Gold: Picking Up Pennies In Front Of A Steamroller

by: CDM Capital

"If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience." -George Bernard Shaw

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- All data provided by Macrotrends, compares historical real (inflation-adjusted) gold prices back to 1915. Each series is deflated using the headline Consumer Price Index (CPI) with a base of January 2012.

We started off with a 100-year inflation adjusted chart on gold for a reason: There have been two major parabolic spikes, both with trough-to-peak time frames of approximately 10 years. We can't help but notice that these two periods seem to be almost perfect mirror images, with a 40-year gap in between. We start off with the first period trough in December of 1970, at an inflation adjusted price of $208; Comparing this to the subsequent peak of $1975 in January of 1980, this equates to just under a 10x return over a 10-year period. The second trough in April of 2001, which was approximately at $333, subsequently peaked at $1825. While the second period has a significantly lower trough-to-peak multiple percentage-wise, the dollar size of the moves are very similar.

Looking at the second inflation adjusted chart, which is just a snapshot of the 1976-1983 period from the 100-year chart, a mean reversion took place quickly after the parabolic high at $1975. Within two and a half years, gold prices had a significant collapse and declined 63%. If these charts follow each other from one period to the next, that would equate to a gold price of roughly $675 by February of 2014.

"I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today's market prices about $7 trillion dollars - that's probably about a third of the value of all the stocks in the United States…For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I'll take the farmland and the Exxon Mobils". --Warren Buffett

GLD Chart
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GLD data by YCharts

The divergence has finally started to occur within the last 6 months between the S&P500 (NYSEARCA:SPY) and the SPDR Gold Shares (NYSEARCA:GLD). With the Fed tapering towards the end of the year and the likelihood of a complete halt of quantitative easing by mid-2014, the gold market may diverge even further from the stock market towards the end of 2013. We feel a stronger dollar, along with a rising yield on the 10-year, would likely push gold and silver prices to new 2 year lows. Given the backdrop of Fed tapering, eventual end of quantitative easing, and higher yields forecasted in the bond market, it looks like an uphill battle going into 2014. We share a similar viewpoint as Bart Melek, head of commodities strategy at TDS, in that he expects a higher opportunity cost of gold from multiple factors going into 2014.

"TD Securities looks for the Fed to start tapering this fall, perhaps in September. As a result, gold prices may fall back to around $1,275 and silver to $20.

The TDS view is that 10-year yields will rise to around 2.45% by the end of the fourth quarter and around 3% next year. "That suggests the opportunity cost of holding gold is likely to go higher and higher," Melek said.

Wilshire 5000 vs. Gold over a 35 year timeframe.

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U.S. Treasuries a proxy and alternative for gold?

GLD Chart
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GLD data by YCharts

Overall, we feel investors have piled into gold on the basis of the "fear trade," and more recently, on the basis of the "inflation trade." Unfortunately, we don't feel gold works under both scenarios of boom and bust. We have yet to see any significant inflation, and Bernanke has already made his warning shot over the bow to investors, with the announced taper later this year. We feel there are significant macro headwinds- higher rates/stronger dollar, Fed tapering, and the end of QE in 2014- that will push gold even lower over the next 12 months.

If history is any guide for the future of gold it should move back towards a growth rate around inflation. For example, gold has diverged so significantly from inflation that from June 2005 to January 2011 gold was up approximately 350%, while inflation increased only 17%. We don't feel with very low levels of inflation in the U.S. around 2-3 percent that gold can sustain these abnormally high prices. The only real risk we see to our long-term short thesis is if the U.S. experiences hyper-inflation, which we feel is a very low probability.

To summarize only twice in 100 years have investors seen this type of speculative bubble, and we think now is an excellent opportunity to profit from the eventual further fall of gold. We strongly feel that gold has already peaked ($1825), and that we are now on the downward slide. To execute this gold thesis, we would short SPDR Gold Shares, Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ), or Direxion Daily Gold Miners Bull 3X Shrs (NYSEARCA:NUGT). We are closely watching the SPDR Gold Shares for an entry price on the short side, while also playing a small short position on Sandstorm Gold (NYSEMKT:SAND).

Disclosure: I am short SAND. 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.

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