Many crosscurrents affect the prices of precious metals, particularly gold. Supply and demand is a primary influence, but when it comes to gold in particular, artificial demand can be created and exaggerated based on political and economic factors. I try to separate those from the actual production-driven factors, such as a need for gold to make jewelry.
In other words, the gold market is just as susceptible to emotional factors as stocks and bonds are. So from an investment standpoint, the ultimate question is whether gold is just another asset bubble driven by emotion, as we saw with tech stocks in the late 1990s and housing prices a few years ago.
Alternatively, you can choose to look at what’s going on from a trading standpoint and try to take advantage of short- or medium-term moves.
The bull and bear cases for gold are pretty well-known, but I want to focus on investment-driven demand, because I believe that’s what has fueled the recent gold bull market. In that regard, jewelry and technology demand have been relatively stable. The World Gold Council, in its fourth-quarter 2011 brief, noted that while China’s demand for gold has been increasing, it’s been offset by India’s decreasing demand.
Meanwhile, investment demand in 2011 was up 19% year-over-year, although gold bar and coin demand slowed in the fourth quarter after seven straight quarters of growth.
But it was the ETF sector that went wild, with demand up 290% from 2010’s fourth quarter. Much of this was driven in by the eurozone debt crisis. When I look at demand in that context, I start to smell the makings of a manufactured bubble driven by emotion. But how do you balance that out against all the other crosscurrents?
From a long-term investment standpoint, there isn’t much you can do as far as creating a long-term expectation for a return on a gold investment. Stocks have a long-term positive expectation. Over the long term, it’s expected that companies will grow and that the stock market in the aggregate will yield a positive return. Take just about any long-term rolling period, and stocks provide a positive return. It’s a bit like card-counting in blackjack. The casinos don’t allow it because it takes a small house advantage (and negative long-term expectation for the gambler) and reverses it.
Gold, however, has is no such long-term positive expectation. It’s like playing roulette — much more akin to chance. Therefore, I suggest you simply place a small percentage of a diversified portfolio into gold via an ETF like SPDR Gold Shares (NYSE:GLD) and rebalance twice a year. If other investments outperform gold, then the gold percentage of your portfolio will decline, and you buy more to bring it up to the proper level. If gold outperforms, you’ll end up taking some profits and redeploying that capital to other investments.
Alternatively, you could go one step removed from the actual commodity itself, and reduce volatility, by taking a position in a diversified gold-mining ETF, such as the Market Vectors Gold Miners ETF (NYSE:GDX).
On the trading side, I rely almost exclusively on technical analysis. Normally, I don’t use technicals except to assist with entry and exit points on trades — it’s a windsock and not a crystal ball. In the case of gold, when the price fell below $1,600, it breached both short-term and long-term support lines, so I felt good about shorting it via PowerShares DB Gold Short ETN (NYSE:DGZ). Of course, since gold is volatile, I set a stop loss at 6% above my short entry price.
Gold now sits right at the $1,550 support line. A breach here could suggest a much steeper decline, and if that break occurs, I will add the ProShares UltraShort Gold (NYSE:GLL) to my play. This is a 2x leveraged short position, so between this and DGZ, I’ll effectively be triple-short gold, but I’ll also set a much tighter stop.
How convinced am I to go so short? Look at these charts and how support has been breached:
Then add the crumbling euro, which will drive demand for the U.S. dollar, which in turn results in gold selling. That, by the way, is another way to play. You could go long the U.S. dollar, which has also broken through long-term resistance, by buying the PowerShares DB US Dollar Index Bullish (NYSE:UUP).
The key here is not to get greedy. I would gradually cover that short position as gold falls to avoid getting caught in a sudden reversal, selling off 25% of my total position with every 10% drop in the price of gold.
Regardless, gold investing isn’t for those who get upset stomachs easily.
Lawrence Meyers currently holds shares in DGZ and intends to buy GLL within two days of gold falling, and remaining, below $1,550. He’s president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.