So Far a Normal Correction
In last week’s update on the gold sector, we mentioned that there was a lot of negative sentiment detectable on an anecdotal basis. From a positioning perspective only the commitments of traders still appeared a bit stretched though, while from a technical perspective we felt that a pullback to the 200-day moving average in both gold and gold stocks shouldn’t be regarded as anything but a normal – and in this case actually long overdue – event.
Gold has pulled back to its now rising 200 dma (the fact that it is rising differentiates this pullback from declines during the pre-2016 bear market period) – click to enlarge.
Between May and August, gold stocks became quite “overbought”. They had clearly risen too far too fast and a correction shouldn’t have been a surprise. The pullback was quite sharp, adequately mirroring the relentlessness of the preceding rally. This is nothing unusual in this sector:
Gold stocks are revisiting the 200 day ma as well and they are their usual volatile self – click to enlarge.
A Growing Chorus of Bears
Nevertheless, the number of prominent bears has increased noticeably last week, on practically no price movement. Here are a few examples; at Kitco we read: “ABN AMRO Downgrades Gold Outlook As Prices Remain Below 200-DMA”
Really? We heard a similar argument in the previous week, and as we noted, one practically needs a microscope to see by how much gold has undercut its 200-dma. It seems simply not worth mentioning. What is worth mentioning is this though (from Kitco’s article):
“The latest bank to join the chorus of bear calls is ABN AMRO, with analysts at the bank saying that the 2016 bull market is over as gold has dropped below its 200-day moving average…”
When there is a “chorus” of mainstream banks calling for a gold bull market to be over based on such flimsy arguments, it is almost certain that it isn’t over. Just remember, most mainstream observers only turned bullish on the last gold bull market after it was already a decade old.
More importantly, they were extremely reluctant to call for its end after it peaked in 2011. So the speed with which they are reacting to the recent dip this time should be music to the ears of gold bulls.
ABN Amro did mention the commitments of traders as well, which admittedly still was a legitimate concern last week. But they should perhaps have considered the matter more deeply (see our remarks on trading volume after the CoT report cut-off date).
Yet another bank called for the bull market’s end last week: “Gold’s Bull Market Over; Prices To Fall In Next Two Years – Natixis”. Natixis offers three main arguments for this call, only one of which makes sense, at least “technically”, if you will:
“For 2017 and 2018, we think that the biggest factor influencing the price of gold is the expected path of U.S. interest rate hikes,” the analysts said. “Also, we do not expect further rate cuts by the [European Central Bank] or [Bank of Japan] as this is likely to damage their banking system especially in the case of Europe.”
Natixis economists are expecting to see the Federal Reserve raise interest rates by 25 basis points three times next year: June, September and December.
Not only will higher bond yields raise gold’s opportunity costs but they will also boost the U.S. dollar, providing another headwind for the precious metals, the analysts explained.”
We are inclined to agree that the ECB and the BoJ are not likely to ease further in the near term, but their actions are of little importance compared to those of the Fed. It is true that if the Fed were to hike rates several times, it would likely represent a headwind for gold, but only if these rate hikes actually exceed the market’s “inflation expectations”.
As this chart shows, context is very important. In the 1970s, Fed rate hikes lagged behind inflation expectations and gold prices actually surged in parallel with the FF rate most of the time – click to enlarge.
The question is of course whether the Fed will really continue to hike rates beyond what at the moment looks like a very likely hike in December. We have grave doubts about that for a variety of reasons, and we think the Natixis analysts are simply guessing. Neither they, nor the Fed itself have even the foggiest idea what the Fed will do next year.
It is not even certain that additional rate hikes will be negative for gold if inflation expectations decline or remain unchanged, as rate hikes could lead to a plunge in risk asset prices. This would be a positive factor for gold, as the gold market tends to anticipate the reaction of central banks to falling asset prices with a very long lead time.
The other two arguments forwarded by Natixis make no sense to us:
“Although demand for gold from physically backed ETPs has provided a substantial boost to gold prices, we expect the trend to reverse and for investors to become a source of supply of the metal,” they said. “At current levels, the total amount held in physically backed ETPs is equivalent to roughly 60% of 2015’s mined output and 47% of that year’s total production. As we saw in 2013 when 850 tonnes of gold exited physically backed ETPs, the effect on gold prices can be very negative.”
