Has Gold Reached Bottom Or Is More Downside Ahead?

Includes: GLD
by: Robert Kientz

"Calm waters may make for smooth sailing but they do not make a good sailor."

Never have truer words been spoken in the precious metals markets. If you have spent any time in them, you know there are never smooth upward or downward trending lines. The path to precious metals investing success instead lay over jagged rocks and sinkholes. Caveat emptor to the timid buyer!

But those who brave the storms of investing in precious metals come out stronger and more resilient, in my experience. Indeed as I write this article gold is up 2.5% and silver 3%, which are pretty serious moves for a single day's time.

Looking at gold price chart since 1975 we see what looks like a rough sea pattern. Gold rises, falls, rises, falls, and rises again.

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On a long chart such as the one above, it appears as though gold reached a cyclical peak in 1980 and then another strong cyclical peak this year, before beginning a fairly steady fall since September 2011. If this is all I knew about precious metals patterns, I'd quickly surmise gold was in a bubble and due for a major correction to the downside. And that appears to be what we have been witnessing over the last several months.

If we zoom in quite a bit on a gold chart and add some technical indicators, the likelihood of the most recent correction seems even more sensible.

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I have drawn a few lines on the chart to show likely price support points. Wednesday, we bounced along the top of those lines at 1536. Prices have rebounded off support but even so remain in a strong 8 month trading range between 1540 and 1900. So even though price action is intense again on Thursday, over the longer term is it is merely a blip on the radar. You see, strong corrections in this current bull gold market are normal.

Looking at the first chart presented, gold had corrections of 20% in 2006 and 25% in 2008. The correction we have seen since September highs is only 18%. While the overall numbers are larger, this correction is the smallest of the 3 big corrections of gold in the last 11 years.

The question has been asked by many analysts in the last few days whether gold would break through support at 1540 and move through next support at 1510. While that isn't happening today, the intermediate trend is still to the downside. The next firm support line is about 1300, which is about the lowest bottom most analysts see it reaching before enough longs re-enter the market to the upside.

What does all that mean? Well what I just did was look at price action for a given time period and figure out psychologically where most traders would re-enter the market long, creating support at a given bottom point.

You also have to understand what I described is a paper price trade, and a large majority of it is speculation, or people trading for short term profits. Most of these people don't actually own gold. So, does this confirm whether gold has lost it's safe haven status to the investing public? Well I believe that answer requires more information than just looking at a price chart.

An alternate view on whether gold is in a bubble is comparing to amount of money printed which bids up prices on all goods, including precious metals.

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The following chart includes both M2, a conventional view of money, and TMS, the Austrian view of money (sans credit) in circulation. Both show aggressive printing and parallel the rise in gold prices. So while gold has risen sharply in the now 11 year bull run, it is not outside rational explanation as to why.

Physical Gold Prices

There are quite a few things that affect gold on a longer timeline. Namely, it is considered a safe haven against printing of fiat paper currency by central banks. Those who lived in Weimar Germany or recently in Mexico or Argentina understand this concept quite well. In each case, the banks printed so much currency that it eventually became close to worthless, there was so much of it floating around.

People know that when economy's shudder, as is happening in Europe now, that gold intrinsically will retain it's value during hard times. Thanks to Charlie Munger, we are reminded that the Jews prosecuted in Germany often sewed gold into their jackets in order to escape confiscation and retain some of their savings. They chose gold over other assets for a reason.

Physical Markets

Supply and demand in the physical markets also affect the price, albeit less right now than the paper trading does. According to the World Gold Council (www.gold.org), demand exceeded supply in 2011 and Q1 of 2012 has also seen strong demand for the metal.

Central banks became net buyers of gold in 2011 and bought more gold last year than any other since 1971. Banks purchasing gold lately include China, India, Mexico, Mongolia, Thailand, Ukraine, South Korea, Russia, Kazakhstan, the Phillipines, Ukraine, Tajikistan, and Turkey which has become the 5th largest demander of the yellow metal. Argentina purchased 7 tons last year, an increase of 12% YoY.

Indeed, the pace at which the world central banks are buying gold is quickening, gobbling up 57.9 tons already in March.

