Three reasons why gold may be due a correction

published 21 June 2010

After moving above $1,260 an ounce on Friday afternoon, gold closed the week at $1,256. It's a new record.

And it's no surprise.

Governments and central banks have between them created an environment of negative real rates. For example, retail price index inflation in the UK is above 5%. Yet the Bank of England has kept the bank rate at 0.5%. By the time they've paid tax, savers need to find a bank that pays more than 7%, just to keep up.

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The result is that savers are being mugged by policy-makers. Money in the bank is losing its purchasing power, as the people in charge attempt to devalue the currency. Watching your savings shrink by the day isn't much fun. So people are being driven to find a more effective store of value.

Is it any wonder people are flocking to gold?

What's driven the gold price to new dollar highs?

Higher interest rates are inevitable sooner or later. But, as long as this environment of negative real rates continues, gold will continue to rise. Many myself included have been looking for a sizeable correction in the market in order to get repositioned. You normally get one or two a year. But, since late 2008, even the slightest sell-off has quickly been met with buying. A lot of people want to get into this market.

It's worth noting that much of the rally we have seen over the past fortnight has largely been a function of dollar weakness. In euros and pounds, gold is trading a few pennies below the highs made on 7 June. So it's not that big a landmark. But looking at the bigger picture, gold, a currency in itself, is rising against all fiat currencies, as policy-makers worldwide debase them.

However, there are some divergences that suggest gold might soon suffer some sort of correction.

Three signs that gold may be due a correction

Firstly, June, July and August are typically weak months for gold. The summer often sees one of the best entry-points (i.e. a low) of the year.

Secondly, even after the rally of the past few weeks, gold stocks are still trading below the highs of December 2009 and March 2008. That could simply mean that the stocks are currently a better opportunity than the metal. But that divergence can often indicate impending nastiness. It certainly did in the spring of 2008.

Thirdly, gold's highs are also unconfirmed by silver, which, at $19 an ounce, is still 10% or so off the March 2008 high of $21.50.

Now, I'm not too concerned about silver's comparative weakness. Typically, the ratio between gold and silver falls during good times and rises during the bad. For example, between 2003 and 2007, when credit markets were at their most buoyant, the ratio fell from 80 to 45 (so it would have taken 45 ounces of silver to buy an ounce of gold). In other words, silver was rising in price faster than gold.

This happens because, unlike gold, silver is as much an industrial metal as it is a monetary one. Its comparative surge in price was due to the fact that this was a booming period of speculation. Silver does well in such an environment.

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What the gold/silver ratio can tell us about the wider economy

However, in periods of credit tightening, the ratio between gold and silver rises, as deflationary pressures cause money to move from speculative assets to stores of wealth. During the bust of 2008, that ratio quickly went from 48 to almost 85. In other words, silver slid in price much more quickly than gold.

Indeed some experts like to use this ratio as an indicator of impending stress or buoyancy in the credit markets. A move above 70 would tell us there's more trouble coming.

The chart below shows the ratio between gold and silver over the last ten years. As you can see, a clear uptrend has been in place since late 2006.

The ratio is useful as a guide to tell us when to move your gold into silver (above 80 on the ratio) and when to move your silver back into gold (below 50). But the current ratio of 65 is not necessarily warning of an impending correction in the gold price.

All in all, while the evidence is not conclusive, I'm not a buyer of gold here. I don't like to buy at all-time highs. But nor am I selling. We may see some sort of summer pull-back, particularly if stock markets turn back down. But, longer term, this bull market has further go.

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