Gold, Oil At The Crossroads: Analysis

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Summary

After a strong run with a great-looking chart formation, gold has wobbled badly and suddenly is down in price year-on-year.

Further technical analysis with commentary on gold's fundamentals is provided.

Crude oil similarly has been down in price since last June, an unusual pattern if it's in a bull market.

Additional technical and fundamental commentary on crude also shows why it may be at an important pivot point, and why this matters for other markets such as bonds.

Introduction

The main topics of this article are the assets themselves, gold (NYSEARCA:GLD) and crude oil (NYSEARCA:USO), both of which drive lots of investor ownership and trading, both directly and through shares of producers and refiners of the product.

In addition, both gold and oil have psychological effects on investors, and oil price changes have significant knock-on effects on the pace and composition of economic activity. Both the level and direction of price changes in gold and oil matter a good deal to investors and the public. Thus, both for analysis of these commodities (if I may call gold a commodity though it usually trades in banks on currency desks) as their own assets and for broader reasons, the interesting patterns forming in both gold and oil now are worth discussing.

Also, because gold and oil prices tend to move in the same direction as interest rates (not always, of course, but think of 2003-7, 2009-11, and 1965-80), there are some implications to bond and utility stock investors that I'll comment on later.

I'll begin with some of the technicals of gold, then oil, then some fundamental commentary and a brief wrap-up that brings interest rate considerations into the picture.

Gold begins to falter for real

This could be the biggest challenge for the metal since it made a very promising bottom just above its 2008 top at $1,000 (all prices are per ounce in USD). That's because gold has just gone negative yoy, something that I view as a negative. From YCharts:

GLD Chart

This pattern is a little weak given how many years gold was in a bear market. Gold, GLD and other funds are very actively traded. After a bear market that lasted more than four years - far more than the intermittent bears seen in the wild '70s bull market in gold - gold and GLD were only up yoy for about 12 months, beginning in Q1 last year.

Thus, this now looks like a fairly weak bull run, and it's notable that the latest little sell-off in gold came directly after Fed speakers finally talked a little tough, i.e. one of these years the Fed funds rate may actually equal the inflation rate as measured by the CPI (snark alert). But talk is cheap, and a strong gold bull move should easily resist tough talk from the Fed, or even an interest rate hike to a level that's still well below the inflation rate.

The relative weakness here can be seen in a longer-term FINVIZ chart of gold, which also shows speculative positioning. The specs are represented by the blue and red lines; the green line shows the commercial hedgers and equals the sum of the net positioning of the two classes of specs. So a simple way of looking at the trend of speculative sentiment on the futures market is to look at the green line. You will notice that in a good bull market, which is so long ago that I need to also show the monthly very long-term chart, bulls feel the love and get on the right side of the trend. Now, we see gold faltering without a lot of bullishness amongst the specs. I take this as showing a weak level of conviction. First, the weekly chart, then the monthly chart:

From the weekly chart, it's apparent that playable bottoms in gold have been associated throughout the bear market with the green line ascending to the zero line. That repeatedly marked the give-up price range at which the specs net gave up their bullish positioning. Then the price rose, the specs got bullish again, only to see the bear trend resume. This time, beginning in late 2015, looked different. Now, the question has to be raised as to whether gold will fall again, and in response, the specs will cave and go flat in their net positioning.

Not only is this a reasonable hypothesis for a cautious potential gold investor, but also the long-term chart (where gold prices are less accurate the farther back in time one goes, because this is a futures chart, not a spot chart) shows that in the late '90s, when gold was fully out of favor, the speculative contingent was repeatedly bearish, and correctly so on trend. Periodically their net negative positioning would go neutral, as shown by the green line dropping from a positive level to the zero line.

This means that within recent history, there are years of precedent for speculators to have a net bearish posture. This is one bearish potential set-up. Might gold be heading for a period of true neglect and disfavor, as in the '90s?

There are some fundamental reasons to think so, discussed later.

Next, another reason gold may be at a crossroads comes from a way of tracking the gold price that appeared to "work" several years ago.

What happened to the relationship between gold and the real interest rate?

The financial maven and blogger Eddy Elfenbein created his most popular blog post in October 2010 with a post titled A Possible Model for the Price of Gold.

In this article, he discussed Gibson's paradox and moved on to apply research on it to gold, concluding via both theory and back-testing that gold's price trend tracked the level of T-bill rates versus the inflation rate. From the blog post:

The key is that gold is tied to real interest rates. Where I differ from them is that I use real short-term interest rates whereas they focused on long-term rates.

Here's how it works. I've done some back-testing and found that the magic number is 2% (I'm dumbing this down for ease of explanation). Whenever the dollar's real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It's my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Here is the chart he posted:

If I remember correctly, Mr. Elfenbein fine-tuned the model perhaps the next year. Subsequent to this blog post, other analysts and bloggers posted variations on the theme.

Here's the problem. Whatever precise formula one uses, the concept was that years of near-zero short-term rates and a 10-year T-bond rate around 2%, with the CPI also around 2%, should have been bullish for gold. But instead, by 2015, gold was back almost to its 2009 price range.

