable effect through early May. In fact, the gains made by DGZ and DZZ outstripped those by futures (see Table 1), reflecting the collateral return and the degree of leverage commanded.

Over time, though, the total return can vary further when “roll yields” are counted. The DB ETF and ETN index methodologies requires constant exposure--short or long—to gold futures. Futures, unlike stocks, have limited tenure and so must be rolled forward into longer-lived contracts when expiry approaches. To roll a long position from the August to October delivery month, for example, the August contract is sold and the October contract is purchased. If, as is typical for the gold market, October gold is trading a higher price than the August delivery, a cost—a negative roll yield—is incurred. Rolling a short position forward in a normal market, on the other hand, nets a positive roll yield because the higher-priced contract (e.g., October) is sold as the cheaper (e.g., August)  delivery is bought back in a covering purchase.

The new inverse products offer some distinct advantages over short sales of a long-only gold ETF or grantor trust. First, and probably most important of all, no margin is required. Risk, therefore, is limited. There’s also a tax advantage. Profits from long position in an inverse note are subject to long-term capital gains treatment after a holding period of 12 months. Conversely, gains derived from a retail customer’s short sale of a gold product will always be treated as a short-term investment, no matter how long the position is held.

Returns earned from short sales, too, may diverge from those obtained from inverse products. The beta coefficients shown in Table 1 represent the returns that can reasonably be expected for each product when compared to futures. That’s potential only, mind you. Compounding can skew returns significantly.

To illustrate the compounding effect, let’s look at market prices on May 5. Shorting DGL at $89.51 just before a hypothetical five-day run of 1% declines would have put the ETF at $85.12 for a 4.9% gain on the short sale. Ignore collateral returns for the moment and posit five consecutive 1% rises in DGZ’s price over the same time. Following a purchase at $27.39 on May 5, DGZ would then be worth $28.79, for a 5.1% gain. In a market decline, DGZ increases in value, augmenting the position's size and compounding the gain.

If the market instead gained 1% per day for five days, DGL would end up at $94.08, for a loss of 5.1%, but DGZ would give away only 4.9% of its value — the compounding effect in reverse.

The final score

With all these attributes, the new gold ETNs appear to be winners, They certainly offer investors and their advisors an opportunity to efficiently speculate in or hedge the gold market, no matter what direction the yellow metal may be heading.

That should put investors ahead of the game.

click to enlarge images

Figure 1

Source: Federal Reserve, ShadowStats.com, London Bullion Market Association

Figure 2

Source: Commodity Futures Trading Commission, COMEX

Table 1 – Gold Products (February 28 – May 5, 2008)

Source: Commodity Systems, Inc., Brad Zigler

Comments

[GMiki1:]

Now would not be the time to short gold, which was up something like $23 on Friday. Of course the bulls would like to see a short squeeze, so you're welcome to try.

2008 Jun 08 11:20 AM

[Managing Ed...:]

GMiki -

COMEX June gold had last settled at $894.50 when you wrote your comment. Three trading sessions later, the contract settled at $869.20.

Some might consider a $2,530 return a nice short. At exchange minimum margins, that's a 59% gain.

2008 Jun 12 10:49 PM