There was a huge correction in gold for the last 2 days. It dropped about 18%. I kind of expected in as mentioned in my
last update on September 8th.
But I was caught by surprise that gold and silver miners are brought down together with stocks.
I suffered some damage on my portfolio despite the fact that it is heavily hedged. I also have shorts for 12 positions for other stocks on the general market but my gold portfolio suffered.
So where do we go from here?
In this post, I shall revisit the fundamentals and list down my strategies to deal with this downfall.
For the time being, I am knock down but not knock out.
Most of my positions are hedged except for junior miners which had been hit hard. I even cut back some positions today but add more PHYS – which is for physical gold and silver.
Fundamentals.
I trade mainly on
fundamentals. I use options only for hedging and
technical for short term entry and exits.
To me the fundamentals have not changed. Lets do the analysis by asking a few questions.
1. Have the countries around the world stopped printing money?
How will Europe and the world deal with the current crisis? The direction is clearly to print more money.
Greece default is probably built into the market. But what about Italy, Spain and Portugal. Germany is the only nation in European Union that has a sound balance sheet but can it sustain the all the EU countries?
The Fed did an operational twist in the market this week. Instead it turns out to be a hurricane in the market. DOW dropped more 300 points for 2 consecutive days!
For those that expected QE 3, this is some kind of QE 3 – the attempt to keep interest rates low and close to zero.
Here is an interesting chart from Casey Research.
To keep interest rates low from 2009 to 2010, it took $2T. With extrapolation, it will take another $2T to be in line with the FED ‘s objectives of maintaining interest rates close to zero.
Money supply is and will continue to increase.
As worldwide monetary supply increases, paper currencies lose value. There must something that maintains its value. The monetary base took over 200 years to rise to 800 billion dollars. Between 2008 and 2011, it rose from 800- 2.7 T. This guarantee that gold and silver will remain in a bull market fundamentally for years to come.
There is a debate that whether gold is money. Roubini, Bernanke and Buffet have publicly declared that gold is not money.
Aristotle defined five reasons why gold is money in the fourth century BC (which may only have been the first time it was put down on paper). Those five reasons are as valid today as they were then. A good form of money must be: durable, divisible, consistent, convenient, and have value in and of itself.
Gold has been used as money for millennia. If there is a crisis, people still flock to gold
Although the days of getting back to gold back currency is slim but it will always be a reference to real value of economic power – directly or indirectly
Bottomline: Gold cannot be created from thin air. It has limited supply.
Currency wars have intensified. The last of safe Haven currency is gone this week as the Swiss pegged their currency to the Euro.
2. Is Gold in a bubble?
There are many analysts that predict that gold is in a bubble. Lets examine whether gold is in a bubble.
What constitute a bubble? There is wild euphoria. Fundamentals are totally misaligned with the price. During the dot.com bubble, P/E of more than 500, and price to sales of more than 300 were common.
It seems to me now that a lot of people are talking about gold but not many people are buying. In a room of traders, it is normal to find only a few has invested in gold.
The number of analysts that are bearish for gold still outnumber the number of them that are bullish.
In a bubble, the typical stock market trader believed stocks were headed much, much higher — and, therefore, that any pullback should be used to buy more. In today’s gold market, in contrast, there is a remarkable level of skittishness in the gold-timer community. That is not the typical sentiment hallmark of a top of a bubble.
Gold was thought to be a bubble at 800 and then 1000, 1500 and now almost 1900.
Technically, it is overbought. Price has gone parabolic. A correction is needed. But it is not a bubble.
a. If you compare gold to various assets and the NASDAQ on the price peak in a bubble. gold has a lot to catch up.
b. Gold is not even a mainstream investment. As a percentage, it is held in small amount by most pension and hedge funds. For hedge funds, it is only 1%. It is not a dominant investment now.
Eventually, gold will be in a bubble. I want to be in that bubble. It will be a maniac phase whether junior miners can go up 1000%. I want to be positioned for that day.
c. Gold reserve as a percent of monetary base is only 20%. In 1980, it is was 120%. 20% is close to a low.
What does it tells me that gold is in a bubble. Basically the reverse of all the above. Somehow, I like to see the monetary problems are magically solved. Also, suddenly all the deficits somehow disappeared and there are definite solutions to the European sovereign debt crisis.
3. Supply and demand.
a. To put in perspective, there is very limited amount of physical gold available. It is said that there is enough gold only to fill an Olympic size swimming pool. There is also a lack of major discoveries.
b. Demand for gold is now higher from China and India than the Western world mainly USA and Europe.
The eastern hemisphere has a cultural affinity to gold. With increase income and growing middle class, gold purchase has increased substantially. There is more affordability.
In a price drop like today, there were massive buying of physical silver. Sprout assets management has announced that they are out of physical silver for sale. Check with many dealers, they will verify that there are massive buying on physicals especially for silver. When price drops, many sophisticated investors are buying more.
There is clearly a shortage of supply right now.
Seasonal factors favor gold. We have the Ramadan, the Indian New Year, Christmas and Chinese New year coming in the next 5 months.It will bought as gifts for the festivals.
Gold can be divided into the fear trade, the luxury trade and currency confidence trade.
When investors buy gold because of fall of Europe, it is a fear trade.
When investors buy gold because of fiscal policy ( increase spending and social programs ) and money policies ( increase monetary supply), it is currency confidence trade.
When investors buy gold jewellery for seasonal gifts, it is luxury trade. The luxury trade is sizeable compare to total demand. In 2010, it was 50% of demand. There are no signs that it will be lower this year looking at the way gold is being bought in China and India. Despite the 25% increase in price, demand has increase 7.5%.
