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If You Had Any Doubts About Gold ...

Since Ben Bernanke?s announcement of QE3 last week, new forecasts for gold have been popping up like acne at a high school prom. They range from the conservative to the absurd, from $1,900 to $55,000. But they all have one thing in common: higher. Before you head down to the local coin store to load up on bags of one ounce American gold eagles, let me go through the simplest of the many bull arguments.

The most positive interpretation of QE3 is that it will expand the Federal Reserve?s balance sheet from $2.7 trillion to $5 trillion over the next two years. This is up from only $800 billion in 2008. QE1&2 took the Fed balance sheet up by $2 trillion, but the money supply (M0) increased by only $300 billion. Where did the rest of the money go?

The answer is that it went into the reserves of private banks, where it still sits today. When these funds are released, everyone will rush out and buy stuff, and the inflationary implications will be awesome. This is bad news for the dollar. As gold is priced in dollars, it will be the first to feel the impact. Witness the 18% rise we have seen off of the July bottom.

How far does it have to run? The correlation between the price of gold and the broader money supply M1, a measure of the currency in circulation plus demand deposits or checking account balances at banks, is almost 1:1. In 2008, M1 doubled from $800 billion to $1.6 trillion, and so did the yellow metal, from $500 to $1,000. The Fed?s balance sheet is roughly equivalent to M1. So a near doubling of the balance sheet to $5 trillion should take gold up a similar amount. Using $1,720 as the base level before the Fed?s announcement, that takes the barbarous relic up to $3,440 over the next two years.

Spoiler alert! Gold tends to front run the growth of M1. So while we may see a disciplined straight-line rise in the Fed balance sheet as it diligently buys $40 billion a month in mortgage-backed securities, gold won?t be so patient. It could go parabolic at any time. My first target: the old inflation adjusted high of $2,300, which we could see some time in 2013.

The instruments to entertain here are the gold ETF?s (GLD) and (IAU), gold miners like Barrick Gold (ABX), and the gold miners ETF (GDX). If you are hyper aggressive, you might look into 100 ounce gold futures contracts traded on the COMEX. They offer leverage of 19:1, with an initial margin requirement of $9,113. ?If my $3,440 target is achieved, the value of one contract would rocket to $166,800, an increase of 17,300%. But this is only for those who wish to play at the deep end of the pool and are authorized for futures trading.

And then there are those one-ounce American gold eagles, now retailing for $2,300.

Growth of M1 to 2014

One Ounce American Gold Eagle

Gold is Making a Comeback

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One of my best calls of the year was to plead with readers to avoid gold like the plague, periodically dipping in on the short side only. The barbarous relic has been in a bear market since it peaked at $1,922 an ounce at the end of August last year. Gold shares have fared much worse, with lead stock Barrack Gold (ABX) dropping 36% since then and the gold miners ETF (GDX) suffering a heart rending 43% haircut.

However, the recent price action suggests that hard times may be over for this hardest of all assets. Despite repeated attempts, the yellow metal has failed to break down below the $1,500 support level that I have been broadcasting as the line in the sand.

It has rallied $100 since the last try a few weeks ago. (GDX) has performed even better, popping 23%. For the last month, the entire precious metals space has traded like it was a call option on global quantitative easing (see yesterday?s piece). Dramatically worsening economic data is increasing the likelihood of further monetary easing generating a nice bid for gold.

Now the calendar is about to ride to the rescue as a close ally. It turns out that in recent years, there has been a major seasonal element to the gold trade, almost as good as the November/May cycle that drives the stock market. Gold typically sees a summer low. Then traders start anticipating the September Indian gold season when the purchase of gifts and dowries become a big price driver. That explains why India, with a population of 1.2 billion, is the world?s largest gold buyer.

Next comes the Christmas jewelry buying season in western countries. That is followed by the gift giving and debt repayments during the Chinese Lunar New Year, during which we see multi month peaks in the yellow metal. That is exactly what we saw this year. The only weakness in this argument is that a slowing Chinese economy could generate less demand this time.

These are heady inflows into such a small space. All of the gold mined in human history, from King Solomon's mines, to the bars still in Swiss bank vaults bearing Nazi eagles (I've seen them) would only fill 2.5 Olympic sized swimming pools. That amounts to 5.3 billion ounces, about $8.6 trillion at today's prices. For you trivia freaks out there, that is a cube with 66 feet on an edge. China is the largest producer (13.1%), followed by Australia (10%) and the US (8.8%).

Peak gold may well be upon us. Production has been falling for a decade, although it reached 94 million ounces last year worth $153 billion at today?s prices. That would rank gold 5th as a Fortune 500 company, just ahead of General Electric (GE). It is also only .38% of global public debt markets worth $40 trillion.

