Is It Time to Short Gold?

The case for gold is compelling.  The Federal Reserve is in the midst of a reflation cycle which, by the signs of life in M2 growth, appear to be gaining traction.  The Euro zone is in free-fall.  The Chinese are hoarding the stuff.  And the North Koreans are threatening to blow up the world.

Unfortunately, from a purely objective angle, there is no way to come up with a "fundamental" value for gold.  It has some utility in a number of industrial and consumer applications, but for the most part it is used as a "store" of value.  That value, of course, being dependent solely upon what someone else in the future might be willing to pay later for that store of value.

There are some interesting historical ratios that merit watching.  By virtue of their being global commodities which otherwise tend to move in tandem, the gold-to-oil ratio has some utility in deciding whether gold might be overvalued relative to crude.  At Friday's prices, that ratio is just under 16, which is not extreme by historic norms.  The flaw in the gold-oil ratio is that nearly every barrel of oil ever extracted from the earth was consumed, whereas nearly every ounce of gold ever mined during the history of mankind remains in our global inventory.

But the real case against gold is the fervor amongst gold investors and the outlets that have appeared to tap into investors who've become disillusioned with stocks and bonds.  Gold is now the "can't-miss" investment, with a current year-to-date return of 19.4%, a one-year return of 29.4%, and a three-year return of 76.4%.  That kind of historic performance tends to attract new investors to an asset.

Unfortunately, that type of investor tends to be a "late to the party" type of investor.  And as we saw with past "can't-miss" investments, like tech stocks in the late '90's and real estate in 2007, those "late to the party" investors are the ones who get hammered the worst when markets ultimately corrected.

So how much higher can gold?  Unknown.  Gold trades purely on psychology and there's no reasonable way to estimate how much higher it'll go before it corrects.  $2000/oz would be a surprise, but hardly shocking.  Nor is there any way to forecast how low it'll go once the enthusiasm for the metal wanes.  As for an historic perspective, in 1980, after trading at $850/oz in January, gold would trade at $484/oz less than two months later, a 43% drop.

While most of the new instruments used to trade gold are intended to give investors the ability to take long positions, they've also opened up some opportunities for investors with the willingness and ability to take a position against gold.  The SPDR Gold Shares ETF, symbol GLD, has been around since late 2004, and options trade on these shares.  As of Friday, the December 2011, $100 put on GLD was offered at $2.  A 40% correction would send the GLD shares below $83.  Chances are those $100 puts will expire worthless, but their potential to generate huge gains in the face of a sharp sell-off in gold is intriguing.

Investors with a stomach for volatility might want to consider shorting a deep in-the-money call option against GLD.  This could be a rough ride and there is bound to be some more price volatility in the days, weeks, and months ahead, but barring some cataclysmic geopolitical disaster, gold prices will probably cool off, rewarding those investors who had the guts to bet against the crowd.