Gary Tanashian's  Instablog

Excerpted from this week's edition of Notes From the Rabbit Hole, NFTRH 235:

Is Gold as an Investment Finished?

Before delving deeper into that question, perhaps we should see what the mainstream media thinks. In fairness to the MSM, we note there are plenty of articles on both sides of the debate. Yet there has been some media piling-on since the recent hard breakdown in gold. The aptly named Howard Gold explains:

The Case for Owning Gold Has Collapsed; Yellow metal could be headed much, much lower http://is.gd/h5KW6v.

Gold could be headed not much lower, but much much lower. This was written on April 18, when the value assigned to the monetary relic (AKA its nominal price) resided at $1391 per ounce. So be warned, Mr. Gold advises that gold could go much much lower. Gold bugs take heed; Mr. Gold himself has put the double 'much' whammy on you!

After critical support at 1524 was lost our first downside target of 1440 or so was sawn through like Balsa Wood. Okay fine. For those who micro manage every tick in the price of gold (I am not one), then here is the situation; the current little rebound must extend back up to and through the broken support level at 1440 or the next target in the low 1200's is up next.

See the weekly chart on page 3, which was produced 5 weeks ago in NFTRH 230. While not a favored outcome, recent events with gold's price are not surprising.

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Gold weekly chart

To review, the two potential points to watch for in the event of a breakdown from 1524 were the weekly EMA 200, which supported the 2008 decline and then the conservative measurement from the pattern breakdown, which is in the low 1200's, which also includes a visual support shelf from 2010. The less conservative measurement (the top at 1900 to 1524) would target around 1150.

So that is the price picture, now on to the fundamentals courtesy of Mr. Gold. From the article linked above:

"But gold's price could be headed much, much lower, said Campbell Harvey, a professor at the Fuqua School of Business at Duke University. Harvey has looked at gold prices over the centuries, and concludes that it's still trading at lofty multiples of inflation."

In the article linked above there is another link where you can download the research of Mr. Harvey and colleague Claude Erb - currently making the rounds like a good gold bug horror movie - that talks about gold's "real" price as measured by CPI and GDP. Boiling it all down, gold is historically over valued as compared to measures of the effects of inflation on consumer prices and relative to GDP.

We will steer clear of the debate about government number fudging, because it is a battle that is not necessary. The Federal Reserve and many of its counterparts around the globe are inflating, or trying their damnedest to inflate. They are using debt instruments to create money out of nowhere and pumping it into big banks, which are supposedly expected to release the money out to the public.

This could one day manifest in an out of control inflation problem (as measured by the lagging effects that Harvey and Erb call inflation, or resolve into a more intense deflationary phase as the thing that is just a whiff now gains momentum and swallows the entire spectrum of inflated assets in one big gulp of illiquidity.

The economy has depended on inflationary policy since the age of Inflation onDemand began under Alan Greenspan's oversight in and around 2000.

Ask yourself this; why are they inflating? Why are they printing money at a furious pace if the GDP is real and sustainable? The answer is likely because they know that the financial system is a leveraged thing that must not be allowed to start deflating because if it starts deleveraging, it is not going to stop until the books are cleared.

Gold vs. Commodities, What is the Message?

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Gold-CCI Ratio, weekly chart

The authors noted above measure gold's 'real' price in CPI and GDP. Here we have always measured it relative to the commodity complex, which is generally positively correlated to the global economy. Above is gold vs. the CCI commodity index.

I had originally thought that a decline to the lower moving average would come with a continued economic bump, stock bull market and inflation-fueled commodity bounce. But instead, gold has tanked vs. commodities even as a deflationary pull starts to take hold with signs of economic deceleration, commodities down and the stock market potentially in some kind of a topping process.

Yet the 'real' price is still in a secular uptrend because the ratio has held above another parameter point we noted as important. If the blue arrow is confirmed by turning green one day, the message will continue to be a secular era of economic contraction, which has thus far been fought tooth and nail by inflationary policy. That is and has been the case for gold since day one. Not the case most gold bugs root for, which is inflationary effects, the likes of which are used as data points by Harvey and Erb. See?

Of course Harvey and Erb scare the gold "community" because a majority of the "community" sees gold as a hedge against higher prices. If the above chart breaks down and makes a lower low to the spring of 2011 (the height of the last commodity/inflation blowout) then we may have to admit Bernanke wins, Draghi wins, BoJ, China Central Planning and all other inflators win. They will have managed to create sustainable economies literally out of thin air.

The alternative to that is hyperinflation, where an asset grab of epic proportions could engage with gold under performing things you can actually eat, keep warm with and use for fuel. This asset grab would come out of a debased monetary system.

