Gold, Silver At A Crossroads: Opportunity For Gains Or Risk Of Extended Decline?

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Includes: GLD, SLV
by: John Tobey, CFA

Gold and silver prices, after peaking in 2011, have sought to reestablish foundation levels. They seem to have succeeded in two ways.

First, both metals once again travel in unison with silver having given up its wanderlust. Since their lengthy uptrends began in late 2006, both have risen about 200%. [To chart investor returns, I have used the leading exchange traded funds: SPDR Gold Trust Shares (NYSEARCA:GLD) and iShares Silver Trust (NYSEARCA:SLV).]

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Gold and silver long-term performance comparison

(All stock charts courtesy of StockCharts.com)

Second, they have recently had similarly encouraging price movements, testing downside breakouts, then easily reversing them - typically, a sign of strength. And now both have regained lost ground, rising to key upside barriers.

Silver, peaking first and at a higher level, has had two drops, with two sets of barriers:

Silver stock chart

Gold, peaking at a lower level, has had one drop.

Gold stock chart

So, what's next? While there is the opportunity for further gains, there is also the risk of a significant, extended decline.

Personal note: Gold and silver investors have been buffeted by loud, extreme and contradictory visions and warnings. As a result, many (most?) investors have become inured to such warnings. So, why should you pay attention to this article? Two reasons:

(1) I do not and have not taken any positions in the metals. My views are based solely on my analysis.

(2) I have a record you can examine. Last year, I warned about silver's and gold's tops as they were occurring:

April 29: "Silver Is in Blow-off Phase - Top Could Be Near"

Silver 2011 stock chart

Conclusion: Silver looks to be in a blow-off stage. Could it go higher? Yes. However, it's just a matter of time before buying at ever-higher prices dries up. Then, nervous holders can create the next phase: Rapid downtrend.

September 12: "Gold Enters Dangerous Territory"

Gold 2011 stock chart

Conclusion: Gold has entered a new, dangerous phase. Rising at an unsustainable 300% annual rate, it puts holders into a precarious position. Should the investor stay, hoping for more outsized gains? Or should the position be sold before gold's trend reverses.

Risk of rapid loss is now higher because dramatic price rises attract short-term traders. These speculators track prices by the second, their fingers poised over the "sell" button as they watch for the slightest worrisome sign. This dynamic is why bubbles can pop dramatically, seemingly without warning.

Add to that risk that CME acts more quickly this time around, and the return/risk outlook for gold looks unfavorable.

But that was then, so let's look at where we are today.

Both gold and silver are at crossroads

Many investors are studying the charts. Bolstered by the recent price movements, they envision positive returns once the upside barriers are broken. Such an action would seemingly prove that new foundations were built and new uptrends are in place. Gold and silver then should be able to move up to the next barriers and, perhaps, even to new highs.

The upside problem: Fewer fundamental supports

Strongly held fundamental beliefs created the long price uptrend, but they are now weakening. These fundamentals have been forecasts of reversal or calamity, against which the metals would provide protection.

Using the Great Recession events and data, a common expectation was high (hyper) inflation from ballooning money supply, linked to government deficits with a prolonged stagnant economy (sometimes tied to the end of consumerism). Also common were the mega-fears, with visions of global economic and financial crisis or collapse. Finally, there was the view that the only way to regain order was to restore hard money to replace worthless fiat currency.

Today, however, those basic underpinnings are weakening because conditions are getting noticeably better. Since late 2011, there has been a steady stream of positive economic reports. The U.S. dollar has maintained its exchange rate and global reserve position. Stock investors have shaken off their mega-fears, and the market has been rising steadily. There is no sign of rapid inflation or an attendant ramp up in interest rates. Even government revenues are improving.

The downside risk: A return to inflation protection only

Deteriorating fundamental support means the chart readers' expectations are too optimistic. With the return to economic and financial normality, not only will investor interest in gold and silver dissipate (nothing to protect against), but also the metals' price supports will shrink to the long-standing one: Inflation protection.

And that's why the risk is large. Today's gold and silver prices are far above their inflation protection value. How far? After gold's similar peak in 1980, it fell 80%. Based on my previous analyses (listed here), gold's price based on inflation protection fundamentals could be as low as $570, 68% below today's price of $1,773.

The bottom line

Gold and silver prices are at a crossroads. The chart pattern of a reversed downside breakout followed by a rise to an upside barrier carries the hope that a foundation has been built upon which a new uptrend is in place.

However, the fundamental underpinnings for gold and silver prices are disappearing, meaning the price foundation is returning to its root determinant: Inflation protection. The problem is that the inflation-based values, using historical analysis, are much lower than today's prices.

Therefore, the crossroads can be viewed as either:

  • A slow upward rise, as the metals break their current high barriers and work to recapture lost ground by rekindling investor interest
  • A reversal and downside breakdown, confirming the 2011 tops as speculative blow-offs and setting the stage for a large, prolonged downtrend

My belief is that the risk isn't worth the possible return and, moreover, that the probability of a reversal outweighs the possibility of a continued rise.

A final note: Ignore the diversification argument

Looking at gold articles today, we see large ads from the SPDR group (sponsors of GLD) saying, "There's nothing like gold to diversify a portfolio."

Over the decades, I have seen and heard many "buy this for diversification" arguments, typically from Wall Street, people associated with the "this" and consultants enamored of statistics. Ignore them all. Just because something moves differently doesn't mean you want to own it. Only buy "this" if it makes sense and you believe it will produce a positive return. Investors (individual and institutional) have lost a lot of money by embracing diversification statistics and ignoring the positive return rule.

Perhaps more worrisome for gold investors, the diversification argument often gets wheeled out when trends end and returns fade.

Disclosure: I am long U.S. stocks and U.S. stock funds