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Dan Denning

Dan Denning

Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks,…

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Gold and Gravity

Is the gold price giving us a repeat performance of October's fake-out in the oil market? My suspicion is that gold is acting a lot like crude did last month...running up to fresh highs - and making headlines all the way...

But this isn't the main event. Not yet.

The day of reckoning for America, her deficits and her dollar is surely on its way. Investors who haven't yet bought gold as protection could be forgiven for thinking they've missed their chance. But we may see gold make the inevitable run up to $450 - as early as next week - and then experience a serious correction and consolidation.

For that, investors still not holding gold should read "last chance to buy before the bull is untethered..."

First, note that as gold has screamed up since the summer, gold mining stocks have failed to confirm the move. Just as happened with the Oil Sector in October, the underlying commodity has gotten way ahead of its producers. For instance, gold put on $5 - one full percent - between its Tuesday close in London and its Wednesday close in New York this week. Yet the two biggest gold producers in the world did not follow. AngloGold eked out a 0.56% gain on the day; Newmont mining, the world's largest gold producer, managed a 0.71% gain.

Is this quibbling? Well...no. Newmont climbed as high as $49.96 in intraday trading Wednesday. But when you take a closer look at the chart, you see that it even though it closed up for the day, the second half of the session was all downhill...until it reached $49.55. In short, Newmont made a bid for $50 and couldn't make it. The largest gold stock in the world is failing to confirm gold's bullish move. Why?

The answer is "earnings' gravity". If you want to buy Newmont at p/e of 50, be my guest...and many investors will. But until the bullion price moves much higher - and starts making its way onto the income statements of the gold producers - the dearth of gold shares means you have too many investors chasing too few gold stocks, and paying too much for them. The total market capitalisation of the gold and silver mining sector in the US is less than $136 billion. By comparison, Microsoft's market cap is $296 billion. The equity upside of gold is limited until the bullion upside gets much, much higher.

Of course, there is the chance that the next "psychological level" for gold is $500 - that being simply such a glorious number that traders can't resist it. Kevin Kerr at Outstanding Investments believes the technicals support gold all the way up to $475 in short order. This move would be aided and abetted by a huge increase in speculative longs in the futures market AND a surge in liquidity inspired by the launch of GLD, the New York listing for the World Gold Council's bullion backed gold fund. It's due next month, if not in the New Year.

Several hundred million dollars could flood into GLD as soon as it's launched. The stock will enable US institutions to take a position in 'paper gold'. Wall Street's appetite for such financial chimeras is growing at what seems an exponential rate. Last week, cash inflows into Exchange-Traded Funds exceeded US equity mutual fund inflows for the first time that I can recall - and this during a week when over $1.3 billion came in from the cold of the money market to the stock market sauna!

Moreover, such a flood of funds into GLD would be a vindication of the idea of 'paper gold', at least in the short term. The idea behind GLD - and its London-list equivalent GBS, which has successfully matched the price of gold since its launch in January 2004 - is that they introduce liquidity to the gold market and create institutional demand for the metal. Up until now, US pension funds and institutions - which is just a fancy way of saying mutual funds, banks, insurance companies, and brokerages - had no easy way to buy gold through the stock market. They had to do it through futures contract, or buy bullion. And legally, US pension funds weren't allowed to own commodities outright.

Few institutions want to buy bullion anyway, because it never pays a dividend. It's essentially a savings account with zero interest, although if the dollar is getting worth less and less...then things priced in dollars go up...and pure inflation becomes one way to explain the rising gold price.

It's like a can of Coke that used to cost 25 cents now costing 75c or $1.00. Has the Coke gone up in value? Or has the purchasing power of your money gone down? Owning bullion when the currency inflates is one way to profit - in terms of paper dollars, at least.

The question today is whether there is pent up institutional demand for 'paper gold' that is bullish for bullion. A lot of institutions could allocate a small percentage of their cash to gold, perhaps as much as 5%. And with gold rising in dollar terms - and also in terms of British pounds now as well - there would be no 'yield penalty' to pay. The gain in bullion prices would match, or exceed, the yield on UK gilts or US Treasuries  plus you'd have the safety of owning nature's own currency!

With paper gold like GBS and GLD accepted and flourishing, "earnings' gravity" on gold stocks may no longer be a check on making money in the yellow metal. With GBS and GLD, so the theory goes, you get more liquidity in the equity side of the gold market. And whichever way the gold price goes in the near-term, the launch of the new Amex Gold Miner's Index (GDM) should also be great news for options investors if and when those vehicles become "optionable" - especially as it's composed of more volatile junior exploration stocks.

I made the enhanced liquidity argument myself - about a year and a half ago, when gold was much less popular. Today is different. Gold is "hot". But is it "hot" in the way that, say, Britney Spears in a skin-tight red rubber suit is "hot"? Or is gold warming up because it's at the centre of a major shift in investor sentiment about asset allocation and the need for diversification?

With gold making 16-year highs, the dollar making fresh lows in euro and yen terms, I'm more inclined to take recent developments as a sign of a near-term top in the gold price. In contrarian terms, whenever the crowd is all on the same side of the trade, the trade is nearly over.

In this scenario, GLD launches...goes a-googling its way up briefly...and then plummets to earth at the rate of 32 feet per second per second when the lustre of the first buy tarnishes.

That's when we should buy it. And that's when you should go hunting for gold stocks again - buying them at a much lower price. Or, you can do what I'm telling my options readers: sit tight with your long gold positions, and buy put options on them for a near-term correction in the gold price.

In the long-term - but before we're all dead - I'm still mega-bullish on gold. Market's rarely move in straight lines, however. Just ask anyone who bought crude oil futures over $55 a barrel in October.

And with so much sentiment so universally bullish on gold, even the staunchest bug should take note.


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