More realistically however, we might look for the real price of gold to gain support in its secular uptrend. This would see economic contraction and by extension, further decline in commodities and stocks markets. We have noted all along that the nominal gold price can decline in this environment, so people should know why they own the thing. Also, getting out of the 'death of the dollar' cult might be wise as well.

The USD, as long as implied confidence in our leaders remains intact, may be pulled upward with the real price of gold as a contraction phase bites harder. This is the world's reserve currency in which a majority of global transactions are settled. As long as this remains the case, there will be claims on Uncle Buck. USD, as of the moment, is liquidity within the system. Gold by the way, is liquidity outside the system.

The average gold bug's worst enemy is… the inflation tout. It is not the government or the big banks. It is the individual's expectations of a lump of shiny metal. If they have not gotten this simple concept yet, after the recent damage, I am afraid they will never get it. And they will puke up their gold, which failed to protect them from the dreaded inflation that wasn't.

Bottom Line

The "dreaded inflation" is measured in the mainstream by prices (CPI, etc.), not policy-making actions. Gold is a barometer and the pressure it would indicate could be inflationary or deflationary.

If one day you see the gold price skyrocket, then be prepared for a coming (lagging) inflation problem that would indeed eventually show up in prices. This could propel commodities, resources, productive economies and even stock markets to new heights.

If on the other hand gold just hangs around or declines, yet the 'real' price as measured in commodities rises again, the backdrop would be one of continued economic contraction and declining asset prices.

The third alternative is the least likely; gold hangs around or declines and yet the 'real' price loses its secular uptrend. This would indicate a sustainable economic expansion, created by inflationary policy has engaged. Thus far, inflationary policy has served to build in distortions that subject the system to extreme liquidations. That right there is the continuing case for gold - and for the time being I might add - cash, lots of it.

Okay now, that's the theory. I have got a technical report to write, so lets get to it. NFTRH 235 then goes on to review the technical pictures of the precious metals, precious metals stocks, commodities and stock markets in an unbiased manner. This has kept the analysis on the right side of the markets throughout recent dynamic events. If you would like a hard-working service that does whatever it takes to be prepared for what the market throws at us, consider a subscription to NFTRH.

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That was the question I asked myself after being 100% cash into the last hour yesterday and seeing the bottom fall out on the gold stocks once again. Classic trading methodology teaches that you do not try to catch a falling knife. 'Screw classic trading methodology' thought I, 'I'm taking some positions', which ended up being in the gold and silver bullion fund CEF (now selling at a discount), a few individual items I consider to be of relative quality and the leveraged NUGT in a high risk trading account.

The above was noted in an update to NFTRH subscribers in the last hour and certainly was not a call to action. It was just a note from a market manager who had been updating subscribers all along this frustrating journey since the gold stocks lost critical support in November. With that final plunge yesterday afternoon, something bullish welled up inside me.

But as usual, the chart takes out the human element (e.g. "something bullish welled up inside me"), so let's look at the one for GDX, as it shows an awe inspiring picture of volume.

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GDX daily

I won't recount the whole agonizing history of the breakdown from the September 'QE' euphoria. The busy chart does that for me. What is important now is the series of 'rolling capitulations' that manifested in Bear Flags, which in turn served to reset over sold status just enough to continue a series of plunges.

Yesterday's impulsive mega volume drop blew the Bollinger Bands to their widest separation in maybe forever. RSI came to an opposite condition to its very over bought status from September. While on this subject, my stance in September/October was that gold stocks were over bought and in need of a 'healthy' correction. That is what TA said. I was wrong about the "healthy" part and was proven so when the red dotted neckline broke down. We are going to be wrong, but it is what we do with that knowledge (deny it or face it?) that is important. When that critical support failed, we labeled the correction "abnormal" and in need of constant risk management.

Which brings us to today. I may be right or I may be wrong in having bought the puke-fest close yesterday. I have plenty of dry powder (too much, if a real rally is forthcoming), but these are the times we wait for people. That chart above has finally woken up with capitulation after a 6 month grind.

A long standing target of HUI 250-260 was hammered yesterday into the close. There are targets lower in the low 200′s (secular trend line by linear chart) and 100 (measurement off a huge topping pattern). So this is all just a trade until it proves otherwise. But look at that chart again. People are being driven out with extreme cruelty and force. This is a picture of massive pain and tumult. Sometimes you just gotta buy that. As noted to subscribers, this will be undone quickly if proven wrong.

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Disclosure: I am long CEF.

Additional disclosure: Long CEF at time of yesterday's close.

The last week has been a fright fest for the gold "community". But these are the financial markets, not a community. There is a world outside of what ever is going on in gold and silver. A macro economic backdrop filled with entwined and correlated assets and markets all trying to form a message when taken as a whole.

