Gold: Correction Or Bubble Bust?

Includes: DIA, GLD, SPY
by: Macrotheme Capital Management LLC

The gold swing trade based on the $1550-$1800/oz range is now history. The gold futures and (NYSEARCA:GLD) sharply broke-down below the key support level, most likely caused by the filled stop-loss sell orders right below the $1550/oz level. So how do you trade gold now? We think that there are two possible scenarios: 1) the gold bubble bust, in which the price of gold goes down to the $600-700/oz level over the next 2-3 months; or 2) the gold price correction, in which the price of gold bottoms out at the $1200-1300/oz range and resumes the long-term uptrend to the new all-time highs.

Correction or Bubble Bust?

Let's first consider the possibility of the gold bubble bust scenario. To justify the bubble bust theory, one would have to find a fundamental reason for it. For example, in early 1980s the gold bubble collapsed due to the easing inflationary pressures of the late 1970's or what's known as the "slaying of the inflation dragon". With rising bond prices (falling interest rates) investors removed the inflation hedge by selling gold and reallocating funds to equities and bonds - which worked well over the next 20 years! Thus, selling gold in the early 1980's fundamentally made sense.

But now, the bond prices are at the all time highs (interest rates at the all time lows), which suggests that the deflationary pressures are in force. Similarly, the stock market is also at the all time highs, propelled by the central banks fighting these deflationary pressures with the QE and the low interest rates globally.

The prevailing thesis for the gold bears is that perhaps the Fed is becoming successful in the efforts to fight deflation, and that, consequently, the U.S. economy will return to a normal 2-3% growth rate - without the need to further stimulate the economy (the end of the QE and slowly rising interest rates). This thesis is essentially equivalent to the "slaying of the deflation dragon" scenario, which would trigger another long-term uptrend in the stock market, and thus, fundamentally justify the bust of the gold bubble.

Is there any evidence that the deflationary pressures are abating? No, on the contrary, the interest rates are still falling. The futures market is now looking at the 50 basis points or 0.50% in Fed Funds rate in January 2016 (see figure 1), and just a few weeks ago, the expectation of the first hike by the Fed to 0.50% was for the October of 2015. Thus, the economic fundamentals recently got even more bearish, suggesting that the deflationary pressures have even increased. How can you then justify a reallocation of funds from gold, which in this case is a hedge against deflation (debasement of currencies), to equities? You can't, selling gold now fundamentally does not make sense.

Thus, since there are no fundamental economic reasons to justify the gold bubble bust, we propose that the price of gold is currently in a correction, potentially caused by the technical breakdown, and a likely liquidating position by a hedge fund due to the margin call.

How to trade gold now?

Long term investors that did not sell their holdings should stay put, it's now too late to sell. Long term investors that liquidated some of their positions can slowly re-enter the market with the new long positions. Traders should NOT try to pick the bottom and rather wait for the new pattern to develop with a clearly defined NEW support level for gold futures or GLD.

Figure 1. Rising Fed Funds futures (Jan 2016) shows a more bearish economic fundamentals, while gold is crashing.

(Click to enlarge)

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