Recommendation: Buy GLD after breakout on ECB catalyst; look for move past $159 to confirm bullish pattern.
Option Alternative: Buy to open the January 2013, 159 Calls when the stock breaks above $159 per share.
Dividend yields … a defensive business mode … room to expand in emerging economies … a savvy management team — gold offers none of these. Strictly speaking, it can’t be valued as an investment because it produces no cash flows or the potential for any.
What gold does bring to the table is an insurance policy that can counterbalance the threats born to a portfolio every time a central banker says measures will be taken to protect a monetary union, stimulate an economy or spur activity toward full employment.
So last week, when European Central Bank chief Mario Draghi didn’t just hint that the ECB would stand behind the euro, but made it unquestionably explicit, gold rallied as an almost law-of-physics reaction. Draghi’s statement that the ECB would do “whatever it takes” to save the euro was as much of a surprise to fellow ECB officials as it was to traders. Markets around the world rallied on the comments, and gold jumped $39 in the following four days to $1,627 per ounce.
Although Draghi didn’t go into much detail, or explain the planned mechanisms for bolstering the euro, the presumed goal would be to lower borrowing costs for Spain and Italy. The idea would be to buy time for the EU to fix its structural weaknesses, get its economic growth engines revving again and pare down the deficits of the most troubled countries.
On Wednesday and Thursday of this week the Fed and the ECB released statements to the public that bond buying was available and could be deployed if economic conditions deteriorate. Although that was far short of what most people were expecting, at this point, that criterion seems likely to be met within the next month or two.
Draghi’s comments on Thursday were actually very bold and hinted at direct bond buying that may not be “sterilized,” which means it would be inflationary — and good for gold. Although the events this week indicate there will be a delay in bond buying and inflation, we suspect that the wait won’t be long.
Let’s leave aside for a moment whether Draghi’s massive bond-buying plan would be effective and whether he could garner enough of Germany’s support to implement it. Boiled down, a central bank has only so many tools it can employ, and printing a lot of money is an all-time favorite when things get really dire. So, despite the many euphemisms coined in the financial press to dress up the essence of the activity, when traders and investors perceive renewed central bank commitment to print more money, they understandably get eager to click the “gold buy button.”
No surprise, then, that the ECB chief’s comments helped gold and its exchange-traded tracking fund (ETF), the SPDR Gold Trust (NYSE:GLD), break out of a long consolidation pattern that has been forming for nearly all of 2012. The breakout has been minor — but given the length of time GLD had been consolidating, could it be the beginning of a new sustained trend?
But first, a little background.
The Nuts and Bolts of the SPDR Gold Trust
SPDR Gold Trust is an exchange-traded fund that represents an undivided beneficial ownership in the trust’s assets. The fund’s sole assets are in the form of allocated gold and, occasionally, cash. GLD was designed to allow investors to participate in the gold bullion market without needing to take delivery of physical gold, and also to buy and sell that interest through the trading of a security on a regulated exchange.
Through the means of an exchange-traded security, the fund’s objective is to eliminate the obstacles of access, custody and transaction and shipment costs that precluded many investors from buying gold directly.
GLD Vaults – Not Your Typical Crate Merchandise
The price of GLD is intended to represent 1/10 the price of an ounce of gold, net of fund expenses. The fund’s underlying gold is held in the form of allocated London Good Delivery bars in the London vault of HSBC Bank, USA. The trust currently holds nearly 1,250 tonnes of gold (or 40.14 million ounces), making it the largest physically backed gold exchange fund in the world — as well as the largest private reserve anywhere.
While the vaults may look rather indistinguishable from a Costco (NASDAQ:COST) warehouse, with over $65 billion worth of bullion bars stored inside, forklift operators would certainly have to go through a more rigorous background check!
Rumblings of New Stimulus
There’s no doubt that much of the euphoria that propelled GLD to over $180 in the summer of 2011 has long since dissipated. In its place, a prolonged period of uncertainty has shaken out short-term momentum players and tested the resolve of long-term bulls.
The $149-$150 level has been a crucial support level that has stood its ground up to this point, but has also been increasingly challenged over the last three months. Rallies that reached lower highs on each sequential turn showed that bulls were losing steam. As the Fed remained in its holding pattern and stayed its QE3 hand, GLD’s price action seemed to suggest a sense of deflation (no pun intended) on the part of bulls and encroachment on the part of GLD shorts.
Click to EnlargeGiven that gold spot prices did suffer knee-jerk losses as recently as Thursday, as traders registered disappointment with the latest statement from the ECB, GLD certainly isn’t out of the woods yet. Many technicians note that $1,640 on the spot price is a key resistance level on the upper end — surpassing and holding this level will indicate the necessary follow-through to convince gold observers that gold could have renewed legs.
Several prominent banks, including Deutsche Bank (NYSE:DB) and Morgan Stanley (NYSE:MS), have lofty price targets on gold, projecting that prices of $1,800 to north of $2,000 could be seen in 2013. These outcomes, however, are precipitated on economic conditions worsening in both the U.S. and Europe, thus necessitating further sweeping action on the part of central banks.
Click to EnlargeOption premiums shot up on July 26, the day of Draghi’s boldest comments, indicating that traders expected volatility to increase in the coming weeks — and rightly so. Option volume that day was near 260,000 vs. average volume of 68,000. The put-call ratio was 1:3. Also note that the correlation between gold and the euro/U.S. dollar for the month of July was 0.72. So, it will be difficult for gold to mount a sustained trend if the euro continues to break down and head back to new lows.
Expect some tug-of-war here between two magnetic technical poles: bears pulling GLD back down toward the $150 support, and bulls pushing for another key breakthrough at the $158-$159 level.
Speaking of tug-of-war, there’s still division among Fed governors about the need (and likely effectiveness) of QE3. At this point, it’s impossible to divorce the price action in GLD from the verbal indications of the Fed and ECB. But this GLD squeeze and initial breakout may be good reason to play the ETF in anticipation of further monetary action.
Even after the latest negative headline from the ECB, GLD has stayed well above its $149-$150 support level. A definitive stop just below $149 — representing only a -5.4% loss if things go south — is a worthwhile risk for the insurance policy GLD represents if central bank action begins to heat up again.
Options Alternative
As an alternative, intermediate-term investors could consider an outright long call position with a longer-dated expiration. If the stock breaks above $159, we would recommend the at-the-money strike. If such a break occurs within the next 5-10 trading sessions, we would recommend the GLD Jan. (2013) 159 Calls for $9.50 per share or less.
It’s possible that such a break could happen very quickly, so a conditional order could be set to automatically enter the position when the stock’s price moves above $159 and into the $159.50 area. The long call will provide theoretically unlimited upside, and would be useful for traders hoping to avoid the whipsaw risk of using a tight stop-loss when buying the stock alone.
