Hedge Funds Re-evaluate Gold’s Potential

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Gold’s biggest problem since February has been one of relative weakness. This weakness in turn has kept the market-moving hedge fund players away from gold. But as we’ll see in the latest commentary, that may be about to change.

In late February when the gold price rallied sharply to its highest level of the year at $1,793 it looked, on the surface, like gold was finally about to break out of its holding pattern since last September when the metal took a sharp dive. The February rally proved to be a “head fake” however. The yellow metal took another plunge within days of making its late February high at $1,793 and fell to a low of $1,538 on May 16.

Although the gold price made a series of higher peaks in the month of February, the relative strength indicator for gold told a completely different story. Instead of confirming the new high in the gold price, the relative strength line made a conspicuously negative divergence. Notice the lower high in the chart shown below, which plots the daily relative strength reading for the iShares Gold Trust (IAU), our favorite gold proxy.

iau relative strength jan. through may

This lower high in February in the relative strength chart warned that gold was under distribution and almost immediately the gold price collapsed, making a continuous series of lower highs and lower lows until only a few days ago. Relative strength is the key to understanding not only gold’s underperformance since the late February sell-off, but also the lack of interest in hedge fund traders for gold. See the IAU chart shown below.

IAU chart

In an earlier commentary I also pointed out the technical significance of the longer-term 60-week (300-day) moving average for gold and the gold ETF. This is signified by the yellow line in the above chart. In breaking down below the $1,650 level earlier this month, gold violated its 60-week MA for the first time since the 2008 credit crisis. This served as additional confirmation that the bear market that began last summer when CME Group raised gold’s margin requirements had reached a critical point. It also served as a wake-up call for the big market players and forced them to re-evaluate their holdings in the metal.

Hedge fund traders were heavy liquidators of gold last summer after the series of margin requirement increases. Many hedge funds operate using a momentum-chasing system and the consecutive margin increases was a huge disincentive for fund managers to be heavily long gold. When the big players aren’t allowed to heavily leverage their trades they tend to look elsewhere for excitement.

The latest fears over the Greek debt crisis and the possibility that it may withdraw from the euro-zone hasn’t helped gold, either, and has caused a further evaluation of gold’s performance as a monetary safe haven. Gold has been pressured in recent days on the latest outbreak of fears over the euro-zone situation as concerned investors have liquidated stocks and commodities and fled to the dollar as a safe haven instead of gold.

Yet there is now reason for investors and hedge funds alike to begin re-evaluating gold’s intermediate-term potential in a more positive light. The preliminary case for gold was first made visible the week of May 14-18 when the S&P 500 Index (SPX) fell out of bed and declined every day last week. Meanwhile gold and the iShares Gold Trust (IAU) showed relative strength versus the SPX for the first time this year. This is noteworthy in that the relative strength line shown below not only refused to confirm the lower low made in the gold price and the IAU earlier this month, but also the relative strength line made a higher high above its previous peak in April. This by itself doesn’t qualify as a buy signal for gold, but it does serve as a “heads up” that relative strength is gradually returning to gold. This indicator is closely watched by hedge fund traders and you can bet it hasn’t escaped their notice.

relative strength 2 chart

Another event that should bode well for gold beginning in June is an improvement in gold’s 10-month price oscillator. This indicator measures the rate of change in the gold price by comparing the gold price on the last day of each month with that closing price from 10 months ago. Over the last several years this indicator has given us some reliable buy and sell signals from a longer-term investment standpoint (although the indicator has little value from a short-term timing standpoint). Here’s what the latest indicator reading looks like as of April 30 the last time it was updated.

We examined this indicator earlier several weeks ago and saw that this important longer-term indicator was telling us gold was still “overbought” and in need of further correcting. The rate of change for this indicator strongly suggests, however, that by the beginning of June we could have not only a return to a normal, healthy reading in this indicator but likely even an “oversold” reading. This would be a huge improvement for the gold market as an “oversold” reading in the 10-month oscillator hasn’t been seen in years. If the return to a normal reading in the 10-month oscillator is accompanied by further improvement in the relative strength line the odds will increase that gold will see a summer turnaround.

gold oscillator

The other important factor weighing in gold’s favor in June is a seasonal consideration. Unlike August, which has a distinctive bullish bias, June doesn’t have a clear bias for gold one way or the other. Since the year 2000, gold had an up June in 5 cases, was down in 6 cases and unchanged in one case. The one constant over this 12-year period, however, has been gold’s technical condition entering the start of June. Each time that gold entered June in an “oversold” condition as defined by the price oscillators, gold has rallied in June. Coming off a major sell-off in May – and with the 10-month price oscillator set to flash its first oversold reading since May 1, 2009 – gold is in prime condition for a summer rally.

For now we continue to wait for a confirmed immediate-term buy signal from the gold ETF as it remains under its dominant immediate-term 15-day moving average. The evidence suggests that by June we could finally have our long-awaited first confirmed breakout signal since January.

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About Clif Droke

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