Preparing For The Big Gold Short With DZZ

| About: DB Gold (DZZ)
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Now is a good time to lay the ground work for the Big Gold Short. Gold bulls believe gold is headed into uncharted territory. Market moving firms such as UBS have revised their Gold targets suggesting prices close to $2100 per ounce. Deutsche Bank’s target is $2000 per ounce.

Gold market pundits would have investors believe a parabolic leg up to the $2300 to $2700 range is plausible.

My view is that investors that are risk averse to going long at what may prove to be a gold market top given lofty historic valuations may wish to consider sitting back and watching while building up a cash position that can be used to short gold after the market flushes out the irrational exuberance.

Exchange Traded Note DZZ could be the perfect vehicle for which to short gold, depending upon whether or not one believes Deutsche Bank, the underwriter of the ETN, is a sound bank, and whether or not one believes the Europeans will allow free markets operate without stepping in to shutdown short sellers, both of which could leave buyers of DZZ holding the bag.

European banks were put through stress tests, and if one is to believe these tests were of sufficient rigor then Deutsche Bank would appear to be a sound bank. According to a press release from Deutsche Bank published on July 23, 2011:

The exercise was conducted using the scenarios, methodology and key assumptions provided by CEBS (see the aggregate report published on the CEBS website). As a result of the assumed shock under the adverse scenario, the estimated consolidated Tier 1 capital ratio would change to 10.3% in 2011 compared to 12.6% as of end of 2009. An additional sovereign risk scenario would have a further impact of 0.6 percentage points on the estimated Tier 1 capital ratio, bringing it to 9.7% at the end of 2011, compared with the regulatory minimum of 4%.

With the ongoing sovereign default crisis situation in Europe, the above numbers may need revisiting. Deutsche bank recently announced a seriously bad third quarter of earnings and stated it has $4.8 Billion euros worth of exposure to the PIGS – Portugal, Italy, Greece, and Spain. Banking officials have already marked down their Greek debt by 54%.

These stress tests were heavily criticized, but Deutsche Bank insists that by reducing its risk-weighted assets it can thereby increase its capital to weather the storm.

The market has now shifted its focus to Italy, so one might expect markdowns coming fast and furious, which suggests future earnings in the upcoming quarters for Deutsche Bank will be lackluster at best. Although U.S. market pundits are wishing the crisis to be cleaned up lickety-split, one can easily see why Angela Merkel and the Germans wish play the Too Big to Fail game and put a TARP-like backstop in place. This would allow for a slow but steady recapitalization process.

I believe that with Merkel in the driver’s seat in Europe, Deutsche Bank should come out OK. Deutsche Bank is to Germany is what JP Morgan is to the United States, more or less a sacred cow. Keep in mind that Deutsche bank has already been propped up by U.S. Taxpayers through the Maiden Lane Agreements and the AIG Bailout to the tune of $11.6 Billion Dollars. These funds were slotted as payments for counter-party risks and it has been noted that these payouts were made even though the actual “risk event” did not take place. This would appear to mean for all practical purposes, that Deutsche Bank and others may have received a windfall from U.S. taxpayers. A forensic accountant might be needed to prove this one way or the other.

The point is, there is a great deal of risk involved in participating in an ETN underwritten by a bank going through a banking crisis that must be carefully considered by investors.

The following footnote from DZZ fund provider Invesco should serve as sufficient warning to investors regarding the risk:

2 The PowerShares DB Gold ETNs are senior unsecured obligations of Deutsche Bank AG, London Branch, and the amount due on the PowerShares DB Gold ETNs is dependent on Deutsche Bank AG, London Branch’s ability to pay. The PowerShares DB Gold ETNs are riskier than ordinary unsecured debt securities and have no principal protection. Risks of investing in the PowerShares DB Gold ETNs include limited portfolio diversification, uncertain principal repayment, trade price fluctuations, illiquidity and leveraged losses. Investing in the PowerShares DB Gold ETNs is not equivalent to a direct investment in the index or index components. The investor fee will reduce the amount of your return at maturity or upon redemption of your PowerShares DB Gold ETNs even if the value of the relevant index has increased. If at any time the redemption value of the PowerShares DB Gold ETNs is zero, your Investment will expire worthless.

However, as most investors know, no risk, no gain.

I plan on taking that risk and intend to set up a position in the DZZ should gold hit $2000 per ounce. Even if gold peaks at $2100 or $2300, I would be comfortable being long DZZ and waiting out the top to ensure I am in for the ride down.

In order to mitigate the risk of being unable to close the position, I will sell when gold hits around $1650 on the way down.

Disclosure: No positions. If gold were to run-up to 2000 in the next 72 hours, I'm in.