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October 9, 2008

Thoughts on Gold

As readers know, I have maintained a bearish slant on gold despite the full wrath of Uncle Ben's helicopters and the fact that gold has been acting very strong the last few sessions. I keep staring at the charts and pondering the macro situation to see if I can convince myself otherwise... kind of like playing devil's advocate with myself... but I just don't see the bulish case for gold on the near-to-intermediate term.

Much of gold's recent strength has come, I believe, from the unwinding of paired trades on gold/silver:

gold silver ratio

Since silver tends to outperform gold while the metals are in a bull market, hedge funds were putting on massive paired positions of long silver / short gold. As the cash crunch took hold, these positions were unwound fervently in a scramble to free cash. The price ratio between the metals is now back to where the bull market began! The unified strength of the metals over the last couple days were likely related to the anticipation and execution of coordinated global rate cuts.

The conclusion is that gold's recent strength has been primarily related to the liquidity panic of the last three weeks. When stocks finally manage to print a bottom and enter their first sustained bounce, gold is likely to crater. I am going to pick up a small short position in gold in anticipation of this scenario. If the yellow metal does not crater when the market bounces hard, it will indicate underlying strength, and I will then likely flip my trade to the long side.


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