Does the gold market have more upside potential, or is a top being made?

The gold market has been making a powerful move to the upside lately. In fact over the last three weeks it has been up almost every day, with prices now turning nearly vertical with many gaps on the daily and weekly charts. Is this move sustainable? Are the fundamentals or the perception of future fundamentals sufficient to justify the prices this market has achieved? Before attempting to shed some light on those questions I need to discuss that character and structure of a fast trending market.

When analyzing accelerating trends on numerous charts from the past a few observations can be made. First, in markets with large public participation the character of uptrends and downtrends are substantially different. In commodity markets where the participants are mostly professional traders and commercial interests the difference is not as great. But in popular markets the public is oriented toward the long side, and will react one way to greed, and react in quite another way to fear. Despite what you might read on gold oriented web sites that are always bullish, the gold markets that are traded on exchanges have mostly public participation on the long side. When markets accelerate to the upside greed can take over and the bandwagon effect is in full force. At some point the bandwagon will knock off most of the speculators who are not strong hands. But the character of the bandwagon effect can take two different forms.

Consider scenario #1. A healthy uptrend will occur after a period of accumulation. This can be characterized by a sideways trending market where the smart money is quietly accumulating their position. Usually there is little chatter or mention in the popular media or on many of the trading blogs. The general public is often looking the other way. There is little momentum to chase. The market is not bearish, but it is also not in favor at the moment. Such a condition occurred in the gold market while it was building that large triangle that I pointed out in a previous post on this blog that started in February, after a large run-up, until the breakout on the 2nd day of September. Once the breakout occurs the momentum chasers and eventually the public gets on board the bandwagon as the smart money starts to sell to those now entering the trend. This can last for some time as the public and late money pours in. By this time the smart money is usually gone. As usual the dumb money gets left holding the bag. The bandwagon tips over as the market enters a correction. If the longer-term uptrend is not violated there will most likely be a new area of accumulation where the smart money re-enters the market and picks up bargains from the public that sells out near the bottom. The whole process of accumulation repeats. And then on the next breakout the momentum chasers and public re-enter, and the whole process repeats. On each of these impulse moves prices most likely will accelerate a bit into the cycle high, but then get pulled back by the inevitable correction. As long as this process occurs in a somewhat orderly fashion the trend is probably still alive and well. The impulses up followed by reactions back down are healthy for the trend and suggest continuation of the primary trend.

Consider scenario #2. The same accumulation occurs as in scenario #1 above. However this time the bandwagon keeps getting more and more crowded. Instead of prices backing and filling, prices accelerate at an even faster pace and become parabolic. There is little downside. Maybe there is a down day here and there, but almost every day is up. The media gets on board and discusses the uptrend at faster intervals the higher prices go. All the news is bullish. Dissenting voices are mostly absent. Gaps start occurring on the chart. It looks like a straight moonshot where there will never again be a downside to consider. At some point, without warning, the market makes a quick reversal down. I’ve seen this occur numerous times in commodities where there would be limit up day followed by limit up day, and then on one of the limit up days the market would suddenly be limit down. At first this looks like a bad print. But after being locked limit down it is obvious that the market has quickly reversed. Often this is followed my numerous limit down days. In stocks and many commodities a limit move is not a consideration, but the same effect can be experience by a huge gap down on an opening, when stop loss order are useless. Usually following such price destruction there is disbelief because all the news is still so bullish. Most traders think the drop is temporary, but if the market retraces most of the last impulse move up, it is most likely that the bull is dead. Usually there will be some small bounce or even a retracement a third to a half of the way back up. But in most cases these markets enter serious bear markets that can last for a very long time and it will take a brand new bull market to get any kind of meaningful uptrend to start. We have seen many examples of this type of blow-off move in many popular stocks and futures markets in the last several years. Silver is a good example. It went to $50 in 1980 and it quickly went all the way back down to $5 after a series of limit down moves. It has never returned to the $50 level, and has taken nearly 30 years to regain about a third of the previous high price. Dry Ships is a more recent example of a stock that went parabolic all the way up to $131 two years ago, and is now priced at about $6 and trading flat.

So the question now is which scenario does the gold market belong to. Is it in the exponential, parabolic blow-off stage, or is it just make a nice impulse move higher that will correct at some point and eventually continue on its way within a secular bull market? At the risk of sounding indecisive, I would say we are somewhere in between the two scenarios. There are various forces economically and politically at work in the gold market.

