The experts are confounded.
The stock market is at all time highs. The commodity sector has
been battered -- down roughly 20% from its May, 2006 highs. Crude
oil has plummeted from its dizzying highs made late last year.
Everyone is talking about the Goldilocks economy. Yet, through
all of it, gold is in an upswing of its own. In 2006, while the
mainstream financial media focused its attention on the rising
stock market, gold quietly outperformed stocks by a significant
margin. Similarly, thus far in 2007, gold has risen twice as
fast as the Dow Jones Industrial Average, yet somehow it goes
relatively unnoticed. Just 45 days ago, I forecasted
$715 per ounce as a minimum target for 2007. At the time,
gold was trading in $625 range. When gold hit $670 last week,
we were exactly halfway there and the year is barely a month
and half old. Gold's strength has caught many by surprise and
sent analysts scurrying for an explanation. Others say that gold's
strength signals a sea change in the way investors globally view
their currencies and economies.
What is going on with gold?
What is it telling us?
Major shift in gold dynamics
More than anything, gold is
telling us that something has been altered in the collective
global psyche about the value of money. Gold has always been
viewed as a safe haven when national currencies go bad. Now with
national governments across the globe in a race to see who can
devalue their currencies the fastest, private gold ownership
for asset preservation purposes is growing in leaps and bounds.
The Japanese investor has just as much reason to own gold coins
and bullion as the American; the American as much reason as the
European. And so on. In China and India where gold is a cultural
icon, the amount demanded has risen proportionately to the income
gains of ordinary citizens. This cross cultural, global interest
in physical metal has put a solid floor under the price. In addition,
over the past year, we increasingly hear of large private institutions
taking an interest in gold -- pension funds, big international
banks and major investment houses (on behalf of their upper end
clientele). In addition, we have begun to see rapid growth in
physically-owned gold held by international gold banks, various
types of funds and ETFs. Gold, as a result, is rising in all
currencies across the boards.
On the public ownership side
of the gold ledger, central banks have altered long-held policies
to lease and sell gold and have adopted instead policies to hold
onto their metal reserves, and in some cases acquire more. In
2006, the participants in the Central Bank Gold Agreement failed
-- and failed in a major way -- to meet the 500 tonne sales quota
they assigned themselves a year earlier. Germany, which has been
pressured for years to sell its gold both internally and externally,
refused to sell. Switzerland had previously bowed-out as a seller.
Russia announced itself as a buyer, as did South Africa, and
more obliquely China. In short, official sector sales in the
future are likely to be met by official sector purchases. This
is another major shift in the gold dynamic.
The fact that both private
and public views on gold have shifted is one thing. That they
have shifted and grown significantly on the fundamental precept
of long-term asset preservation has sent a powerful message
to market participants: Fundamental physical demand in the current
economic environment is unlikely to dry up any time soon. What's
more, gold selling from these sources would be an unlikely event
until the conditions which caused the diversification in the
first place were set right. As far as the mining companies are
concerned, there has been strong incentive to square forward
sales, and this in turn has created a new source of demand
few had contemplated -- from the very mining companies that traditionally
serve as source of supply. On top of that, gold experts,
including a few who run major gold mining companies, are forecasting
a gradual, on-going decline in production that probably won't
reverse itself for a decade or more.
Enter the hedge funds
None of this has been lost
on speculators in the paper markets -- the hedge and commodity
funds, as well as high net worth investors. Seeing all this as
a fundamental shift in long term sentiment and the very nature
of the gold market, they have begun to take positions on the
long side in the options, commodity and forward markets. In particular,
it is perhaps the participation of the widely-publicized hedge
funds with their need to find winning trades that has done more
to alter the long term balance in the gold market than any other
factor. Long-time gold watchers often warn that the "commercials,"
mostly represented by professional institutional/industrial traders,
are almost always right about the direction of the market and
that it is foolhardy to bet against them.
Presently the commercials are
short as a group according to the weekly Commitment of Traders.
The funds are long. Fund long positions on the Comex and CBOT
are currently at nine month highs and represent roughly 40% of
net open interest. This is not, however, the first time the funds
have been in the gold market. Last May, when gold hit the $725
mark, the funds were at 60% of net open interest. My point is
not so much that we have a ways to go in terms of speculative
interest in gold (though that certainly is indicated). It is
that there is now institutional fire power on the long
side of the market every bit as formidable as that on the short
side (which up until recently dominated action in the paper
markets). At no time was this change in market dynamic more forceful,
than today (2/21/07) when gold rose nearly $25 in a move that
stunned the markets and counfounded the pundits.
Certainly the hedge funds will
come and go throwing a great deal of volatility
into the mix, and that is why short term trading and leverage
can be dangerous for the average investor. Overall though I rate
their presence as a net positive. The question becomes "Have
the commercials met their match in the hedge funds? Has the commercials'
stranglehold on the gold market come to an end?" The jury
is still out, but there is plenty of intriguing evidence suggesting
that the old gold market dynamic may be giving way to
the new.