Unlike the past three-year bear market, Natixis is not expecting to see strong physical demand from India or China to help support prices. They added that the Indian government’s gold tariffs are expected to continue to curtail domestic demand.
“Should tariffs be reduced, we could expect a stronger return in demand for Indian gold, but we believe that the current government will keep the tariffs unchanged as it pushes for its gold scheme to gain further momentum,” they said.”
We think this is simply erroneous. The holdings of gold ETFs change in reaction to moves in the gold price, they are not causing moves in the gold price. First of all, ETF holdings represent only a tiny portion of the global gold supply (which amounts to approx. 180,000 tons).
Secondly, their holdings increase when ETFs like GLD trade at a premium to the gold price and decrease when they trade at a discount to the gold price, as these arbitrage opportunities are the only reason for “authorized participants” to either create new or dissolve existing baskets of GLD shares (and buy or sell the offsetting physical gold holdings). ETF holdings may be useful as a sentiment indicator, but that’s about it.
The arguments about demand from China and India are falling flat for exactly the same reason. These essentially concern price elastic jewelry demand. Gold prices are solely driven by investment demand though, and the by far largest part of investment demand is reservation demand. There simply is no way to “measure” reservation demand (see Robert Blumen’s excellent article “What Determines the Price of Gold” for a detailed explanation).
Lastly, Wells Fargo is also calling for gold to resume its downtrend and we believe the reasoning behind this call is flawed as well:
“Traditionally those long bear markets for commodities average about 20 years—and that is using data back to 1800—and we are only in year five.” Laforge sees gold heading back to its December lows since a commodity will “go back and test its lows off of the first move down multiple times.”
It is in principle not wrong to consult history – however, as we have pointed out previously, the current gold bull market is actually shadowing the 1970s bull market, only everything is taking precisely 2.1 times as long (see: “Eerie Pattern Repetition Revisited” for details).
Thus the bear market from 2011 to 2015 is more likely to turn out to be a cousin of the mid-cycle correction of 1974 to 1976 rather than the first leg of a 20 year long bear market. There is also the problem – roundly ignored by Wells Fargo’s analyst as well as the others quoted above – that the current time period with its utterly crazy monetary experiments is pretty much historically unique.
Historical samples since 1800 contain a plethora of monetary regimes, none of which are comparable to what we are currently experiencing.
Naturally, the bears could still turn out to be correct for the wrong reasons. It is also to be expected that gold won’t have it easy until the December rate hike is actually out of the way. We expect it to remain stuck in a sideways move until then, and a deeper correction cannot be ruled out either.
However, concerns over positioning in the futures markets have diminished considerably with the release of last week’s CoT report:
The total net speculative long position in gold futures has declined by another 50,000 contracts as of the last reporting week, to around 220,000 contracts net. This is down more than 120,000 contracts from the peak reading of early July – click to enlarge.
Admittedly, a 220,000 contract net speculative position is still large, and more selling may be required to create the foundation for a renewed advance. We cannot be certain of that though; it is possible that an upward shift in futures positioning has occurred and that what used to be a sufficiently small position in the past is now situated at a higher level.
Until the market has gone through several rally and correction cycles we can only guess. It is worth noting though that the net position of the “managed money” category in the disaggregated CoT report has declined by about 40% from its peak:
The managed money net long position in gold futures is down about 40% from its peak level – click to enlarge.
Gold remains the asset Wall Street loves to hate. It is currently under pressure due to the recent increase in rate hike odds and there was definitely a need for stale long positions to be cleared out. When we see the mainstream gang up on gold so quickly though, we tend doubt that the bears will be correct.
Of course we have no crystal ball either, but we remain convinced that the monetary experiments of recent years will end quite badly. As far as we are concerned, the long term case for gold remains intact regardless of short term price gyrations.
Currently the fundamental drivers of gold are mixed, which makes a sideways move the most likely prospect, barring new developments. We would regard any additional short to medium term weakness in the gold price as an opportunity though – and although we obviously cannot rule it out, we are not at all convinced that a lot more weakness is actually in store.