Gold Should Go Sideways In 2013, But Hedged Strategy Could Yield 40%-Plus

Includes: DUST, GLD, NUGT
by: Macro Investor

The yellow metal brings emotions to the fore for both bulls and bears. After an incredible climb, however, the market has stagnated for the past couple of years. Bulls are hanging on to hope, bears are waiting for the other shoe to drop, and the fight is tense.

Witness the sideways movement of the SPDR Gold Trust ETF (NYSEARCA:GLD).

Relax, I say.

Gold is not going anywhere. It is not going up, it is not going down. The facts are too fragile in one direction, sentiments too strong in the other. So gold will move sideways, but there is still a great way to make money.

To begin, let's debunk the bull case. The main issue is that inflation is not going anywhere. As I noted in an earlier article, inflation expectations remain tame and bond vigilantes are AWOL. If there is no runaway inflation, it is hard to justify a rise in the price of gold.

It seems as if the banks agree. BNP cut its 2013 gold price forecast and, in fact, believes that 2014 will see a price drop.

BNP Paribas cut its gold price forecast for 2013, citing cautious market sentiment, and sees prices dropping in 2014, which would be the first annual decline in 14 years.

'Our downward revision (for 2013) is largely due to mark-to-market considerations rather than a change in our fundamental view,' analyst Anne-Laure Tremblay said in a note to clients on Thursday.

The analyst said gold's performance was disappointing in the last two months as the metal failed to benefit from the absence of extreme episodes of risk aversion, Federal Reserve easing, or seasonal demand in India and the West.

Goldman Sachs agrees:

Goldman Sachs cut its 2013 gold forecasts on Wednesday and said gold's current price cycle will likely turn next year as a rise in real interest rates on the back of improved growth offsets any further balance sheet expansion from the Federal Reserve.

Goldman cut its three, six and 12-month forecasts for gold prices -- currently near $1,700 an ounce -- to $1,825 an ounce, $1,805 an ounce, and $1,800 an ounce, respectively.

It also introduced a 2014 forecast of $1,750 an ounce, suggesting price growth could tail off.

But does this mean there will be an exodus out of gold? I doubt it. Ultimately, gold is driven by sentiment and the sentiment, while choppy, is in no way going away. Witness the Bloomberg commodity sentiment for gold. The choppy pattern has stayed throughout the year, and with that gold has gone sideways.

So, how do you make money in this kind of a choppy market? Is market timing the only way? Fortunately, our friends at Direxion have provided us with a wonderful vehicle to make money in gold as the market moves sideways with plenty of volatility.

Let's consider two leveraged ETFs from Direxion: the Direxion Daily Gold Miners Bull 3x Shares ETF (NYSEARCA:NUGT) and the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST). Both are leveraged 3x on the NYSE Arca Gold Miners Index, in opposite bull/bear directions.

Both NUGT and DUST were initiated almost exactly two years ago. This is opportune, as this is the exact time when gold stagnated and the volatility swings were prominent.

Let's try the following strategy. Short $10,000 worth of NUGT and $10,000 worth of DUST, combine that with $10,000 of cash and hold the position for 200 days. Theoretically, since this is a perfectly hedged position, it should return nothing and stay flat.

The reality, however, is different. The chart below shows the return on a series of such positions, started each day on and after Dec. 13, 2010, and liquidated after 200 days.

Click to enlarge image.

There are 303 such portfolios. Of those, only four have negative returns. This is not surprising as, after all, this is a hedged strategy. However, the interesting thing is how all the volatility plays. The average return of such portfolios is 42%, and the median return is 41%.

Now, this strategy has a lot of risk. There are quite a few portfolios that drop more than 50% within the 200 days, in which case the holder may get stopped out. One way to reduce that risk is to add to the cash position. It dampens returns, but also gives the holder more of a safety buffer.

This strategy seems to work best in choppy markets with lots of volatility. I believe this effect will show up in other pairs of leveraged ETFs -- e.g., those on energy prices.

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