"To give some perspective on this number, in 2011, central banks bought just under 440 tons of gold bullion, a rate of 37 tons a month," says Lombardi. (Source)

And according to Michael Lombardi, this pace puts the world's central banks on a pace for 700 tons, a 59% increase over 2011. Just over half of all gold production from mines is currently being purchased by central banks. In addition, Lombardi believes all Chinese buying has not been reported and would add very significantly to that number.

Other large demand sources for gold include George Soros, PIMCO, John Paulson, and the Texas Teacher Retirement Fund. Soros nearly quadrupled his SPDR Gold Trust (NYSEARCA:GLD) holdings.

By all accounts, even though the paper traded price for gold is falling, the demand is not and is currently outpacing supply. Those are very bullish signals for the long term price trend.

Morgan Stanley believes gold will reach $2175 in 2013 due to "continued buying by central banks, eurozone unrest, and more recently the build up of net longs by hedge funds." Morgan Stanley continues to invest in the metal.

Goldman Sachs has predicted an $1840 price in the next six months because they believe the Fed will resume printing (QE3) in the third quarter of this year. With the current economy and elections coming up, I agree with this. The Fed has not failed a sitting president yet.

Real Interest Rates

Real interest rates, that is the rate of interest minus inflation, have been negative for quite some time now. The Fed has continued to state they will not raise rates until 2014 because they see current government stated inflation rates as reasonable. And they are trying to goose the economy with easy cash even while lending is down significantly from it's peak.

When real interest rates are negative, investors will lose money to inflation. This ends up forcing people into alternatives such as gold who tend to hold value better during periods of high inflation and negative real interest rates. As long as real interest rates remain negative, namely until the Fed raises it's rate, gold will continue to receive physical investment.

Lease Rates and Gold as Collateral

Lease rates are those accepted by holders of gold who then loan it out to others to use in the market. Lease rates have been exceptionally low since 2003, with the exception of the financial crisis in 2008. It is interesting to note that when serious financial setbacks occur, lease rates go up; gold holders are much less likely to give away their safe haven during these times and demand more money in return for doing so.

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The most interesting thing about gold lease rates to me is why gold holders do it. What are the practical uses of gold in the market? Jewelry is number one followed by some industrial use as a conductor. What else is going to be done with the gold? If I'm a gold holder, I don't lease it unless I never expect to see it back!

Whether or not the gold is returned when the lease ends, leasing acts as a source of supply in the market. This satisfies demand for the metal suppresses the price below what it would otherwise be. It will be interesting if in a few years a significant portion of the gold leased is not returned, contracts are settled in cash, and subsequently gold demand rises by the amount of the defunct lease agreements as holders attempt to recover their gold from the current market supply.

An interesting development in the gold market is the use of gold as collateral. Because of excessive use of leverage in the market, gold is being used in lending because it lacks counter-party risk. And because of recent negative lease rates, gold may be replacing treasuries as the ultimate collateral. The additional gold in the market, acting as excess supply, may also be slowing the price. We'll see if this development continues.


This is the worst time of year for gold. Like most asset classes, demand for gold wanes in the summer months as people turn their attention to other activities. Physical demand picks up in the fall as Chinese, Indian, and Western customs and holidays demand gold. This pattern has held pretty steadily for decades in the physical markets. So it is not unusual to see gold price soften a bit leading up to and during the summer season.

So the question is do I believe in the bullish case or the bearish one? I am on record as a bull and am not reversing that trend now. I am firmly entrenched in the camp that suggests physical buying will overwhelm the paper markets eventually.

After all, as banks print more money around the world and Europe continues to all apart, demand for gold will continue to rise. This will be the largest factor, in my opinion, driving the cost of gold higher.

Last Word

Victoria Grant, a12 year old from Cambridge Ontario, made news headlines when she outlined her view on banking in Canada. It's quite a show. The good news is the younger generation is paying attention, and maybe they will escape the follies of their parents in allowing banks to enslave the people through debt creation, as Victoria puts it. Until then, we all need to hold some gold to preserve our wealth through these turbulent times.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.