A Counter Trend Thought on Gold

The gold market has had quite a climb since bottoming in December of ’08, rallying nearly 50%. I think a solid case can be made that this market is due for a correction. Furthermore, given the variables in play, the first leg of the correction could come hard and fast. As many of you know, I tend to place the general direction of my trades in line with commercial traders. Over the course of time, this has been a proven strategy. However, there are times when it would be foolish to blindly follow a given position when so much evidence is clearly stacked against it. This is a case when a choice should be made- AT MINIMUM – to take either one of the following actions. First, avoid buying the pullback. New long positions should be avoided. Second, crank up protective stops on existing long positions. Investors who have been long the gold market have done well. Whether in the physical gold market or the futures market, those profits should be protected. For those in the physical market, now would be a great time to use commodity futures to lock in profits without having to off load your physical holdings.

The most obvious caution flag we can see is that gold is testing its weekly trend, now coming in around $1170. From a purely technical standpoint, that should be enough to get your attention and cause protective measures to be taken for long positions.

The daily chart shows that gold was unable to make new highs during the “Flash Crash,” and that the recent highs at $1203 are providing the top side of a consolidation level that, when broken will take out the existing trend. The consolidation pattern over the last six trading sessions suggests a fall to $1148 is imminent. Activation of this short term pattern would be a clear violation of the previously mentioned weekly trend.

A deeper look shows divergent technical and inter-market analysis that suggests the gold market is top heavy here. The final chart shows a large build in commercial positions through  June and so far into July. Typically, this would be enough buying to push the market above the highs at $1220 and make a strong argument for new highs above $1270. The fact that the market’s reaction has been oblivious to this is a clear warning sign of impending weakness. The lack of a positive response to the commercial buying via the commitment of traders report is clearly visible in the blue line of the last chart as each successive rally attempt has shown less fervor than the last.

Finally, a brief survey of macro- economic analysis shows that the interest rate markets have no pending fears of inflation. The stock market shows the July lows may have been a short trap and market crash fake out. And lastly, the Dollar’s pull back is to be expected after the run up its had and we are already seeing new buying come in to slow its descent.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Market Flux

Analyzing the markets requires a combination of quantitative and correlational research. It’s easy to track jobless numbers, productivity, crop acreage or crude oil stocks.  These numbers help define the fundamental supply and demand of the price equation. Trading, actual trading, is different from quantitative analysis because we are looking for actionable clues to imminent price movement and what will trigger it. These are the support and resistance numbers, spread ratios like gold to oil or, corn to beans. These are the chart patterns like head and shoulders, bull and bear flags and reversals that people watch for confirmation of the impact of their quantitative analysis.

Correlational research is an integral part of both fundamental and technical analysis. How many times have you heard the phrase, “Flight to quality?” This phrase is based on money being pulled out of risky assets and placed in safer asset classes like bonds, money markets or, the safe haven of gold. Investors are willing to settle for the bird in the hand rather than chase after the two in the bush. We also see this behavior in the inflation markets. How many times have you heard gold touted as an inflation hedge? Investors concerned with rising interest rates, a falling dollar or financial panic frequently place a percentage of their portfolio in gold because theoretically, its price should rise with inflation and panic.

Currently, there are several market relationships that are bucking their theoretical correlations. Positive and negative correlations provide clues into market behavior and when these relationships get out of whack, we should take notice. We can tie the examples mentioned above to two distinct market relationships. The flight to quality is typically measured as money coming out of the stock market and flowing into the bond market. This is visible on charts as a falling stock market and a rising bond prices. However, my application of flight to quality is based on the relationship between the stock market and the volatility index (VIX). The VIX measures market fear. The more fear there is in the stock market, the more anxious traders should be to pull money out of it. The typical relationship is for the VIX to rise as the stock market falls. Tracking the relationship in this manner means that I don’t have to search out the final destination for funds coming out of the stock market.  It is clear from the chart below that there was far less fear in the stock market when we made the new lows in July than there was when we made the lows of the, “Flash Crash” in early May or the lows at the end of May when the VIX peaked at 48. The correlational assessment of this relationship suggests that there was far less fear in the market when we made the July lows and therefore, the stock market outlook may not be totally bearish.

 

The second chart illustrates the inflation relationship between U.S. Government bonds and the price of gold. Typically, this is an inverse relationship. We see treasury prices fall as gold rallies. This represents investors’ view of future inflation. Gold is purchased as a hedge during inflationary times and sold off in times of economic stability or falling interest rates. Clearly, we are not witnessing the typical relationship between these markets. The bond market is pointing towards lower and lower rates while the gold market has also enjoyed a considerable rally. An important point in the gold chart comes at the start of the downtrend. The stock market made its most recent low on July 6th. This is two days after the gold market began to sell off. In a panic situation, such as the stock market taking out the May lows, one would expect to see the gold market rally. This is especially true in a market that has enjoyed the strength of its current trend and was sitting so near its highs. The stock market’s sell off should have provided the catalyst to move gold ever higher. This is an important divergence. When markets behave abnormally, we must sit up and take notice.

Unfortunately, I have little to offer as an answer to this riddle. Over the last few months, I’ve seen other relationships breakdown as well. The U.S. Dollar typically moves opposite the oil market. However, oil has remained stagnant, in spite of oil’s seasonal strength and a weak Dollar since early June. Finally, the Commercial Traders that I track through the weekly Commitment of Traders Report have shown large and contradictory moves. Commercial momentum in the gold and stock markets continue to build. These two inversely related markets are continuing to see inflows of capital from far smarter men than myself.  Just to complicate matters further, I have also seen a significant build in momentum going out on the term rate structure. This means that big money is flowing from nearby treasuries and into longer dated treasuries. These moves, charts and relationships should provide for an interesting third quarter. Hold on tight and feel free to share your thoughts.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.