The damage in gold has been far more than expected. The severe weakness seems all out of proportion to the modest rise in the dollar. With policies of QE and ZIRP being pursued by no less than 40 central banks, and deficits out of control in the US, and Europe far from healed, China inflating, and Japan doing the same; this all seems very odd.
Many veteran followers of gold such as Richard Russell and the Aden Sisters, have been blindsided by the ferocity of this decline. It has been more than we expected as well. Our technical people in Zurich were projecting $1580 on the downside as their worst case. We are below that this morning. Only time will tell what level we will begin to stabilize. Yesterday, we suggested $1525 area will be more likely.
For current holders of gold, the question now is: given the sharp break, should we sell or should we be a buyer? The answer pivots on whether you think this is a correction within an ongoing upward trend, or whether you believe a bear market for gold is now underway and will last for some years.
This is more than an academic discussion. It will make a big difference to investment outcomes if this is just a correction or the beginning of a long bear market. Holding now, buying now, will pay off if this is a correction. It would be a disaster if it turns out to be a bear market. So, getting the answer right would be helpful.
Our view is, this is a correction. That is additionally the view of Mueller and Riesner. We will attempt to make the case for this position in just a moment.
Readers should know our short term position was a compromise, i.e. hold a long term hedge positions (because we don’t see a change in long term fundamentals that will lead to the decline in the value of paper money), but sell down to the “I can sleep level”, and not re-enter the market until gold builds a bottom and puts in some sort of reversal pattern to the upside. The “I can sleep level” will vary, depending on individual financial circumstance and the degree to which you believe in the utility of holding gold. As a rough estimate, we would say any more than 10 to 15% in gold, is beyond a hedge position and into the realm of speculating or investing. That is OK, as long as you know what you are doing. For the true believer, this may be heresy, but as we have said, losing money in gold is just as damaging as losing money in anything else. But, each investor must face his own demons.
In addition, getting out of markets usually cause the investor to lose attention, and often place the money in other investments. Then, when the turn comes, the money and the mind are preoccupied elsewhere, and the opportunity is lost. Thus trading is a hazard, but holding too much in a primary bear market is also a hazard. There is no easy answer to this problem.
Now, as to the question as to whether gold is now in a primary bear market, we would make a few observations.
Bull markets usually end in a parabolic blow off, with heavy public participation. We have not seen parabolic like patterns in gold. In fact, gold and mining shares have been in a corrective phase for about a year and a half. So, at least the typical long term market top type of behavior is missing from gold. There has been an uncomfortable amount of public advertising about gold, especially around conservatively oriented radio talk shows. But that is not what we mean by “heavy public participation.” This has been mostly a war for market share among a narrow group of already believing buyers. According to the World Gold Council, only about 1% of world wide investable capital is in gold. We don’t think that constitutes a mania. We don’t think gold is over owned by the general public.
Usually, there is a palpable change in underlying fundamentals to end a bull market. That does not seem present either. Supplies of gold are static or shrinking. Gold production has declined during the decade of price increase, a highly unusual circumstance. Usually rising prices stimulates an increase in supply. Not so in gold’s case, as gold production peaked about a decade ago. Oil people speculate about peak oil but in the gold market, it is reality.
Gold’s use as an alternative currency or bank reserve is growing, with central banks buying more gold than at any time since 1964. And as mentioned above, all major central bank systems are printing money and unfortunately relieving their political leaders from having to deal with the long term effects of welfare state structures and promises. Central banks have amply demonstrated that they will do whatever it takes to avoid deflation. Counterparty risk has only been partially reduced in the financial system and the world still has trillions in derivatives and highly leveraged banks, and lots of bad debt that is being hidden from view. Recent data on junk bond issuance and covenant deterioration suggest that speculative financial juices are running again. More somber financial views are vanishing again. Owning some gold, which has no counterparty risk, still seems like a necessary thing to do.
