Back in July last year, when China’s woes were getting out of hand, we recommended using SPDR Gold Trust (ETF) (GLD) as a hedge. Well, GLD, the gold ETF, has more than delivered on its promise as a viable hedge and has since gained roughly 5%.
Of course, the negative deposit rates in Europe and Japan haven’t been too bad for gold either.
But now, the tide is once again set to turn against that very precious metal. And with that, the GLD ETF turns from an effective hedge to an inevitable short.
Why the GLD ETF Is Going Down
To understand why the GLD ETF is turning bearish, we must first understand what was behind the latest rally in the metal. Yes, we mentioned it as a solid hedge for China, but why?
Gold is typically used as a hedge against hyperinflation and currency devaluation. It’s especially relevant in India and China, the two largest gold markets, from an investors’ standpoint. And let’s not dismiss the importance of home-grown consumers of gold, especially in China.
Naturally, there is fear for the yuan’s integrity and for China’s financial system. When that fear intensified, Chinese investors and investors with exposure to China quickly switched gears. They went straight to gold rather than yuan-denominated assets (aka stocks and debt). In fact, for the common Chinese, there is very little alternative to anything yuan-denominated except for gold.
Of course, understanding that scenario, hedge funds and other market movers moved to gold. Thus, the impact was amplified.
But as one might expect, when the China factor fades, gold’s allure will evaporate very quickly — and that is exactly what appears to be happening.
The key to ending China’s turmoil is to stabilize its banking system. There is a growing consensus that China will have to enforce tough capital controls. When that occurs, the risk in China will fade and with it will go the fear and massive capital outflows.
This bears a great resemblance to what the Bush Administration had to do at the climax of the 2007 credit crisis. If you recall, President George W. Bush effectively nationalized some U.S. banks. Though the particulars are different, the effect will be the same. Essentially, the government puts a backstop to the deterioration and takes charge. And that will literally pull the rug out from under gold.
Moreover, the recent 8% surge in the price of iron ore and 3% in the price of aluminum, which outperformed gold for the past week, signals that optimism has returned. Investors prefer to own those industrial metals which are tied to economic activity and industrial output rather than gold.
Shorting GLD: Down to Practice
As can be seen in the chart below, the spike in gold prices — in the grander scheme of things — is just a correction. Trading now at $115, the GLD ETF is set to return and test its ultimate support at $100, which is roughly 13% lower. That makes it a rather lucrative short for GLD bears.
Click to Enlarge
However, a word of caution is warranted. The $100 support is the gateway to much lower levels of the GLD ETF. The last time that GLD tried to break below the $100 level, the volume of buyers was high.
That means that once the $100 is hit, one should proceed with caution. Wait for evidence of further weakening before expecting the GLD to be pushed below the magic $100 mark.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.
