Salivating Madly Over Gold

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Includes: ABX, DGL, DGLD, DGP, DGZ, DZZ, GDX, GEUR, GHE, GHS, GLD, GLDI, GLDW, GLL, GTU, GYEN, IAU, OUNZ, PHYS, QGLDX, SGOL, SLV, UBG, UGL, UGLD
by: The Mad Hedge Fund Trader

Summary

Geopolitical events offer supreme entry points into GLD related option spreads.

ABX, GLD, GDX all great buy-and-hold vehicles.

If GLD rockets, miners are next to launch if you can catch the move.

Now that the barbarous relic is finally back in fashion, and now that we have a double long position in the gold miners, how high could it really go?

The question begs your rapt attention, as the recent instability in Washington has unleashed a plethora of new positive fundamentals for the yellow metal.

It turns out that gold is THE deflationary asset to own.

Who knew?

I was an unmitigated bear on the price of gold after it peaked in 2011. In recent years, the world has been obsessed with yields, chasing them down to historic levels across all asset classes.

But now that much of the world already has, or is about to have negative interest rates, a bizarre new kind of mathematics applies to gold ownership.

Gold’s problem used to be that it yielded absolutely nothing, cost you money to store, and carried hefty transaction costs. That asset class didn’t fit anywhere in a yield obsessed universe.

Now we have a horse of a different color.

Europeans wishing to put money in a bank now have to pay for the privilege to do so. Place €1 million on deposit in an overnight account, and you will have only 996,000 euros in a year. You just lost 40 basis points on your -0.40% negative interest rate.

With gold, you still earn zero, an extravagant return in this upside down world. All of a sudden, zero is a win.

For the first time in human history, that gives you a 40-basis point yield advantage over euros. Similar numbers now apply to Japanese yen deposits as well.

As a result, the numbers are so compelling that it has sparked a new gold fever among hedge funds and European and Japanese individuals alike.

Websites purveying investment grade coins and bars crashed multiple times last week due to overwhelming demand (I occasionally have the same problem). Some retailers have run out of stock.

So I’ll take this opportunity to review a short history of the gold market (GLD) for the young and the uninformed.

Since it peaked in the summer of 2011, the barbarous relic was beaten like the proverbial red headed stepchild, dragging silver (SLV) down with it. It faced a perfect storm.

Gold was traditionally sought after as an inflation hedge. But with economic growth weak, wages stagnant and much work still being outsourced abroad, deflation became rampant.

The biggest buyers of gold in the world, the Indians, have seen their purchasing power drop by half, thanks to the collapse of the rupee against the US dollar.

The government there increased taxes on gold in order to staunch precious capital outflows.

You could also blame the China slowdown for declining interest in the yellow metal, which is now in its fifth year of falling economic growth.

Chart gold against the Shanghai index and the similarity is striking, until negative interest rates became widespread in 2016.

The brief bump gold caught in 2015 over war fears in Syria, the Ukraine and then Iraq was worth an impressive $160 rise.

But the diplomats then got involved and hostilities were at least delayed. That caused gold to roll over like the Bismarck.

In the meantime, gold supply/demand balance was changing dramatically.

While no one was looking, the average price of gold production soared from $5 in 1920 to $1,300 today. Over the last 100 years, the price of producing gold has risen four times faster than the underlying metal.

It’s almost as if the gold mining industry is the only one in the world which sees real inflation, which has seen costs soar at a 15% annual rate for the past five years.

This is a function of what I call “peak gold.” They’re not making it anymore. Miners are increasingly being driven to higher risk, more expensive parts of the world to find the stuff.

You know those tires on heavy dump trucks? They now cost $200,000 each, and buyers face a three-year waiting list to buy one.

Barrick Gold (ABX) didn’t try to mine gold at 15,000 feet in the Andes, where freezing water is a major problem, because it likes the fresh air.

What this means is that when the spot price of gold fell below the cost of production, miners will simply shut down their most marginal facilities, drying up supply. That has recently been happening on a large scale.

Barrick Gold, a client of the Mad Hedge Fund Trader, can still operate as older mines carry costs that go all the way down to $700 an ounce.

