Alim Abdulla: The Downside Risk to Gold

Why the gold bull thesis is wrong on a near-term (3-months or less) and medium-term (6-months or more) basis.

gold vault

“With all of Bernanke’s cards on the table there is no rumor to facilitate further speculative buying in gold.” — Alim Abdulla

I am and always will be a student of the market, and nothing is more valuable to me than credible, accountable and transparent sources; Keith McCullough of Hedgeye Risk Management taught me that. He has also taught me that contextualizing data is imperative when making investment decisions. The fact of the matter is, that since this past October, the data has been signalling a decline in the price of gold.

The bull case for gold is smartly summarized by Hedgeye as: stagnating/decelerating economic growth leads to further QE initiatives, resulting in the depreciation of the US Dollar, translating into higher gold prices as investors hedge against future inflation and discount further devaluation of the currency.

I am not an expert on gold, but I do study history and listen to data, and I would argue that the risk in gold is to the downside rather than to the upside due to the bullish trend in the US Dollar. The reasons why the US Dollar is strengthening and could continue gaining strength is for three primary reasons:

1) The expectation of further QE by the US Federal Reserve has been obliterated subsequent to the announcement of QE4 infinity. Markets are a function of expectations and fundamentals, and with all of Bernanke’s cards on the table there is no rumor to facilitate further speculative buying in gold. In fact, it is the expectation of a reduction in QE that is currently being priced into gold. Expectation is something that every junior mining investor knows about, it’s the only way we have ever made money. Expectations move markets.

2) Funds from around the world are flowing to the US. The most dangerous bubble is upon us, and that is the global Cash Bubble; Ray Dalio of Bridgewater Associates (the largest hedge fund in the world) speaks to this point often: “The returns of cash are terrible. So as a result of that, what we have is a lot of money in a place – and it needed to go there to make up for the contraction in credit – but a lot of money that is getting a very bad return. That, in this particular year, in my opinion, will shift.” Fund flows are the most important factor to consider in a Cash Bubble. Where will they go? Year-to-date the SP500 is up + 13.3%, Gold is down -12.3%. Make no mistake about it, the US Federal Reserve is in the business of manufacturing bubbles (Tech, Real Estate, Commodities). The only way to maintain the largest debt bubble in the history of mankind is to move on to the next one.

Every mini crisis, whether it’s the Italian Election or Cyprus, sensationalized by the media creates further momentum for funds flowing to the US. We live in a very inter-connected world, and data and trends need to be put into context and evaluated relative to what is going on elsewhere. To say that because the US Federal Reserve is monetizing $85b a month in US debt is why gold is on a path upwards is incorrect. Investors must contextualize the data and understand that the expectation of Europe and Japan’s relatively dovish fiscal and monetary policies, and relatively weak economies, is bullish for the US Dollar. The question to ask is: Where is the relative strength? In addition, gold does not have the capacity to facilitate the shift Mr. Dalio speaks of; there is simply too much liquidity that has been created and it has to go somewhere that can accommodate it. 2013, thus far, is an indication: US Dollar +2.3%, SP500 +13.3%, Gold -12.3%, Silver -20.7%, Brent Oil -6.2%, Corn -6.1%, Copper -10.7%. Numbers do not lie.

3) The US economy is improving on the margin as Consumers benefit from commodity deflation. The deflation of commodities is not a result of growth slowing, it is the catalyst for growth stabilizing. If you think the former you are operating on an outdated playbook. Hedgeye has been strong on this theme. As Keith McCullough points out regularly, correlations are not perpetual; study history. Inflation is not growth, it impedes growth, and at a point central bank engineered bubbles become the enemy of global economics via price distortion. The bullish case for US Equities continues to gain strength because a strengthening US Dollar empowers the consumer. The US economy is greater than 70% consumption based and less expensive food and gas is an immediate tax cut. The further commodities deflate the more US consumers can afford to spend, and they are. What is being reduced is US government spending, which, on the margin, is US Dollar bullish; again, context.

The behavioral finance perspective behind all of this, and as George Soros has expressed time and time again, is that markets are reflexive and people chase price, which will only add further momentum to the case for US Consumption stocks and US Housing prices. If Mr. Soros is correct, there is a tsunami of cash that could participate in this race to the US, and specifically, to US equities.

