What's Up With Gold?

Have you ever held a basketball underwater in a swimming pool and let go? It flies to the upside and pops you in the nose. That is exactly what gold is doing now. After the barbarous relic peaked at $1,922 on Aug. 24, it traded like an absolute pig, giving up 20% in a matter of weeks. I managed to coin it with a couple of quick in and out trades in (GLD) puts, some doubling over a weekend. So much for the "safe asset" theory.

You can thank hedge fund titan, John Paulsen, for the action. John gained international notoriety when he earned a $4 billion bonus after making huge bets against subprime loans going into the housing crash.

Since then, his touch has grown somewhat icy. He started out 2011 with a huge, bullish bet on US banks, a play, I confess, I never really understood. This was back when Bank of America (BAC) was trading at a lofty $14/share. As a hedge, he backed up these gargantuan positions with big holdings in gold, which quickly made him the largest owner of the ETF (GLD).

John's P&L held up reasonably well during the first part of the year. As the banks faded, gold went from strength to strength, limiting his damage. That all changed on April 29 when global financial markets flipped into "RISK OFF" mode and gold melted along with everything else. Its hedging capability proved to be nil. By August, John's losses approached a near death 50%.

Needless to say, his investors failed to see the humor in the situation, and rumors of cataclysmic redemptions started sweeping the street. By implication, this could only mean large scale liquidation of the yellow metal. This was happening when the rest of the hedge fund industry was catching daily margin calls, forcing them to dump even more gold into a downward spiral, their best performing holding for the year. When the sushi hits the fan, you sell what you can, not what you want to. By the time the carnage ended, gold was down $392.

When the crying was over, Paulson had reduced his ownership in the ETF (GLD) from 31.5 million shares to 20.3 million. That's a haircut of $1.76 billion of the shiny stuff. In the end, Paulson says he only suffered redemptions of 10% of his somewhat reduced funds, much lower than expected.

Gold actually anticipated the new "risk on" trade by a week, bottoming on September 26. Since then it has behaved like a paper asset, tracking the S&P 500 almost tick for tick, adding a quick 19.6%. So, what's up with gold?

As we approach yearend, the downward pressure of this redemption selling is waning, hence my basketball analogy. New bull arguments have also come to the fore. The contagion in Europe has prompted massive buying of all precious metals by panicky individuals, including silver (SLV), platinum (PPLT), palladium (PALL), and even neglected rhodium, with a collapse of the Euro imminent. And how will the ECB eventually end the crisis? With a continental TARP and quantitative easing, which we here in the US already know is hugely positive for gold prices.

How far will the gold get this time? The gold bugs say we're going to break the old high and power on through to the inflation adjusted high at $2,300. I'm not so sure. I am not willing to bet the ranch here on an asset class that could plunge $1,000 going into the next recession, which could be just around the corner.

But there may be a trade here in precious metals space for the nimble. My pick has been to buy lagging silver, which offers much more bang per buck if the sector starts to build a head of steam. The white metal will not get hit with IMF gold sales, which are also a rumored part of any European bailout package.

From the Diary of a Mad Hedge Fund Trader.

About the Author
The Mad Hedge Fund Trader

John Thomas writes the Diary of a Mad Hedge Fund Trader

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