Gold is not a Religion

Based on copious amounts of anecdotal evidence, gold investors tend to be highly sensitive to criticism. The gold bugs would have you believe -- and proclaim zealously -- that the precious metal must be held in all portfolios to protect against everything wrong in the world... and how dare you say otherwise! There is too much money printing and currency debasement, with massive inflation on the horizon and geopolitical risk on the rise.

Of course, there may be some truth to that, which is why we hold a small gold position in our portfolios. But we prefer to view gold as any other asset, and we have done very well managing the position.

Below is a chart of gold from 9/30/2009 to present. At four different times over the last two years, we changed our position weight in gold. In early 2010, we increased our gold position to 5% in all portfolios. Gold then had a massive rally for the entire year and we decided to take our position down to 3%. Very quickly -- in one month -- gold worked off excessive optimism, become oversold on momentum indicators and came back to the longer trend. At that point, we felt it was time to add back to our position by increasing it to 4%. Gold proceeded to have an even bigger rally from $1330 to $1800, as optimism surged. We felt this was too far, too fast and the price looked stretched, so we once again reduced our position to 3%.

Treating gold as a tradable asset has served us very well, and we will continue to manage the position in this way. At some point, we may not even own any gold. Blasphemy!

What Goes Up…

Gold has been powering ahead and we watched in awe as our hedge worked fantastically over the last month. Stocks fell 17% but gold rose 21%, and this parabolic-esque move seemed too enticing to ignore. The price of gold stretched to 20% above its 200-day moving average which historically is a very overbought level. So we decided to act, reducing our gold target for the five models we run from 4% to 3%. The price of gold at the time of our sale was around $1775 per ounce (marked by the green line in the chart below). The next 7 trading days were hard to watch.

The rise continued, and I’m sure Ken was grinding his teeth since he was reluctant to sell. Our 3% position moved to $1917/ounce, an 8% move, during the trading day on August 22nd. The term gets used a lot today but gold was possibly entering bubble territory. That was 3 days and $158 dollars/ounce ago as gold fell to $1760. That is a two day, 9% move lower. What goes up, must come down, and many times it will plummet.

This parabolic rise and quick fall is eerily similar to the movement of silver in April and May. Silver lost 25% of its value falling from $40/ounce to $30/ounce in a few weeks. If gold follows that pattern the price could fall to $1450/ounce. That is not our base case but we did feel the rapid rise needed to be addressed.  Now that it's falling, we may be looking for an opportunity to increase our position again. You have to love tactical management!

Watching Gold Closely

Lately we’ve been watching the price of gold closely. What’s on our mind is that despite extreme havoc in the Middle East, a nuclear disaster in Japan, and a nasty plunge in dollar, the shiny metal has not been able to break convincingly to new highs. Late last week some analysts were noting a key reversal in gold on Thursday when it started up on the day and broke to new highs, but then reversed suddenly intraday and ended the session in the red. That day we did note that there was an increase in margin requirements on silver, which clouded the picture of whether it was showing a very bearish pattern, or just reacting to a short term event.

At the moment we hold 4% gold in our portfolios as a hedge for many things: inflation, banking system risk, geopolitical tensions, terrorism, money printing, potential flight from the dollar, etc. We still believe there are structural risks in the world, and therefore it makes sense not to abandon the asset class completely at this juncture. But we are contemplating bringing down exposure on a tactical basis if it breaks down much further. Why is gold dropping? It could be that the dollar is ready to bounce, it could be that real interest rates are set to rise, or maybe it’s a simple as Warren Buffet saying he doesn’t like it. Any way you slice it, it’s a volatile asset, and we must assess how much of the glittery metal we want to own at any point in time. We’ll be mulling this over and watching the price action closely.

Correlation Breakdown

Over time, the price of gold typically has a fairly strong inverse correlation with the value of the U.S. dollar, meaning that they tend to move in opposite directions. But lately the dollar and gold have been moving higher in lockstep as the long-term inverse correlation has broken down (see chart below). There are a number of plausible reasons for the breakdown in the normal relationship between these two asset classes.

Start with gold. We are currently engulfed in the middle of a perfect storm of uncertainty: fears of eventual currency debasement in developed economies, worries about the long term viability of the Euro-zone, geopolitical tensions in Korea and Thailand, new signs of stress in the banking system, and even the recently attempted terrorist attack in New York City. That is one hearty list of unstable conditions, which has been supporting the gold trade recently.

As for the dollar, the trade-weighted dollar index, which is based on our largest trading partners, is made up of approximately 58% Euro. So, movements in that index are largely driven by movements in the Euro/dollar relationship. As the Euro has plummeted in recent weeks, this has been a huge driver of dollar gains. Other fundamentals such as purchasing power parity, real interest differentials, and future growth rates are no doubt operating beneath the surface. But quite simply, recently it seems like the Euro’s pain has been the dollars gain.

The traditional inverse correlation between dollar and gold appears to have recently decoupled. However, if the history of gold and the dollar remains a decent guide, then the longer-term relationship is likely to reassert itself at some point, implying that one of these asset classes is going to be wrong. The key will be in figuring out which one that is.

What’s So “Golden” About the Current Market Environment?