The predominant Global Macro themes for 2013 year-to-date have centered around understanding the causal impact of central planning on their domestic currencies. “Get the central plan right, you get the currency right. Get the currency right, you get the correlation right. Get the correlation right, you get the money.” (McCullough)

Where is the bottom in gold? I don’t know, but I’m not in the business of catching a chainsaw, and I know that price is not a catalyst. Why call a bottom in Gold with the US Dollar in a bullish trend? Why call a bottom in gold when both the economy (on an inflation adjusted basis) and employment in the US are strengthening on the margin? I don’t know how this all ends or even if it ends well, but I will let the market tell me what to do next. If the US Federal Reserve decided to expand its QE initiative tomorrow I would re-evaluate my position and change my mind if the data was compelling enough to do so. If systemic risks emerge, whether due to European sovereign debt concerns or a crashing Yen, I will do the same. But hope is not an investment thesis. I will change as the market changes, it’s a less stressful way to live.

“To improve is to change; to be perfect is to change often.” – Winston Churchill.

 

Alim

Alim

Alim Abdulla is an Investment Advisor at Leede Financial and is a co-founder of the Trading Analytics Group (TAG). He has been with Leede for nine years and began his career in the Financial Industry a year prior at Canaccord Capital. Alim considers himself to be an Active Risk Manager focused on long/short equity portfolios.

Disclaimer: The comments and opinions expressed herein reflect the personal views of Alim Abdulla. They may differ from the opinions of Leede Financial Markets Inc. and should not be considered representative of the research beliefs, opinions or recommendations of Leede Financial Markets Inc. The information included in this document, including any opinion, is based on various sources believed to be reliable, but its accuracy and completeness is not guaranteed. Member CIPF.

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About Alim Abdulla

Alim Abdulla is an Investment Advisor at Leede Financial and is a co-founder of the Trading Analytics Group (TAG). He has been with Leede for nine years and began his career in the Financial Industry a year prior at Canaccord Capital. Alim considers himself to be an Active Risk Manager focused on long/short equity portfolios.

  • http://www.anthonymaw.com/ Anthony Maw

    Now is a good time to buy physical gold. The article is correct that there is a huge market bubble in US Equities and *any* bad news, real or fake, will cause a sell-off by itchy fingered market speculator-investors.I believe gold is being sold at not much more than the cost of production right now.As you know, the cost of mining and refining has shot up dramatically in the last few years, largely on the price of diesel fuel, which has quadrupled in the last ten years, which is needed to operate the mines.When I worked at Placer Dome back in the 90′s, gold was “cheap” because the Bank of England dumped most of it’s gold in preparation for joining the Euro causing gold to be sold down to a floor of US$250.The reason it didn’t go lower was NOT co-incidentally because it was about the same as what it costs producers like Placer Dome to mine the stuff. If gold goes much below US $1400 for a protracted period of time, the highest cost refiners will shut down production and there will be supply-side destruction.At some mines, they can dig, move, crush down to pea-size, heap leach up to 30 tons of hard rock ore to eventually produce an single ounce of refined gold.So we have a price support situation right now.In Economics this is known as Price-Quantity equilibrium.Also look at the cultural perspective: Asian countries, especially China and India, are buying gold on the price drop on a massive amounts so there is definitely demand.And Central Banks are re-establishing their bullion reserves, in the face of US QE and the resulting currency dilution.Also the price of gold appears to have bounced off a bottom.Gold is back on it’s normal inflation-adjusted trend line, now that the paper gold speculators are out of the market.If these analysts don’t work in the mining business then their opinions are speculation at best – I did my time working at Canada-based Placer Dome gold miner “getting my hands dirty, learning about these things on-the-job”.

  • Brian Richards

    Alim,
    First, if you looked at a long term chart of the US dollar, and you were told it was a stock, would you buy it? Not me. But, I do agree with you that there are good reasons for the dollar to strengthen. You’re right that there is tremendous liquidity throughout the world, and not very many safe harbors in which to park it.

    Gold may be signalling a deflationary period ahead, and although it is the “mangy street dog” of this period, it probably offers pretty good value. If you are going to elude to George Soro’s market savvy, you might have mentioned that he bought 25 million worth of GDXJ call options recently. I would say he may be somewhat bullish on the barbaric metal, no?
    Best wishes.

    • Alim Abdulla

      Yes I would and I have. Gold hit a 40yr high and the US Dollar a 40yr low in August 2011. Since then both have been trending in opposite directions. The $USD should continue its bullish trend relative to other major currencies and Gold. Gold and bonds do not like growth, tops and bottoms are processes, and price is not a catalyst. With respect to Soros, $25M is peanuts, that’s why he is taking the options route…it’s simply an insurance policy on systemic risk imho.

  • Alim Abdulla

    Yes I would and have. Gold hit a 40yr high and the US Dollar a 40yr low in August 2011. Since then both have been trending in opposite directions. The $USD should continue its bullish trend relative to other major currencies and Gold. Gold and bonds do not like growth, tops and bottoms are processes, and price is not a catalyst. With respect to Soros, $25M is peanuts, that’s why he is taking the options route…it’s simply an insurance policy on systemic risk imho.