The Sell-Off in Paper Gold

By Kevin Brekke

Last week was enough to give anyone attempting to squint through the media haze a headache. Operation whack-a-mole, the desert dictator’s edition… scalpel versus axe budget bickering… ballot box bungling in a state Supreme Court election… we-didn’t-until-we-did need a bailout plea from our port-sipping friends… the truth was scuttled by a violent torpedo… and on and on.

It’s getting harder every day to tell the editorial from the funnies page. Where is that bottle of aspirin?

The week just past also delivered some attention-grabbing news of a different sort. Silver continued to shine, waving goodbye to the $30 handle as it broke through the $40 level. The once forgotten stepchild of the precious metals family continues to thrill investors, up 31% this year.

Gold was no slouch either, closing at an all-time nominal high on Friday and chugging ahead 5.8% so far in 2011.

Amidst the swirl of concerns about not-so-latent inflation pressures adding helium beneath the entire commodities complex, a development in the gold ETF GLD that has been underway and largely unnoticed caught my attention. Take a look at this chart:

As highlighted within the oval, the number of ounces held in trust at GLD peaked in July 2010 and has been in decline since, as the number of shares redeemed has exceeded those created. Concurrent with the exodus of 3+ million ounces from GLD’s holdings was the steady rise in the gold price.

It’s impossible to know for certain what the motivation behind those doing the selling might be. However, it seems reasonable to assume that a good chunk of it is due to profit taking.

I know, I know. Who in their right mind would be selling now?

To those of us in the pro-gold, hard-money camp, selling now is like canceling your homeowners insurance upon sighting flames lapping above the canyon rim.

But the run-up in gold and silver prices has, as expected, attracted a lot of newbies into our sector that do not understand, and probably don’t care about, the fundamentals behind gold ownership. This is a sector with momentum, and they intend to play it for short- or medium-term profit. I’d be surprised if many of them own physical gold.

This underscores an important psychological difference in perception between physical and paper gold. The permanence and security of physical gold renders its owner less likely to sell. Paper gold is ownership in abstractato be traded online with a few mouse clicks. This is why we recommend that every investor have a good-sized chunk of their wealth in physical gold (and silver) in their possession and under their control.

The selling in GLD bolsters our warnings about a possible correction in gold. Although we are delighted to see our favorite metal surge ahead, the surging has taken the price a bit too far, too fast. We are long overdue for a breather. The odds of a correction are further raised as we head into summer, historically a seasonally weak period for gold.

Corrections are a regular part of any trend and should be anticipated, even welcomed. Not only will they shake out speculative excess, they give us great entry points as a set-up for the next leg higher in the trend. If you are new to our sector or looking to add to your holdings, be patient. If you are adding to your holdings now, be prepared to add more at lower prices.

That’s exactly what the smart money does.

The arrows on the chart show that the big decline in gold in 2008 was followed by heavy buying that saw GLD’s holdings rocket by 17 million ounces. There is no reason not to think the same would happen again if we get a decent retreat in gold this summer.

Our motto for the next few months: Be smart. Be patient. Be prepared.