$800 or $1,200 Gold, Panic Vs. Inflation, ETF's (GLD, UGL, DZZ, DGP, DGZ, GDX)

We have probably covered more gold stocks over the last couple of months than we care to recall, but we have been getting more and more inquiries on the ETF’s and on how to play the shiny yellow stuff directly.  When we see the media covering any topic with this frenzy and traders getting more and more interested, history and calm dictate that an inflection point has been reached.  Following this inflection point is almost certainly what will be a sharp move in either direction.  Gold breached the $1,000.00 threshold Friday as panic set further and further in, so in theory we could either be at $1,200.00 or $800.00 with a near-equal probablity in just a few months.

For starters, let’s go ahead and get the “why do you think $1,200.00 or $800.00 is imminent?” question addressed.  Every time you see major inflections like this, there is either the panic buying or the crescendo selling.  Oil is the best and most recent example of this.  When oil was trading north of $90.00 for the first time and everyone was scared of $100.00 oil, it became a chasing game and a game based upon speculation rather than a game based upon reality.  We had many traders calling for $120.00 and we had many oil companies saying that anything north of $75.00 did not make sense to them.  So use the $100.00.00 level as the key pivot.  It turned out that both the traders and the oil companies were right.  It also turned out that they were both wrong.  Oil went to twice what many of those oil companies thought was a peak intrinsic value.  And in just six months or so it was back to half of that same “intrinsic value” of $75.00.

So where this gets funny is that you could see gold go to BOTH $1,200.00 and $800.00.  We aren’t able to give you a crystal ball reading, so we are not cheerleaders and we certainly have no pom-poms waving.  But we are human and we understand that everyone, truly everyone, is affected by the state of the global economy right now.  Some market pundits are calling for gold to go to $1,500 and some have even dangled the $2,000 gold carrot for you.  We were sharply criticized for forecasting last year that unemployment could be 8.5% by summer 2009.  It turns out that this may now just be a mere speed bump.  The FOMC minutes showed a forecast of 9% unemployment by the end of the year, and Jamie Dimon said that the coming government stress tests might include how well the banks can hold up if unemployment reached 10% to 11%.

Why do we note unemployment?  Simple.  More job losses adds further and further to the panic.  More panic is only adding to the price of gold.  Gold is often thought of as the perfect inflation hedge.  Just over three months ago in October and November, an ounce of gold was trading between $710.00 and $750.00.  Just less than a year ago gold was at the same $1,000.00 mark.  But the differences of time and the reasons for the pricing was for entirely different reasons.  A year ago you had a daily game of how oil was going.  You had some saying that real inflation was running at levels that might be close to 10%.  By November you had all the calls and scares of deflationary pressure.  And that had gold on its backside at levels that many thought gold might be heading much farther south.

There is no real inflation today.  Even if the Obama stimulus package ends up reaching $2 Trillion in theoretical printed dollars from what the TARP of 2008 started out with and what the new package will ultimately cost with bank and industry bailouts over the next two years, the CIA world fact book estimates the US 2008 GDP at $14.3 trillion.  Smooth out the $2 trillion over 2008 to 2010 and you do have a lot of funny money, but spread over 3 years or more and you don’t have hyper-inflation.   Industry is on its backside.  The jewelry business is on its backside.  The consumer is so far on its backside that yoga poses are in order.  Every industry that uses gold is on its backside.  And almost none of the major central banks have gold as the basis of their currencies.  So you have no actual hard demand for the shiny yellow stuff.  Not today any how.  The demand for gold is for gold coins, a massive flurry of bullion buying by ETF’s (and investors), and the institutions and traders buying the hell out of it.  The reason is simple… pure fear.

Gold may be a perfect hedge against inflation.  But what you are witnessing today is that gold is also a pure hedge against fear.  There is fear of nationalizing some of the major banks.  There is a fear that the DJIA could go to 6,000 and the S&P 500 could go to under 700.00.  There is a fear that unemployment will hit double-digit levels.  And there is a fear that our massive and nasty recession is going to be the modern day version of the 1930’s.  These are currently all real fears, and this has not yet happened.  A year ago the DJIA was north of 12,000 and the S&P 500 was north of 1,300.00.  The closing levels yesterday were 7,365.67 on the DJIA and the S&P 500 closed at 770.05.