Also, the well-known charts tracking the quantity of Federal debt and/or the Fed's money supply and the price of gold have also broken down.

These sorts of divergences "should" be self-correcting if they are to be valid. That's why a renewed downturn in gold ups the ante on the bet that other factors are more important in gold's price ranges.

So, as an interim summary, gold was acting well, correcting but staying positive yoy and well above its 2015 lows. Then it turned down when it should have at least held its recovery gains if the bull case were the winning one, went negative yoy, and is much more in a neutral posture technically. At least as worrisome to the bulls is the worsening argument that quantity of money or unduly loose Fed policy is what will drive gold's price upward. These hypotheses are not working, and every year they increasingly do not work, practical investors are going to ignore them.

Now, a few words on oil.

Oil also at a crossroads, not looking energetic

This is the weekly chart on WTI crude:

There are two striking facts in the above price-trading patterns chart. The first relates to price. For all the world, the drop-off in price now looks like a fractal pattern is setting up at the new, approximately halved price level. Is oil getting ready to collapse once more? Technicals are consistent with that.

The second striking pattern is that the speculators have been nothing but bullish this whole bear market, which began after the Libyan War and Fukushima meltdown in H1 2011. Not only have they been consistently wrong, but this is now another peak in bullish positioning. The last time we saw this high a volume of net long contracts on the bullish side was the major peak in 2014, just before the bottom fell out of the crude oil market (For those tracking prior performance of authors, I went bearish on oil in Q2 2014 and stayed bearish even after its first major price collapse, as I discussed in an Oct. 15, 2014, article titled Why I'm Not Buying The Dip In Domestic Energy Stocks. This article concluded with points that are eerily relevant today, so I quote:

On the futures market, speculators have been stubbornly sticking to a heavy long position in West Texas Intermediate oil and to their heavy short position in the 10-year Treasury bond...

I'm comfortable taking the opposite side of the speculators in this case, i.e. not fighting the tape as the speculators in both oil and bonds have been doing.

The prior two points alone raise bearish possibilities for crude price; there are two others worth mentioning.

One additional point relates to the flattish price curve for crude out to 2025, with some portions of the time period in frank backwardation; see this CME link for real time data. It's one thing for a Saudi-led price war in crude to knock the spot price way down. It's another for traders to foresee a $57 price for a barrel of oil out to the end of 2025. That's a level that a mere three years ago would have been thought almost impossible. Yet here we are.

A final point that relates to oil being at a crosswords is seasonality. I discussed that in late December 2015 in an article that asked Is It Finally Time To Scale Into The Oil Sector? and pointed to SeasonalCharts.com, which I update now:

Rohöl Future saisonal

The traditional February low should be followed by a March surge. It's very early days, but the short-term trend looks flat to down. Also, the price chart shows crude typically rising from its May-June interim seasonal peaking period by another 5%, from about 106 to 111, before moving flat in price from year-end to now in early March. Yet, as the daily chart in crude shows, crude is below its level of mid-May/June of 2016. If crude prices were truly depressed, they should follow or exceed the seasonal pattern and have worked higher, not slightly lower.

Furthermore, while not shown above, the late-dated contracts on the CME for WTI crude have actually been moving down over the past year; they used to be at and above $60, now they're $57 or so.

So, in many ways, oil as well as gold is in a vulnerable technical situation. Yet the seasonals favor price increases, so does an improving economy, and at some point, speculators are in business to make money, not lose on such an important commodity year after year. Oil certainly may be forming a base here and has lots of running room should it blast off.

There's no way to foretell, but this prolonged sideways action and the points made above suggest that a decisive-looking move soon might occur.

Some comments on fundamental forces in gold and crude oil

Gold

A basic question about gold is whether there are two factors that are keeping it from ascending in price despite the high money supply, unduly low interest rate structure (no matter what the Fed decides on March 15). One fundamental issue that's more cyclical though possibly eventually secular is that improving public mood is bearish for gold. Gold is falling, or failing to rise, with a sharply improving public perception of the economy. As an example, the Bloomberg Consumer Comfort Index was just reported by Econoday as booming:

Released On 3/2/2017 9:45:00 AM For wk2/26, 2017

Prior Actual
Level 48.0 49.8

Highlights
Tuesday's consumer confidence index showed enormous strength as does today's consumer comfort index which jumped nearly 2 points in the February 26 week to 49.8 and a new high for the economic cycle. Record gains in confidence, however, have to result in significant gains for consumer spending.

What's special here, and correlates closely with the rising stock market (NYSEARCA:SPY), is that this is a number derived by averaging four weekly numbers. So if the average surges to a multi-year, perhaps even 10-year high by such a large amount, what happened is that perhaps a 47 or 48 weekly number from what became five weeks ago dropped out of the calculation. It had to be replaced by a monster number far above 50 in order to move so far in only one week. 55, maybe?

Who needs gold as a hedge if the real world is looking better?

