As our readers know, we are what one might call "intellectually friendly" toward gold. For one thing, we regard it as the money of the free market, the characteristics of which make it superior in every way that counts to State-issued fiat confetti. Of course we acknowledge that currently, gold is not money in the strict sense, as it is not employed as the general medium of exchange. It should be clear though that it would be used as money in an unhampered free market economy, and that even in its "demonetized" state of today it retains a great many monetary features.
In addition, we happen to have argued for many years that gold would prove to be an excellent investment (since 1999 in fact -- i.e., at a time when it was widely considered the least fashionable investment asset on the planet.). Naturally, whenever a sharp and unexpected correction occurs after many years of gains, one is forced to take a step back and consider whether the bull market has breathed its last. Frankly, we don't think it has, but the best way to go about this exercise is to consider legitimate bearish arguments.
Bearish Technical Arguments
Regarding the market's technical condition, there are a number of more or less obvious problems. The biggest one from our perspective continues to be that gold mining stocks -- which have led the decline -- continue to fail to show signs of life, never mind putting in a convincing reversal. Maybe that will have changed by the time you read these words, but as of Wednesday's close the carnage in the sector has continued without even a pause. Given that the gold stocks have led the decline, we must assume that they will very likely also signal the turn and lead the next advance. Any failure to do so should be viewed with suspicion (if, for example, the stocks were reluctantly "dragged up" by a rising gold price, we would consider that a bearish omen at this juncture).
Obviously, the fact that gold has broken through a lateral support line that has held for many months isn't a good thing either. It means this support will now act as resistance (at least we do have that information now).
There is one more technical fact that bothers us a bit, one of a more long-term nature. Namely the temporal distance between the April 2011 top in silver vs. the November 2011 top in gold. This is a "double divergence" -- first gold didn't confirm silver's new high, then silver didn't confirm gold's. We have observed such double non-confirmations at the bear market lows in the late 1990s/early 2000s as well.
At the time, we felt that this was one more piece of evidence arguing in favor of the idea that a major secular low was being put in place by the precious metals. We can therefore not simply gloss over the fact that the opposite has just happened in 2011. Of course, there are also good fundamental reasons for why silver did better at first and gold did better a few months later. It may yet turn out that this particular divergence was not meaningful with respect to the long-term bull market, but was only of medium-term significance. However, it nevertheless remains a concern. In order to help readers visualize the problem, we show annotated monthly charts of gold and silver below:
A 25-year chart of gold, monthly candlesticks. The annotations show the important points that need to be compared with the action in silver.
A 25-year chart of silver, monthly candlesticks. Here we have detailed the divergences at the long-term lows, as well as the more recent ones.
As an aside to the above, gold stocks too have produced such divergences with the metals, both at the long-term lows of 1999-2000 and the highs of 2011. One cannot simply dismiss these technical warning signs out of hand at this point.
Bearish Fundamental Arguments
We have already highlighted what we believe to be a major underlying theme (namely growing, if misguided, "deflation" fears) behind the recent sell-off. However, a friend reminded us yesterday of an additional point that we neglected to mention in our previous missive and which needs to be considered.
One day before the massive sell-off last Friday, President Obama signed the new "sequester" for the next fiscal year, amounting to $109 billion. As our friend noted, he has also ended the two costly legacy wars of the Bush administration, while starting new, more cost-effective and likewise undeclared wars by using drones (the "video game wars," you might say). This ensures that the production of future enemies remains at a steady level, so that there will always be new reasons to continue with the defense spending racket due to the inevitable blowback. At the same time, it ensures that opportunities for bigger wars will remain open, in the event a big distraction is required (if for instance the economy and the stock market were to tank shortly before an election, to name an example).
The point remains though that the costs of these ongoing low-level wars are much lower than the occupation costs of Iraq and Afghanistan have been. As a result of the cohabitation of a Democratic president with a Republican congress (remember Clinton/Gingrich?), there is thus a genuine chance that the budget deficit will shrink noticeably in coming years. This tends to be somewhat bearish for gold -- it always has been. The reason is that the U.S. dollar is gold's major antagonist in the currency universe. It has replaced gold as the major foreign central bank reserve asset after the 1971 Nixon gold default (a "temporary measure," by the way -- we're still waiting for rescission). Thus a sharply rising U.S. public debt and rising deficits have traditionally been regarded as bullish factors for gold, and, conversely, shrinking deficits are deemed to be a bearish factor.
We recommend therefore to keep a close eye on how the deficit develops from here. A renewed economic downturn would, of course, see it explode again, sequester or no sequester.
What We Like -- A Few Bullish Data Points
Technically we like that the recent selling squall occurred on such huge trading volume. (By the way, we must correct an erratum that made its way into our initial discussion of Monday's trading volume earlier this week: 658,000 contracts was the Globex volume for the June contract alone. Combined volume of all futures contracts across all exchanges amounted to an even more stunning 751,000 contracts, with open interest at a mere 426,000 contracts by comparison.)
Such extremely high trading volume is rarely encountered at the beginning of a bear market -- rather it usually indicates a climactic panic. Of course, we have no historical basis that could tell us what a "climactic panic" really should look like nowadays. Perhaps it requires even higher volume. However, 751,000 contracts in a single trading day does strike us as pretty significant. It represents a historical record high. In terms of tonnage, it handily exceeds the annual production of all gold mines on the planet (even if it was just "paper gold" that was traded).
Gold, June contract daily -- trading volume hit an all-time high on Monday.
