In a weekly summary published last Sunday on my Unorthodox Mining Investing service, I discussed two possible scenarios playing out at the precious metals market. The first one was pessimistic:
Any analysis of the gold market is overshadowed by the simple fact that the price of gold has once again reached its very strong resistance level ($1,350 - $1,375 per ounce). In the past such an event was triggering pretty strong price drops and it looks like this time we are going to see a similar pattern. As a result, despite many optimistic articles on gold in the media, an unbiased analyst has to be pessimistic…"
The second scenario was optimistic, with the following factors standing behind:
"History teaches that a final breakout is supported by high optimism
For example, in October 2009 a price of gold broke above its strong resistance level of $1,000 per ounce at high optimism (the gold sentiment index of 80%)
I am not surprised - to break up the price of gold has to be supported by high optimism (nothing goes up strongly when there are only stubborn pessimists)
These days this scenario is supported by the deteriorating US dollar and a strong bull market in treasuries"
Yesterday, the Fed made a decision to hold rates steady and indicated that no cuts were coming this year. Definitely, low and steady rates should support precious metals in the medium term; so yesterday, we saw a very positive market reaction to this announcement, with gold and silver prices significantly strengthening. As a result, it looks like the second scenario, positive for precious metals, is currently developing. In this article, I discuss this thesis.
As the chart below shows, today, the price of gold is sitting at its long term, very strong resistance level of $1,350-1,375 per ounce (the area marked in orange):
Interestingly, at the time of writing this piece, the price of gold is fluctuating around $1,380 per ounce, so it looks like the Asian and European investors are heavily betting on a positive scenario.
Another interesting fact - since the beginning of 2016, the price of silver has been out of sync with gold and now it is trying to break above its long-term downward trend line (the upper panel of the chart and the red down-sloping line).
Factors supporting a positive scenario
The answer is in US Treasuries
My subscribers know very well that the treasury notes futures market and the relationship between treasury notes prices and the US dollar are crucial for precious metals. For example, as the chart below shows (the panel on the right), strong treasuries and a weak US dollar support the precious metals in the long and medium term:
- between 2002 and 2011, gold was in a vicious bull market supported by the rising the 10Y/USD index ratio
- since 2012, the opposite relationship was behind the 2012-2015 bear market in gold, then followed by a three-year period of flat prices
Source: Simple Digressions
Note: 10Y/USD index ratio = the price of 10-year treasury notes/USD index
Now, as the panel on the left illustrates, this magical ratio has just broken above its strong resistance level, putting sunny optimism into gold bulls' hearts.
Goldollar index has just broken up
Further, as the chart below shows (the panel on the right), the Goldollar index, a very helpful indicator used by the author to describe the state of the precious metals market, has just broken above its long-term resistance level (the green circle):
Source: Simple Digressions
Note: "Goldollar index", invented by Tom McClellan of McClellan Financial, is calculated by multiplying the price of gold by the U.S. Dollar Index. Its purpose is to cancel the effects of currency fluctuations on the price of gold. By comparing it with the spot gold index, we can determine if there is inherent strength/weakness in the price of gold
In my opinion, it is the second, very strong indication that the precious metals market is at its pivotal point now. However, to trumpet a real change, both the gold and goldollar index have to be in sync. Today, it is not the case (look at the panel on the left). At least not yet…
Commitments of Traders reports
I am using Commitments of Traders reports to identify the market sentiment. For example, from the contrarian speculator's point of view, extreme optimism creates a selling opportunity. And the opposite mood (extreme pessimism) whispers that a long position makes sense.
However, there are times when we have to abandon this pretty simple approach and do something totally different. In other words, history teaches that strong resistance/support levels are broken at high or even extreme optimism/pessimism. For example, look at the chart below and the panel on the left:
Source: Simple Digressions
I think it is easy to spot that the last strong leg up in gold (2009 - 2011) started when the price of gold broke above its strong resistance level of $1,000 per ounce (the blue circle). And my point is that this milestone event had happened when the sentiment index was flashing 100% (i.e. extreme optimism).
Interestingly, as the panel on the right shows, today a similar pattern is emerging:
- The gold sentiment index is flashing 76.2% (as at June 11, 2019)
- It means that money managers trading gold futures are very optimistic about gold
- As a result, a final breakout could be in the cards
Of course, there are a few risks or patterns still overshadowing a positive scenario. Let me discuss a few of them.
As a rule, gold and silver go in sync. However, as discussed in the beginning of this article, since the summer of 2016, a price of silver has been in a long-term downward trend. At the same time, the price of gold has been flat or in a slight upward trend (depending on the time horizon we are looking at the market) so, definitely, the popular wisdom that both metals go in sync is not that obvious to me…
What is more, most recently the gold/silver ratio has reached one of the highest readings in history (90.3), making the silver bulls hesitating whether silver still qualifies as a precious metal (in my opinion, it does).
In other words, the extreme weakness of silver compared to gold overshadows the optimistic scenario.
Investors are getting out of GDX and GDXJ
Generally, during a healthy bull market in precious metals, the two most popular gold mining ETFs (GDX and GDXJ) report higher share count. It means that the authorized participants (large specialized investors) have an incentive to buy gold mining shares on the market and sell them to ETFs - as a result, share count goes up. During a bear market, the opposite pattern emerges.
Now, as the charts below show, most recently, the authorized participants have been very busy liquidating their holdings in both ETFs (red, down-sloping lines):
Source: Simple Digressions
Definitely, such a behavior does not support a bullish stance…
In my opinion, a conservative precious metals investor should be cautious now. This week, the price of gold reached its long-term, very strong resistance at $1,350-1,375 per ounce. During the current cycle (starting from the beginning of 2016), each time a price of gold reached this level (there were four such cases), a rapid and deep price drop was occurring. Hence, cautiousness is advised…
On the other hand, a positive scenario, with gold prices finally breaking up to the upside, is also likely. I discuss this thesis in this article.
Finally, my personal bets seem to satisfy two scenarios:
- I am cautious, so I have no long position in gold futures
- At the same time, I accept some risk, holding a long position in silver futures. Simply put, if a positive scenario develops, I think that silver will finally outperform gold. On the other hand, if the market chooses the standard path and a price of gold goes down, I think that the silver's downside potential is pretty limited.
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Disclosure: I am/we are long CEF, GDX, ARREF, SAND, DNGDF. 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: I also hold a long position in silver and copper futures