Gold Bug or Not, Get Positioned Now for the Rebound

Back in 2012, Stephanie Pomboy, founder of MacroMavens, made a rather scary prediction in a Barron's interview. She called for the end of fiat money and a return to gold as the backing of global monetary value.

The argument wasn't an uncommon one at the time. Central banks around the world were printing money as fast as they could to dig their economies out of the deepest recession in nearly eight decades. The Federal Reserve was well on its way to quadrupling its assets to $3 trillion from 2007. The Bank of Japan was embarking on a plan to double its own assets by 2015. Even the conservative European Central Bank (ECB) was cutting rates, though it did not join the asset-buying party until recently.

The idea was that if debtor nations were going to devalue their own currencies by massive money-printing programs, then creditor nations would demand a return to gold-backed monies.

Pomboy's prediction for a return to gold has obviously not come about yet. To be fair, her five-year window doesn't close until mid-2017. While I don't agree that fiat money will come to an end, Pomboy certainly hasn't been alone in calling for investors to look to gold for protection.

Hedge fund guru John Paulson saw his reputation sink along with gold prices when the metal lost 28% of its value in 2013, the steepest drop in 32 years. Yet Paulson, one of the most well-known "gold bugs," still owned 10.2 million shares of SPDR Gold Shares (NYSE: GLD) worth $1.31 billion as of his firm's June 30 SEC filing.

The graphic below paints a pretty strong picture for what gold bulls have been saying for years. As a percentage of GDP, central bank balance sheets exploded after the financial crisis. The debt held by the Bank of Japan is approaching half of the country's total economy with the ECB and Federal Reserve not far behind.

Central Bank Debt

To date, warnings for faster inflation have not panned out. Price increases of 1.6% in the United States remain below the Fed's 2% target, and policymakers are still worried about deflation in Europe. But the whole scenario feels eerily similar to the lead up to the bursting of the past two stock market bubbles. Many warned for years that Internet stocks were overvalued and that real estate prices were escaping reality before their respective crashes.

Even billionaire George Soros, who referred to gold as "the ultimate bubble" in 2011, bought 6.3 million shares of Barrick Gold (NYSE: ABX) in the fourth quarter of 2013 for more than $100 million. Soros recently sold much of his Barrick stake but increased his stake in Market Vectors Gold Miners ETF (NYSE: GDX) in the second quarter of 2014.

Technicals Indicate GLD is Oversold 

While the price of gold tumbled violently from its highs early in the decade, it has traded mostly sideways for more than a year. In fact, GLD has not deviated more than 8% from the median price of $124 throughout the past year. Even when the price of gold tumbled to $1,193 per ounce in December 2013, GLD touched just under $115 per share. 

The chart below presents the trading range for GLD over the past two years with Bollinger Bands at 2 standard deviations around the price. Shares may find support in the near-term as the price bounces off of the lower Band.

GLD Chart

GLD now looks oversold after falling more than 6% since the beginning of July, with the slow stochastic below 20. This condition has occurred several times this year, and each time shares have bounced. 

GLD Covered Call Strategy

Even if it takes years to see the gold bugs proven right on monetary policies and inflation, the price of gold has found considerable support around $1,200 an ounce. 

I would expect jewelry demand in India and China to rebound over the next several months following steep drops earlier this year as consumers snap up lower prices. The Indian festivals of Dhanteras and Diwali should boost demand, along with the upcoming Indian wedding season. 

With GLD trading at $120.87 per share at the time of this writing, we can set up a covered call trade by buying 100 shares and simultaneously sell one GLD Nov 125 Call, which is trading around $1.35 ($135 per contract) for a net cost of $119.52 per share. This offers you about 1% downside protection from current levels.

If GLD rebounds above $125 by expiration on Nov. 22, your shares will be called away at the $125 strike price. In this case, you will earn a $5.48 per-share profit, or 4.6%, in 73 days. That amounts to a 23% per-year rate of return.

I like the trade as long as you can get in for a cost basis below $120, which still leaves you with a gain of 4.2% if shares are called. If GLD fails to rally to $125 by expiration, you keep the option premium and can sell more calls with later expirations. Your total cost on the position will decrease with each successive round of calls sold.

The current price of the option is about 1.1% of the stock's price. Selling an option for that amount every 73 days would generate income of about 5.6% a year. Since gold pays no dividends, this is a great opportunity for income investors.

I would not count myself in the camp calling for an end to fiat money or even inflation of more than 3% in developed markets, but I do believe there is significant support for gold prices here. Some short-term pain is possible if prices fall back toward $1,200 per ounce, but that seems to be a natural low. A covered call strategy can provide a consistent paycheck with a nice upside surprise when prices eventually rebound.

Note: Selling covered calls is like collecting "rental income" on the stocks you own. If you're not renting out the stocks in your portfolio, you may be missing out on the easiest income around. See how you can collect $1,200 or more each month by clicking here.

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