Economists will debate the merits of inflation at this point in the economic cycle. From an academic standpoint it makes no sense considering the Fed is hard at work tightening the money supply and raising interest rates. Traditionally this has been a force against inflation however for a variety of reasons, none of which we’ll cover in this article but you may review HERE or HERE, economic data such as the CPI is telling us inflation is upon us. Investors or traders now have a choice to either embrace the trend or act in denial and miss one of the many opportunities for profit we’re seeing today.
Today I’d like to walk you through three specific ways you can potentially profit from the inflationary trend that seems to have just begun with actionable trading plans for each setup.
Gold – One of the most obvious trades during an inflationary cycle is gold. Traditionally the precious metal has proved as a store of value should a currency be in decline and thus purchasing power eroding. The difficulty in trading gold however is the shorter term volatility that seems to take place within the context of a longer term trend. For whatever reason it has been my experience that Gold is best to be bought when the short term move is ugly but the longer term trend remains in place. For my broader trend setups I like to look at the monthly chart which can be seen utilizing the ETF: GLD below.
As you can see GLD has been stuck in a range going back to 2012 however this is the first time in 5 years the metal is holding levels above all critical long term moving averages. In addition, it seems to have broken out of a shorter term downtrend going back to the 2016 high.
The setup is attractive to my eyes and it looks to me as if the bottom for Gold is definitely in with the longer term potential of a new uptrend beginning. From a risk standpoint there looks to be two obvious pivots where one could set stops. The first being the December low of $117.40 or if you want to give yourself even more room you could use the July 2017 low of $114.80.
Let’s break it down even further and say you wanted to risk 1% of your portfolio to see if Gold was in fact starting a new trend. Assuming you were to use the $117.40 low as a stop, and also assuming a purchase price of $128.00, this would equate to an approximate loss for the position of 8.2%. In order to risk 1% of your portfolio you would take an approximate position of 12% of your trading capital. (.12*.082) = .98 Since it is gold and not any single corporation presenting single stock specific risk, I believe a 10-12% position in gold is appropriate however investors would definitely want to be sure this was in-line with your overall goals and risk tolerance. Our clients have a 10% position in our aggressive accounts. This amount is pro-rated lower according to client risk tolerance.
Silver – Considered the ‘Poor Man’s Gold’ silver is often a tad behind the Gold move but can easily make up for the delay through increased beta and potential out performance. While not a pure play on inflation, Silver does have industry use and can be found in the development of many items such as semiconductors and other building materials. At this point the metal is not as technically attractive as Gold and is why I prefer the yellow metal however my experience tells me that if Gold continues to garner attention, it is only a matter of time before Silver follows suit.
If you wanted to get ahead of the trade, which does include additional risk as anticipatory trades typically do, it may reward those with a disciplined plan. In full disclosure while this is not a trade within our predominant managed portfolios, I do have this held within a tactical trend model as well as some personal retirement accounts.
Unlike Gold, Silver remains stuck below critical long term moving averages as well as below a declining trend line going back almost 8 years. It does however have the bottoming look as one can clearly see a reverse head and shoulders which is nothing more than a subtle sentiment shift and a trends first significant higher low. Silver holders are clearly anticipating a surge above both the critical moving averages and the descending trend-line, which would indicate that their anticipatory read was spot on. Let’s look at how one could build a trade in SLV.
First off, the pivot low from July of 2017 is a critical level and would serve as a $14.44 stop. Because the trade is anticipatory, one does not want to get shaken out on a normal but erratic shake so widening this to $14.00 may be appropriate. Trading around $15.75 this would equal a stop of $1.75 or 11.11% from entry. In order to expose the trade to a max 1% portfolio risk the trader would need to take an approximate 9% position in SLV. (.09 * .1111)= 1.0%
Side note, it is unlikely that Silver moves higher without Gold and thus taking the same amount of risk in each of these trades may be overdone. Traders may consider halving the risk in each trade in order to justify a total portfolio risk within Gold and Silver of 1%.
There are many variations of the gold and silver trade to consider which I can write about another time. GDX looks to be bottoming and may present significant opportunity and additional beta while individual metal and mining stocks may also be in play. My objective with this trend is not to catch short term beta but remain in the thick of the trend for many years. My metal ETFs may be boring to some, but I will not fret about balance sheets, international mining strikes or corporate tax issues. It has taken me nearly 20 years to realize the benefits and power of keeping trades simple.
One of the reasons we were so early on the inflation call was not because of our macro economic prowess but our ability to recognize the movement transpiring in raw materials such as copper, iron ore and aluminum. This led to a deep dive into the world of steel and the ability to recognize a fantastic opportunity transpiring within the SLX.
Months ago this trade presented much better risk versus reward however if in fact this has just begun, traders can still position themselves in SLX with appropriate risk versus reward, looking to add on any dip.
As you can see from the chart above, SLX has clearly broken a trend going back to the 2007 high and after a significant drop correlating with the great oil splat of 2015 the metal has recovered nicely. After spending several months around the critical 35 level has now begun moving out and seems to be gathering some steam. I’m not sure I would chase a position here with any size but let’s say a trader wanted to at least gain some exposure, looking to add more on a retracement. I would use $39 or the November low as my pivot / stop level which gives me an initial risk of over 24%. This is quite a bit, and one would definitely anticipate a pullback at some point. One could begin a position of around 1 or 2% of a portfolio and in the event of complete destruction, never getting to add but rather being stopped out on a total drop, would lose approximately .2 – .4% of a portfolio. Again, the desire here would be to simply take a marker position and look to add on a retracement, thus increasing size and risk appropriately.
In summary it looks as if inflation will soon be moving from a subtle undertone to a mainstream, widely accepted phenomenon. One can argue with this or embrace the trend opportunities presented in order to capitalize on the money making opportunities. As always making sure stops are appropriate to ensure a level of safety in the event of a complete change.