The gold price is set to keep falling - for now

The price of gold has fallen by nearly $100 an ounce in the past four days. And the correction is set to continue. Dominic Frisby explains what's behind the fall – and what it means for your investments.

We finally have our shake-out in gold.

After peaking last Wednesday at about $1,220 an ounce, the price has fallen almost $100 in just four trading days. Friday's capitulation - some $60 - was particularly ugly. It shows just how much speculative, hot money there is in the sector.

So what now?

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Now is not the best time to buy gold

In the week to last Wednesday 7 December, almost $300m of call options (options betting the market will rise) were traded in the largest gold exchange-traded fund (ETF), GLD.

That is more than the entire call volume of the second and third quarters of this year in just five trading days. On Wednesday alone, trading volume in GLD calls amounted to almost 50% of what the market traded in the entire second quarter. That is a sign of extreme speculative excess. It is not the time for short-term investors to buy. At such extremes, you have to ask where are the next buyers going to come from?

The time to buy is when the put volume (bets that the market will fall) is at record highs. Or, as the Wall Street proverb puts it: 'When there is blood on the streets'. I daresay there will be just such opportunities again.

As gold plummeted on Friday, we saw around 80 million shares traded in GLD. That is the highest daily volume ever. Nor is a market falling on such high volume something to buy into.

The clues that a correction was coming were there. Gold stocks had lagged badly on gold's last move higher. Silver had also lagged. It had been many weeks since we'd seen any meaningful pullback. There was too much bullish sentiment and the position taken by the Comex futures traders (the 'smart' money) was also very negative.

What's driving gold's fall?

But what is driving the falls? Surely everyone can see the fundamentals behind gold? That may be, but short-term speculative capital does not care about long-term fundamentals. It is looking for quick gains and it appears to have driven gold into some kind of short-term, blow-off top.

As we head into year end, there are a lot of fund managers who will want to lock in their profits for the year. I'm afraid that means they will sell their gold and anything else they own that has done well at the slightest hint of a turn in the markets, because they will want to secure their gains (and their bonuses) on what will have been an excellent year. That's what we saw on Friday and why the market fell so hard, so fast.

In the short term, this does not bode well for any market except one. It may be that we are finally seeing the end of the 'Great Reflation Trade', this astonishing rally out of the crash. For the large majority, locking in profits will mean locking in US dollars. And we have repeatedly said that it's the US dollar vs everything else. If it rises, stocks will fall, commodities will fall even corporate bonds and UK house prices may start to fall.

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Keep your eyes on the dollar

Of course, the US dollar is being debased into oblivion by its issuer the Federal Reserve, of course it is undermined by America's gargantuan debt levels, but it is still the currency in which Mr Margin Call and just about everyone else demands settlement.

Despite the falls we have seen in the dollar since the spring, the longer-term channel up has held for now at least. This chart shows the US dollar index the dollar vs a basket of other currencies over the last four years.

09-12-09-dollar-index

If the dollar rallies back to the top side of the channel, we will see a level north of 90 and, correspondingly, we will see the proverbial blood on the streets in just about every other market.

Looking at the shorter-term chart of the dollar, we can also see it has broken out of its downtrend.

09-12-09-dollar-index-2

Remember the excessively bullish sentiment I described in the GLD options trading in the opening paragraphs? There has been just such extreme sentiment about the US dollar only in reverse, and for much longer.

Not only have there been extreme levels of pessimism - 95%, 97%, 98% bears, according to which survey you read - this negativity has been ongoing since the summer. In the four or five months since then, the bearish sentiment has increased, yet we are just three or four points lower on the index. The downside momentum, so forceful between March and June, has petered out, even although the negative sentiment hasn't. I would suggest that is bullish.

I remain of the mind that we are going are going to see gold at silly numbers one day. Even gold exploration stocks run by incompetent geologists who can't add up and have repeatedly diluted their stock after taking bad advice from unscrupulous investment bankers will trade like the tech stocks of the late 90s. But we are still several years from such a scenario. For now, we must keep our eyes on the dollar, which is due a rally.

This might be our healthy 10% shake-out in gold en route to a higher spring high (reaching my $1,400 spring target) or last week's huge call option position may mark an intermediate term top in gold. We shall see. Either way, I think this correction in gold has further to go.

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