Let's take a look at the
charts
So, with the fundamentals described
above in mind, let's take a look at the charts and see what they
might be telling us at the moment. Some very interesting patterns
have shown up which merit discussion. Before proceeding though,
I should add a word of caution. Even though current chart patterns
introduce some interesting possibilities for gold in the future,
they are by no means foolproof. There is considerable room for
misinterpretation and error
Reverse head and shoulders
pattern signals potential upside break
The first chart shows a distinct
reversed head and shoulders pattern -- a formation which generally
signals the onset of a major move to the upside. In recent weeks,
many gold analysts have marveled at the strength of gold since
last January despite a massive short position established by
the commercials. I suspect the strength in part could have been
inspired by the reverse head and shoulders pattern shown in the
graph immediately below. We have begun to see sufficient buying
on breaks to the downside to add some character to the market.
This underlying strength has been noted with interest by various
commentators over the past several weeks.
Quoting old reliable for me
with repect to the basics of technical analysis, "How to
Forecast Prices with Futures Charts" by Commodity Traders'
Consumer Report (1989):
[The reverse head and shoulders
pattern] is one of the best known and most reliable reversal
patterns. It consists of two shoulders and a head to form a top
formation at the end of an extended advance or a bottom formation
terminating a decline. A head-and-shoulders bottom is just the
inverse of a top formation. In a textbook-perfect formation,
both shoulders are about the same height. Volume is heavy on
the left shoulder but lighter during the head and right shoulder.
On a head-and-shoulders bottom,
the neckline is drawn across the rally tops of both shoulders
and ahead as shown on the gold chart above. The formation is
completed when prices penetrate the head-and-shoulders neckline.
In addition to signaling a trend reversal, head-and-shoulders
formations also make price projections. Measure the vertical
distance from the top of the head to the neckline. Project this
same distance from the point where the neckline was broken for
the price target."
The gold chart above is projecting
an interim top in the $750/$760 range.
Elliott wave pattern confirms
potential upside break
The second chart offers further
confirmation of the trend predicted in the one above. Ever since
Robert Prechter first resurrected Elliott Wave Theory in the
1970s, I have taken an interest in it, though I've never gone
public with my own version of the gold wave count. Once again,
I have to caution you that this is opinion, not science. All
depends on where one puts the first number on the chart. All
else follows from there and an incorrect placement makes all
subsequent placements meaningless.
My count has the first leg
of the current supercycle ending in May, 2006. Thus the wave
5 peak of the first primary wave (5 of I) shown here at the May,
2005 high of $725. We are now in the second up wave, or wave
III of the primary [and current] supercycle. This wave is usually
described as a strong, long term pull to the upside -- the wave
that sets the stage for the final Wave V spike. This wave, according
to Elliott Wave standard analysis, could last for years.
A study of the weekly gold
chart (not shown) from the bull market's inception shows a clear
Elliott Wave pattern beginning in 1999 with the first, brief
bump upward (wave 1); then the correction that ended in 2001
(wave 2); followed by the long pull higher through 2004 (wave
3); its brief correction in early 2005 (wave 4); and, then the
sharp spike which topped in May, 2006 (Wave 5 of I noted in the
chart below). As Elliot predicted, the peak was followed by a
sharp downward correction (wave a), a sharp upward correction
(wave b) and then a longer correction which bottomed in October,
2005 (wave c). Then the second up leg in the Elliott sequence
(Wave III) began with the rally back to $650 (the new wave 1
of III), followed by another short term correction (new wave
2 of III) and now the market appears to have embarked on another
possible longer term up trend (new wave 3 of III in progress).
By the way, Alf Field, who specializes in Elliott Wave
analysis and publishes at GoldSeek, has nearly the same count.
It could take years for the current wave III to take its course
in which case the $750 predicted by the inverse head and shoulders
could become just a stop along the way. Once again, the point
I am attempting to make is that institutional traders and hedge
funds may be looking at the charts and at the same, or similar,
patterns and drawing bullish conclusions.
What does this analysis
mean for the long term asset preservation investor?
To sum it up, gold appears
poised for the next leg up in the bull market. Gold's bull market
has not occurred in a vacuum, but is driven by very strong fundamentals
not likely to be altered any time soon. The charts, as shown
above, have begun to reflect fundamental interest by major players
on the long side of the market which points to both long term
volatility and the possibility of a strong market for gold that
could stretch to many years. Recognition of this change in sentiment
is what I believe is going on in the gold market. Why things
are simply different now than they were in the early 2000s.
There is always the question
as to when one should pull the trigger, so to speak, and make
the next purchase. Since our clientele's interest is principally
in asset preservation (as opposed to paper speculation), the
basic goal is to buy as cheaply as possible. With this analysis
in mind, if you do not own gold, there is little incentive to
wait. If you do own it, the question becomes "Do you own
enough?" I continue to recommend a 10% to 30% diversification
in gold coins and bullion depending on your own view of the economy
and the dollar. Those with a casual concern should consider something
near the 10% figure. Those with stronger inclinations might consider
moving to the 30% figure while gold still looks the bargain.
There is always the chance that gold could go into a tailspin,
but waiting for that, in my view, involves more risk for the
long term asset preservation investor than buying at current
prices. Alf Field, the Elliott Wave analyst previously mentioned,
projects a Wave 5 peak to this cycle in the $1600 range.
Caveat: The above should not
be contrued as investment or trading advice. For trading advice,
please seek the assistance of a qualified professional. Anyone
trading on this analysis, which is meant only to identify possible
longer term trends in the gold market, does so at their own risk.
The author disclaims any personal liability, loss or risk incurred
as a consequence of the use and application, either directly
or indirectly, of any advice or information presented above.
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