Buy UGL To Capture The Rally In Gold

ETFS

As you can see in the following chart, it’s been a fairly strong year for the gold bulls with the ProShares Ultra Gold ETF (UGL) seeing year-to-date gains of nearly 40%.

It is my belief that UGL is headed higher over the next year. I believe that gold is set to rally over the next 12 months due to fairly strong economic relationships. However, I believe that investors in UGL need to be aware of key instrument limitations which will impact returns in this leveraged ETP.

Gold Markets

To start this piece off, let’s take a look at the technical chart of the short-term trading action seen in the price of gold.

At present, the gold markets are in an extended selloff, with momentum turning negative in early August and remaining negative through today. Over the past week, negative momentum accelerated and price pushed to the lowest levels since early August.

I believe that what we are seeing at work in the gold markets is an extended pullback in an ongoing uptrend. What I mean by this is that from a technical standpoint, I believe the data suggests that a purchase somewhere in the location of where we are now will prove to be a fairly strong buying point in the short term.

I based this view on the fact that we are currently finding a degree of support near the bottom of the current channel. As I read the market, we would need to see the price of gold conclusively break beneath the current lows for this trend to be broken. Also, given the fact that we’ve had momentum turn negative for the longest stretch in over a year, and the last time we saw momentum turn negative for this long (last September), the price was higher over the next few months, I believe this bearish period will prove to be a solid buying point in hindsight.

Put simply, I believe the short-term technicals suggest that now is a good time to add to exposure in gold. However, that said, my personal preference is to ultimately rely on fundamental analysis for trade recommendations. I hold that technical analysis should only be a supplement and assist with short-term trading around a solid fundamental theme and relationship. It is my view that the current fundamental landscape is solidly bullish at this point.

One of the key fundamental relationships I’m relying on at this point is the link between investing in gold as a safe haven and global market volatility. As you can see in the following chart, there’s a solid link between future gold performance and the VIX level.

The VIX is an index which is calculated from a basket of options on the S&P 500. When the VIX is elevated, it suggests that investors are bidding up options – and investors tend to bid up options for downside production during market volatility. In other words, when the VIX is rallying, the market tends to be falling – as seen in the following chart.

Over the past month, we have seen the VIX hit as high as 35-40 percent (the VIX outright number represents implied volatility in annualized percentage points).

As seen from our first VIX chart, the last 27 years of data would strongly imply that we can expect a rally in gold over the next year. In fact, historical averages show that when the VIX reaches the heights that were seen earlier this month, gold rallies by around 20% over the next year – or in UGL’s terms, this could potentially be a 40% rally.

While we are currently sitting in the immediate wake of a bullish signal, the historical seasonality of the VIX suggests that we are potentially going to see additional upside in the VIX over the next 1-2 months.

Seasonally speaking, the VIX tends to be highest during the latter part of October and early/mid-November.

Additionally, there’s a fairly strong pattern in that election years tend to exemplify this seasonal pattern, with 4 of the last 6 election cycles seeing at minimum a rise in the VIX around the time of the election and through the remainder of the year.

The data is a little complicated by the fact that prior market crashes have occurred during some of the data points; however, there is a clear trend in election years in which volatility tends to rise from September through the end of the year.

Put simply, I believe we are looking at two bullish signals on gold. The first signal occurred over the past month, as volatility surged, while the market indices rolled over and headed lower. And the second signal is likely going to occur over the next 1-2 months due to seasonal and election year tendencies in the VIX.

The key tie-in to gold here is this: investors tend to view gold as a safe commodity. Not only is this the perception, but it is also the market reality. Gold tends to rally over the next 12 months when we see outsized market volatility. Given that we’ve recently seen heightened volatility and given that additional volatility is likely headed our way, gold is likely going to be a strong holding over the next 12 months.

An additional bullish facet at this time is the fact that the market has reversed its recent trend and brought the year-over-year change to around 9-10%. Historically speaking, environments like these tend to see higher gold prices over the next year.

As you can see, there’s a very clear trend in that the more tepid S&P 500 returns are, the stronger the next-year performance in gold. Given that we’re seeing market returns moderate a on a year-over-year basis, gold is increasingly becoming a more attractive commodity.

I believe the key driver here is that investors seek yield. During periods of poor performance in the S&P 500, investors look for other assets to earn return, and gold is one of those key assets. Given the weakening performance of the market, I believe that we are going to see this relationship play out once again with gold performing over the next year.

About UGL

In the gold ETP space, methodology matters. This said, we need to pay attention to the architecture of UGL to understand the sources of return which investors will be exposed to. Put simply, UGL is an ETF which is holding gold to achieve a two times leverage return for shareholders. As you can see in the following table, UGL is currently holding December futures, as well as a few swaps which track its benchmark.

While the Bloomberg family of commodity indices is solid and widely used, there are a few problems that investors need to be aware of. The major issue as it relates to UGL is roll yield.

Roll yield is what you get when you’re holding futures and they converge towards the spot price of a commodity. They key problem for gold futures holders is that the shape of the futures curve is essentially almost always contango – or futures are priced above spot. What this means is that roll yield is negative for gold futures holders because futures are priced above spot and are converging towards the spot price during a typical month.

The reason why gold futures are almost always in contango has to do with the difference between borrowing rates of capital and any fees paid or yields earned for holding and storing gold. It’s beyond the scope of this piece, but if you’re looking for the formal pricing method, see here for the fine points of math.

How the math essentially works out is that at today’s interest rates, gold futures are in about 2% per year of contango. In other words, until we see a material change in borrowing costs, we can expect futures 1 year in the future to be priced 2% above the spot price of gold. And because futures contracts eventually converge to the spot price, this means that on average, gold futures traders are losing 2% per year of value from futures convergence.

What this means for UGL traders is that on a two times leveraged basis, we can expect UGL to lose 4% per year compared to the spot return of gold. For example, if we see gold rally by 20% over the next year, UGL will likely go up only 36%, since it is doubling the underlying gold return but losing 4% from its double roll yield impact.

I do not believe that roll yield disqualifies UGL from investment; however, investors need to be aware of the impact on shares of UGL. I am bullish gold, but I must temper it somewhat as it is expressed through UGL due to roll yield.

Conclusion

Gold is setting up for a strong rally over the next year, as market volatility has been elevated and will likely be elevated for the remainder of the year. As the market return shrinks, investors are likely to shift capital into gold for additional returns. UGL is subject to roll yield losses, which will pull down returns somewhat over the next year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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