Has the upturn in Gold started?

by JDH on November 22, 2008

Last week I said this:

I’m holding on to all of my gold and gold stocks, and I’m holding on to my short plays on the market. I’m a pessimist. I think we see Dow 5,000 before we see Dow 11,000, but I hope I’m wrong.

Well, it’s not looking like I’m going to be wrong, is it?

I’m not going to be wrong, I’m afraid, because the world has changed.

The modern world began in 1978, with the start of the reigns of those icons of capitalism, Ronald Reagan (in 1980), Margaret Thatcher (1979), and Deng Xiaoping. (Okay, okay, Deng Xiaoping was never officially the leader of China, but from 1978 onwards he had significant influence on China, and he did encourage the Chinese people to individually begin taking risks, and that did bring about the greatest increase in the standard of living that any society has ever seen in a 25 year period). In the 1980s and 1990s we all worked hard to get ahead, and taxes were being lowered to reward earners.

Those days are gone. 50% of voting age Americans no longer pay taxes. They receive from the government, and therefore have no incentive to work. A “soak the rich” methodology is now politically expedient if none of us are rich anymore. More government spending is inevitable, although I’m not sure President Obama is capable of spending as much as that other icon of freedom, George W. It’s hard to top a trillion dollar deficit, but I digress.

The change became obvious on July 13 of this year when the Boys agreed to bail out Fannie and Freddie, boosting the bank stocks (temporarily) and the U.S. dollar (temporarily) and killing the commodities markets (oil dropping from $140 to $50).

It could be argued that oil dropping from $140 to $50 is deflationary. It could be argued that the huge number of house foreclosures will drop the price of a house, which is also deflationary. Perhaps, in the short term, that’s true. Longer term, not so much.

Inflation is an increase in the money supply; deflation is a decrease in the money supply. If twice as much currency is chasing the same number of goods, prices appear to rise, which is why we think rising prices means inflation. The money supply certainly appears to be increasing, with the national debt set to increase by somewhere between 50% and 100% this year thanks to the bailouts of Fannie and Freddie, the TARP program of $750 billion to bailout out the banks, and who knows what else to bail out the auto industry and everyone else. Longer term, that’s inflationary.

Let me be more specific:

Short term, prices are falling. The price of a barrel of oil has dropped by two thirds in the last few months. House prices are crashing. Unemployment is rising, which drives down the price of labour (or “labor” for my American friends). But that is a short term phenomenon.

In the medium term, all of the new money created by governments around the world will be inflationary. There is no way you can print that much money without the money supply increasing. That’s inflationary, and that’s good for gold. Really good, if you look at Friday’s action:

Gold peaked in March, and is still in an obvious down trend, but Friday’s $51 increase in the spot price is a nice start.

Even better is the action in individual gold stocks, like K.TO – Kinross Gold Corp. , up 28% on Friday. That’s more like it. Most impressive is that the Kinross chart is different than the gold chart. Gold is still in a downtrend, but Kinross appears to have broken the downtrend, which is a very positive development. I’m not selling.

Interestingly, every gold stock is not the same.

ABX.TO – Barrick Gold Corp. had an even bigger gain on Friday, up 32% on the day. However, as the chart shows, it’s downtrend from the summer remains in place, so all is not perfect, yet. We could still be experiencing a bear market rally. In fact, by definition, that’s exactly what we are experiencing.

Let’s take a closer look at the numbers. Specifically, let’s take a look at my gold and silver holdings, and compare their closing price today to their closing price on October 31, 2008:

Oct. 31/08 Nov. 21/08 Gain $ Gain %
K.TO – Kinross Gold Corp.
G.TO – Goldcorp Inc.
ABX.TO – Barrick Gold Corp.
AEM.TO – Agnico-Eagle Mines Ltd.
PAA.TO – Pan American Silver Corp.
SSO.TO – Silver Standard Resources, Inc.
SLM.TO – Silver Wheaton Corp.

