Gold

Gold.  The utility of this precious metal rests on its ability to be a concentrated form of wealth. Its immutable nature gives it a permanent shine – not just now, but throughout human history. Unlike silver and platinum, whose fortunes wax and wane with their industrial applications, gold's value is independent of its utility. Unlike precious gems, which can be subjectively graded and valued, gold is a commodity – capable of being perfectly standardized and objectively valued at a myriad of transparent, liquid, and interconnected global markets. Gold is the preeminent sign of wealth all over the world. Gold, hoarded in government vaults, underwrites geopolitical power and imparts a sense of tangible value to currencies.

Adopting a contrarian perspective on the long term role of gold is futile. To argue that humanity will leave gold behind and focus on new Apple products as the ultimate sign of wealth is nonsense – the current crop of the spendthrift ultra-wealthy will be encasing their new high-tech gadgets in bejeweled gold cases, and spinning gold taps to brush their teeth, while ordinary mortals will continue to aspire to own a gold trinket or two. The combination of an increasing global population and affluence will continue to drive the demand for gold as a display of status and wealth, while economic uncertainties will guarantee its place in diversified investment portfolios.

Gold is proclaimed as the panacea for a wide array of troubles. In politically uncertain times, gold is a perfect hedge. Its high density and value means it can be easily transported and stored, which is good news both for desert nomads and central banks, and it's widely acknowledged that in an inflationary environment, gold is a hedge. This last decade, “gold bugs” have been well rewarded for their appreciation of the noble metal. During an extended period of falling interest rates, decreasing dividends, and equity markets struggling to regain lost ground, gold has more than doubled in value. As a “doomsday” investment it has shown greater resilience than reserve currencies and government bonds, and we are still waiting for it to take its starring role as the lead inflation fighter.

Now, let's have a look at price action. From a technical perspective, gold has obviously been in a multiyear bull trend, notable price action includes very strong performance during the last half of 2007 continuing into 2008, followed by a sell off combined with high volatility for the rest of 2008.  2009 marked the beginning of another leg in the bull rally, with gold prices going parabolic in August 2011 before a “blow off” top later that month, followed by a false continuation in September. Since topping gold has remained volatile, and, while its trading channel remains hard to define, it is narrowing. If the current consolidation in gold continues and gold conforms to a “standard” breakout from a lower volatility environment, then gold should be set for its next directional move towards the end of this summer.

Despite gold's recent price corrections, it remains in a major secular bull trend. Major areas of support have been breached and the trend is questioned – the first area has been breached (around 1600 – corresponding to around today's level of 155+ on the above ETF, NYSE:GLD), the second area of support is around 1300 (which, with GLD ETF costs will probably equate to close to 130, as opposed to 125). While it's possible to directly trade off these areas of support, the lowest risk strategy is probably to sell puts targeting these supports – incidentally, December GLD 150 contracts are trading at prices offering a sound entry and a 3.6% holding period return, or about 9% annualized.  This would never amount to a serious leveraged gold play, but as an "exposure to gold", or perhaps even as a commodity exposure this, or similar trades, deserve allocation.

In closing, some time ago, back in March (when I first thought that we were seeing a constructive consolidation price pattern begin to form) I had a conversation with a long time "gold bug" about miners' expense ratios.  I confessed that I could not understand how gold could trade at more than twice its "cost" (many miners report costs of just a little more than USD700).  The economic argument is simple: supply will ramp up until equilibrium is reached; lower grades will be exploited, higher fees will be paid etc etc.  While I knew that this equation was subject to externalities, such as government regulations, and political risks, to name just a few, it's still hard to accept gold's "premium".  To help overcome aversion to overpaying for gold (ignoring its historical roles as outlined above), the two major considerations are:

1. While miners are claiming low productions costs, supply remains inflexible due to the sector's inability to access capital (basically, investor trust was all but destroyed in the multi decade secular bear market that preceded the current bull market).  It's also natural to conclude that today's capital markets present huge barriers to entry for any speculative capital intensive company.

2. Most mining operations exist in politically challenging environments.  Whether it's a threat of nationalization, or simply permit risks; gold mining is a high risk venture and demands a big risk premium.

Establishing a long position in gold today implies that you're buying into these arguments (an adverse capital market, and risks galore - both political and environmental).