Will Gold Glitter Again – Part II

With gold having a strong start to the year and a solid 20% off its 2015 lows, the bulls vs. bear’s arguments have taken center stage. Let’s review both arguments.

Bear Case for Lower Gold

1. Gold is an inflation hedge and performs poorly in deflationary times. The most commonly referenced example is the 20-30% decline in gold prices during the 2008 financial crisis.
2. Gold has very little real world purpose, mostly for jewelry.
3. Gold is a barbaric relic that has lost its role as world money.

The current arguments against gold are best illustrated by Goldman Sachs comments that this rally was an “overreaction” to the systemic risks from oil, China and negative interest rates. Read the full comments.

The commercial hedgers in the futures markets echo those sentiments as they have been actively locking in the current gold prices with short futures contracts almost at 52 week highs.

When you put it into context, one can quickly develop a healthy amount of skepticism about the excitement of the best performing asset of 2016. So what is the bull case?

Bull Case for Higher Gold

1. Gold is not an inflation hedge, but a hedge on Central Banks and the Monetary System. The argument about gold’s decline during the 2008 crisis has to be put into the context that gold was coming off an all time high and in an overbought state, having risen over 100% in the prior two years. That is structurally a different condition than today where gold has been stuck in a 4 year bear market decline.
2. Gold is not only being held by central banks, but is actively being accumulated. If gold was a barbaric relic as many Keynesian’s would have you believe, it would have been actively distributed and abandoned by the banks.
3. Gold has bullishly reversed the bear market downtrend. This is best illustrated by simply observing the 20 month moving average. The price of gold has remained in a bear market decline since January 2013. The February 2016 monthly close, represents the first bullish close above that moving average.

The current argument can be illustrated by Deutsche Bank’s remarks that “gold is still expensive, but rising economic risks and market turmoil mean investors should buy it for insurance. click to read.

Looking Back

We have been here before; when back in October we made a case for gold mining stocks, not based on fundamentals but on sentiment. Here is what we said:

Often the perspective of many investors is that the biggest profit opportunity is when a sector goes from “being bad to good”. Alternatively, over my many years of experience I have often found that there are opportunities for greatest returns when conditions in a sector have moved from being “very bad” to just being “less bad”.

Gold stocks have rallied close to 50% higher off their lows and 30% from the levels when we wrote the article.

How Can An Investor Participate While Managing Risk?

No matter how bullish an investor would like to be, one can recognize that off the existing price levels on gold and gold mining stocks, there is considerable downside risk if the investor is wrong and the stocks return back to 2015 lows. How does someone participate while managing risk?

One can consider buying the underlying stocks and overlaying the position with a protective put. As an example:

• Investor buys 1000 shares of the iShares Gold Bullion ETF (TSX:CGL)
• Investor invests $10,920.00 (trading at $10.92 per share)
• Investor buys 10 put options to April at the $10.00 strike for $0.15 or $150.00

What has the investor done?

The investor has 100% of the upside of gold, no risk of being “noised” out of the investment with tight stop losses, or panicking out from day to day volatility. Equally, if the bear case was proven to be correct and gold declines back to its 2015 lows, the investor is guaranteed to have their risk limited to $10.00 a share over the next 2 months. This strategy is just one of many interesting ways investors can hedge and manage risk with options, when entering speculative positions in the markets.