Shorting Gold

I started a new position in my Covestor Model Portfolio: Short Gold.

This unconventional move requires some explanation, since headlines in almost every newspaper and magazine are suggesting to buy Gold.

Let’s start with the technicals. Gold is in a long-term uptrend. The monthly chart doesn’t allow a different conclusion:

However, I believe that there are compelling arguments to support a short position. Most important: the risk reward ratio for this trade is extremely favorable: I plan to close the position if prices should rise above 1260. Price target is 1060 for a first profit target and 1000 to close the position, so I’m ending up with a risk/reward ratio of almost 3.

By the way: I believe that Gold is ALWAYS (and has always been) a trade and not an investment. Two of the reasons being that Gold doesn’t pay dividends or generates earnings.

Note that even if Gold hits $1000 by the end of the year or so, the long-term uptrend would still be intact.

The daily chart has been showing some weakness recently. In fact, I’m characterizing the structure as a “fractal rising wedge pattern” (I apologize for the geeky term, but I liked it):

In a fractal structure, certain properties repeat themselves on different scales, creating effects of “self-similarity”. Gold is a great example: we can identify two bearish rising wedge patterns. One of them (blue) took over 12 months to develop, prices needed 8 weeks to complete the smaller one (red). Based on classical technical analysis, the completion of the larger pattern would take prices down to the $1000 level.

So much for the technical picture. I think there are also fundamental reasons why Gold could trade lower for the rest of 2010:

• The Gold trade is extremely crowded. One of the arguments is that “the big hedge funds are buying”. If Paulson and Sorros own the yellow metal, maybe everybody else should too. Well, I don’t necessarily agree with this argument. Paulson and Sorros HAVE BEEN buying Gold and loaded the boat. There is no indication that these gentlemen still keep buying. In fact, the next move probably is to rake in some profits. So imagine what would happen to Gold prices if we read that these funds started to lighten up on their position. I’m not saying that they will do that, but at least, the big buyers have bought already.
• There is no and there will be no inflation for the forseeable future. The Gold-inflation trade is valid, but I believe we won’t see significant inflation for the next two years.
• The current Bond-Gold paradox: Bonds have been rallying, so has Gold, which is unusual. Higher prices for treasuries suggest deflation ahead, rising gold indicates higher inflation. Who is wrong? The funniest argument I read recently was: “This time it’s different. Gold and Bonds are predicting on two different time frames.” The “this time is different” argument is a typical bubble argument. People should know that by now. During the Internet bubble, when companies were trading at astronomical prices without any earnings, we heard “this time it’s different, companies don’t need earnings.” When housing prices rose by 30% a year in some US regions annually, we could hear the “This time it’s different” argument as well. It never was and with respect to Gold it will not be different.
• Gold as a fear trade: fear of a Euro currency crash? Looks like that’s off the table. Fear of a double dip recession in the US? I don’t belive it. Once companies start putting their huge amounts of cash to work (and at one point they will), economic activity will pick up.

I might be completely wrong with this, but as I wrote before, the risk/reward ratio is the compelling reason. If I have a 55% chance to be right on this (based on technical and fundamental reasons) and the opportunity to win three times more than I can lose, it is a trade I’m happy to take.