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A Broad Consensus

In the final weeks of 2013, a great number of articles expressing bearishness on gold were published in the mainstream financial press. Scanning Bloomberg, Reuters, Yahoo and other popular news outlets and/or news aggregation sites, it was difficult to come across any positive assessments. Keep in mind that we are only referring to the mainstream consensus, which was largely quiet through most of gold's bull market, and only turned vocally bullish fairly shortly before gold topped in 2011 (there are a few exceptions, but mainstream bullishness really only became pronounced in 2011).

For gold bulls, even those who correctly anticipated the bull market near its beginning, things had become a bit too easy after gold had risen for 12 years running. It was also very easy to underestimate the extent of the bear market that started in 2011. For one thing, money printing not only continued, it even accelerated. For another, the consensus turned bearish shortly before gold fell through a lateral support line that had contained declines for about 18 months and then turned extremely bearish. This surfeit of bearish sentiment made it appear as though the downside would be more limited than it eventually turned out to be (it also means that one must remain cautious and not to read too much into the current sentiment situation).

Nevertheless, something interesting happened after the Fed's "tapering" announcement and after the above mentioned flood of bearish articles poured forth in the final two weeks of the year. Immediately after the announcement, gold declined to retest the low made in late June, but is has quickly reversed course in the new year:

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Spot gold, daily. After the tapering announcement, gold fell to a level very close to the late June intra-day low. Since then, it has roughly regained what it lost in the wake of the announcement.

In other words, gold has not obeyed the script so far in 2014. "QE tapering" is finally no longer a perennial speculation, but the new reality - and yet, after an initial bout of weakness, gold has essentially moved back to where it was prior to the announcement. Given that practically the entire mainstream/sell side consensus expressed at year end insisted that the Fed's "tapering" of QE can only mean further declines, this move was definitely unexpected. To be sure, no major resistance levels have been taken out yet, so it may not mean much. The possibility that the next lateral support level (which lies at $1,040-1,050) will eventually be tested cannot be ruled out. After all, we cannot yet tell how gold will react to further "tapering" announcements, which are likely to be made in coming months. $1,040-1,050 represents the March 2008 pre-crash high that was tested in a pullback in early 2010, turning into support. On the other hand, as the next chart shows, the $1,200 level also represents a long-standing support level, i.e., a price level around which several previous highs and lows were recorded.

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Cash gold over the past five years. Both the $1,200 area and the $1,050 area represent technically important levels.

With regard to current sentiment, below are a few charts illustrating the situation. Sentimentrader recently published a long-term chart of gold's "sister metal" silver that shows both "public opinion" (an amalgamation of the most important sentiment surveys) and the net futures positioning of large speculators. What is interesting is that the current bearish consensus expressed by this combination of survey and positioning sentiment has reached a rare extreme that was last seen near the beginning of the bull market 13 years ago. The main difference is of course that silver trades at a price that is still 400% higher than it was then. One must keep in mind that such data do not necessarily herald the imminent return of a bull market - but at the very least one should expect that a fairly large retracement rally is in store if history is any guide:

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Silver: sentiment surveys and futures positioning by speculators combined are at rarely seen extremes.

Gold sentiment is in the dumps as well. Recently small speculators went slightly net short again, which happens quite rarely in gold (in fact, the last two occasions were a bit earlier in 2013 and in 2000). The public opinion gauge is also at a very low level, however, it has diverged positively from prices at the recent retest of the June low:

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Gold, public opinion: the bullish consensus from the most important sentiment surveys combined is very low, but it still diverges positively from price relative to the June low.

Gold and the Money Supply

One must consider that as mentioned above, the gold price actually fell while the broad US money supply TMS-2 expanded from roughly $8 trillion (as of August 2011) to $9,86 trillion (as of November 2013). So a money supply expansion of 23% in a little over two years was accompanied by a sharp decline in the gold price. There is of course no law that says that the gold price must rise concurrently with the money supply. In fact, the money supply consistently rose during gold's 20-year long bear market as well, although not at rates comparable to those that have been recorded since the year 2000, and especially not since 2008.

One must keep in mind though that the gold price put in a typical bubble peak in January 1980. Not only had the gold price experienced a year-on-year percentage change of 262% at its 1980 intra-day peak (more than twice the already bubble-like 111% y/y change rate attained in late 1974), its value had at that stage increased enormously relative to the outstanding money supply. In fact, it would have been fairly easy to return the monetary system to a gold standard at the time as no large gold revaluation would have been necessary.