It is also interest to note that when market goes up and gold goes up, it is currency confidence trade. Investors are afraid of inflation, assets dilution and currency devaluation.
When market goes down and gold goes up, it is fear trade. It is usually the results of a potential sovereign debt crisis or major banks failure.
What happens when markets goes down and gold goes down? It is a correction and a manipulated trade.
C. Low interest rate favors gold
d. Resolution to the current debt situation and deficit.
Europe, Japan and USA are all in debt situation that will not be easily resolved.
They are all living in borrowed time. The “End Game” ( John Mauldin ) is going to be ugly
I came upon an interesting comparing US deficit situation to a typical household budget.
The market has priced in a default in Greece. Probability is 90%. There is also no solution for US debt or debt for Italy, Portugal, Japan and Spain.
History tells that before settling the deficit, it will devalue its currency before it cuts its deficit.
Upon devaluation, gold price will explode.
Gold Miners
I like to add a few comments on gold miners.
It has followed the decline of gold today. Frankly it was disappointing for me. I expected it to go up. But it was dragged down by the price of gold and the general market conditions.
There are plenty of fundamental reasons to be more bullish on gold miners than gold. There is usually a lag for gold miners to catch up with gold.
I still like gold miners main because they are cheap on valuation. Cash flow and margins are improving rapidly.
During the 1979 to 1980 gold mania, gold producers lagged the metal for 2 full years. From 1977 to 1978, gold rose 58.4%, gold stocks only up 11.7%.
Today, gold is up YTD about 15%, and gold stock has risen only 3%.
After a 10-year bull market, good managers have finally returned to the mining sector.
Top mining companies are finally generating dramatically higher profit margins. Free cash flow is now "gushing" and will double in the next year as huge capital investments by the majors pay off.
Expect enormous consolidation as gold mining majors start buying up smaller producers, at startling premiums to current market prices.
New discoveries are expected as 10 years of new exploration is paying off, and the gains accruing to successful exploration efforts can be explosive.
I still keep 2 position size of junior gold miners. There are minimum trading activities. I re balance every 6 months or when needed. I expect when the action starts, these are going to make me the most money. Already, I went through 1 round in 2009 where I made hundreds of percent from different junior miners. Over the average, my annual return for this group is more than 30%.
Technical
So why does gold and silver corrects so violently the last 2 day.
First, investors were expecting QE 3 and it is not obvious with the Fed announcement.It is just a change on the balance sheet.
There is a margin hike today for gold and silver effective September 25th – Monday. This reinforces my belief that these precious metals are indeed intentional suppressed and manipulated. Why hike the margin when it is falling? The objective is to drive it lower.
Also, gold has gone parabolic short term and some form of regular retracement is both normal and healthy. It happened when it was at 630 in middle 2005. 950 in Q1 2007, 1178 in beginning 2009 and now as it was on verge of exploding upwards.
Retracement can be up to 50% and even 61.8%.
For Silver, a fall to $30 represents a retracement of 50% on a monthly chart. This is the level it may stop. If not it will move to 61.8% which is around $25. The maximum I expect it will go down is to 78.6% which is around $18. Thus technically, I am bearish until it change to align with the bullish fundamentals. It has to hold $31.
At each point, I will add to the positions but will not release the hedge until it is clearly bullish again. Meanwhile there are good trading opportunities even if it continues to fall.
Notice that the correction can be violent but it is also exuberant when it goes up. That’s why the observation of the fib retracement level is important.
Strategy
Since technically, it is bearish, I will be very cautious now with my trades until the technical situation change.
At each retracement level, I will add to my positions with covered calls and then collar once it breaks the support. Continue to add monthly SCs, Only when gold is clearly bullish, I will take off every hedge and let it run. I did in the last quarter of 2009.
Add on position at each retracement level with reversal signals. Some reversal signals at the retracement level are:;
- A turn on the momentum indicators at the hourly chart.
- A V – shape reversal with a candlestick morning star.
- A head and shoulder at the hourly
- Consolidation and break up i.e. a bull flag
Once the weekly turns negative and breaks support, add in the puts.
My positions will be increased each time it goes down. Do not add until they are definite signs of bottom and reversal. This current situation could go a bit longer and price can still go further down. But I maintain the confidence it will turn around.
The maximum is 2 X position size. From time to time, some stocks will be called out. It is a good thing as it will be profitable. I will add positions when the buy signals kick in on my system again.
Thinking back, I am experiencing the same kind of feelings during the last 4 corrections. Each time, there are intense emotions and fears. Every instead since the last 6 years, it ended up with gold going a lot higher. So maintain your faith in the metal.
The best thing now is to trade with a collar until the technical situation change.
It is the fundamental belief that bull rage will eventually come. Just like stock when it drops, it takes the elevator down. Here if it goes up, it will shoot up like a rocket as seen with the breakout in early 2009.
Longer term, the trend has been up since 2005 and will continue to be up. I have put forth the arguments above that gold is not in a bubble.
Once the weekly chart reversed and turn positive together with momentum indicators, I will run with charts again.
My investment style is based on fundamentals. The profits are huge. I did with with the dot.com bubble and housing bubble shorting it. It was no easy feat. Now it is safer managing with collars.
Maintain the bullish bias as long as fundamentals have not changed. Currently it is overwhelming positive. But many times price direction can go in reverse to fundamentals for an extended period of time.
Once it breaks up, there is a lot of money to be made.
STO 500 shares of VXX = 49.4
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