When The Fear Breaks, The Cradle Will Fall

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Includes: GDX, UUP
by: Clif Droke
Summary

Gold's rally is being artificially extended by global trade-related fears.

When this fear subsides, watch for gold prices to break sharply lower.

Gold mining stocks still bullish, but internal momentum is waning.

Gold and gold mining stocks continue to benefit from the latest surge in demand from safety conscious investors. But what happens when the widespread fear which is consuming the minds of financial market participants finally breaks? In today’s report, we’ll discuss a scenario that could unfold once the market’s concerns over the U.S.-China trade war have diminished. I’ll show evidence which supports a potentially sharp drop in the gold price after the fear has faded and equity prices bottom out.

We’ve all heard the bromide, “The more things change, the more they stay the same.” This often applies in markets, particularly where gold is concerned. This saying can be applied to the repetition of a pattern that has become quite common for gold’s price performance in recent years. For instance, last year’s 20% tumble in the S&P 500 Index (SPX) saw the gold price strongly outperform equities as investors treated the metal as a safe haven during the stock market storm – irrespective of the U.S. dollar’s strength.

The tendency for investors to run to the safety of gold repeated yet again in late July when stocks sold off in the wake of the escalation in the trade war between the U.S. and China. While the SPX lost 6% in only a few days, the gold price rallied sharply to a new yearly high as investors bought gold as a hedge against a market meltdown similar to last year’s. Gold’s latest gains can be seen in the continuous contract chart shown below.

Gold Continuous Contract

Source: BigCharts

Gold has made fairly steady forward progress in recent months in spite of a strong U.S. dollar. Gold’s currency component has been correspondingly weakened by the dollar’s strength. This explains why gold spent such a long time in a lateral trading range this summer before its most recent upside breakout. The recent gold price rally was accompanied by a short-term breakdown in the dollar index, which is reflected in the Invesco DB USD Bullish ETF (UUP) shown below.

Invesco DB U.S. Dollar Index Bullish Fund

Source: BigCharts

That gold has stubbornly resisted the dollar’s steady upward drift in the last few months is a testament to the urgency of safety-related demand among investors. Investors apparently feel they can’t buy enough financial protection from the threat of a global economic slowdown. This explains why each and every setback in U.S.-China trade relations is met with fresh new buying of gold bullion and gold mining shares. But there’s a dark side to this paradigm. When the fear behind investors’ safe-haven gold demand subsides, there will be little in the way of support for the gold price when the dollar is as strong as it has been in recent months.

There’s another sign that gold’s rally is being artificially extended by the extreme fear now felt by investors. The copper price has plunged in recent months, most recently falling to a 2-year low as of Aug. 5. Besides being a gauge for the health of China’s manufacturing sector, copper is also a barometer of global industrial demand for metals in general. This includes to some extent precious metals. When copper is falling steadily while gold is rallying, it’s usually a sign that fear is keeping the gold price buoyant. Otherwise, gold prices would likely be falling along with copper right now.

Copper

Source: BigCharts

When the trade-related concerns plaguing investors right now have been addressed by both the U.S. and Chinese governments, there’s every reason to expect gold to sharply “correct” its recent fear-driven gains. Another way of anticipating gold’s next pullback is to watch for signs that the U.S. stock market is bottoming. Gold tends to trade inversely to equities, especially when fear is intense among participants. A reversal of the recent plunge in the S&P 500 will take a lot of impetus away from the “fear trade” in gold.

Turning our attention to the gold mining stocks, most senior and mid-tier producers are still benefiting from the gold price rally. The PHLX Gold/Silver Index (XAU) hit another new high for the year on Aug. 6, so clearly the immediate-term (1-4 week) trend for the gold mining stocks is still up.

PHLX Gold/Silver Index

Source: BigCharts

However, the internal momentum behind the latest gold stock rally isn’t nearly as powerful as it was last month and in prior months. As you can see here, the 4-week rate of change indicator for the new highs and lows among the 50 actively traded U.S.-listed gold stocks has stalled out. It hasn’t yet confirmed the new high in the XAU index, which is somewhat troubling. While I don’t regard this as a sell signal, it’s enough of a divergence to warrant raising protective stop-loss levels on existing gold stock positions. I’d also recommend taking some profit in the top-performing gold stocks in individual portfolios, while pruning the laggards.

Source: NYSE

In conclusion, gold remains in the hands of the buyers thanks to the persistence of fear and uncertainty regarding the global trade outlook. However, due to the recent strength of the U.S. dollar and the extreme weakness in the copper price, investors should be aware that when fear subsides, gold will be vulnerable to a sharp decline. Accordingly, I recommend that investors hold off on initiating any new purchases in gold right now. However, existing longer-term positions in gold and gold ETFs can be retained along with intermediate-term (3-6 month) positions in gold mining stocks.

On a strategic note, I’m currently long gold via the VanEck Vectors Gold Miners ETF (GDX). For this ETF, I’m using a level slightly under $27.00 as a stop-loss on an intraday basis. Participants who haven’t done so should also book some profit in GDX after its impressive run of the last few weeks.

Disclosure: I am/we are long GDX. 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.