Gold can move up temporarily in time of uncertainly or disaster, but for a long term bull market gold really needs inflation. As I see it, right now we have a government that is devaluing the currency at an unprecedented pace. The printing presses are running overtime. Interest rates are down to zero. Conventional wisdom would suggest that inflation should start picking up at any moment. But how can inflation pick up when there is oversupply of just about everything and at the same time demand is shrinking. Of course this is a result of rising and persistent unemployment and falling housing prices. Until the employment situation improves on a sustained basis there is little hope that the supply and demand situation will turn around. There is just too much supply of just about everything you can think off. Obviously there is a huge supply of real estate and autos and just about every other piece of merchandise. Prices are falling on nearly everything. If the sticker price doesn’t fall, then there are sales and then sales on top of the sales. Even oil is in excess supply, although prices don’t always come down based on supply demand in that market. And of course gold has a huge amount of supply. How can that be when 321gold and other bullish gold sites claim there is a shortage because they don’t have enough to mint coins? Nearly every ounce of gold ever mined is potential supply. Very little is used up or consumed in the sense of a pork belly or barrel of oil. It simply transfers from the ground into a vault somewhere. It is all potential supply at some price, or at the perception that future prices will fall. Remember when central banks were dumping gold, thus depressing prices? They kept selling regardless of how low prices went. Every ounce of gold that was available for supply back then is still available as supply now, at least at some price.

So at the moment there is an overactive printing press and deflationary forces at work. There is a huge amount of debt that will obviously have to be monetized at some point. The destruction of the currency will have to eventually result in inflation, but at the moment the deflationary forces are a counteracting factor. This does not mean the situation is stable. Far from it. Once employment turns around, and it will, prices are certain to rise. Is it possible gold is seeing that far ahead to justify the current price? That’s a difficult question to answer. I think it is obvious that gold is looking at the inflation component, but I think it has gotten way ahead of the fundamentals by not taking into consideration the deflation component.

My feeling is that we are still in a primary bull market in gold. I say that because of politics. We have a two-year election cycle that can change the landscape dramatically. Of course it is a four-year cycle for president, but there are also mid-term elections that can change congress. And hopefully it will next year. But it may not help much. The current crop of republicans aren’t much better than the democrats. If we could elect people that understand the economy and would treat the economy and spending in a responsible way, then the currency would be strong and gold would have less interest as a store of value. But with a short-term election cycle politicians would rather have a quick fix to try to boost up the perception of a good economy so they can get re-elected. To do the right thing would probably cause serious dislocations that they would be blamed for. I’m not optimistic that this will change anytime soon. Therefore the long-term irresponsible nature of politicians that don’t understand economics and don’t really care about fixing it for the long term will insure that gold should enjoy many more years of a secular bull market.

But what about the short term? It looks parabolic. And gold has had a multi-year run. It started the bull market from under $300 and it almost hit $1200 today. Markets can obviously go much further than seems logical. I still think that is the case short term for gold. It appears to be in a bubble, in that it has gotten way ahead of its fundamentals and appears to only be discounting potential inflation. Also, it is mostly just moving inversely to the US Dollar, at least in this last part of the impulse. Interest rates will likely stay down as long as the employment situation stays bad, but any uptick in interest rates that would also cause an uptick in the dollar could tip over the gold bandwagon. The dollar is only low in relation to currencies of other countries that are perceived to have a more responsible government. That is another factor that could change. It is difficult to imagine any government more reckless or irresponsible that the current one, but anything is possible.

Gold1125

This market seems ripe for a major correction, in my opinion, but not a new bear market. You can see on the chart three red linear regression lines drawn on the last three impulse moves. They are fairly even in length. Line #3 is a bit less steep, but has already achieved the duration of lines #1 and #2. Prices over the last three weeks (this is a weekly chart so the three candles on the right) have moved parabolic, with gaps, and have moved far away from the regression line. It would seem logical for there to be some reversion to the regression line, although that line will become steeper if prices stay up here. A re-test of the March high at the end of impulse #2 is not out of the question. If prices continue higher from here I would view it as a negative sign, as it would suggest we are entering scenario #2 described above. But my gut says we’ll have a healthy correction, a new accumulation base will form, and there will likely be another drive to much higher prices in the future. At least that is my hope. I’m a long time bull and don’t want to see this market enter a final blow-off stage that will take years to rebuild. But the market will do what it wants. Entering new long positions at these levels could prove to be very dangerous. The smart money buys when there is little interest, and sells, often too early, to those chasing momentum.

Trying to trade the downside of this market can be tricky. In my earlier trading days I would often try to pick tops and bottoms. I had some success, but there were many losers, especially trying to pick tops. Most markets bottom more quickly and decisively. Tops are more difficult. Bulls seem much more difficult to kill. However, there are a couple of ideas using option spreads that may help reduce the risk of a net short position in gold or a net long put position. Some of these spreads can be constructed so a maximum gain can be achieved if the market does break, but can still offer a profit if the market continues higher. There is a zone of loss in the middle. This post is getting a bit long so I will try to give examples of those spreads over the long weekend.

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