The table tells the tale: The major gold producers have done well, the big silver producers have done o.k., and the small silver guy (Silver Wheaton) went down.

This makes perfect sense to me. The market is tanking, so if I want to use gold as a safe haven, I’m not putting my money in the little guys; I’m putting it in the big, safe guys, and that’s exactly what happened.

What To Do From Here

My plan, for your consideration, is as follows:

First, I don’t believe all is good with the market.

Clearly the DOW is back to the bottoms of September, 1998 (7,795) and September, 2002 (7,528). The bottom on Thursday was 7,553. The optimist would tell you to look at the uptrend line (the blue line on the chart above (you can click it to enlarge it); extending back to before the 1987 crash the uptrend line is still in place, so we are simply in a huge correction within a long term bear market. The optimist would also tell you that we are at a triple bottom, which is very strong support, so we should rally from here.

I don’t believe it. The DOW was over 14,000 last year, and it fell to under 8,000 this week. A drop of almost 50% is not a correction in a bull market; that’s a bear market. We have violated the 1998 lows from ten years ago; that means the gains of the last 10 years are gone; that’s not just a correction. That’s a bear market.

Therefore, my plan is to remain short the market.

I continue to hold RSW – Rydex Inverse 2X S&P ETF, an ETF that attempts to increase by twice the drop in the S&P 500. In other words, a drop of 10% in the S&P should lead to a gain of 20% in this ETF. As the chart shows, it’s extremely volatile (obviously twice as volatile as the market). On Friday it was down over 9%, but there are days when it can be up over 10%. It’s volatile, but it’s a great hedge against further drops, and I’m in the money on it now. It’s currently 20% of my portfolio, so that shows you how bearish I still am.

Second, I’m holding my gold and silver shares, as shown in the table above. I realize we are still in the correction phase of the market. However, as I described in detail discussing gold price manipulation in previous posts, the gold price has been artificially depressed by JP Morgan (to increase their profits on the short side), and JP is working with the government (hence the sweat deal on Bear Sterns) to keep the gold price down, lest the populace realize how bad the situation really is (hint: it’s really bad). If gold was at $2,000 per ounce the talking heads couldn’t show up on CNBC and say “now’s the time to buy”. No-one would buy until a new currency was established.

But, you can only keep the lid on a volcano for a limited period of time. Gold was up over 5% on Friday, finally getting over $800 (intra day) for the first time since October, and actually touching it’s 50 day moving average, also for the first time since mid October. Those are positive signs, that lead me to believe the shorts are unwinding their positions, and are even perhaps moving to the long side.

I continue to expect investors to increasingly take delivery of Comex gold contracts in December (which may even lead to a Force Majeure on the gold market if the gold doesn’t exist in the warehouses to cover the contracts. We could easily see $1,000 or more per ounce by the end of next month, so now is not the time to sell gold shares. (Physical gold bullion isn’t a bad idea either).

That being said, the first wave back to gold shares will be a flight to quality, so the senior producers should increase faster than the unproven juniors. So, I’m in the seniors now (see table above), and will only move into the more speculative juniors once the seniors have had a run.

Could I be wrong? Of course. I’ve been wrong for the past year and a half, which is why my portfolio is down 46% year to date. It’s been a disaster. However, as price deflation ends and inflation kicks in, gold will soar, and there will be serious profits to be made.

Timing wise, I expect continued volatility, but since I don’t know when the explosive uptick will start, I’m staying put. (It may have started on Friday, but realistically a pullback for gold on Monday would be more logical, with the big move upward not happening until December or January).

Finally, I’m keeping a third of the portfolio in cash. If I am wrong, I’d like to have some cash on hand for further bargains. (And yes, I believe we will see Dow 5,000 before we see Dow 11,000).

That’s the game plan, so please continue to post your thoughts on the Forum; we’ll chat again next week.

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