Testing Time for Gold

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Gold has gone nowhere since peaking near $2,000 an ounce back in 2011 and with the recent slide this month many gold investors are questioning their resolve. I’d like to look at gold from multiple points of view and identify some lines in the sand which will hopefully allow investors to make some informed decisions.

Fed Threatens to Take the Punch Bowl Away

One of the things weighing on gold and commodities in general is the concern that the Fed will be reducing its quantitative easing (QE) measures and slowing its balance sheet expansion. The uncertainty regarding the Fed’s monetary policy stems from a divided tone in FOMC minutes from the last two meetings in which several committee members voiced their concerns regarding current Fed policy. Not only were some of the members' concerns voiced in the FOMC minutes but some even took to the financial press and shared their opinions in financial interviews.

One thing readers need to understand is that this is par for the course when inflation expectations heat up. We saw this while QE1 and QE2 were well underway where various members commented on dialing back the Fed’s monetary expansion and as soon as the economy cooled we received more easing by the Fed. So the fact that FOMC members are espousing their concerns should be no surprise as they are simply jawboning the market and trying to ratchet down inflationary expectations. This is clearly visible when viewing the number of times the terms “Fed” and “hawk” appear in the news (white line) alongside 5-year inflation breakeven rates (orange line) shown below.

fed hawk
Source: Bloomberg

As soon as inflation expectations fall so too will hawkish Fed commentary. Regardless of inflation expectations, I outlined last month “$3 Trillion Reasons Why the Fed Won't End QE” and then last year why central banks across the globe will continue to print money (Global QE Is Coming: Let the Gold Mania Begin!).

Being Right or Making Money - The Market Always Determines Your Fortunes

Regardless of one’s personal leanings towards precious metals or any other asset class, the market is the ultimate judge of whether such an investment was profitable or not. If the goal is to make money or preserve purchasing power, an investment in metals should be done purely with respect to how well it meets those needs. We can complain all we want of how right we are and wrong the market is but, in the end, it's about making money. So who's right or wrong about gold? Is the bull market over or is this a buying opportunity?

If the gold bulls are right then gold needs to hold its 2011 and 2012 lows. If it fails to do so it’s time to admit you might be wrong and reevaluate your thesis. However, if gold holds here then the gold bears better begin to reevaluate their thesis and prepare to change course. It’s as simple as that!

gold lows
Source: Bloomberg

We should have our first real look at seeing if gold can stabilize as it is deeply oversold while the dollar is overbought. If gold merely stages a weak rally and then rolls over and breaks its 2011-2012 lows then “Katie bar the door.” However, if instead gold firms and the USD Index breaks support at its 2012-2013 lows, then USD bulls should be worried as gold and commodities should rally strongly. The USD Index does look toppy from a long-term view and a decline below $78 should lead to a retest of the 2011 lows near $72.

usd top
Source: Bloomberg

On top of gold testing multi-year support, it is sufficiently oversold enough to meet conditions required for a WEEKLY TrendStall BUY signal, which last occurred right at the 2012 lows and at the 2008 bottom.

gold trend stall
Source: Bloomberg

Our own proprietary indicator for gold shows the most oversold condition in four years while the longer-term smoothed version shows one of the most oversold levels in a decade.

gold short-term
Source: Bloomberg

gold long-term
Source: Bloomberg

Aside from deeply oversold, another thing I would like to point out is the uncanny resemblance to the 2012 correction, which if the current correction plays out in like manner suggests that the lows may be in for gold.

gold 2012 to 2013
Source: Bloomberg

gold overlay
Source: Bloomberg

Remain Flexible and Keep an Open Mind

While there is ample room to make a case for a gold bottom, one can be blinded by tunnel vision and caught off guard. For this reason gold investors need to be open to the bear case for gold and a bullish USD view. I believe the next big move in gold will be determined by the dollar and there is the possibility for a sizable USD rally. Shown below is the USD Index in a trading range bounded by $78 on the downside and $82 on the upside. Gold is likely to break to new lows if the USD Index breaks out of the $82 level while gold should see a sizable rally if the $78 level is breached. Currently the USD Index is testing its upper resistance zone and we’ve met conditions for a Daily TrendStall SELL signal which means gold should get some relief with USD weakness ahead.

usd bull
Source: Bloomberg

Closer to the End than the Beginning

Another point to bear in mind is that gold has come a long way over the last decade when gold bottomed at $253 an ounce in 2001 while at the same time the stock market has made little headway. The longer we move in gold’s secular bull market the more we need to keep an eye on the exit door or gold bulls will be like the technology bulls who rode the tech wave in the 1990s only to ride it all the way down once the tech bubble burst in flames.

Inflation cycles typically last anywhere from 10-20 years and so looking at relative returns over long time frames can help identify when one asset class is over or undervalued relative to another. We’ve seen several secular bull markets in stocks and secular bear markets in gold with several cycles shown below. The late 1960s secular bull market peak in stocks saw the S&P 500 Total Return Index outperform gold by more than 2000% over a preceding 20-year span and to an even larger extent at the 2000 technology bubble peak.

At those times gold was significantly undervalued relative to stocks and investors did well gravitating their capital away from stocks and into gold. Gold’s underperformance relative to stocks would subsequently be unwound as gold outperformed stocks by nearly 1500% at the 1980 gold peak. Looking at the current secular cycle shows that gold has already unwound a sizable portion of its underperformance relative to stocks with its run over the last decade.

Currently we see that gold’s performance relative to stocks is at a comparable level to the late 1940s when stocks were entering a 20-year secular bull market into the late 1960s peak. Gold’s performance relative to stocks is also at the level seen after gold’s big mid 1970s rally, though not quite near the level of outperformance seen at the 1980 peak.

gold vs. stocks
Source: Bloomberg

The point being is that gold investors should not be as bullish now on gold as they were in 2001, which is no different than saying that investors bullish on tech stocks should not have been as bullish in 2000 on the space as they were a decade earlier in 1990. Over the course of the last decade gold has had a great run while other assets have performed poorly, making them attractive relative to gold. For example, relative to the median new U.S. home price, gold is almost at the level seen at its 1980 peak, while in terms of the Japanese Nikkei 225 Index gold is MORE expensive than at its 1980 peak.

gold vs. assets
Source: Bloomberg

While the secular bull market in gold is not likely over, which I believe will coincide with a run on the USD after the Euro and the Yen have gone through their crisis, one shouldn’t cling to an investment simply for ideological reasons. If so, one could make the same mistake of tech investors of the last decade or even gold bulls back in the 80s. As always, remain flexible and listen to the message of the markets.

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