That is not much when you have the entire world bidding for it, governments and individuals alike. Talk about getting a camel through the eye of a needle! We may well see the bull market end only when those two asset classes, government bonds and gold, see outstanding values reach parity, implying a major increase in gold prices from here. That is well above my own personal target of the old inflation adjusted high of $2,300. No wonder buying is spilling out into the other precious metals, silver (SLV), platinum (PPLT), and palladium (PALL).

The thumbnail technical view here is that we have broken the 50 day moving average at $1,610, so we may have a clear shot at the 200 day average at $1,680. There may be an easy $50 here for the nimble, and more if we break that. The current ?RISK ON? mood certainly helps this trade.

When playing in the gold space, I always prefer to buy the futures or the (GLD), the world?s second largest ETF by market cap, either outright or through a longer dated call spread. The dealing costs are far too high for trading physical bars and coins, and can run as high as 30% for a round trip. Having spent 40 years following mining companies, I can tell you that there are just way too many things that can go wrong with them for me to risk capital. They can get nationalized, suffer from incompetent management, hedge out their gold risk, get hit with strikes or floods, or get tarred by poor equity market sentiment. They also must endure the highest inflation rate of any industry, around 15%-20% a year, which hurts the bottom line.

Better just to stick with the sparkly stuff.

It?s Time to Start Dabbling in Gold Again

Has Gold Had It?

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With the Federal Reserve signaling yesterday that QE3 is off the table, many traders are now betting that the barbarous relic is about to take a prolonged vacation.

Without a dividend or an interest yield in a world desperate for cash flow, the yellow metal suddenly doesn?t have so much to offer. Take away the fear of inflation that our deflationary reality assures, and gold is suddenly left wanting, along with all other hard assets. Uncle Buck becomes the big man on campus.

For the first time in many years, gold is ranking high on the list of preferred hedge fund shorts. The US Treasury?s sale of America eagle one ounce gold coins is down 70% from last year and is now plumbing a four year low. Open interest in the gold futures market has hit a 2 ? year low, indicating that capital is fleeing the market. This is usually what happens before prices die.

Physical markets in Asia, long a bulwark in the gold bull case, are suffering from declining volumes. India, long the world?s largest buyer of physical gold, just doubled import taxes, causing widespread strikes among jewelers.

Industry experts have been warning me for some time that the scrapage rate was soaring, thanks to retail gold buying shops popping up on almost every other street corner, and it was just a matter of time before this would have a major dampening effect on prices.? Remember those stories about gold coin vending machines popping up around the world? You don?t hear those anymore.

Indeed, the gold miners have been signaling for some time that the gold bugs were about to suffer a healthy dose of insecticide. Look no further than the chart for Barrack Gold (ABX), the world largest producer of the yellow metal, and a woeful underperformer compared to its benchmark product. Other miners have fared far worse.

Take speculation about future gold price appreciation away, and all of a sudden miners don?t have such a great business model. The problem is that they are not making gold anymore. Companies are having to dig deeper in more dangerous and inaccessible parts of the world, and pay bigger bribes to get there. (ABX) isn?t opening a new mines at 15,000 feet in the Andes because their like the fresh air and the scenery. Freezing water, and essential ingredient in the mining process, has become a major problem.

There is the added dilemma that the inventory sitting in the back of the shop is now falling in value instead of increasing. Barrack has made a big deal about abandoning its gold hedging strategy. That worked great for the past three years, but may not do as well going forward.

Cost inflation suffered by mining companies is the highest in the industrial world, and is now running at about a 20% annual rate, be it for labor, heavy equipment, infrastructure development, royalty fees, and so on. The tires for those giant trucks used in mining now cost $100,000 each and have a three year waiting list. The secondary market for them is booming.

It doesn?t take a rocket scientist to figure out that the technical picture for gold has been rapidly deteriorating. Gold has suffered an 8% sell off since the end of February, and is now up only 6% in 2012, underperforming most other asset classes. Look at the chart below, and the most charitable thing you can say is that with are approaching the bottom end of a $1,500-$1,925 range. But look at the longer term charts and it is clear that we have just witnessed a head and shoulders formation that has dramatically failed.

The chip shot on the downside for gold here is $1,500. More aggressive traders may want to reach for $1,450. Bring a double dip scare for the economy into the picture, which I expect to see this summer, and $1,100 is a possibility. If you get a real stock market crash in 2013, as many analysts are predicting, and you?ll get another chance to buy at $750.

Use the periodic short term bursts of buying, that are increasingly being seen by the trading community as a contrarian trade, as a great chance to leg into short dated puts on the SPDR Gold Trust Shares ETF (GLD).

Long term, I still like gold and expect it to hit the old inflation adjusted high of $2,300 during the next hard asset buying binge. But remember also that long term, we are all dead.

Watch Out for Gold?s Fatal Attraction

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