Market Update: Gold - searching for a bottom

After a solid three weeks, and a strong bounce of the USD $1180oz level in early October, gold prices pulled back overnight, and are currently trading at USD $1232oz, down USD $13oz from their intra day high.

The weakness has also spilled over into silver, which is currently sitting at USD $17.16oz, down $0.20 on the day.

Weakness was driven predominantly by a series of upbeat Markit surveys out of Europe, the majority of which beat expectations. These surveys, which don’t measure actual output or anything tangible, merely represent the expectations of various companies who are asked to give their opinions on expected sales, profitability and the like going forward.

As such, they aren’t hard data – and aren’t in anyway evidence of a strengthening European economy, but financial markets were looking for an excuse to rally, and this was it, with European stock markets up well over 1%.

This positive lead carried across the Atlantic, with the Dow Jones, S&P500 and Nasdaq all also up well over 1% for the day, with the S&P500 within 50 points of reclaiming the 2000 point level.

The strength on Wall Street occurred despite more lukewarm economic data, which showed house prices rising 0.5% for the month of August, but a weakening Manufacturing PMI survey and a rise in initial jobless claims.

It will be interesting to see how the rally on global share markets flows through to Australia today, with the ASX likely to open up. In saying that, iron ore prices have crashed again overnight, the 12m-swap price now trading at $76.22, down 2% for the day.

As iron ore is our key export commodity, and a major driver of earnings for most of our largest resource companies, this could put some pressure on local stocks today, though on aggregate they’re likely to follow suit and head higher.

Where to now for Gold?

The price action in gold this past few weeks, and indeed this past year, has not been surprising. After starting 2014 as the most hated asset class on the planet, with near record levels of bearishness, a solid rally was almost baked in the cake.

Since then, an incredible rally in the US Dollar, a broad commodity sell off, slowing global growth and the spectre of deflation have all come back to the fore, leading to yet another re-test of USD $1180oz for gold, which gave up all its hard fought gains from the first six months.This of course came to pass, with gold the strongest performing asset in the first six months of the year.

Following the re-test of USD $1180oz, the move back toward USD $1250oz was to be expected, which is why we’ve not gotten too excited about the rally over the last three weeks.

Indeed, the strength in the gold price since early October was only able to push gold just back above the USD $1250oz level, in line with the 50 day moving average, and it’s now reversed some of those gains.

They key question remains whether or not USD $1180oz really does represent a triple bottom, or whether or not this latest rally is a head-fake, and we’re headed back to that level or even lower.

Let’s look at the arguments for and against this proposition

Why it is not a triple bottom

Firstly, triple bottoms are incredibly rare. More often than not, markets tend to take a breather from their decline at important levels, bounce back in a minor rally, then head lower.

Secondly, the strength in equity markets over the last week or so, and the likelihood that the Fed will delay rate hikes will only encourage stock market bulls, reducing their appetite to buy alternative assets like gold.

Thirdly, though it perhaps seem counterintuitive in light of the above point, with oil prices plunging and growth slowing, the threat of a global risk off event can’t be dismissed outright. Whilst this would hurt stocks too, in the short term it might also lead to some weakness in the gold price too, much like what we saw in 2008.

Finally, many investment banks and analysts are all still expecting to see gold head below USD $1180oz and potentially as low as USD $1000oz. Whilst this could be looked at as a good sign from a contrarian perspective, it’s hard to see much support for the gold market at this point.

Add all this up and the chance for lower prices can’t be ignored

Why it is a triple bottom

The first argument in favour of it being a triple bottom is that so far, that’s exactly what it looks like, as charts from a couple of weeks ago highlighted.

Every day that we stay above USD $1200oz is a day that this theory gets more credence, and anyone short gold will be paying attention.

Triple bottoms, whilst rare, do give off a very strong technical message that the next move in a market is up, and up strongly. As such, the longer it holds, the more emboldened gold bulls will become, and the more nervous those short the market will become.

There are other arguments supporting the notion that gold has bottomed, and that USD $1200oz will hold.

Firstly, sentiment levels are almost back to record lows, as this article discussing the Hulbert Gold Newseltter Sentiment Index covers. The article is a month old now, but was written as gold was approaching the USD $1200oz level, so its an appropriate gauge of sentiment today.

ETF holdings are also worth looking at. Globally, gold ETF holdings are now back at the levels they were in 2008, when gold was around USD $800oz. This means that anyone buying gold as a result of QE1, QE2 or QE3 from the Fed has sold their positions, leaving the market in stronger hands. This doesn’t mean there can’t be more outflows – but we think this market has more or less stabilised now, which is a positive sign.

Central bank demand was nearly 120 tonnes in Q2 this year (up 28% on Q1 2013), and should be similar again this quarter, whilst physical demand out of Asia is also robust.

Buying has also picked up noticeably each time we’ve threatened the USD $1200 level, so that’s another positive sign for the market going forward.

Finally, there’s the managed money crowd, who are probably gold agnostic in the long run, but like to go either long or short gold at various times, if they see the opportunity to profit from movements up or down in the gold price over the short term.

As the chart below, which also includes the gold price in USD, highlights, managed money shorts (green line), are already short about 80,000 contracts of gold.

What you can also see clearly from that chart, is that the three spikes in the green line (managed money short positions), coincide perfectly with the three times the gold price has tested the USD $1180oz to USD $1200oz range.

The bottom line from to this is that this section of the market is already aggressively positioned for gold price falls. For gold to fall even further, and head toward USD $1100oz as many are predicting, we’d have to see this number stretch even further than it already has.

In the face of a more dovish Fed, and potentially higher market volatility going forward, this, whilst not impossible, would seem unlikely, and also helps support the notion that we’re closer to a bottom.

The fact that nearly everyone thinks we’re going to break lower than USD $1180oz also has me confident from a contrarians perspective, as markets rarely, if ever go where the crowd expects.

Summary

The overnight pullback in gold prices was largely to be expected, especially after the decent bounce we’d seen off the USD $1180 level.

Going forward, expect higher volatility in the metals, and use this period as an opportunity to dollar cost average your holdings in gold and silver. Provided you’ve got the right time frame in mind for your investments (3 years plus), I remain convinced you’ll be well rewarded.

Until next week

Disclaimer
This publication is for education purposes only and should not be considered either general of personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, past performance is not necessarily indicative of future performance. Any prices, quotes or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness. This report was produced in conjunction with ABC Bullion NSW.

Jordan