Monday, June 25, 2012

Gold: A Major Change in My Thinking

I am not a market technician.  I don't base my investment decisions on the price history of an asset.  That is not to say that I do not pay attention to price, as the entry price is crucial in determining the return on an asset.  It's just that I tend not to find much predictive value in scrutinizing the price chart of an asset.

I do, however, pay attention when a price has repeatedly bounced off a low level, as potential price support is corroborated by an attractive valuation.  I also am a proponent of "reversion to the mean," the notion that when a price deviates from its mean level over time by a substantial amount--especially if by two standard deviations or more--it is likely over time to revert to its normal, or mean, level.

Rather than looking at price charts, I am much more comfortable when I can assess the value of an asset using cash flows that are generated relative to the asset's price.

But with some assets, such as commodities, that is not possible.  Granted, one can estimate supply and demand to get a sense of whether the price will likely rise or fall over time.

But gold is different.  I have considered it to be a form of money, not a commodity like petroleum or wheat.  One unique (and challenging) feature of gold is that unlike commodities, it is not consumed.  Most of the gold that has been mined over the centuries still exists.  So unlike a commodity like wheat that might be in surplus at the moment but which will be consumed over time, gold lacks that.

I think that the price action, or technicals, of commodities and of gold matter more than for assets like stocks.  And it is the price action of gold that has caused a major change in my thinking.

Since 2000, I've thought of gold as separate from commodities.  After all, it was a stronger form of money than the U.S. Dollar.  Yet for some time now, it has performed like other commodities, rising in price when market participants embrace risk and falling in price when they shun risk.

More troubling is that the rising trend line of support (connecting the higher lows) since the November, 2008 bottom in the gold price has been broken.  Since gold peaked at $1,925 an ounce last year, the price has been in a clear downtrend (evident by connecting the successively lower high prices).

At $1,566 an ounce today, gold is only about 3% above what appears to be a key level of technical support, approximately $1,520 an ounce.  If that level is broken, it would seem that gold could fall to about $1,300 an ounce, for a further 15% decline.  A decline to that level would still be within the bounds of the rising trend for the price of gold since 2000.

I am concerned about the possibility of being whipsawed by turning tactically negative on gold at current levels.  The gold market is small, and it doesn't take much to cause sharp price reversals.  And the next several months have historically been strong months for the price of gold.  Furthermore, real short-term interest rates remain negative in the U.S. and in many countries, which historically has been positive for the gold price.  With the price of gold now 19% below its record high, it seems late to turn negative.

Let's say instead that I've become cautious on an asset that has risen in price for eleven straight years.  Unlike my usual skepticism about technical analysis, I will wait for price confirmation that gold has broken above the declining trend that began last autumn.  I am willing to miss a near-term gain in order to have more confidence that the bull market that began for gold in 2000 has not ended.

Steve Lehman

Gold:  $1,566

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