In short, we don’t see the likelihood of fiscal sanity breaking out any time soon, especially under the present administration. Even if sequester were to be the outcome over the next few months, we are talking about a reduction in the rate of increase of government spending. No one currently has a viable plan to stop the deficits, let along begin to pay them off. Even the most aggressive of plans, such as that floated by Paul Ryan, put the nation on a path to a balanced budget in 12 years. And as we recall, that was just to get to balance over the span of 6 different Congressional elections, that could at any time, and likely would, veer off from the course. Pardon our skepticism. Finally, there was no plan to deal with whatever the debt would be in twelve years, just a tentative plan get to an annual balance. We won’t even talk about what could happen to the deficits were interest rates were to rise, or the nation face another war.
In the past, gold bear markets have been associated with high, real rates of interest, such as what we saw installed by Paul Volker in 1980-1982. Real rates are negative right now, under the rate of inflation. The Fed has stated their intention to keep them there until unemployment drops below 6.5%. While rates have edged up of late, the increase is very small and rates remain below the rate of inflation.
Money supply is not contracting, but rather rising. M1 over the past six months is up 12%, the broader M2 is up 9.3, and money of zero maturity is up 10.5%.
But let’s get back to market action. So far, the correction we have seen in gold is about the same length in time , but somewhat smaller in percentage decline than the two previous corrections that occurred during gold’s 12 year run. The rate of change and Coppick oscillator are below the levels of the previous two corrections as well. RSI (see top panel) also at about the same level. Despite how bad this feels right now, long term gold holders have ridden through two worse periods.
Readers probably know we have a weakness for the psychological indicators, since over the short term, we think markets are very much emotional mechanisms. Longer term, markets align with fundamentals, but not in the short term.
Major bear markets begin from a point of euphoria. Markets bottom out on intense pessimism. Where are we now regarding the psychological readings?
Probably the best source of these readings is the fine work done by Jason Goepfert at Sentimentrader. He shows public opinion on gold now at the crash levels of 2008, a very extreme bearish reading. It is unlikely that a new primary bear market for gold can develop from such bearish readings. Such readings are associated with major bottoms, not tops; which strongly supports our notion that this is a correction in an ongoing bull market for gold.
The same conclusion can be derived from a survey of newsletter writers done by Hulbert. Newsletter writers are now intensely bearish on gold. Again, this is more indicative of a bottom forming.
Speculative long positions in gold have come down very sharply, indicating there is not a high degree of speculative activity in the futures market. At a major top, you would see the opposite.
Cycle work, such as that done by McClellan( of McClellan Summation fame) suggest the 13 ½ cycle bottom will be due in May, which implies a few more months of pain before a turn upward, but cycle bottoms by definition, don’t occur at tops.
No area of the precious metals complex has been pounded as hard as the mining shares. Below we see PE estimates. At a current PE near 13, the shares are cheap and somewhat lower than the general market. Looking ahead based on estimates, they are in the 8 to 9 range. The median PE is about 28 times earnings. Major tops are formed from over valuation. We have been below the median for almost three years, hardly a case of rampant speculation.
Above are the sentiment indices for various stock market sectors as tabulated by Sentimentrader. Note most readings range from normal to bullish, except for one sector: gold mining shares, which show intense pessimism. Again, this is not the kind of reading one would get at a top.
If one were to measure the relative value of shares to bullion, we find that as shares fall relative to bullion (shares are the denominator) so the ratio rises. Another way to say this, is bullion has behaved better than the shares. But the readings are now at their highest in 20 years, a very extreme reading, suggesting the shares are way over done on the downside.
We could go on for a bit longer, but you get our drift. We do not think this is the beginning of a primary bear market for gold. Rather we think gold, and particularly mining shares, are very over sold.
Right now, we don’t know if the low will be $1580 or $1525. We think it will be in this range.
Long term holders of gold and shares should not sell at this point unless necessary to sleep. Speculative positions can be taken if gold starts to show some decent price reversals.
Neil and Norm
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