Sure, gold - as a monetary metal - is a big one when it comes to macro indications, but what is really important is the great question that has been ping-ponged about for many years now between intellectuals on either side of the debate; inflation or deflation?

This post dials things out from the hysteria of the gold bear market (it is a savage cyclical bear, and we will certainly deal with it in a constructive way on the market's terms) to the big picture and the eternal debate between 'inflationists' and 'deflationists'. Really, as I have felt all along, we have inflation and we have deflation… all along the continuum, as illustrated by the monthly chart of the 30-year T bond yield.

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30 year yield, monthly

The continuum of gently declining interest rates on long-term T bonds implies a deflationary backbone spanning decades. Against this firm disinflationary signal, policy makers have had license to print money at various times and with varying intensity. The MACD trigger on the chart above implies that a new inflation phase is trying to get started, but this is restrained by what looks like the second of two bear flags that have formed just below resistance at a 3.5% yield.

As long as rates remain below that resistance level, the deflation argument is alive and well. The last time the 'continuum' hit the red line (100 month exponential moving average), which has been the limiter of inflation expectations for decades, the second phase of the commodity bubble was exploding to new highs, Bill Gross made a highly publicized short against the long bond (in essence, meaning he was bullish on inflation) and the CCI commodity index topped in early 2011; 2 years ago.

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CCI, weekly

While commodities have not experienced the drama that is the gold market, their persistent weakness has encompassed important 'indicator' commodities like copper/base metals and crude oil. Technical damage is being done in those areas. We have been following the progress of this degradation each week in NFTRH and asking ourselves the question 'could it be deflation on the horizon?'

Folks, that is a breakdown on the weekly CCI chart above. Not only is the index losing a channel, but a moving average cross (red dots) has taken effect that has signaled strong bear phases in the past. Respect the deflationary argument.

But the post is titled 'Gold and Silver as Macro Sign Post' so let's get down to it.

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US dollar & Gold Silver Ratio (GSR), weekly

The gold silver ratio (GSR, bottom panel) would indicate market liquidity contraction and associated deflationary forces. That is because though gold obviously gets hurt badly with a coming deflationary phase silver, the cross-dresser precious metal/commodity gets hurt worse. So is the breakout of a trend that has been in force since 2008 a warning to deflation?

Just as we watch the T bond 'continuum' for indications on yields, we need to watch the GSR for its would-be signals about liquidity, which after all is what the current QE operation is all about. So far, the GSR ain't buyin' it (QE 3, 'to infinity', etc.) as it did in 2010′s inflationary kick off. No, the GSR is rejecting the policy and hammering gold (but silver worse). Gold is a monetary asset that recovered first in the 2008 crisis. This time gold and silver are declining first and hardest and their relation ship (GSR) should be watched as an indicator to coming events.

The deflationary case has not yet been confirmed, but it is strengthening. Likewise, all of this going on today could be a prelude to the mother of all inflation problems. But it is so vitally important that we subordinate ourselves to the market and its indicators because there are super smart people on either side of the 'i'/'d' debate and half of them are going to be very wrong.

If the GSR remains on this signal (in breakout mode), then watch for the US dollar to become strong - not because of any intrinsic value it may have - but because it is a claim on liquidity, which is intensified by its reserve status. Remember how they knee-jerked into gold during the euro crisis and how they knee jerked into USD and then gold during 'Armageddon 08′? That is what happens in a rush for liquidity.

As for the USD's technicals, it is actually losing one of its weekly moving averages, but a new bear signal would not come unless the moving averages cross down. The most recent cross down (first yellow shaded area) was a fake out, as could be the current cross to up, prior to silver beginning to out perform gold and commodities regaining lost support.

But the signals are the signals and if deflation is in the near future - as currently indicated by T bonds, precious metals and the commodity complex, then the USD is going to ramp up.

It is a complicated situation, and that is why I say you have got to be willing to do the work to stay on the right side of it. Or, if you are a normal person with a normal job and life, then associate yourself with people who are willing to do the work with an open mind subject to the many twists and turns that this wonderfully complex macro situation is going to present. People should know by now that nobody has all the answers. This is a work in progress on the macro. Dogmatic beliefs will be (and have been) punished.

It would be my pleasure if you'd join me - if you so desire - at the hardest working newsletter (and dynamic interim 'in-day, in-week' update) service I know of if you are so inclined. We are not trying to predict anything. We are simply using hard work, discipline and open minds to remain on the right side of a complex situation.

Otherwise, I'll keep writing these public articles and I hope you'll keep reading them. Tuning out the usual hysteria, what is happening on the macro is happening and we have all got to be willing to realize we do not have all the answers and there is always learning to do.

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