Gold Bugs Got Squashed: What’s Next?

by Lawrence Meyers | April 17, 2013 11:10 am

My hair stood on end when I saw gold fall by almost 10% on Monday … but not because I own any.

Instead, it was simply because such a hard, quick crash was completely unexpected. The surprise drove me to survey every source I could find in order to uncover some theories on what happened and get an idea on where gold might — key word, might — go from here.

Before I get into that, though, there are some fundamental aspects to gold that investors must understand if they want to get involved in the yellow metal. Numerous crosscurrents are at work in the gold market. The supply/demand side of the equation is difficult to peg because you could read a dozen different reports on gold every day. This variable is simply too difficult to actually forecast.

Next, there’s the psychological aspect of holding gold during tough economic times, along with the issue of quantitative easing. The general theory behind gold in this instance is that it responds inversely to the dollar’s behavior. One reason for its meteoric rise has been that it serves as an inflation hedge.

Theoretically, all the money our government has been printing makes the dollar worth less. The less the dollar is worth, the more expensive goods become. Therefore, anything that has intrinsic value — such as a precious metal — should theoretically become worth more.

That’s what’s going on … at a minimum.

Now mix in the fact that, as some reports indicate, a very large sell order was dropped into the market on Friday. Rumors were cycling that Cyprus would be required to sell of its gold stake in order to remain solvent, representing several million metric tons. And if that was the case, how long might it be before Spain and Italy had to do the same?

As the selling began, stop loss orders began to get triggered, resulting in even more selling, which triggered even more stop loss orders. Monday’s volume in the SPDR Gold Shares (NYSE:GLD[1]) was more than the previous 15 days combined, suggesting a panic climax.

Notice anything about all these theories and crosscurrents? They all center around unpredictability.

Unlike companies, in which you can take a pretty solid educated guess — along with analysts — as to a given quarter’s performance, you cannot predict commodity prices.  For every person who said gold was going to $2,000, another person said it would go to $1,000.

So what the heck do you do about this, as an investor?

It still probably makes sense to have a small piece of your diversified portfolio invested in either precious metals or in a basket of commodities. The basket is probably better since it gives you diversification within that sector. But still, understand that if you try to time the moves in gold, you could get burned badly.

Of course, there is another way to play gold, and that is to take advantage of its volatility.

One way to do this is via various options strategies that provide limited risk and limited returns, such as the Diagonal Spread, which I wrote about this week in my options column.

Another way is to play the pawnshop stocks like First Cash Financial Services (NASDAQ:FCFS[2]) or EZCORP (NASDAQ:EZPW[3]). Most people think that these companies like to see high gold prices because they can buy gold from people at big discounts and then scrap the gold for a huge profit margin. That’s very true.

However, price itself does not drive sale volume — volatility does. So while both of these stocks got hammered on Monday, expect to see their Q2 results offer surprise upside, as people with gold and gold jewelry were waiting for gold to go higher, only to see it crater, which likely will result in them rushing to cash in now lest the price fall further.

As of this writing, Lawrence Meyers was long EZPW.

Endnotes:
  1. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  2. FCFS: http://studio-5.financialcontent.com/investplace/quote?Symbol=FCFS
  3. EZPW: http://studio-5.financialcontent.com/investplace/quote?Symbol=EZPW

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