Rates Up, Fear Down: Washington Crossing Advisors Say 'Stay Away From Gold'

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Includes: GLD, GLL, IAU
by: Robert Wagner

Summary

Fear trade supporting gold is dead... again.

Gold is breaking key support, and likely headed towards a retest of $1,200/oz.

Longer term, China and Russia are likely to alter the dynamics of gold to the downside.

A current video on CNBC/Yahoo Finance pretty much captures just about everything an investor needs to know about gold. Under the current economic environment, gold isn't an inflation hedge, it is a fear trade. This concept is extremely difficult for many gold investors to accept, but gold can rally for more than one reason. People that are holding gold as an inflation hedge against the Fed "printing all this money out of thin air" are likely going to be tremendously disappointed.

Recent events in Russia/Ukraine/Crimea and the first modern Chinese bankruptcy have justifiably gotten investors nervous, but those issues appear to be passing. Gold was justified in rallying with the increase in fear, but as I always point out, fear is a temporary phenomenon, and is best to sell into rather than buy into. Fear isn't a long-term investment strategy, it is a trading opportunity.

In the video, key support levels of $1,300/oz and $1,292/oz (50-day moving average or dma) are mentioned. As I write this article, gold has broken its 50 dma, is resting on its 200 dma and is slightly above its 150 dma. Gold is now trapped between support at the 200 dma, and resistance at the 50 dma and $1,300 psychological level.

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That is the technical condition of gold, and what I don't like about technical analysis is that there is no "why" in the analysis. Chart readers are great at reading historical charts, but that has only limited value when trying to determine the future. Why I'm bearish on gold is the "why" gold went from $1,192/oz to $1,387/oz. Fear drove gold up, and now that the fear is subsiding, gold will fall back down. We started the year with a market correction, and that was followed by the Russian and Chinese stories. All those crises have waned. The driver and support of gold have run out of gas and eroded. The dead cat bounce has likely reached its peak and is headed back down again, and I stress again. This isn't the first gold dead cat bounce that I've written about, and I'm sure it won't be my last.

Gold may bounce off the 200 dma and give some people hope, but unless some new crisis or threat emerges, the fear trade is dead, and so is gold. Looking forward gold faces a recovering economy, yes, it may be a difficult path, but a recovery nonetheless. A recovery means higher interest rates, and that is the ultimate gold slayer. Higher interest rates simply make it too costly to hold gold. Just like the post-1980 disinflationary period, owners of gold will watch a recovering economy send the stock market higher and gold lower. This time however, we are reverting back to the mean from below, so gold owners will watch a recovering economy drive interest rates and the equity markets head higher, and gold lower. It simply isn't a pretty picture for gold looking forward.

What hope gold does have for a sustained rally will be inflation, but inflation is a late business cycle phenomenon, and I'm not even sure we have started a recovery. Holders of gold are going to have to sit through an extended period when gold corrects to a level likely below $770/oz, and the equity markets and interest rates head higher. Gold holders are likely to not only lose money on their gold holdings, the opportunity costs of passing up higher interest rates or riding the equity bull market will cost them even more. Just imagine the return gold investors would have gotten post 1980 had they sold their gold holdings and simply purchased an S&P 500 or Dow Jones Industrial mutual fund. In January 1980 when gold reached its peak, the Dow Jones Industrials traded around 850. Ironically, gold peaked around the $850/oz at that same time.

Gold didn't bottom for another 21 years, reaching its low of around $255/oz in 2001.

The point being, gold cycles can take an awful long time to complete themselves. World gold production was 1,500 tons in 1985, and was estimated to be 2,500 to 2,700 tons in 2010, with new supplies coming on line each year. China barely registered as a gold producer 3 decades ago, and now they are the world's largest producer.

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With the falling price of gold, I would imagine these heavily capital intensive industries will be rushing to either hedge their gold production or produce as much as possible before gold goes lower. Right now it doesn't look like hedging has become a major trend, but it is definitely something to watch. Gold miners appear to be suffering from the "once bit twice shy syndrome," which may be making them hesitant, and preventing them from making the right decisions during a period of falling gold prices. If gold miners fail to hedge their price risk, and gold continues lower, this will greatly impact gold miners' earnings. The cost structure of these firms is heavily skewed towards fixed costs, so like the airlines, they are susceptible to price wars and long periods of producing at breakeven or even at an accounting loss. Depreciation isn't a cash flow expense, so as long as a mine covers its variable costs, it may stay in production.

The other factor gold investors must consider is that the gold industry dynamics have greatly changed. China and Russia are major gold producers, and they don't necessarily follow free market principles. State run/controlled/subsidized/supported industries play by a different set of rules. If China and Russia decide gold production is in the Nation's best interest, gold will be produced regardless of cost. China is a country that builds ghost cities just to keep its people busy. Over supply, over production and inefficiency are what defines the centralized Chinese business model designed to undercut all other producers. Russia will likely simply throw a disagreeable gold producer CEO in jail if he/she disagrees. Bottom line, the free market economics of the past may not govern the gold markets going forward. Russia and China are not South Africa and Australia, so I would expect the low in gold to be lower than the market expects, simply because of who is producing it. Adam Smith no longer runs the gold market, Karl Marx does.

Bottom line, as the videos says, "stay away from gold."

Disclaimer: This article is not an investment recommendation or solicitation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Past performance is no guarantee of future results. For my full disclaimer and disclosure, click here.

Disclosure: I am long GLL. 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.

Additional disclosure: I also own puts on GLL