Investing Lessons from the Gold Collapse

The other day legendary financial blogger and current Bloomberg View columnist, Barry Ritholtz, put together a great piece on the 40 percent collapse in gold prices called “10 reasons gold bugs lost their shirts.” What I love about the piece is not what he says specifically about gold, but some of the universal investing truths Barry extrapolates from bullions’ rise and fall.

Here are a few in particular that spoke to me.

Beware of the narrative: Story telling is a massive part of the human experience, but in investing, this can become a hindrance. Barry notes that storytelling plays a crucial role in the Wall Street sales process, but I would argue that all investors build their own narratives in their minds, subconsciously or not, and we become attached to these narratives—which as we learned from gold, can be spectacularly wrong.

As a blogger, I know this is something I must contend with as I often write about the markets I am looking to trade and I must be careful not to become too emotionally invested in the pieces I craft. For example, I wrote an extremely bearish note about gold the other week…and I have been wrong ever since I hit the publish button. Should gold keep rising, I will need to admit my narrative was incorrect and reconsider my bias that gold has at least one more down leg in the near term. It hurts to admit being wrong, but I’d rather be wrong than sacrifice my bankroll.

Gold does not have many industrial applications but it looks good as a toilet seat...

Gold does not have many industrial applications but it looks good as a toilet seat…

Ignore history at your peril: I’ve touched on this theme is the past during my discussion about “this time it’s different.” As gold bugs chose to ignore the fact that gold is just like any other commodity market in that it is not a “safe haven” but a highly leveraged, zero-sum game that trends both up and down.

Barry points out not just one or two, but nine gold run-ups and selloffs in the last century. It happens nearly once a decade.

Ignoring history, or in the gold bugs’ case, selective history that fits neatly into one’s narrative leads nowhere but to financial ruin.

Barry Ritholtz: 10 Reasons Gold Bugs Lost Their Shirts

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A Final Goodbye to the Gold Bugs

Since the spring I’ve been super bearish on gold and my short in April will go down as my single best trade of the year. Yet, I don’t think this long-term downtrend is finished. There are still some gold bugs left to squash.

But before I go full greed mode and leverage myself to the neck shorting gold, let me explain a bit about my trading philosophy.

When I enter a trade, I usually check three criteria before I jump in: a strong fundamental basis, a technical breakout and matching sentiment. (I say ‘usually’ because sometimes I let hope interfere and I enter a trade without proper vetting. I often pay a hefty price for this lack of discipline.)

1) A Strong Fundamental Basis. With the fed signaling the end of qualitative easing in a largely symbolic tapering move, for the first time in years we see a faint sign on the horizon that dollar debasement may be ending. In other words, the gold bug dream of returning to the gold standard is fading. Finally, the dearth of high inflation data essentially dismisses any shred of credibility left in the gold bug argument.

 2) A Technical Breakout. The front-month contract of gold futures is currently hovering around $1,200, dangerously close to its year low of $1,179 set in June. Since that time, gold has put in what appears to be a head and shoulders pattern on the weekly chart.

The front month NYMEX gold weekly chart

The front month NYMEX gold weekly chart

Granted, one could probably find a head and shoulders pattern in just about any chart; but, if we can close below $1,800 that will crush a major resistance point. From there we will be staring down $925 an ounce or possibly even lower.

3) Matching Sentiment. Despite the vitality of the gold bug crowd, it is shrinking fast. We are in a full-fledged bear market and big player John Paulson, though sticking with his gold position, is no longer buying. There is certainly room for more bears.

Another tool I use often is the significant news indicator, which I have already discussed. Right before the Fed announcement yesterday, gold prices shot up to more than $1,240 an ounce. Unfortunately for the bulls, price action could not maintain this level after the announcement crossed the wire and Ben Bernanke’s press conference ended. Once gold broke below $1,220 late in the afternoon, the market had made its decision. The news was bearish, creating a low-risk short opportunity.

Hitting the trifecta on my trading criteria, I am short gold with expectations for a fresh multi-year low. If I am wrong, I will gladly accept the scorn of gold bugs everywhere. Yet, I won’t regret my decision because I believe my reasoning is sound.

After all, I don’t own a crystal ball!