What Should Investors Do About Gold?

Includes: GDXJ, GLD
by: Cam Hui, CFA

As gold continues to melt down, I have had a number of discussions with both individual and professional investors about the outlook for the shiny precious metal. Notwithstanding the global conspiracy to suppress the gold price*, here is my view on gold.

First of all, I am relatively agnostic on gold. I am no gold bug, nor am I a permabear on bullion. I do believe that the financialization of gold and other commodity prices has made the precious metal more volatile. No one complained when money poured into GLD and the price was rising, but as Josh Brown aptly put it:

Personally, I think that Bitcoin caused the crash in gold. When Bitcoin, another alternative currency crashed, it created so many margin calls that the effects spilled over into gold**.

The bull and bear case for gold
There is no question that what happened to gold on Monday was what Dennis Gartman termed "a margin clerk market". We saw a disorderly liquidation. Tuesday saw some stabilization. Gold tried to rally but ended up only slightly up on the day - not good.

On a longer-term basis, the chart below of the gold to SPX ratio shows that this relationship is testing a long-term relative support zone. Under such panic conditions, we may see a decent bounce.

In addition, there may be some fundamental underpinnings for a bottom in gold equities. The dividend yield on the junior gold miner ETF GDXJ is 4.5% according to Yahoo Finance and 6.2% according to Bloomberg. (Given how quickly the dividend has fallen, I am not sure how real that yield is, though.)

The bear case

While I recognize that gold is off-the-charts oversold, I worry that a significant bottom may not be in place because investor psychology hasn't gotten bearish enough. I have heard anecdotal evidence that people are lined up at the local bullion dealer to buy gold bullion and bars - which is contrarian bearish and an indication that Joe Public hasn't given up on the precious metal yet. (Can anyone else confirm that?)

As well, Bloomberg reports that Indians, who are a large source of physical demand, are still buying:

Gold buyers in India, the world's biggest consumer, are flocking to stores to buy jewelry and coins, betting a sell off that plunged bullion to a two-year low may be overdone.

"My daughter is just six months old, but I think it is never too early to buy gold," said Sharmila Shirodkar, a 28- year-old housewife, while displaying a new pair of earrings she bought from a store in Mumbai's Zaveri Bazaar. "I had been asking my husband every day if prices will go down more. I couldn't wait anymore."

A durable bottom will not be in place until the small retail buyer capitulates - and these are not signs of capitulation.

As well, I watch the Silver/Gold ratio to measure the level of speculative activity in precious metals. Silver, another precious metal, is considered to be the poor man's gold and the relative Silver/Gold ratio is an important indicator of precious metal risk appetite. As the chart below indicates, this ratio remains in the middle of its historical range and is showing no signs of a washout yet.

Personally, I would be inclined to step aside for now and watch how this trade develops. Gold could have great upside potential once it bottoms, but prudence calls for waiting for some signs of stabilization before getting long. I would rather miss the first 10-20% move than lose another 50% should I get long prematurely.

* Relax! That's a joke
** Don't take everything I say so seriously!

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.