The #1 Reason Why Gold Collapsed

I am an affiliate of INO, a website which is geared to individual investors. I haven’t posted much from their site here but I thought their latest video on gold was interesting so I’ll say a few words about it. (disclosure: as an affiliate I receive a fee for referring customers).

Last month I wrote the following about gold:

I have been concerned about the medium-term risk/reward on both sides of this trade. Gold was hitting new highs every day for two weeks as of yesterday. And the ten-year bond, while well off its 2010 low yield of 2.48, still has an unfavourable risk/reward now. James Montier says it best:

It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of  Cinderella’s ball  as described by Warren Buffett “The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!” Personally I prefer to stick to investment rather than speculation.

It’s not whether the asset price deflation case is ‘right.’ I think it is and have been saying a double dip is 50-60% odds as a result of the real economy effects of the resulting deleveraging. The question is whether the potential upside in bonds warrants an overweight investment given the potential downside. Last year at this time, the answer was yes. But, yields were 3.4% then. The same goes for gold. When I see gold vaulting up nine days in a row, I think ‘overbought.’  I still think gold is a good longer-term buy, however.

The question is why are people buying gold in the first place. The usual answers have to do with currency revulsion and inflation. David Rosenberg’s argument has been that we are in a disinflationary/deflationary environment right now, so those people loading up on gold because of inflation are way too early. He has a fair point, but of course that leaves currency revulsion i.e. loss of faith in fiat money.

With regard to inflation, I think the piece "On the Value of Gold" from EconomPic quoting Eddy Elfenbein of Crossing Wall Street is a good read. Here’s what Eddy says:

Whenever the dollar’s real short-term interest rate is below 2%, gold rallies. Whenever the real short-term rate is above 2%, the price of gold falls. Gold holds steady at the equilibrium rate of 2%. It’s my contention that this was what the Gibson Paradox was all about since the price of gold was tied to the general price level.

Now here’s the kicker: there’s a lot of volatility in this relationship. According to my backtest, for every one percentage point real rates differ from 2%, gold moves by eight times that amount per year. So if the real rates are at 1%, gold will move up at an 8% annualized rate. If real rates are at 0%, then gold will move up at a 16% rate (that’s been about the story for the past decade). Conversely, if the real rate jumps to 3%, then gold will drop at an 8% rate.

With real short-term rates well below 2%, you can see why gold has been bid up. But again, gold was way overbought. INO talks about this in their latest video. Adam Hewison writes:

Following the gold market as we do here at MarketClub, it was amazing that nobody, and I mean nobody, was bearish on this market. This always creates a problem as the markets tend to reverse when everyone is on one side and there’s no one else left to buy.

Another tip-off was on Fox Business News and also on CNBC indicating that gold was going to hit $1400 almost immediately. Well after Tuesday, we know what was to happen to the price of gold. If gold were so strong, should it really have gone down almost $70 in 4 days?

This is where technical analysis and Japanese candlestick charts really shine in my opinion. What happened in gold was a classic candlestick formation that any trader, whether they trade gold or other markets, should be aware of.

In this short video, I illustrate how this formation occurred and how it was confirmed the next day – and I don’t mean on Tuesday.

https://www.ino.com/info/645/CD3364/&dp=0&l=0&campaignid=3

I also have a free candlestick book that I’m making available along with this video, be sure to stay tuned at the end of the video or visit:

https://www.ino.com/info/646/CD3364/&dp=0&l=0&campaignid=21

As always there is no need for registration and the video is with our compliments.

All the best,
Adam Hewison
President of INO.com
Co-founder of MarketClub

Anyway, I think technical analysis has its limits but the video is pretty interesting as it captures the overbought condition well. Longer-term I still think gold (and other precious metals are a compelling play). Felix Zulauf tells King World News in this recent podcast why.