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Is The Gold Bull Market Over?

Why the pullback?
Putting it in context
Warning signs
Bull market intact
Merry Christmas

The most common question from subscribers right now is: what's your view on the falling gold price? As most of you would know, I've been an advocate for gold as an asset that should outperform as governments attempt to print their way out of crippling debt problems. In this issue, I'll explore the likely reasons for recent price declines. I'll explain why the odds favor a correction of 30% or more at some point in this cycle. That point could well be now. But I'll also try to show why the current gold bull market is far from over and you should expect higher prices before it's through.

Why the pullback?
I read somewhere once that your views on gold often reflect your personality. Those that are pessimistic, conspiratorial, survivalist or suspicious of authority tend to hold a favourable view towards the metal. Whereas people who are more optimistic etc. generally have no time for gold. I'm not a convert to this theory but there could be a pinch of truth to it, if recent commentary on the falling gold price is anything to go by.

The first reaction by many gold observers has been denial. There seems to have been a genuine degree of shock that when the Fed announced QE4, gold was flat on the day and has since declined. These observers had obviously expected gold to soar as per every previous announcement of quantitative easing. Instead of addressing the possible reasons for the price decline, many chose to simply ignore it or restate platitudes about a still upward price trend for gold.

The second reaction to the falling gold price has been all too predictable: it's a conspiracy. The Fed has been keeping the price down to make its actions look better. Goldman Sachs has been helped the Fed to achieve its aims. The Chinese have been pushing the price lower so they can buy more at a better price. A handful of high frequency traders now control the world's markets and they've been responsible for the lower gold prices. All manner of conspiracy theories have been put forward as possible explanations.

Chris Martenson from the Peak Prosperity newsletter reflects much of the conspirator thinking:

"The markets are now well and truly broken. Not because they don't conform to my predictions, but because they are no longer sending useful price signals. Instead, my hypothesis here is that the markets are now just a giant and rigged casino, where a handful of big firms and other tightly coupled players are gaming their orders to take advantage of this flood of money."

This is a cop-out. It's saying: "If it doesn't confirm my views, it's not worth analyzing". Yes, all markets, including gold, may be rigged to a degree. But it hasn't stopped gold from rising over 6x since 1999 and won't stop it going higher if warranted. Ultimately, supply and demand dictate prices, no matter what the conspiracy theorists would have you believe.

Alternative theories for the gold price decline deserve more attention. Goldman Sachs has come out with a big report effectively calling an end to the gold bull market:

"Medium term...the gold outlook is caught between the opposing forces of more Fed easing and a gradual increase in real rates on better U.S. economic growth.

Our expanded modeling suggests that the improving U.S. growth outlook will outweigh further Fed balance sheet expansion and that the cycle in gold prices will likely turn in 2013."

This view probably reflects the biggest risk to the gold outlook. If Goldman Sachs is right and you get a fully fledged economic recovery in the U.S. with rising real rates but no serious inflation, gold should struggle in this environment.

As I detailed in last week's issue though, this scenario seems unlikely when the U.S. government and households still remain significantly over-indebted. Corporate investment won't be enough to offset the headwinds from government and households having to reduce these debts.

A different take on gold comes from Mark Dow. He suggests the recent price decline is the result of investors coming to realize that QE is ineffective and won't lead to much higher inflation anytime soon. This view has a lot of merit, though his optimistic conclusions on a U.S. recovery differ from mine.

I'll detail more of my own views later, but let's first step back a bit and analyze the recent gold price action in greater detail.

Putting it into context
The gold price reached an all-time of US$1,924/oz in September last year. Since that time, it's dipped to US$1,522/oz in May before rising and then falling to the current US$1,648/oz.

Source: Bloomberg

The low reached in May was a 21% decline, top to bottom. We are now 14% from that 2011 all-time high.

You can see from the above chart that gold has been in a consolidation phase, in technical jargon, for 15 months. And how important it is for gold to hold above the May lows from a technical perspective. The recent correction isn't as severe as the 2008 correction of 29% or the 2006 correction of 22%.

Corrections of +30% during bull markets is more common than not. During the 1982-2000 U.S. bull market, the U.S. market had many corrections along the way, including a 34% correction in 1987. It didn't stop that bull market.

And gold itself corrected 47% from 1974-1976 before rising more than 8x to US$887/oz in 1980.

The point is that the current correction isn't unusual and isn't severe. And a more serious correction in gold at some point, perhaps now, could happen before the final phrase of the bull market begins.

Warning signs
There are a couple of danger signs that the current correction could get more serious. Until the past fortnight, it's clear speculators had been piling into gold. This is best reflected in open interest on the CFTC - these are the number of open gold futures and option contracts.

Source: Bloomberg

Recently, the number of call options - betting on a rising gold price - outnumbered put options - betting on the opposite - 2:1. And separately, gold ETF holdings reached all-time highs, with more than US$150bn in total.

The other danger sign is the accumulation of gold by the world's central banks. Many gold bulls understandably view this as positive, with increased demand for the metal. But I view it as a potential contrary signal as central banks have a bad habit of making poor bets. You only have to hark back to Great Britain's mass sale of gold in 1999 to understand this.

A sharper correction would shake out a lot of this recent speculation.

Bull market intact
To better understand why I think the gold bull market is far from over, perhaps I'll venture back in time a bit. My full appreciation for the bull market was formed in 2005 when I switched careers from journalism to finance and joined the Asian brokerage, CLSA.

At CLSA, gold already enjoyed a cult-like status. Well-known strategist, Chris Wood and economist, Jim Walker, were long-time devotees. They nailed the gold bull market, amongst other things. It was at the famous CLSA forums in Hong Kong where I was introduced to well-known gold bulls, Marc Faber and Jim Rogers.

Then in 2010, I joined a fund manager, where holding gold in a portfolio was considered somewhat radical and contrary to a principally stock-picking philosophy.

Since launching Asia Confidential this year, I have read more of the newsletters devoted to gold and had some conversations with some of the authors involved. While there are good gold newsletters out there, many are somewhat extreme, advocating gold because "the world is about to end".

All of this experience has led me to these conclusions on the gold bull market:

1. The good bull market started in 1999.

2. Over the past century, the average bull market in commodities has lasted 18 years. The shortest has been 14 years.

3. Money printing to cure over-indebtedness is likely to have disastrous results. History says so.

4. Deflation or hyperinflation are the probable outcomes. Gold should perform well in both scenarios as money printing will lead to distrust of any currency.

5. Bull markets always end with parabolic spikes. Gold went up 4x in 13 months in its previous bull market. Expect something similar this time around.

6. Gold is an asset like any other and should be sold at the appropriate time. The world is not going to end and will get better at some point. Other assets will be better choices when that time comes.

In sum, the recent gold price decline appears a correction in an on-going bull market. A sharper correction seems more likely than not at some point. But the bull market hasn't ended. One sign that's we're close to a market peak will be when a parabolic price spike happens, as per other recent bull markets.

Until then, buying physical gold on further dips is a sensible strategy. Towards the May lows of US$1,522/oz, gold starts to look very compelling value.

For the bold, gold shares appear cheap compared to physical gold. In terms of price per reserves, many gold companies are as cheap as they were in 2001.

Physical silver looks a better long-term investment than physical gold too, given a still relatively depressed silver/gold ratio. Own both precious metals but silver should outperform gold in this bull market.

Merry Christmas
It's almost time to hit the send button. Please note that Asia Confidential is taking a week off before re-appearing next year.

Until next time,

James Gruber