On the Gold Market, Fundamentals, Technicals and Sell-Offs

After last week's call on a gold pullback, we've gotten several questions asking how that could be so.  Thus, we've opted to explain a little about timing gold and the dollar in the short, intermediate, and long term.

Keep in mind that we're looking at only a short term consolidation, with the possibility of an intermediate term consolidation in the near future.  For most people, they shouldn't be concerned unless they need to buy more gold, at which point reading short and intermediate term lows is valuable as a buying point.

Over the long term, keep in mind that fundamentals are the most important factor.  As long as the nations of the world run with fiat currencies coinciding with global banking crises, the central banks of the world will create more currency.  This is a net increase in supply since there is a winner for every derivative contract loser.  The result is a devaluing of currency.  Given that the primary country in need of devaluation to reconcile its debts is the United States, and the US dollar is the world's reserve currency, then all countries will try to devalue relative to the dollar to stay competitive for as long as the dollar maintains its reserve currency status.

The fundamental result is that paper currencies will all weaken relative to hard assets, notably gold (and oil being a close second).

Thus, the first question that is necessary to ask is "when will it all be over and time to get out of gold?"  First, the fundamentals need to change so that the competitive devaluation of currencies globally ends.  That implies that either the US needs to get its financial house in order (which is not happening at this time) and/or the dollar needs to be removed from its position as reserve currency (there are many discussions about that going on).  It will probably take many more years.  It is even possible that, given the extreme devaluation of currencies, that this will be truly devastating--like nothing we've seen in our lifetimes.  This is one reason we advocate a strong position in physical bullion and not simply ownership of "paper gold."  Gold will not make you rich, but it will preserve your purchasing power in times of extreme stress--and the stress is far from over.  This is simply an intermission.

From a charting perspective, we look at cycles, historical precedent, and technical analysis for answers.  One of the best long term indicators of when the worst should be over is the DJIA:Gold ratio:

We call these market periods where there is extreme financial distress and gold begins to outperform everything "gold superbulls."

At some point, that ratio should approach 1, meaning that 1 ounce of gold is worth the same as the DJIA.  In fact, however, if you really examine the linear trendline connecting the bottom of each period, you get a ratio of 0.53, or roughly translated, an ounce of gold will buy the DJIA twice over.  Will it get that extreme?  That's a question of how the fundamentals develop, but given present course, it's not out of the question.  Also, given that during periods of extreme central bank money printing during secular bear markets, the DJIA tends to bottom at a much higher level than it would otherwise (due to inflation), and the duration of the secular bear market cycle is longer than it would be otherwise.  Presently, we are well on track for a very high gold price, a very long bear market, dramatic devaluation of all currencies--especially US dollars, Japanese yen, and British pounds--and ultimately, a very high DJIA.  We'd give you the numbers for gold, the US dollar, inflation rates, and the DJIA that we derived, but you'd just shake your head in disbelief or sit in the corner and cry...

The lesson here is that gold is a buy and hold--especially the physical stuff.  For those more inclined to trade, the short and intermediate term moves can be valuable, but being caught without physical could be financially crippling (talk to the Argentinians or Icelanders).  In our opinion, in September we began the second leg of this gold superbull which will be very strong and last a long time.

Thus far in this market, the USDX has really governed the gold moves.  However, gold has broken out in all currencies.  The one pseudo-exception has been the Australian dollar.  Gold in Aussie terms based from June to November and recently broke out.  Although it has consolidated a bit since, we expect the trend to continue very soon of gold rising in Australian dollars.

Thus far, we know that gold is in a long term bull.  We have some common sense about the fundamental picture and some technical indicators to support knowing when the gold bull will end.  We know that gold is generally rising in all currencies and it appears to be entering its second leg up in the long term bull market.  Note that while the USDX generally commands the gold price, which is because of its reserve currency status.  Gold may ultimately rise due to inflation, and not simply because of a weakening dollar (in currency flow terms).  Please make sure you've read our discussion on Inflation, Floating Exchange Rates, and Competitive Devaluation for more information on our position on this topic.

The moral of the story here is, again, gold should be a core position moving forward.  We use the indicators to find good entry points in the intermediate and short term.  If you already have a good physical position, then trading paper gold--in the form of ETFs, mutual funds, or gold stocks--can be a good play.  Note that we'd never bet against (that is, short) gold in this environment since it will be unpredictable and its upside strength must be respected.  It's simply too risky to bet against gold (just ask an honest deflationist).  Worst case, on a trade, we'd move to cash and wait for a consolidation if we expected a large sell-off (see more below).

That brings us to the intermediate and short term charts, and our prediction last Thursday.  Keep in mind that this prediction was about a short term move with a possible intermediate term move.

First, the short term:

Here we see the daily gold chart, plotted against the dollar.  We can see the breakout from the triangle in September that set this rally period off.  Readers should already know about the intermediate-to-longer term bullish inverse head and shoulders that should take gold to 1300 or more in this move.  You can see the neckline of that pattern in the chart above, with the purple dotted line.  Since the triangle breakout, note the channel pattern where gold rises quickly, hits resistance, and the RSI and slow stochastic indicators BOTH go into overbought.  Gold then trends sideways for a couple of weeks, corrects to the previous resistance line (about 4% in these recent cases), and then takes off to the upside again.  Since the RSI and slow stochastic were entering overbought territory and 1100 marked the near top end of the channel, it made sense that we were due for a correction--in this case, perhaps to 1070--the previous resistance zone.

But what about the dollar?  Don't we always look at the dollar, too?

Yes, of course....

Note that while the US dollar has resumed its downtrend (as predicted), it is at the low end of its support zone.  In support of this view has been the EURUSD cross, which is struggling again with the 1.50 level.

