Why Gold is Slipping

To every question there is at least one answer. At “least” one? Well, sometimes there are two answers, especially if you’re discussing gold.

Since gold is a reactionary investment bought and sold in response to something else, its behavior is much more difficult to understand, for it really doesn’t have any true behavior of its own but instead relies on the behavior of everything else.

For the first 11 years of the new millennium, gold in USD terms was reacting to two U.S. recessions (2001 and 2008) and the government’s responses to them – namely, the lowering of interest rates twice and several rounds of bailouts and stimuli. Since these measures weakened the USD, gold rose relative to it.

Then came a sustained wave of buying by central banks and a long line of exchange traded products that took gold off the market and parked it in vaults, lifting the metal’s price even further.

Every question concerning gold at the time had a positive answer: buy. That seems not to be so anymore. After reaching a peak of $1,920 an ounce in September 2011, gold slid some 38% to its July 2013 low of $1,180. Despite a rebound to last month’s high of $1,430, gold has by this morning given back half of those gains, starting the day at $1,300, down some 23% year-to-date and on pace for its first losing calendar year of the millennium.

It is time to ask some key questions again. What is driving gold now? Are gold’s best friends – inflation and stimulus – no longer there to help? Or is the Federal Reserve’s new policy on monthly bond purchases going to finally kill the gold bull? How should we trade gold now?

Four Golden Questions

Since we’re discussing gold, we will likely get two different answers per question. If you hold gold long enough, either answer is bound to be right at some point.

Question 1: Are U.S. Federal Reserve changes bad or good for gold?

Answer: Both bad and good, for there are two changes coming.

The first change is the reduction of the Fed’s monthly bond buying program, which is expected to be announced later today. Less money pumped into the economy will strengthen the USD, thereby lowering gold.

However, there will be a second change at the Fed which is good for gold – the likely appointment of Vice Chair Janet L. Yellen to chairwoman later this year for a late January start. This is seen by analysts as positive for gold, since Yellen is considered dovish and will likely promote current easy-money policies.

The first answer, then, would issue a sell signal for gold in the immediate term, likely pushing gold to retest its recent $1,180 low. Some, including Harvard professor of economics Nouriel Roubini and investment banking firm Goldman Sachs (NYSE: GS), are even expecting a retest of 2008’s high of $1,035.

But after the bond tapering induced wash-out, the second answer would issue a buy signal, since a still dovish Federal Reserve would likely keep the remaining easy-money policies in place.

Question 2: Is inflation going to lift gold at some point, as has been anticipated?

Answer: Again we have two. In the immediate term, no; there is not enough inflation to seriously damage the USD’s buying power and lift gold. The latest 1.1% inflation rate is tame and manageable.

But over the longer term, inflation should support the gold price. The Federal Reserve has committed itself to stoking inflation up to an annual 2% and to keep interest rates unchanged at near zero – even if inflation rises to 2.5% – to make up for some lost years of growth.

Combine this with the prospect for a still dovish Fed under the leadership of Yellen, and the commitment to coax inflation is still alive, keeping the gold bull alive as well.

Question 3: Is gold going to get a lift from geopolitical tensions, as in a strike against Syria?

Answer: Two answers here too. In the immediate term, the pursuit of a diplomatic solution to confiscate Syria’s gas weapons will put downward pressure on gold, as easing tensions lessen the need for the safety of gold.

But remember the path the U.S. and other Western nations have taken over the past 12 years since the 2001 tragedy at New York’s World Trade Center. First came the occupation of Afghanistan, then of Iraq – both bordering Iran. A strike against Iran’s nuclear enrichment facilities has long been proponed. Syria is simply one means to that end, a way of drawing ally Iran into conflict, permitting the West to strike.

But there are other ways to strike Iran without taking the Syria route. The U.S. has less than a year in which to find one, given the progress of Iran’s nuclear program. This is positive for gold, although I am ashamed to hear myself say that.

Question 4: Gold may be a good investment in times of crisis, whether financial or geopolitical. But in the meantime, between crises, it produces no income and pays no dividend. Should it be held even during these quiet periods?

Answer: You guessed it, there are two answers here as well. If you trade gold itself, either the metal or an ETF, then there is no point holding it during “quiet” periods of economic or political stability. You can get better returns from equities, which is why gold has been selling off for almost two years while stock markets have been rising.

But does anyone know when a crisis will strike? Investors need to have some gold in their portfolios before crises happen. A great way to keep a stake in gold at all times while still gaining the benefit of regular income is to invest in gold producers and gold streamers (companies that collect royalties for financing gold miners and explorers).

These include: Freeport-McMoRan Copper & Gold Inc. (NYSE: FCX), yielding 3.73%; Newmont Mining (NYSE: NEM), yielding 3.51%; Gold Fields (NYSE: GFI), yielding 3.47%; and Royal Gold Inc (NASDAQ: RGLD), yielding 1.55%.

Although RGLD’s dividend is low, it moves with gold more closely than the producers do, regularly outperforming gold on the way up. But be careful with this one, as it also drops more than gold on the way down.

The Relative Trade

Stringing the above questions and their answers together, then, we arrive at the typical forecast: gold should fall over the near term but climb over the longer term. Yet we need not fret over the timing, as there exists a way to stay long gold and still take advantage of its volatility to lock in extra gains – through relative value trading.

You can pick any two stocks you like and simply trade them against each other – using profit from the one to buy more of the other, and then switching back when the stocks reverse. You can also structure more complex strings by trading three or more stocks following the same principle.

The following graph couples the SPDR Gold Trust (NYSE: GLD) in black with the Royal Gold streamer noted above, RGLD, in beige (click to enlarge).

Source: BigCharts.com

If you start with an equal investment in both instruments, in a few days and weeks you will see the pair begin to separate from each other. When the gap between them is a few percentage points, you would sell a few shares of the better performer and buy a few shares of the worse performer. (First blue arrow.)

It does not matter if both are up or if both are down. What matters is that your money always moves from top to bottom; that is, from the better performer to the worse performer. This improves the dollar cost average of the combined investment in both positions.

As the pair continues to drift, they will eventually cross each other and reverse positions. At this point, you would again move funds from top to bottom, only this time you’d be selling the one you previously bought and buying the one you previously sold. (Second blue arrow.)

The end result is the locking-in of capital gains, generating revenue from instruments that may or may not offer income of their own.

Keep in mind, though, that the two stocks may not always cross over each other for very long. Even so, if the ratio between the two is tighter than it was on your last trade, you can still move a little money between them at a profit. (Third blue arrow.)

The easiest way to keep track of when to switch between the two is to note their ratio to each other, sliding funds in portions every 5 percentage points or so. You may have several slides from A to B in a row before having one going back from B to A.

Joseph Cafariello

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