Eight Signs Gold Is Headed for a Correction

February 26, 2009 | By: Investment U

by Louis Basenese

Two weeks ago I told you it was time to start shorting gold. And the recommendation, as I expected, ignited a brouhaha on our Investment U message board.

That’s because there’s not much middle ground. Most investors are either fanatical or supremely skeptical. If you have any doubt, check out the comments - and all the wonderful names I got called - on our website.

But since I’m a glutton for punishment, and since gold moved in exactly the opposite direction I predicted, it’s time for an update and a little clarification.

A Morsel of Clarification on Shorting Gold

Let me start off with a morsel of clarification. I don’t hate gold. I own it, or more accurately, an interest in gold via gold mining shares. And I believe a small allocation (5% to 7%) has a useful place in a well-diversified portfolio. Over the long haul, studies confirm it helps increase returns while minimizing risk - a benefit we can all agree is desirable.

But over the short-to-intermediate term - the next six to nine months - I think gold is a terrible investment. After breaching the $1,000 per ounce mark again, as I suggested would happen to my subscribers on February 2, it is overdue for a retracement back to roughly $700 per ounce.

Those of you who expected it to drop the day after I suggested shorting gold need to understand that “short term” doesn’t mean “this week.” Just because it moved higher doesn’t negate the point of the recommendation.

Long story short, I view shorting gold as a way for me to hedge my long-term holdings. For traders, it’s a profit opportunity to consider. And whether we see eye to eye on this is irrelevant. Ultimately, the market will be the great arbiter of our differences.

For kicks though, let’s address a few of those minor points of disagreement…

Shorting Gold is Not Really Contrarian

A small army of you suggested I was being an “arbitrary” contrarian when I suggested that it was time to start shorting gold. That no evidence, just a warm and fuzzy feeling, existed to back up my call.

Are you kidding?

Sure your “Cousin Vinnie”, as chronic poster Todd opined, the trash collector or the newspaper boy might not be investing in gold. But the rest of the lemmings certainly are…

• Investments in coins and bars increased 811% in the fourth quarter, according to the World Gold Council.

• Headlines abound in the mainstream press like this one from The Financial Times - “Gold primed to be ‘mania asset.’”

• Wannabe gold bugs are paying - willfully I might add - 20% premiums for coins and small bars. Forget buying gold, we should all become coin dealers!

• Investors - like teenage girls at New Kids on the Block concerts in the late 1980s - can’t reach out and touch the SPDR Gold ETF (GLD) enough. It’s now the second-largest ETF in the United States with a market cap of roughly $33 billion. With more than 1,000 metric tonnes of gold, speculators now control more gold than many industrialized nations. If that doesn’t scream “out of whack” I don’t know what does. Many of you respond by saying the investors here are institutions, so the inflows are not indicative of a top. You’re wrong. Individuals, according to Morningstar, accounted for an estimated 60% to 70% of the investments in the last four years.

• The world’s largest gold refinery is pumping gold coin blanks at a rate not seen in 23 years, according to Bloomberg.

• Reuters reports investment consultants are now advising pension funds and high-net worth clients to invest a 5% to 7% allocation toward gold and gold stocks. After being an investment consultant to such clients, I can confirm such allocations are new. And will be followed, if they haven’t been already.

• If you’re a newsletter junkie, like myself, no doubt you also noticed the sudden explosion in “gold experts” that have some overlooked, stealth play on gold you need to consider. It’s poised for 500% gains (or more), they say! All you have to do is read a 16-page teaser and sign-up for some newsletter. Marketers tap into what’s hot, typically as a trend is cresting. Don’t expect this time to be any different.

• From Thursday’s Wall Street Journal, futures investors are taking delivery of gold at more than double recent levels (4.5% versus 2%). Paranoia anyone?

If the above isn’t sufficient evidence to be a contrarian, I don’t know what qualifies then.

Why should I listen to you, Lou?

Others of you simply wanted to know, why you should listen to me - a Wall Street flunky, “idiot” or a “young analyst who thinks he’s got the magic touch and will never be wrong.”

Forget that the last reader - and yes it’s the chronic poster and my new “buddy” Todd - is completely clueless and didn’t catch my transparent about-face on the dollar here. Or my confession that I flubbed the rebound in financials.

I’m human. I will be wrong. I’m man enough to admit it. But I don’t think shorting gold will be one of those times.

And if I don’t have enough credentials to make such a claim, in your opinion, fine by me. Listen to someone more “qualified.” Plenty of them exist that are also starting to question the merits of investing in gold, or at least acknowledge the mania…

…Newsletter god Dennis Gartman says, “It’s a little worrisome that so many people are piling in [to gold].” He expects a pullback, too. Just not as far as me.

…Peter Munk, founder of Barrick Gold (ABX), says he’s never seen such strong interest in physical gold ownership.

…”This will all end badly, just like all other bubbles,” predicts Leonard Kaplan, President of Prospector Asset Management, a commodities futures brokerage in Evanston, Ill.

…”Historically, when stocks begin to underperform gold, that’s a sign that gold is running out of steam,” according to Ray Hanson, a technical analyst at RBC.

My Biggest Concern

What really scares me is that some people take gold investing to an extreme. They actually believe in a government-orchestrated conspiracy to suppress prices, as some of you revealed in your comments.

It’s pointless to engage in lengthy debates with conspiracy theorists. Logic means little. But let’s suspend disbelief for a millisecond and say you’re right, that the price of gold is being fixed.

Why in the world would you throw hard-earned money after the slim prospects of actually exposing and overturning the fix? Talk about a low probability of success.

But I digress. What’s most troubling is many investors, including some in my industry, say gold is a forever position and they are committed to “a lifetime pattern of purchasing” and will never sell. Some of you even revealed 50% of your portfolio is invested in gold.

Here’s the thing. I know that Christopher Columbus says, “Whoever possesses it [gold] is lord of all he wants. By means of gold one can even get souls into Paradise.” But if financial Armageddon unfolds, which many gold bulls predict and in some sickly way wish for, gold will be priceless and worthless at the same time.

How so?

If world governments collapse, social order goes to heck, McDonald’s won’t magically be set-up to “make change” for your gold bars. ATMs won’t spit out Krugerrands.

What’s more, even if the price of gold tops, say, $5,000 per ounce under such circumstances, what can you do about it? Cashing in on the gains means accepting the thing gold bugs completely despise, paper currency, in return. So indeed, it will be priceless, useless and worthless all at the same time.

Bottom line, the world isn’t set up to handle gold as a currency. Not now. Not ever. It’s merely an asset. And like all other assets, it’s susceptible to bubbles.

If you’re in the speculative mood, I recommend shorting gold in the coming months. Especially since, as the saying goes, “gold goes up on an escalator and comes down in an elevator.”

At the very least, examine your reasons for owning gold. If you believe the end of capitalism is nigh and financial ruin is imminent, just remember you need gold to be liquid, acceptable and portable for your investment to be really worth anything.

All three are big question marks, convincing me John Maynard Keynes was more right than most want to admit. Outside of a small allocation for diversification purposes, gold is indeed a barbarous relic.

I’m off to the message board to prepare for the onslaught of “fan mail”…

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