Blowing Bubbles, Gold Bubbles

I have to say I thoroughly enjoyed the Discovery Channel's show "Gold Rush, Alaska."
On the last episode we learn that the season really wasn't the success the good old boys thought it would be. The stars of the show, the Hoffman family from Oregon spent over two-hundred-thousand dollars on equipment and operational costs. The idea was to go up to Alaska, dig a hole and get rich. It was a bad bet in my book. Not only were they betting that they could find enough gold to cover their expenses and produce a profit, they were also taking a directional bet on the gold market. The ironic thing is that they were right about the price of gold, but the digging it out of the ground part was a sorry waste of a huge chunk of capital. Had the Hoffmans taken their money and simply purchased Gold contracts, they'd be sitting pretty nice right about now. Since they are were willing to risk losing all their money, they could of even leveraged up their bets, it would have been a lot easier than driving an excavator around all summer. Sorry Hoffmans, just sayin'.

So what's the deal with gold? Why are there people paying $1430/ounce for the stuff? Oh that's right, the world is ending and when the world ends the cool thing to do is spend all your money on gold. Even the folks who work in public radio are buying the stuff they actually have a whole series on gold. I think they do a good job of approaching the topic from many different angles. Here is a link to the series:

NPR's Planet Money, Series on Gold

Over at ForexFactory.com I've talked a lot about order flow and market microstructure in the last couple years. Knowing how markets operate is essential in understanding why buying gold is not the best idea right now, especially in any significant quantity.

The sleeping giant in the gold market is the open interest. Open interest is basically open/existing trades. When market participants buy mass quantities of something and don't sell it back, the market delays any negative feedback trading.

Mark Andrew Ritchie in his book "God In The Pits" gives a great first hand account of the Hunt Brothers corner in the silver market in the late 1970's and early 1980's. The hunt family began buying silver contracts but would not sell them back in the market, after a while, they held so many silver contracts that they could basically demand whatever price they wanted. Their goal was to take physical delivery of silver, but because of the quantity of silver contracts they held and the disruptions they caused in the market, they ended up being forced to sell out of their positions. I mention the Hunt brothers simply for the sake of an example of a market that is not really trading, but hoarding. I believe gold is in much the same situation right now. It's not a single entity causing gold to go parabolic, but a mass of people who are irrationally buying because "it's the end of the world."

Every minute gold continues it's rise into the stratosphere, the fewer buyers there will be. To realize profits at these inflated prices, those who are long gold need someone willing to pay them the high price for their contracts to net them out at a profit. Those who are populating the sell side of the price ladder now, are the smart ones. The only way everyone who is holding gold right now can profit, is if new buyers come in and match the volume that has caused this bubble. I don't know if you've noticed or not, but gold is getting really expensive. What is the probability that there is enough money sitting out there in the form of new buyers to provide enough liquidity to such an already irrationally inflated market? The USA is still in the throws of a recession, but is going to pull out of it. I have no doubts about that. Every day that passes brings the United States one day closer to an inevitable interest rate hike. That day might still be a couple of years ahead of us, but when even a hint of a US rate hike is in the wind, the Gold bulls are going to realize that the world is not ending and sheer pandemonium in the gold market will be unleashed. Gold will collapse down to the $400-$500 dollar mark within months, and many will experience substantial losses. To liquidate gold at current prices means you need increasingly irrational investors to sell to, when those buyers are all gone, the gold bubble will burst. When all that open interest sells when the panic sets in, they will be selling at a steep discount in the land of realistic bids.

As a trader, I'm watching the markets closely and looking for signs of US Dollar strength. I think we will see gold reach > $1500 before the collapse. My tentative plan is to start averaging into the gold market above the $1500 mark, and riding the wave down to $500.

Right now I'm continuing to hold my long positions in the Euro, and plan to through the year or until 1.5 is reached. I'll watch news coming out of the US very closely, but I think when it's time to short Euro it will be time to sell Gold. We are about a year out, in my humble opinion that is--it'd sure be convenient anyways.