Gold Bulls are Back!

On hitting a two-year low at the end of June for a total correction of 38% from its 2011 all-time high, gold seems to have found some interested buyers once again. And not just your average investors either, but a couple of real heavyweights, such as famed fund managers John Paulson and George Soros.

But weren’t these the fellows who dumped gold in massive quantities earlier this year? With Paulson selling almost 50% of his gold products and Soros selling all of his? What has happened recently to get them – and other investors – to change their minds?

There have been two major changes as of late that may be influencing this change in sentiment toward gold: a change within the gold mining sector that can be likened to a massive house cleaning, and a change at the U.S. Federal Reserve that actually implies no change at all.

The Change of Heart

It took about two years of relentless price drops to turn most investors against gold. Even gold hedge fund manager John Paulson of PFR Gold Fund cut his stake in the largest gold ETF, the SPDR Gold Trust (NYSE: GLD), by more than 50% in early Q2 of this year, while another hedge fund mover-and-shaker, George Soros of Soros Fund Management, sold his entire stake of GLD, as well as his entire position in the Market Vectors Gold Miners ETF (NYSE: GDX).

It seemed everyone hated gold, and most still do. “The big sell off we saw earlier this year drove several investors away,” Peter Jankovskis, co-chief investment officer of Oakbrook Investments LLC, recounted to Bloomberg. “The worst may be over, but the outlook remains bearish, and it’s not a sought after sector.”

Investment bank Goldman Sachs (NYSE: GS) expects the bearishness to continue into next year, forecasting lower prices to $1,100 by the end of 2014. The largest fixed income investment firm in the world, PIMCO, actioned its bearish sentiment in Q3 by selling 80% of the GLD position it held in Q2.

It is important to note, however, that the specific dates of PIMCO’s trades were not released. For all we know, the firm could have simply decided to lock in profits as gold rose $250 from the end of Q2 into early Q3.

Though gold has given back half of that $250 gain over the past two months, it has successfully tested and held the $1,270 area three times since July and seems to be poised for higher prices through the winter and into the spring, a historically bullish time of year for the metals.

Gold’s possible bottoming in June has drawn Soros back into the GDX gold miners fund as he repurchased almost half of his previous sales and exited his large put position in the Market Vectors Junior Gold Miners ETF (NYSE: GDXJ).

Meanwhile, Paulson’s recent filing with the SEC shows he still held the same gold exposure at the end of Q3 as he had at the end of Q2.

So what has changed? Paulson holds; Soros adds. It would be wise to pay attention, as Reuters noted:

“Investors pay close attention to the quarterly filings by Paulson and other notable hedge fund managers because they provide the best insight into whether the so-called ‘smart money’ has lost faith in gold as a hedge against inflation and economic uncertainty.”

Changes Within Mining

There is a good reason why Soros is getting back into the gold miners, as they have been hit so hard by gold’s two-year correction that they have hit rock bottom and have nowhere to go but up. With the gold price dangerously close to their all-in operating costs, miners have the smallest profit margin since 2008, and their stocks have taken a beating because of it.

In response, gold producers have closed their more expensive mines, fired workers, and written-down a combined $26 billion in losses this year alone. Sounds like bad news, doesn’t it?

Well it’s not. It’s actually great news looking forward, for what we have now are lean mining operations with the bulk of their losses already written out of their stock prices. A lower quantity of open mines means less supply; demand need only pick up just a little, and the constrained output capacity would not be able to keep up, resulting in a rapidly rising gold price.

When that happens, mining stocks will rise even more quickly, since their companies have already trimmed the fat and cleaned house, while their shares currently represent the leanest value in years.

Changes Within the Fed

Then we have the upcoming change at the head of the Federal Reserve, which really means nothing will change there at all. With the Senate’s approval of Janet Yellen as the new Fed chair practically an assurance, investment markets across the board, from equities to bonds to commodities, have captured a second wind as Yellen’s dovish views promise a continuation of the Fed’s current market-friendly policies for another four-year term.

At her nomination confirmation hearing before the Senate Banking Committee last week, Yellen’s answers to the panel’s questions assured all markets, including the precious metals, that she favors keeping benchmark interest rates unchanged at their historic lows for years to come. And though she reiterated the Fed’s current view that its $85 billion monthly injections into the bond and mortgage markets will at some point need to be removed, Yellen gave no indication as to when – which the markets took as an indication she is intent on using all available tools at her disposal to support the economic recovery.

“Supporting the recovery today is the surest path to returning to a more normal approach to monetary policy,” Yellen made her priority clear, as cited by Bloomberg. What she is ultimately saying is, ‘Let’s first get the economy back on track. Then we’ll work on returning monetary policy back to normal.’

That priority means that any consequential erosion to the value of the dollar in the meantime – and the risk of inflation caused by it – are quite simply necessary evils that must be tolerated, kind of like the temporary pain and bruising from a critical life-saving operation.

What a Yellen appointment to the Fed Chairmanship means for gold, then, is a continuation of the same easy-money policies and the continuing risk of inflation that propelled it from $750 in 2008 up to $1,900 by 2011 for a gain of over 150% in three years. If low interest rates and Fed stimulus worked wonders for gold then, why wouldn’t such conditions do the same again?

“With Janet Yellen, we know that the Federal Reserve is likely to err on the side of inflation,” Axel Merk, portfolio manager at Merk Funds, whose firm holds a position in GLD, elaborated to Reuters. “So there is a good reason to continue holding onto [gold].”

Now we know why Paulson is holding onto his gold. “The risk of high inflation in the future makes gold a desirable long-term investment,” he presented his bullish view in a letter to investors obtained by Bloomberg.

Digging Up Opportunities

While monetary policy clearly favors gold going forward, it may take a bit of convincing before the crowd returns to the space. During most bull runs, the largest price moves come at the end, while the smallest are at the beginning. So we may still see some price turbulence short term.

Yet even the most bearish forecasts down to $1,100 or even $1,050 give gold no more than about another 15% downside risk, which many investors will find quite tolerable compared with the 50% upside potential to the previous all-time high.

Perhaps following Soros’ lead into the GDX gold miners ETF might offset some of that downside risk with its 1.91% annual dividend yield.

Moreover, as noted in the graph below comparing the GDX miners ETF to the GLD bullion ETF all the way back to the end of the 2008 correction, miner stocks tend to outperform the metal during the first part of a recovery – their gains climbing ever higher as the rally extends (blue lines). Just keep in mind that because they incur operating costs, miners will fall harder than gold on the way down.

Source: BigCharts.com

Joseph Cafariello

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