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Profiting from the End of Gold’s Big Correction

By George Kleinman, on Dec. 27, 2013

In August 2011, I owned profitable gold contracts for my clients and my personal account.

At the time, my wife and I were preparing for a whitewater rafting trip down the Tuolumne River in California, where we’d be without Internet or cell phone service for three days.

I considered placing a sell-stop order on these positions to lock in some profits, but decided sell the contracts before we left so that I wouldn’t worry about the market while we were on the river. That day, gold traded at $1,880 per ounce. Although I expected gold to hit $2000 before year-end, safe felt better than potentially sorry.

The night before our launch, we stayed in a small hotel in Groveland, Calif., a town where AT&T had no service. As we left that morning to meet the river guide, I caught one gold quote on CNBC–$1900 per ounce (an all-time high at that point).

“Damn,” I thought to myself. “Probably should have stood pat, looks like gold is making its move to $2000.” But there was nothing I could do until we got back.

I had no way of knowing that gold would climb to $1,909 later that day.

When we got off the river three days later, the first thing I did was power up my smartphone for a gold quote. To my surprise, gold futures had tumbled to $1,685 per ounce.

Clients later asked how I’d known to cash out the day before gold prices peaked. I told them the truth: My river trip planned the exit for us–a reminder that being lucky is sometimes better than being smart.

That 2011 top marked the all-time high price for gold in US dollar terms and inaugurated a major correction to the multi-decade uptrend in gold prices. This correction has now lasted more than two years.

Source: Bloomberg

But it appears this correction just may have run its course.

Why do I call this multiyear price break a correction? It has to do with the historical relationship between gold and money.

Money has purchasing power primarily because of the populace’s belief. For most of the history of modern money, the major currencies were backed by gold.

Public belief in a currency was stronger when it was backed by something tangible. When a country’s currency is backed by gold, the central bank can’t create money at will. Gold-backed money historically resulted in stable and strong currencies.

John Maynard Keynes and other economists argued the that gold standard limited the ability of a government to prime the pump during economic contractions. However, without the discipline gold backing creates, money’s value has eroded because of a growing oversupply.

The US dollar was backed by gold and other major currencies were pegged to the dollar from the end of WWII until 1971–a period of monetary stability and sustained economic growth.

But in August 1971, President Richard Nixon ended the dollar’s convertibility to gold, spurred by France demanding gold in return for dollars. From then on, the world’s currencies have been backed by nothing but the market’s faith in the credit of the country itself. Thus began the rise in currency value of gold.

The Swiss franc continued to be 40 percent gold-backed until 2000. It’s no coincidence that many currencies threatened with overproduction declined in value relative to the Swiss franc while the latter was still backed by gold.

For three decades, the Swiss franc held its value remarkably well relative to other major currencies–one of the reasons that Swiss bank accounts became the gold standard of the world’s financial elite. Plus, Switzerland enjoyed some of the lowest interest rates in the world and a stable economy.

Today, no currency is backed by gold. Although governments try to convince the populace that inflation remains in check, the truth is that over the past decade the prices of staples (food and fuel) have increased by more than 100 percent. Meanwhile, the average salary has stagnated.

As long as central banks can create new currency units at will, the long-term uptrend in gold’s value should remain intact. However, that’s not to suggest that gold won’t experience the occasional correction; the precious metal has given up about 25 percent of its value this year and almost 60 percent since its peak in summer 2011.

Does that make gold a bad investment? It depends on your perspective. Gold has rallied by more than 500 percent since its low of $255 per ounce in 2000. Despite the current correction, gold has outpaced the reduced buying power of every major currency of this time period and throughout history.

Major industrial countries’ have increased their currency units eightfold since summer 2011, creating a major distortion in the price of gold. And this newly created money needn’t flow to gold. Much of this money has flowed into real estate, fine art and stocks. However, it’s not a question of whether this money will flow back into gold; it’s a question of when.

For the record, I am not a gold bug. I have no qualms about shorting the precious metal when that’s a money-making strategy. Nevertheless, I expect gold to remain in a long-term uptrend for the reasons previously stated. And I look to technical analysis for timing.

Recently, gold pulled back to $1,210 per ounce–higher than its June low of $1,180 per ounce. Although gold hasn’t reversed its downtrend, this higher low (a double bottom) is the first sign of recovery.

Bottom Line: Because gold appears undervalued relative to paper assets, this could be a good time to build a position in this precious metal. Investors should look for gold to rally to more than $1,270 per ounce to confirm the first meaningful “higher high” in this cycle.

That brings us to the final question. If the market confirms our buy signal, what’s the best way to profit?

An investor or trader has a number of options to benefit from gold appreciation. These paths range from bullion and coins–non-leveraged but with fairly high mark-ups–to exchange-traded funds, mutual funds and hundreds of publicly traded miners. Futures and options offer low transaction fees with the highest leverage to any uptrend.

As a former COMEX member, I prefer to trade gold futures for clients and my own account.

Investors looking to add exposure to gold’s long-term uptrend via shares of publicly traded miners should keep in mind that many junior operators will tread water or go belly up. Shares of larger gold miners that have proved reserves usually track the price of gold. 

My two favorite gold producers are Royal Gold (TSX: RGL, NSDQ: RGLD) and Agnico Eagle Mines (TSX: AEM, NYSE: AEM).

Headed by an astute management team, Royal Gold is a royalty trust that finances smaller producing mines and those that are in development. The trust receives a percentage of the mines’ production as compensation.

I would look to buy Royal Gold on strength–above US$48.00 per share–a trade that involves a downside risk of about US$5.00 per share. My longer-term price objective for Royal Gold’s Nasdaq-listed shares is $75.00.

Canada-based Agnico Eagle Mines is an established gold producer that boasts proven reserves of more than 4 million ounces and operates primarily in politically stable countries–the US, Canada, Mexico and Finland.

Agnico Eagle Mines is a buy once the stock hits US$28.00 per share, a level that would indicate an uptrend and involve downside risk of about $3.00 per share. Over the long term, the US-traded stock could appreciate to $45.00 per share.

Investors should bear in mind that rising gold prices won’t cure production issues or other company-specific challenges–the main reason I prefer to speculate directly in the gold market.

Readers interested in a managed strategy to goal and silver futures and option–an approach that involves higher risks and potentially higher rewards–should feel free to contact me at geo@commodity.com. I use a proprietary, momentum-based methodology to buy and sell gold and silver futures.  

Yes, the gold market is volatile but with correct timing it can be ‘golden’.

George Kleinman is president of Commodity Resource Corp, a futures advisory and trading firm that assists individual traders as well as corporate hedgers. He is also the author of Trading Commodities and Financial Futures: A Step-by-Step Guide to Mastering the Markets. There is risk of loss when trading commodity futures and this asset class is not appropriate for all investors.

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