Yesteryear’s $1,000.00 gold was inflation related trading.  Today’s $1,000.00 gold is the hedge of fear.    Again, we are merely saying that this $1,000.00 mark is an inflection point.  The cases for $800.00 or $1,200.00 are equally as easy to make.  OK, so you got the history lesson and you have the most basic explanation for why gold is where it is.

But there is another issue affecting the price of gold today.  Exchange traded funds and exchange traded notes.  Investors and traders are buying the hell out of these.  These ETF’s and ETN’s have to in turn go into the spot market and futures markets and buy the shiny yellow stuff.  We have seen some figures showing that there could be as much as $100.00 or $200.00 extra in the price of gold because of the ETF’s and ETN’s buying it up.  That number is probably impossible to give with any certainty, and you have to always use the notion that things are worth what the market is willing to pay for them.  So whether gold is overvalued or undervalued, the value IS almost $1,000.00 today.  This is also happening at a time when the banks and hedge funds that would have been buying can only do it with minimal leverage rather than the massive leverage used just a year ago.

These are the major gold ETF’s and ETN’s we track.  There are other instruments of course.  These just happen to be the ones we track.

SPDR Gold Shares (NYSE: GLD) is the mother load of all gold ETF’s.  It tracks the performance of the price of gold bullion, less the trust expenses of course.  It holds gold and is expected to issue baskets in exchange for deposits of gold.  For fair measure, you can usually take the ratio at one-tenth to see where the price of spot gold happens to be.  There are then the trust fees and the discrepancy of time and whichever direction the wind blows that factor in on its actual pricing.  This closed at $97.80 Friday vs. $993.20 in spot gold.  Again, not a perfect 1:10 ratio, but close enough.  There are also large discrepancies in the actual market cap: Yahoo Finance shows $24.93 billion as this ETF market cap, and Google Finance shows $27.47 billion.  The SPDR site itself shows a market cap of $24.891 billion.  This one is massive regardless.  To show how much of a bogey it is, it trades over 16 million shares on an average day, but it traded over 43 million shares Friday and on February 11 it traded some 55 million shares.  On two different days in September its volume was north of 60 million shares.

Then there is the schizophrenic gold ETF that is supposed to employ TWO-TIMES leverage on gold.  The Ultra Gold ProShares (NYSE: UGL) seeks to replicate, net of expenses, twice the performance of gold bullion as measured by the U.S. Dollar p.m. fixing price for delivery in London.   The difference here between this is that it has to use “financial instruments”… swap agreements, forward contracts, and futures and options contracts.  So besides the fact that it aims for twice the performance, it has an extra measure of added volatility in its trading.  ProShares lists its net asset value premium and discount as having been roughly -2.0% to as high as +6.0%.  It noted Friday’s level was a premium of $0.44. It trades over 200,000 shares per day, but it traded over 664,000 yesterday and it saw some 882,600 shares trade hands on FEB 17.  As gold is on highs, this one is too.

There are also two ETN’s which essentially offset each other.  PowerShares employs more DOUBLE-LEVERAGE ETN’s.  The PowerShares DB Gold Double Short ETN (NYSE: DZZ) and the PowerShares DB Gold Double Long ETN (NYSE: DGP) are the leveraged instruments.  The PowerShares DB Gold Short ETN (NYSE: DGZ) is just the inverse, just… The average volume on these can be lower as well.  “DZZ” traded over 1.6 million shares Friday, more than double its normal volume. “DGP” traded over 4.2 million shares Friday, almost twice its normal volume.  DGZ traded over 38,000 shares Friday, about 150% of normal volume.

One gold ETF that is not keeping up with the shiny yellow stuff is the Market Vectors Gold Miners ETF (NYSE: GDX).  While it closed up almost 4% at $37.03 Friday, its 52-week trading range is $15.83 to $56.87.  This one tracks the Gold Miners Index in proportion to the company weighting in the index, so it invests in the common stocks of global gold miners which are not all US-based companies.  Our most recent data shows that Barrick Gold, Goldcorp, and Newmont account for almost 35% of the entire ETF.  Its 25 top holdings also account for about 97.8% of the entire ETF.  It trades an average of over 8.5 million shares, and it saw over 19.5 million shares trade hands Friday.

We are not going to give trade set-ups here for how you can bet on $1,200.00 or $800.00 gold.  That will either be done tomorrow or in our newsletters.  And early this week we’ll show you how and why many of the more speculative gold stocks have not been tracking the price of the shiny yellow stuff.

JON C. OGG
February 21, 2009