Finally, we do of course continue to like the sentiment backdrop. An absolutely amazing flood of anti-gold vitriol has been spewing forth in the media in recent days, in many cases penned by people who demonstrably know absolutely nothing about gold, mostly Keynesian gold haters from the statolatry faction. Not one of them ever told people to buy gold at the lows of course, or at any point on the way up. But they sure all just know now that the bull market is over!
The media blitz looks almost orchestrated. Sell-side analysts have been harping about gold's weakness for several weeks already. This culminated in the Goldman Sachs call to go short gold, which was given rather unusual prominence in the media as well. Normally the press doesn't engage in such extensive reportage every time Goldman issues a market call. (This is actually a good thing, as these calls are as a rule not much better than flipping a coin. Remember the $200 crude oil call in 2008? That got plenty of play in the press as well and within a few weeks turned out to have been the sell signal of the decade.)
Admittedly, we were surprised by the breakdown (we wrongly assumed the support line would continue to hold), as were many of those whose gold related opinions we actually value. However, it should be clear that markets can surprise just about everyone from time to time (in fact, it happens quite often). One's knowledge about the gold market is not necessarily dependent on getting every forecast right. Indeed, forecasts are of little value in the short term anyway -- way too many things can potentially derail them. At best one can gauge probabilities, which then need to be continually reassessed in light of the actual market action.
However, the recent flood of nonsense sweeping the press (which often reads like a not very sophisticated anti-gold promotion aiming to bring home the point that "gold is a bad investment") is quite a sight to see. We didn't know that so many people apparently just hate gold. Anyway, all of this has further solidified the already very bearish sentiment backdrop. While that has not helped the market so far, it will be very helpful when this surfeit of bearish sentiment finally unwinds in the next rally.
As an aside, many of the so-called experts are groping in the dark as well, to put it mildly. Morgan Stanley says that it sees the "four pillars" of the gold bull market crumbling. What are those pillars? We list them below, with the typos removed:
1. Rising investment demand through ETFs, 2. Controlled central bank selling and significant buying by emerging market central banks, 3. Gold buybacks (we assume this refers to hedge books), 4. Weak mine supply growth. (comment in parentheses ours)
So this is what the gold analysts of one of the world's biggest investment banks believe drives the gold price. We think this is downright embarrassing, but there it is. This is what actually passes for thoughtful "expert" gold analysis nowadays. Evidently the opposition is coming to the fight unarmed.
The additional surge in bearish sentiment this recent flood of negativity has produced is mirrored in various survey data -- and here we can see potentially positive divergences:
Gold, public opinion. This is an example of a bullish divergence: More bearishness at a higher price level than in 2008, and amid a correction of similar size (in percentage terms). This chart by SentimenTrader merges the responses to several prominent sentiment surveys (such as Consensus Inc., Market Vane, etc.).
Silver, public opinion -- we see the same thing here, lower levels of bullishness at a higher price and amid a decline that is roughly similar in percentage terms as that of 2008.
Lastly, it should be noted that most of the people who insist now that the bull market is over, not only never saw the bull market coming in the first place, but have told us on several previous occasions already that it was over. Anyone who shorted gold when arch-Keynesian Nouriel Roubini first declared his bearishness would have been carried out on a stretcher a long time ago and would still be massively underwater even after the recent crash-like rout.
Even many of the arguments sound very similar as last time around. There is for instance this one: There is a crisis and gold fails to rise in the face of it -- this must be bearish. The same was said in 2008 over and over again, and it has repeated recently mainly in the context of Cyprus. In reality, gold rarely does what it allegedly should be doing according to various theories. However, it does have a tendency to discount massive money printing and rising fiscal deficits. Various leads and lags are involved that generally follow no fixed pattern. In hindsight it appears as though it has probably gone too far too fast in 2011.
This brings us to the fundamental bullish case: It largely remains the same as before (with the above-mentioned deficit reduction efforts representing a bit of a fly in the ointment in the short to medium term, depending on how they actually play out). In essence, the case rests on the fact that the money printing efforts by central banks are doomed, as they will produce exactly the opposite outcome in the long term as that intended. Moreover, the reaction of the monetary authorities to this failure will be to do more of the same -- i.e., to print money on an even greater scale.
The evidence pointing to such an outcome is extremely strong at present. The first half of the thesis is based on sound economic reasoning, the second half on observations of the behavior and statements by central bankers up until recently. Of course it is always possible that we will need to revise this assessment at a later date. We cannot make definite pronouncements on the unknown states of knowledge of an unknown future. However, given that we are dealing with probabilities, we can definitely state that this particular case is one that without a doubt favors the bulls. After all, today's central banks are essentially pursuing the same basic strategies that were pursued by people like John Law, the revolutionary assembly of France and many others who sought to "revive the economy" by flooding it with additional money. Only they are of course going about it in a so much more "scientific" manner today that nothing can possibly go wrong. It is precisely this hubris that ensures that more of the same is in the offing.
We certainly don't know what the old market will do in the short to medium term. There are as usual both bearish and bullish data points one needs to consider. However, we can make a few educated guesses as to what is required to restore the bullish trend, and what would likely argue in favor of a continued bearish trend. In the short term, we would closely watch the action in gold stocks relative to gold. In the medium term, developments on the inflation/deflation front and government's debt and deficits must be monitored.
Technically, gold would now need to overcome stiff resistance at the former support line in the $1,525-$1,540 region. Support is provided by the previously discussed $1,300 and $1,040 levels (a few more minor support levels lie between those two). The sentiment backdrop continues to suggest that the decline is a major correction in a secular bull market. (One reader has suggested that it would be more accurate to call it a cyclical bear market rather than a correction. Cyclical bear markets are the corrections of one lower degree in the context of a secular bull market, so both terms are essentially appropriate).