Gold had a strong rally the first trading day of February. This rally was significant for two reasons. First, gold hit a significant support level last Friday and needed to bounce at that point if it is going to form a double bottom. Secondly, assets in bull markets should rally the first few trading days of the month. Despite a barrage of press coverage during the last several weeks, the threat of inflation hasn't diminished, nor are the world's governments likely to return to fiscal and monetary responsibility for many years into the future. Gold will continue its long-term rally until that happens.
The Credit Crisis has forced the U.S. and a number of other industrialized countries to risk either a long prolonged recessionary period or massive inflation. Modern democracies will always chose inflation because the voters will turn on any government that allows a recession to continue for a long time (unemployment rates will be what voters make their judgment on, not manipulated GDP numbers). While the Obama administration spent the last three weeks trumpeting deficit control, the 2011 proposed budget submitted by the administration on February 1st indicated deficit out-of-control instead. While there was supposedly an item here and an item there that would save $20 billion or so in the next many years, this is laughable. The budget deficit for fiscal 2010, which ends this September 30th, was revised downward on January 26th by $150 billion and then upward by $190 billion on February 1st. These people can't predict 10 days in advance, let alone 10 years and yet the mainstream press treated their multi-year predictions as something that should be taken seriously instead of as an item worthy of the comic pages.
Gold was also selling down because the trade-weighted U.S. dollar has been rallying since early December. The dollar rally first began because Japan and China were acting in concert to drive down the Japanese yen. In January, the euro has had the major sell off because of fears of a sovereign default by Greece. There is a real risk of this, but can the ECB let Greece default? It should be kept in mind that Greece represents only 2% of the euro zone economy. The euro has fallen by over 7% against the U.S. dollar because of the crisis. A sovereign default in Greece is likely to be much more costly than a bailout and so a bailout should be expected. It will also only be more expensive as time goes on, so an obvious question is why have the ECB leaders avoided it so far? When this problem is resolved, both the euro and gold will rally strongly.
The press has also released items lately that are obviously meant to drive the price of gold down. The most interesting of these concerned comments made by legendary investor George Soros at the recent Davos conclave. Speaking about the excess money creation and govenment spending taking place globally, Soros said that gold would be the ultimate bubble because of these. Soros did not indicate that the bubble he foresaw was going to peak anytime soon, although the press slanted its coverage to indicate otherwise. Gold rose 25% in 2009 versus around 400% in its last year of the 1970s rally. Bubbles end in massive rallies and we have an approximate measurement of how large that rally amount is for gold because it previously ended a bubble three decades ago. When investors see gold going up several hundred percent in one year, they should worry about gold being in a bubble that is about to burst. Before then, they shouldn't. Expect to continually hear that gold is in a bubble for the next several years, especially every time it hits a new high.
In the short-term, gold is not out of the woods just yet. Investors should watch the $105.00 level on GLD. Any significant break of this would indicate that GLD will drop to its 200-day moving average, which is around $100.00 and that spot gold would test the $1000 level. Silver would also break down from its trading range, roughly between the $16 to $19 an ounce level for spot (slightly lower for SLV). Seasonals are generally strong for both gold and silver in February, but weak in late spring. In any given short-term period, price drops are possible because of temporary liquidity restrictions from the central bank or government policy changes. Investors should particularly watch out for the increase in capital gains taxes that will take place in the U.S. on January 1, 2011. Many American long-term holders of the precious metals have big profits and if they want them taxed at a lower rate, they will have to sell before the end of 2010. Bargain hunters should take advantage of this as well as any other major sell offs in the precious metals. Gold has maintained its value for over 5000 years; paper currencies are usually lucky if they last 100 years.
Disclosure: Long gold and silver.