That's one cyclical/secular bearish consideration for gold.

A fundamental one is that the modern and post-modern world is very different from the one where gold was the ultimate form of monetary wealth. Think of the 1700s and earlier. If a merchant or traveler moved around, there were no ways for wherever (s)he went to verify credit-worthiness. If Marco Polo went from what we now call Italy to China, a bank letter of credit was useless. However, if he brought gold, he had universal wealth/money. He could transfer it to a Chinese vendor of silks, spices, etc., who knew that whether the gold was exchanged for raw materials locally, or sent on a boat to use in trade with a different country, the gold would be accepted.

Now, all one needs is an Internet connection or, if necessary, a phone call, and credit can be verified instantaneously. Basically, all one needs is dollars, either USD or something like Eurodollars. There simply is no need for gold to return to the center of the monetary system any longer. The rising prominence of electronic money, such as Bitcoin, attests to that.

Regardless of exactly what the Fed does from one meeting to the next, the big picture may be that growing interconnectedness of the world's monetary system makes gold obsolete. Further, it is gold that must be taken on trust. One can trust a big bank, dishonest though it might be in some ways, to transfer funds as promised. Whereas any large gold holder might either not have clear title to the gold, or the gold might be gold-plated tungsten, and even the Fed which could show you the gold deep underground might have sold calls or the equivalent against it and might lose title to it even though the gold was in its vault.

This is just one of the existential risks to gold's pricing structure. Not that any of them will materialize. An open-minded approach to all possibilities makes sense here.

Oil

I'm on record as saying that the Oil Age has begun to fade. I think that the flat price structure of crude on the futures market is consistent with that. The reason would largely be growing use of solar and other renewable energy along with much improved battery and perhaps other methods of energy storage.

In addition, it is already being predicted that shale oil and nat gas liquids will soon be able to be produced profitably from a number of geologic formations at $40/barrel, with predictions of $30 in the foreseeable future being made as well.

So just as solar energy production can continue to ride the familiar deflationary semiconductor cost curve downwards, and more economical storage of the energy produced make solar installations attractive for many more end users, partly matching that could be declining production costs for shale, the swing factor in global oil production.

Just as a series of inventions allowed people to move from the Era of Biomass to the Coal Age, thence to the Oil Age, the next transformation to a yet cleaner, more efficient set of fuels (sun, wind, etc.) may be upon us. If so, structurally lower oil prices await, possibly in nominal terms and almost certainly in real terms.

Concluding thoughts

In the short or intermediate run, the Fed has a lot of power over commodity prices. If it normalizes real rates in the US while the European Central Bank and the Bank of Japan continue their programs of saver abuse, the USD will rise against those currencies and commodities will tend to fall. If the Fed becomes even easier, say by sitting tight on rates as general inflation worsens, the USD will tend to fall and prices of gold and oil will tend to rise.

The various technical factors discussed above suggest that both gold and oil could be at or nearing "decision points." For what it's worth, I'm more neutral than anything on them right now, but there appear to be some modest negatives technically. Fundamentally, I just do not see any special reason to own energy stocks (NYSEARCA:XLE) given their generally high valuations. As for gold, I wrote a bearish article on it last Sept. 9 when it was near $1,350 per ounce, titled Gold Overvalued By Many Metrics: A Balanced Analysis. With a lower gold price now and potentially more fiscal stimulus coming, along with (maybe) an improving level of economic activity, I'm more on the neutral side. But I'm not at all bullish on either gold or the mining stocks (NYSEARCA:GDX). If oil does head down, I do think that gold fundamentally can be justified as trading below $1,000/ounce.

As we see how the future unfolds, it's important to think of the implications of an inflationary or disinflationary/deflationary trend in gold and oil. The yield curve for Treasuries has flattened, which matches the price chart for crude oil. This has occurred many times since 1981, and every time it has happened, it has been with the backdrop that rates had nowhere to go but up. Yet, every time, they have dropped, not risen. The bearish sentiment on the futures market amongst speculators for the 10- and 30-year T-bonds (NYSEARCA:TLT) is very high. Price-bearish action in gold and oil, should it occur this year or even next, might be associated with a decline in inflation rates and a good real return on longer-term bonds. If so, strong utility stocks could benefit as well, and could outperform Treasuries if they are selling more power and raising their dividends in the setting of a stronger economy.

Right now the markets are acting in "Goldilocks" fashion. Interest rates are stable and low, and stocks are high and rising. Could this be foreshadowing a virtuous disinflation/deflation? Or, could oil and gold break higher, along with silver (NYSEARCA:SLV) and copper (NYSEARCA:JJC)? If so, both equities and debt markets could be in some trouble.

Thus, my view is that gold and crude are important assets to follow, both because of their intrinsic importance and because of their effects on and correlation with other, even larger markets. Next step: how hawkish will the Fed really act, rather than just talk, and how will markets and the economy react?

Thanks for reading and sharing any comments you may wish to contribute.

Disclosure: I am/we are long TLT.

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: Not investment advice. I am not an investment adviser.