No one is going to want to supply the sparkly stuff at a loss. That should prevent gold from falling dramatically from here.

I am constantly barraged with emails from gold bugs who passionately argue that their beloved metal is trading at a tiny fraction of its true value and that the barbaric relic is really worth $5,000, $10,000, or even $50,000 an ounce.

They claim the move in the yellow metal we are seeing is only the beginning of a 30-fold rise in price similar to what we saw from 1972 to 1979, when it leapt from $32 to $950.

So when the chart below popped up in my inbox showing the gold backing of the U.S. monetary base, I felt obligated to pass it on to you to illustrate one of the intellectual arguments these people are using.

To match the gain seen since the 1936 monetary value peak of $35 an ounce, when the money supply was collapsing during the Great Depression, and the double top in 1979 when gold futures first tickled $950, this precious metal has to increase in value by 800% from the recent $1,050 low.

That would take our barbarous relic friend up to $8,400 an ounce!

If you think that price is exorbitant, then recent inquiries for bitcoin, seen as a flight-to-safety instrument, being driven by analysis from friends of mine, like Tom Lee of Fundstrat, concluded that the theoretical value of bitcoin could be as high as $50,000.

These are based on some obscure calculations of bitcoin’s value relative to the size of the global monetary base.

By the way, the same calculations done elsewhere suggest that gold should also be worth $50,000 an ounce!

To match the move from the $35/ounce-1972 low to the $950/ounce-1979 top in absolute dollar terms, we need to see another 27.14 times move to $28,497/ounce.

Have I gotten you interested yet?

I am long-term bullish on gold, other precious metals, and virtually all commodities for that matter. But I am not that bullish. These figures make my own $2,300/ounce long-term prediction positively wimp-like by comparison.

The seven-year spike up in prices we saw in the 70s, which found me in a very long line in Johannesburg, South Africa, to unload my own krugerrands in 1979, was triggered by a number of one-off events that will never be repeated.

Some 40 years of unrequited demand was unleashed when Richard Nixon took the U.S. off the gold standard and decriminalized private ownership in 1972.

Inflation then peaked around 20%. Newly enriched sellers of oil had a strong historical affinity with gold.

South Africa, the world’s largest gold producer, was then a boycotted international pariah and teetering on the edge of disaster. We are nowhere near the same geopolitical neighborhood today, and hence my more subdued forecast.

But then again, I could be wrong.

In the end, gold may have to wait for a return of inflation to resume its push to new highs. The previous bear market in gold lasted 18 years, from 1980 to 1998, so don’t hold your breath.

What should we look for? When your friends start getting surprise, out-of-the-blue pay increases, the largest component of the inflation calculation.

That is happening now in the technology sector, but nowhere else. When I visit open houses in my neighborhood in San Francisco, half the visitors are 30-somethings wearing hoodies offering to pay cash.

It could be a long wait for real inflation, possibly into the mid-2020s, when shocking wage hikes spread elsewhere.

The North Korean hermit kingdom leader also gift-wrapped me a few trades that I just took profits on.

All the war rhetoric had the masses pile into gold, and all the net commotion meant that an in-the-money vertical BULL call spread was a great trade to execute.

This was the VanEck Vectors Gold Miners ETF (GDX) September 2017 $20.50-21.50 in-the-money vertical BULL that I picked up for 85 cents and almost didn't have a down day when I held onto it.

Panic buying helps gold, silver, the miners' shares, and the gold- and silver-related ETFs.

That’s what I love: panic buying of my longs. It is music to a trader’s ears, even one who has been at it for half a century.

This is why I get up in the morning.

That means the value of our position in the Barrick Gold September 2017 $15-16 in-the-money vertical BULL CALL spread soared as well before we closed out for another successful trade.

I have to thank North Korea’s Kim Jong-un for the move for firing a ballistic missile at Japan, which fortunately broke up half way over the sea.

Whenever the North Korean dictator gets trigger-happy, the precious metals do extremely well.

As for the many investment advisor readers who have stayed long gold all along to hedge their clients' other risk assets, good for you.

If you are holding gold miner stocks or the gold ETF, then keep holding them and go take a nap.

You’re finally learning!

Disclosure: I/we 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.