Why Gold Investors Should Carefully Watch The Passion Play Of John Paulson

Includes: DUST, GLD
by: Macro Investor

Last we checked, as of September 30, 2012, the SPDR Gold Trust ETF (NYSEARCA:GLD) was John Paulson's largest holding. About 30% of his portfolio was in GLD. In turn, Paulson was the second largest holder of GLD -- about 10% of total GLD shares was held by John Paulson. The new numbers are out, and not much has changed in 3 months. Paulson has still not slimmed his GLD holdings. In turn, he is sitting on about $250 million in paper losses, as gold has dropped about 5% in the last quarter.

How much more pain can John Paulson take?

The market has already put a big target on Paulson's position. Morgan Stanley has recommended that investors run away from Paulson. Citigroup's private bank has pulled significant money ($410M) from Paulson's hedge fund as well. Other hedge funds are shorting gold to force Paulson's hand. Now, it seems that other big shots who bet big and bet wrong on gold are folding. Soros, Robertson, and Pimco are all starting to liquidate their long positions in gold as the inexorable downtrend in gold continues.

GLD Total Return Price Chart

GLD Total Return Price data by YCharts

Reports MoneyNews:

Notable institutional investors, including George Soros, Julian Robertson and Allianz's Pimco reduced their bets on gold during the quarter, when bullion posted its biggest quarterly loss in more than four years.

Paulson is a smart guy. It is unlikely that he will wait to be the last guy at the party. At some point, therefore, we will likely see Paulson starting to sell GLD in bulk. It may not even be his choice if he is faced with massive redemption. This is something no one can predict, but this has in the past happened to some of the hedge fund greats -- remember Long Term Capital Management? Unfortunately, if this happens, we may get a crash in gold -- a catastrophic drop if Paulson's hand is forced. With Soros et al selling, gold dropped about 5%. Paulson's position is far bigger than theirs. A 10-20% drop is, therefore, more likely if Paulson were to liquidate his position.

So, what does that mean for your investment thesis, dear reader? I continue to believe that while shorting gold is a fine play indeed, the real play is in the miners. The miners are really a leveraged bet on gold prices. As gold prices drop, the profit margins of the miners get squeezed. Their cost structure is already going up at around ~15% each year, as the easy gold has been extracted already. Labor and fuel costs keep going up as well. At a sub-1200 price of gold, many miners would have no option but to shut down operations, given that the marginal cost of production is now at around $1200/oz. That's where the real money is.

In my mind, the obvious choice to benefit from this squeeze would be to hold the Direxion Daily Gold Miners Bear 3x Shares ETF (NYSEARCA:DUST). This ETF is up some 70% in the past three months, and some 40% in 2013. I believe there is another 10-15% left in this ETF this year, as I expect gold prices to collapse as Paulson inevitably folds, while gold extraction costs keep going up. Of course, nothing is a guarantee, but the immutable laws of hedge fund economics and geology give me comfort that DUST is on the way up.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.

Disclosure: I am long DUST. 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.