Gold's Rally: Breakout or Fakeout?

Fri, Sep 17, 2010 - 12:38pm

Many commodity traders are familiar with the question of whether a stock or commodity has broken out for “real” or not. In other words, when making a new high for the first time, many speculators are unsure if the trend will continue.

Gold touched record highs this week and silver is also moving very close to record highs. Gold’s breakout above the $1,250 an ounce level moves it into new territory, making the move very bullish.

There is one main reason for gold to rise: supply. This year, two major suppliers of gold, Russia and South Africa, have reported lower gold mining yields, meaning these supplies have peaked. There may be plenty of gold above ground, in jewelry, currency, electronics, etc., but the year-over-year supply has not been increasing.

This is a reminder to everybody that the price pressure on gold will continue to the upside since we are nearing the point of peak gold in the global production at the same time new investors are coming into the market.

Combine slower new gold mining yields with massive instability in the global economy, and it’s easy to see how there will continue to be a strong upward pressure on gold prices. It’s also important for the average person to understand that the demand is not only coming from individual and corporate investors - it’s also coming from national governments. Just like personal investors, countries (two good examples are China and India) are increasingly turning to gold as both a safe haven investment and a currency substitute in certain international business transactions.

Part of the international economic instability is due to the U.S. government’s domestic spending programs that are significantly increasing the size of its national debt. Markets usually anticipate the future, and gold seems to be signaling that the U.S. Federal Reserve will make good on its promise to flood the markets with more debt. Printing money to buy government debt always devalues a currency. Gold senses this and is moving upward.

There are also technical reasons behind gold’s climb. Normally, when prices make new highs, they tend to continue because there are a lot of previous owners that begin to ask: “How high is high?” In other words, greed sets in, and owners hold for a while to see how much further the rally may continue. Therefore, any new buying will drive the price higher.

But price levels can be deceiving, volume is what tells the real story. Much of the demand is coming from the SPDR Gold Trust (NYSE: GLD) and we note that almost 25 million shares traded on Sept. 14. This represents a value of $30 billion for the day, when the average volume for the GLD is normally around 12 million shares. So, we know the volume was about double and that usually means there is strength in that direction.

If gold tests the $1,250 level and holds to the upside, we could see a $1,300 level fairly easily before the end of the year.

Fast money follows gold, and momentum players will come into the market. So, technically speaking: Are we overbought? Yes, the chart is going vertical, we are overbought, the put to call ratio is giving warning signs that this market is too high.

Yet I still ask: “Is gold too high relative to the quantitative easing that gold senses just ahead?” The answer to that question is exactly what makes the markets move.

So, how should the individual investor get into gold?

I strongly recommend owning physical gold as the safest and most secure way to invest in this commodity. However, I also realize that at its current price point, physical gold is becoming too expensive for the average person or family to own. Here are two other options:

Gold ETFs

Gold ETFs have become extremely popular in the past few years; however, I am reluctant to invest in them personally as these investments are pure “paper” gold. By that, I mean the investor does not own any actual, physical gold - just the certificate of their investment. ETFs are, by nature, higher risk: an ETF’s gold quantities are oversold to its many investors, so no investor has any ownership of the physical commodity. ETFs are audited less regularly than other gold investments, such as gold trusts. As a result, the security of an ETF investment is entirely based on the stability of the financial institution behind the ETF fund.

There are fees associated with gold ETFs, of which investors should be aware. These include a trading commission, annual storage fee, insurance and management fees. Additionally, selling a gold ETF will apply the capital gains tax.

For those investors who are interested in ETFs, here are a few prominent funds:

• UGL - the ProShares Ultra Gold ETF

• SOGL - the ETFS Physical Swiss Gold Shares

• IAU - iShares COMEX Gold Trust ETF

Gold Trusts

A more secure investment option in gold, barring actual physical ownership - is the gold trust, also known as a gold-holding company.

The difference between a gold ETF and a gold trust is that the latter is more frequently audited. Also, in a gold trust, the investor does actually own part of an ounce of physical gold which is held for them by the trust. An investor can buy any fraction of an ounce that he or she chooses - however, at no time is she allowed to redeem her investment for the physical commodity.

There are fees associated with gold trusts, of which investors should be aware. These include a premium, usually in the neighborhood of 7%, that can increase with the price of gold.

Originally published: Fox Business

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