This level WILL give way at some point, pushing the dollar lower and gold higher (gold's rise yesterday was due to the dollar falling more abruptly than expected...), but given the importance of this level, we expect the struggle to continue a bit longer and give gold time to correct.  We expect gold will lead to the upside and forecast the 1.50 break.

But wait...that's not all...  Didn't we mention something about a *possible* intermediate term consolidation?  We got a lot of questions on this, especially in light of Marc Faber's market commentary on Friday:

INTERNATIONAL. Marc Faber the Swiss fund manager and Gloom Boom & Doom editor said he has some short-term concerns about commodity prices including gold. He is also reluctant to invest in bonds.

In the latest issue of the Gloom Boom & Doom, Faber writes: "Since we had in 2008 the third best annual return (41%) in the last 35 years and since each time high returns were followed by negative returns I would be, regardless of the economic outlook, very reluctant to invest in long term government and also in corporate bonds.

Faber says he is more negative about US bonds under a further deterioration of the economy than under a recovery, adding that 'inevitable' further economic weakness 'will lead to further fiscal stimulus packages and necessitate further money printing'.

He believes the latest GPP growth figures are a result of massive government interventions into the free market which inevitably resulted in extremely volatile economic and financial conditions.

As a result assets are over-stretched: equities are too high, the euro is over-bought the dollar is over-sold. Even gold may be due for a short term correction, he says.

"I should also mention some concerns (for now of short-term nature) I have about commodity prices including gold. A large number of commodities including oil, the CRB Index, and gold broke out on the upside in early October," Faber said.

"I would regard a failure to hold above the “upside breakout points” in the period directly ahead with great caution. In the case of gold a decline below US$1,000 would likely lead to further more meaningful weakness, possibly down to between US$800 and US$900," Faber added.

Faber has been reiterating, in various recent interviews, the notion of over-stretched assets and a possible short-term dollar turnaround.

Speaking in a Bloomberg interview from Istanbul on Tuesday, Faber said: "Maybe the dollar has made a turn, it can easily rebound by 10%”.

“It may have started already since the asset markets started to go down 10 days ago.”

“I don’t think that the dollar will be a strong currency, but you can have periods like in 2008 that the liquidity tightens”.

“If you have the private sector withdrawing credit and the government throwing credit at the system you can get a lot of volatility,” Faber said, adding he would be careful to buy equities now as “we are in a correction period.”

For more information, please visit www.GloomBoomDoom.com

While we agree with Marc Faber's commentary on government and bonds, and are cautious about large consolidations in this environment, we believe he's a bit premature.  We believe there's still more upside before a major gold consolidation (see below) and equity consolidation.  Of course, the USDX drives all right now, and if the EURUSD cannot rally above 1.50 once gold has consolidated, then that should be a concern.  Unless that condition becomes prevalent, we believe our thesis on the big dollar/gold move to be correct.  For the record, we would consider any large gold sell off after a major dollar bottom to be an intermediate term move, and this is one reason we have considered owning paper gold in this particular case (we will be taking paper profits and buying more physical gold after the move).  The long term trend is intact.

As we have discussed several times, the USDX controls everything else--the whole world of assets is being traded against the dollar.  We have a proprietary indicator we call the "Window of Opportunity" indicator for the dollar.  Essentially, this foreshadows major intermediate and long term changes in trend for the dollar.  It has been particularly accurate for forecasting when the dollar will fall and about 60% accurate for dollar rises, including the March 2008 rise and the March 2009 fall.

Something similar can be done with looking at different RSI and stochastics over various trading periods (daily, weekly, monthly).  While going through that analysis is a thesis in and of itself, let's just point out a few things of interest.

Below are three charts.  Each chart is a 10 year view of the gold bull market.  The first chart is a monthly, the second is a weekly, and the final is a daily. 

 

 

The gold market, and all markets for that matter, are dotted with short term, intermediate term, and longer term sell-offs (just like we showed on the short term chart).  We use the term "longer term" to differentiate from long term in the multi-year, megatrend sense like a during a secular bull or bear market.  We are essentially talking about corrections in this case.  These sell-offs are small, medium, and large in magnitude (like that fancy categorization?).  All of the medium and large magnitude sell-offs have been forecast with the combination of the RSI and slow stochastic.  Over the last 10 years, since the bull market began, we have had two large magnitude sell-offs, approximately two years apart (circled).  In both cases, the monthly, daily, and weekly charts have all forecast these moves with the 16 period RSI and 14,3 period slow stochastic showing overbought.  In both cases, the monthly RSI was overbought for at least a couple of months before the correction occurred.  (Side note, in the last correction, the TED was elevated dramatically as this sell-off was the sell-off of the credit crisis).  If these conditions were not present, the gold sell-off was only "medium," meaning no more than about a 10% correction.  If you look at the charts above, you will see that the daily and weekly charts are overbought, though the weekly is "just barely" overbought.  The monthly "still has room."  Thus, we believe we are due for a short term correction (small) and possibly an intermediate term correction (medium) of up to 10%.  The larger, longer term correction is not YET in the cards....

What this means to us is that our "dollar to 72, gold to 1300" thesis is alive and well.  Within the next 6 months or so, we expect to see the dollar bottom, a major consolidation of assets, and gold to sell off for an intermediate term correction of about 25%, ala what Marc Faber mentioned.  But we're not there yet--at least by historical measures.  We do, however, concede the possibility in the shorter term of a gold sell-off taking the price back toward 1025, which would be a medium level sell-off.  For the time being, we believe that the neckline will serve as the primary support level.  Once gold completes its longer term pattern, then that support line will not be as important.

There you have it.  If there are any questions or clarifications, or if you'd like to get in on our free mailing alert list, email us.

Soon, we'll be providing a more in-depth energy discussion by popular demand.