The main point though is that it took a long time for gold and the money supply to once again diverge to a notable extent in the other direction. In 1980, gold had discounted a lot of what was to come in terms of debt and money supply expansion. Moreover, a large part of the run-up into the peak occurred in a very short time period, and was accompanied by a mixture of very strong worries about CPI inflation as well as a series of geopolitical events that seemingly promised a great deal of instability (the Islamic revolution in Iran and the Soviet invasion of Afghanistan).

Below is a chart that shows gold's propensity to build triangles both during rallies and after they have ended, during the 1970-1980 bull market, something that has happened in the bull market since 2000 as well (even the long bear market after 1980 actually took the form of a very large triangle/wedge):

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Bullish (red circles) and bearish (green circles) triangles in gold's 1970 to 1980 bull market.

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The wedge-like shape of the 1980-2000 bear market, within which once again numerous wedges and triangles formed.

Here are briefly the factors which we believe to be the main drivers of the cyclical bear market from the early September 2011 high. First of all, at the 2011 high, there was a large premium embedded in the gold price as a result of the euro area debt crisis. This combined sovereign debt/banking system crisis was likely a very important factor driving the rally from about $1,300 to $1,900. This "crisis premium" was subsequently lost, something that was also mirrored in "safe haven currencies" like the Swiss franc and the yen (it is interesting in this context that the interim peaks in gold in 2012 all coincided with major central bank announcements aimed at getting both real and imagined crisis situations under control).

Secondly, the US federal deficit has begun to decline from its previous record highs. This has received very little attention, but we tend to believe that it is one of the factors playing a role in determining gold's price trend (it is fairly easy to figure out why: the larger the deficit, the greater the probability that it will be financed by central bank monetization, notwithstanding official protestations to the contrary).

Thirdly, inflation expectations have incongruously declined quite sharply in 2013, but without entering the "deflation scare" zone. Such an environment of declining expectations regarding future CPI rates of change tends to be bearish for gold. We are not saying that these expectations will turn out to be correct - we merely note that this is what could be observed.

And finally, expectations regarding the state of the economy have become as distorted as the economy itself. There is now an almost unanimous consensus among economists, Wall Street strategists and in the financial press that we are on the cusp of what could be termed "business as usual," i.e., a "normal" economic expansion. This consensus is even more deeply entrenched than the bearish consensus on gold and it seems highly likely that it will turn out to be quite misguided. This won't necessarily happen immediately, but it will as soon as "tapering" leads to a distinct slowdown in money supply growth.

To us it is just amazing that people seriously believe that following the biggest financial crisis since the 1930s and right after the biggest money supply and debt expansion since the end of WW2 (which was accompanied by the weakest "recovery" of the entire post WW2 era to boot) we are about to return to something resembling "normalcy." That strikes us as a case of wishful thinking (the image that suggest itself is that of a herd of buffalo in the African plains that thinks the pride of lions that was stalking it is gone because it has temporarily ducked behind a copse of trees).

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Gold from 1999 to 2014 - once again, many triangles have formed on the way up, followed by a large triangle preceding the recent cyclical bear market - we believe the last triangle and the bear market since then is a somewhat expanded 1975-1976 analog.

Possible Future Developments

Considering all of the above factors, we have formed an opinion as to what is likely going to happen over the next few years. Of course you should take this opinion with a grain of salt - we may well turn out to be wrong. First of all, given that gold declined during QE3/4, it is reasonable to assume that it inter alia discounted a coming slowdown in money supply expansion well in advance. This makes us think that it will begin to discount the next expansion phase with a large lead time as well. Moreover, we do not think that the problems that are currently widely regarded as solved, such as the debt crisis in Europe, are really gone for good. After all, since it was first recognized that there might be a sovereign debt problem, said debt has done nothing but grow further, at what are in many cases astonishing rates of change (see "The End Game Approaches," where the rates of change in sovereign debt in the euro area as of late September are shown. Most people are unaware of these data, mainly because there was no market trouble lately).

