From a piece I originally wrote and sent out 11th August 2011. For various reasons I did not want to include the charts in this posting, and it was not accepted by the editors without charts. At this stage (end of 2011), I would focus my view on being bearish Gold in dollars rather than being bullish Gold in foreign currencies.
Following that piece, Gold saw a blow-off rally followed by a reversal. It's too early to be certain this is the end of the uptrend, but I certainly would use bounces to exit stale longs and on confirmation from longer-term Ichimoku chart start to establish bearish positions in the precious metals complex.
I focused on gold rather than the other precious metals since it is the benchmark. In fact other precious (and base) metals are likely to be better shorts.
Gold – is the bullish trend getting tired?
First of all, in the Gold market, there has been since last year an outstanding annual (!) Demark TD Combo sell signal on the spot Gold price. This is a signal that identifies certain repeating patterns in markets in order to identify a potential exhaustion of the previous trend. The longer the time frame, the more significant, and the longer-lasting a reversal in price might be. News about the increase in margin requirements by the Chicago Mercantile Exchange came out just as Gold was testing the risk level (dotted purple line on the chart below).
Markets top when the last buyer has bought – they don’t wait until sellers arrive en masse and so it is often the case that the high is made amidst good news for the underlying asset and the low is made amidst terrible news. (In the case of Gold, the cash low of 251.95 was made amidst news of ongoing central bank sales and a mass enthusiasm for equities – particularly US technology stocks. This was a time when it was said that Warren Buffett was ‘past it’, and gold bugs were less even than figures of fun).
I mention this because the flow of fundamental news over the past few years has been relentlessly negative for mass belief in fiat money and positive for Gold. Everybody is aware that the credit worthiness not just of many European states, but also of the US sovereign is in question and of course the concern about a possible technical default on Treasury coupon payments drew a great deal of attention. Superficially it seems positively reckless not to have a substantial asset allocation to the Gold market, but to the trained eyes of a contrarian analyst, what everybody knows is probably wrong, at least from a market timing perspective, and such news items are the stuff of major tops.
From a more prosaic perspective, I note that since 2006 real yields in US two years have fallen from a high of 3.5% to -2.0% back in April, and according to “Gibson’s Paradox” this has been tremendously supportive for the Gold price (since the real yield is the opportunity cost of holding specie). The chart below demonstrates the relationship between real yields (inverted) and the Gold price – I use the five year point, since this has a better series than two years.
In the flight to safety, Gold has held up very much better than other hard commodities – the chart below shows performance of Gold, Copper, Crude Oil and Wheat:-
In the event we are truly in for an imminent repeat of 2008, with a disintegration of financing markets for sovereign issuers in Europe, and an acceleration of the silent run on banks across Europe that has in recent days been drawing attention, then there is no saying how Gold might go in extremis.
But should that not be the case (and our research has put forward some compelling arguments as to why we might expect a stabilisation from here) then Gold is beginning to look expensive against every other asset, and some of the fundamental factors that have been underpinning its valuation might start to become less supportive.
Despite the rally in the two year note contract, two year real yields have actually risen since they made a low of -2.10% in April this year (they are currently -86 bps). Over this period nominal yields have actually fallen from 86 bps to 22 bps. It’s relatively unusual to see nominal and real yields move in opposite directions and this has occurred because breakeven inflation expectations have been crushed. A chart of two year real yields follows:-
What would lead to a fall in real yields? With Fed Funds at 25 bps, two year notes have pretty much run out of room to rally. On the other hand, a further slowdown in growth expectations would lead to downside to commodity prices and would likely lead to a further decline in inflation breakeven expectations. So it is possible that real yields may be running out of room to decline much further. If this is the case, then one key factor that has been supportive of Gold may be disappearing. Should we see some stabilization in risk assets then there could potentially be a very significant correction indeed ahead for the Gold price.
If Gold were indeed to correct, would this mean the end of the bull market? Not at all. In the last previous secular bull market we saw a 44% correction from the high of 185.25 in Feb 1975 to the August 1976 low. That must certainly have shaken the faith of many Gold bulls, but after this period of consolidation Gold went on to make a new high of 835 in Jan 1980. Charts of this move follow over the page.
It would be imprudent to try and identify a Gold top with high conviction in this kind of commentary, but given the determination of the authorities to fight the forces of disintegration in the financial system and the tremendous overbought condition in the Gold market (the _quarterly_ RSI is currently over 95!), it would not be surprising to see a repeat performance. Given the underlying imbalances in the developed world, any large correction is no doubt a buying opportunity but the prospective return on risk to establishing new long positions in Gold here is far from attractive.
All of this being said, it is possible that although Gold may be tiring in dollar terms that we could see further upside against other currencies should the US dollar continue to rally.