Gold recently traded to a new closing high, at $1,238 an ounce. In the process, it took out prior technical resistance, and was accompanied by decent trading volume. That prompted a discussion here about the yellow metal this past Wednesday. We’ve held gold in our portfolios for some time as both insurance for a wide array of negative scenarios (hyper inflation, systemic crises, terrorism, currency debasement, etc), as well as the potential for a mania to develop in this asset class over time. Gold hasn’t always worked for us against our benchmark, due to its low correlation to equities, which can make relative performance versus equities very fickle at times (one of the things we like from a diversification and hedging point of view, but hate when it costs us versus our benchmarks).

In our Wednesday meeting we took a few minutes to talk about what was driving gold’s impressive performance of late. In other words, is this a breakout or a fake-out that we are witnessing in the gold market, and what does it mean to us? Should we sell into the rally, pile into the momentum trade, or do nothing at all?

The chart below gives a glimpse into a number of the key issues we discussed at the meeting. At the end of the discussion we decided to leave our positions in place and take no action at this time. If you are a client in Pinnacle portfolios, while we ended up not making a change to our allocations, rest assured that it wasn’t because we weren’t watching or talking about the potentially golden opportunities that moving markets create for our clients.

Head and Shoulders in Gold

One of the most recognizable technical patterns is the head shoulders pattern. This is a pattern that is classified as a reversal pattern because its completion usually means a new trend has started. The pattern starts with a rise in price, followed by a sell-off period that retraces some of the gains. Then there’s a second rally that takes the price to a higher peak, and another sell-off period that falls to roughly the same level as the previous sell-off. Finally, there’s a third, weaker rally that forms a lower peak, and a sell-off that breaks below the low price of the previous two selling periods.

The chart below is a price chart of the June 2010 future contract for gold from 2/1/10 to 3/22/10. The first rise in price, or the left shoulder, peaks at $1,123/oz, as indicated by the first red arrow. The second rise in price, or the head, peaks at $1,144, as indicated by the green arrow. The last rise in price, or the right shoulder, peaks at $1,128, as indicated by the second red arrow. The white line is called the neckline, and if prices break below this line a sell signal is generated.

Furthermore, downside targets can be projected by taking the difference between the head peak and the neckline, and subtracting that number from the neckline. Specifically with gold, the peak is $1,144 and the neckline is $1,100, which would project a decline to at least $1,050, but the closely-watched level of $1,000 could also be reached.

No Buyers Left For Gold

Sentiment is the attitude of the investing community towards the anticipated price action of a particular security. For instance, if the investing community thinks that the price of the S&P 500 will go higher, sentiment is said to be bullish. There are various ways to monitor the sentiment of the market and these tools become very important, when used in conjunction with other market indicators, to determine important trend changes. Due to herd mentality (Psychology 101 will have to wait for another time), at important market peaks the overwhelming majority of investors have the same exact thought – that prices will go higher. It is at these moments that prices are most vulnerable because there are no buyers left. I think gold might have reached such a condition in December.

We have been noticing in the pit for awhile now the increasing amount of commercials about buying gold. No doubt you have seen at least 5 companies broadcast to the world that they want to buy your gold. We even saw an actor from the movie Good Will Hunting in one of the commercials. Gold’s surge in price has certainly attracted interest and there is a huge amount conviction among investors that this price appreciation will continue. Jack Crooks from Black Swan Capital provided us with some anecdotal evidence that the majority of the attendees believed this to be true during a recent currency conference. In this light, it is understandable that gold moved lower over the last two months.

At Pinnacle, we've invested in gold for a variety of reasons including but not limited to hedging sovereign risk, hedging currency concerns, and future inflation concerns. We also believe gold will be an outright performer during this cycle, and therefore deserves more than the hedge label. So even though we cringe a little at the sight of gold commercials we continue to view the recent decline as a price correction in a long-term bull trend. However, we will be closely monitoring important support levels to ensure we are not trampled by the herd as well.

Go-Go-Go-Go-Go-Go GOLD!!

The world is going wild as gold continues to grind higher, and many believe this is just the beginning of a strong bull market. Gold has constantly been in the news and rightfully so. The Chinese have for a very long time expressed concern about the dollar as the world’s reserve currency, and now the United Nations has joined the parade. It has been acknowledged that the Chinese are even looking to invest in gold on dips to diversify their reserves. The developed world has started to fiscally destruct and the aftermath of the implosion of the western banking system is still being felt. Gold has so many benefits that make it appealing during these uncertain times. It offers protection from risk aversion and currency devaluation, defense against inflation and monetary experiments.

With this backdrop, over the last week gold has broken out to the bullish side of a technical trading pattern called a pennant (indicated by the white lines in the chart below). This suggests good things to come for the precious metal as the technicians are looking for a $60 gain on that breakout. Additionally, the widespread media coverage could lure investors to the metal and give another boost. But the bulls have to contend with a strong ceiling as gold is failing to hold $1000 per ounce for the second time this year (the horizontal red line). This seems to be an important psychological barrier to overcome so it will be interesting to see if the buyers or sellers win this short term battle.

While interesting, the short term move has little impact on our long term strategy. We feel confident in our decision to maintain a 5% hedge in gold. Longer-term, global fundamentals remain uncertain and gold provides security for many possible outcomes. After all, gold is gold.