Intra-European current account deficits have largely been "fixed" as a side effect of the deep recessions in the periphery. Banks have at the same time used the ECB's liquidity provisions to support the debt of financially shaky sovereigns by gorging themselves on sovereign paper (especially in Spain and Italy), in return for receiving numerous "guarantees" (for instance, Italy's government made it possible for Italian banks to pawn all sorts of securities with the ECB by guaranteeing them). Not one of these maneuvers is really a durable solution of the underlying problems. In fact if one considers the interaction between Italy's government and Italian banks, it is almost as if Enron were bailing out Worldcom. Let us also not forget that there may be a political storm brewing in Europe unless there is significant improvement in the economic situation of the worst stricken peripherals.

Meanwhile, the relatively better performing (but ex inventories really still quite lame) US economy cannot withstand a large slowdown in money supply growth in our opinion - it is what keeps numerous bubble activities going and likely also still keeps much of the malinvested capital of the last boom period propped up (see this chart of the ratio of capital vs. consumer goods production as an indicator of the growing imbalances in the economy).

Japan's government and central bank are in the middle of an experiment that is nothing but a bigger version of what has already been tried countless times since the bubble peak in late 1989. The problem as we see it is that some sort of resolution is probably on its way, which is to say, it will sooner or later be discovered that it is actually not possible to expand the government's debtberg to ever higher levels without suffering large negative consequences.

In short, as time goes on, we expect a number of the factors that have weighed on the gold price in 2013 to reverse again, some of them quite likely in a violent manner. The main question is when gold will begin to discount this anticipated reversal of perceptions and fortunes. One possibility we have in mind for 2014 is that it could become a year of consolidation, perhaps exhibiting a mild and very choppy uptrend once a final low has been put in (this may already have happened on occasion of the recent retest of the June 2013 low, but as noted above, we cannot yet be certain of that). Then, beginning either later this year or in early 2015, gold may enter an accelerating uptrend again. It seems possible that the steepening of the yield curve that has occurred in 2013 will finally begin to exert a positive influence on the gold price (normally, gold is positively correlated with the yield curve. However, this usually happens in conjunction with either easier monetary policy or rising inflation expectations. Perhaps the yield curve will prove to be a leading indicator of inflation expectations this time - that remains to be seen):

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The 10-year treasury note yield divided by the one year t-note yield as a proxy for the US yield curve.

Among the reasons why we believe the secular bull market in gold is not over yet is also the fact that gold mining stocks have not yet entered the kind of bubble phase that could be observed in 1974, 1979 and especially 1980. While in 2011, gold and silver stocks refused to confirm the new highs in the metals by significantly underperfoming in the latter stages of the rally, something qualitatively slightly different happened at the end of the 1970s bull market. While the shares of mining companies also underperformed during the rally that peaked in January 1980, they subsequently rose to higher highs concurrently with gold and silver putting in secondary lower peaks in September of 1980. In short, there was a great deal of enthusiasm for the sector shortly after the bull market had actually ended. This is the polar opposite of what could recently be observed - in fact, gold stocks haven't declined this much relative to the price of gold in more than seven decades:

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The price of gold relative to gold stocks, as measured by the Gold/BGMI (Barron's gold mining index) ratio, via nowandfutures. The BGMI provides the longest historical data set that can be used for the purpose of calculating this ratio. As can be seen, similar valuation extremes were only seen at the 1938 crash low and shortly after the attack on Pearl Harbor.

Conclusion:

If like us one doesn't believe that things are back to normal in the global economy, one has every reason to expect the gold bull market to sooner or later resume. Given the extent of the technical damage, the initial recovery phase is likely to be quite choppy. Moreover, the decline may not yet be over - however, if the resistance levels established in the second half of 2013 can be overcome, we will have solid evidence that the trend has changed. Regardless of the near to medium term outlook, it appears to us that the area between the 2013 lows and the 2008 high is a very solid support region that is highly likely to contain the turning point. In fact, in the very near term, sentiment and positioning data in gold and silver suggest that some sort of rally is probably in store. So far, we have not seen true bubble conditions in gold (these can be identified by an extreme price rise in a very compressed time frame that occurs concurrently with a clear worsening of the fundamentals, such as happened e.g. in 1979). As for gold stocks, they are one of the most out of favor sectors in the stock market at the moment (only coal stocks are in a comparable position), and their historically low valuation relative to gold is indicative of an extreme in bearish sentiment that is not only likely to be reversed, but could provide considerable fuel for a rally once it unwinds.

Charts by: St. Louis Fed, BarCharts, Sentimentrader, StockCharts, Nowandfutures.com.

Source: Gold In 2014 And Beyond