Gold's still looking good

published 1 December 2009

In my last two Money Mornings I have looked at the bigger picture for gold, so today I want to share a few thoughts on the shorter-term outlook.

Conditions are still ripe for gold to continue its advance upwards. But there is also scope for a sudden, sharp shakeout. Here's why.

Gold remains a great bet

As regular readers will know, I have a target price of somewhere around $1,400 by next spring. I have arrived at this target based on the repeating pattern that gold has displayed over the last decade. It tends to make a large, 50% plus move up, which lasts about six to nine months, and then consolidate for a year to eighteen months before setting off on the next move. The moves tend to start in the summer and peter out the following spring.

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We saw just such a move from August 2005, which ended in May 2006 at around $730 an ounce. Gold then traded sideways for almost a year and a half, whipsawing many out of the market; but in summer 2007 it set off again from about $650 finally peaking above $1000 in March 2008. We then had another violent year with gold retracing almost all of its move at one stage, going as low at $680 an ounce in the liquidity crisis of autumn 2008.

Take a look at this chart from Bloomberg:

Gold appears to be midway through just such an upward move now, from its summer low in early July at just above $900 an ounce.

During all of gold's up moves, however, it is worth remembering that it experienced a couple of violent 10% corrections en route. In the 2005-6 move it hit a wall in late November 2005 at $540 an ounce and quickly fell below $500. It had a similar problem in the 2007-8 move at $850 an ounce falling back to around $775.

So, based on this pattern, I would expect a similar shakeout before a higher high in the spring. We have not had one yet. It might be that the Dubai debt crisis is the catalyst.

But short-term volatility is up

Gold's volatility on Friday was something to behold. It fell some almost $50 over 4% - in barely three hours, before recovering and ending the day with barely any losses. There are two very different interpretations of that move. One is that gold was displaying real strength and there are a lot of buyers waiting for any pullbacks to get into this market. The other is that gold was just 'filling the gap'. Often if a market gaps up or down during trading outside of US hours, it will go back and fill the gap before making its next move.

If the fears stemming from these Dubai debt problems are real and we are on the cusp of another liquidity crisis, then I would expect gold to fall, at least at first. Despite the fact that gold is a safe haven during times of stress in the banking system, there is also a lot of hot and speculative money pushing gold higher. Think how many private investors are holding gold through some kind of spread bet, covered warrant or leveraged ETF. There are an equivalent amount of hedge funds and other momentum-playing institutions at large in the futures market.

It will not take a lot to shake these people out. They are a different kind of player altogether to your long-term investor. It is, in part, these speculators who have pushed the price up so high, so fast in recent months, and if the trade reverses and stops get hit, they could easily push the market back down as fast. It is worth being aware of this, as it's too easy to get delusional about gold and its 'safety' value. I am not saying it will happen. I am just saying it could. Nothing goes up in a straight line.

What is driving the gold price now?

But once the crisis subsides if indeed it happens at all I would once again expect gold to be once again the first asset class to emerge from the ashes and the one to thrive most in the aftermath. Perhaps we need to go back and retest the old high at $1033 and for gold to find support there. That would give a nice symmetry to the chart and give us our 10% mid-move shakeout.

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Another point to note is that this last surge in gold is to a certain extent unconfirmed by the gold stocks and by silver. Although it is up 65% year-on-year, silver, at $18.80, is still some 11% off its high of $21 in March 2008. The gold stocks are also a few points off their March 2008 highs (and they unperformed in that move), while gold is some 20% higher. Goldcorp, for example, is seen by many as the market leader, yet it has only marginally taken out its September high. This divergence creates ambivalence in me. On one hand, it suggests that gold's move is unconfirmed and thus urges caution. On the other hand, it makes me want to buy more gold stocks and silver as they have more potential upside, just playing catch-up.

Here is a chart showing the ratio of gold to gold stocks as measured by the HUI (the Amex gold bugs' index the higher the ratio, the higher the price of gold shares compared to spot gold). Thanks to Nick Laird of Sharelynx for this. Sometimes the stocks lead gold and sometimes it's the other way round. There is no hard and fast rule, but many technicians like to see the gold stocks leading the way with gold in tow. At the moment, however, the ratio having peaked in September is falling.

But central banks are now becoming net buyers of gold. As we discussed last week, central bank buying has the potential to transform gold's bull market into a bigger monster altogether. Meanwhile, governments are debasing their own currencies to oblivion. I had one ranting but eminent City trader collar me at a party on Saturday night. 'Nobody's going to buy the dollar,' he said. 'All this bailing out and quantitative easing has just exposed the dollar for the great big sham that it is.' He has a point, though I expect he might be a little more careful in his use of language come Monday morning. But 'all this bailing out', as he puts it, is why the gold price is going up.

As the dollar falls, gold rises

On the other hand, flawed though the dollar is, another liquidity crisis will mean that people are going to have to buy it as a 'safe haven'. I spoke about this recently in Money Morning: Could the dollar be in a new bull market?

I know readers like strong opinion from their writers, but in the short-term I must confess to being in two minds about gold. If it goes down, I will look to buy some more. If it goes up, I may sell a bit. But, longer term, we are going a lot higher. And we remain on course in fact we are ahead of schedule for $1,400 by next spring.

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