Is the gold bear market really over?

What Could Send the Gold Price Lower? 

1—Gold Didn’t Test Its 2009 Breakout Point

Gold has experienced two significant corrections since the bull market began at the turn of the century.  The first was in 2008 and the second began in 2011 and many investors believe ended at the end of 2013.  One thing that differs between the two besides their durations is that when the market bottomed in 2008 it hit a major support level—about $700/oz.—that had previously been resistance from April, 2006 through August, 2007.  But we have not seen this in the recent bear market.  The last breakout point was the resistance level of about $1,000/oz. where the market peaked in 2008 and under which the market consolidated until the end of 2009.  The breakout led to the subsequent rally all the way to $1,900/oz. in 2011.  Now if the pattern were going to repeat the gold market should test the $1,000/oz. level, but as you can see on the following chart of the SPDR Gold Trust (GLD) we haven’t seen this.

Technical analysts would argue that a test or even a quick breach of the $1,000/oz. level would wipe out the speculative money that entered the market after the gold price broke to its new all-time high, and that this would be needed in order to set the stage for a fundamentally driven leg higher.

2—Stocks and Bonds Remain In Favor

Broadly speaking I am not bullish of stocks, and I am downright bearish of bonds.  But there is no denying that these assets have been performing well over the short and intermediate term.  While the mainstream financial press would have you believe that these assets trade opposite to one another they are historically correlated.  They are both financial assets, meaning that they are claims against another entity that owes something to the stock or bond holder (e.g. dividends or interest).  Despite the fact that stocks and bonds are richly valued on an historic basis investors don’t seem to care.  Bonds will remain expensive because central banks will see to it that interest rates remain low, and stocks respond to this: while stock may be historically overvalued on a price to earnings or on a dividend yield basis, when these earnings and yields are compared with bond yields they appear to be attractive, especially in the case of companies that can borrow money to buy their competitors or to buy back their own stock.

With financial assets in favor real assets are, by extension, out of favor.  While we are seeing strength in select commodities such as zinc, palladium, coffee, and lean hogs, the broader complex is floundering.

Now financial assets are, broadly speaking, overvalued while commodities are generally undervalued, and this includes gold  But the market is not at a point where these disparities really matter.  So long as money remains cheap bond prices can rise and anything that has a yield can rise with them.  At some point this situation will reverse itself, and this could happen very quickly in response to some black swan event.  As investors we need to be prepared for this and I will address this in the next section, but for now it suffices to say that it makes sense to yield to Newton’s first law of motion, and acknowledge that financial assets will keep rising while tangible assets will keep falling.

3—Chinese Gold Demand Is “Falling”

I put the word “falling” in quotation marks because this is the narrative that we are seeing in the mainstream media from sources such as Bloomberg, and Reuters.  Technically this is true—demand is down year over year.  But in a broader context I feel that the claim that Chinese gold production is falling is disingenuous, and we can see this from the following chart.

From this chart we can clearly see that demand is down in the near-term, but it is up sharply over the past few years.  Nevertheless the prevailing narrative is that Chinese demand is down, and this is generating bearishness and apathy among investors.

Now just to be clear I think this chart is extremely bullish, and furthermore the gold withdrawals data (the red, vertical lines) doesn’t tell the whole story, because Chinese gold production has been rising year over year and none of this gold leaves China.

So, Chinese demand for gold is actually not down as much as the first chart would suggest.

Nevertheless, despite these caveats investors are concerned that Chinese gold demand is shrinking, and this could continue to keep them out of the market or even lead some speculators to take short positions.

4—Federal Reserve Tapering Is Perceived To Be Bearish for Gold

Many investors are concerned that if the Federal Reserve continues to taper and if it eventually stops pumping money into the market that this is bearish for gold.  The intuition is that there will be less money in the financial system to bid up gold prices.  While this makes sense it is misguided—the money needed to bid up gold prices dramatically from here is already in the system.  Furthermore, as I’ve argued elsewhere there is a strong correlation between the Fed tightening and a rising gold price.  Nevertheless, the misconception prevails, and when the Fed ends its quantitative easing program in October we could see a knee-jerk reaction in the gold price to the down side.

5—The Dollar Index Has Been Strengthening

One of the big surprises this year has been the strength in the Dollar Index, as you can see on the following chart.

This strength has led investors to believe that the Dollar itself is strong, and it leads investors to avoid investments in gold and in other commodities.

Now gold bulls know that Dollar Index strength is not the same thing as Dollar strength.  The former simply means that the Dollar is increasing in value relative to a basket of currencies that includes the Euro, the Ye, the Pound, and others.  But this doesn’t mean the Dollar itself is strong.  For instance, the Dollar Index has gained about 15% since its 2008 low, but it has lost about a fifth of its value relative to gold.

Nevertheless in the short run perception can often trump reality, and a rising Dollar Index can be short-term bearish for gold.

What Should You Do?

On the one hand there are several catalysts that could drive the gold price lower in the near term, despite the fact that, as I’ve hinted above, many of these catalysts aren’t really bearish for gold.  On the other hand gold remains undervalued, and furthermore, even if gold can fall another 20% or so its upside potential dwarfs this potential correction which might not even take place.

So if you’re an investor looking to accumulate gold what should you do?

1—Dollar Cost Average

Unless you’re in the business of trying to time the market don’t try to time the market.  Allocate a consistent amount of money from your income or your savings to the gold market each week or month or whatever works best for you.  This way you will be increasing your exposure on a regular basis so you won’t miss the upward move should the aforementioned correction never materialize.  You will also be able to capitalize should we get such a correction.  Chances are you won’t catch the exact bottom, but if you’re buying on a weekly or a monthly basis you’ll buy some near the bottom, and because you’re allocating the same amount of Dollars each time period you will buy more gold near the bottom and lower your average buy price.

2—Avoid Leverage!

The worst thing you can do in this environment is to use leverage.  If you use leverage you might face a margin call near the bottom of the market and lose your position.  You’re buying gold to protect your wealth, not to gamble.  If you must have some leverage then devote some of your portfolio to out of the money call options or to the mining space, but options and miners are not gold, and they come with other risk factors.

As a corollary to this you should avoid gold miners that have a lot of debt or high production costs.  These companies can easily go bankrupt if the gold price falls to $1,000/oz. and they miss an interest or debt payment.  We saw companies with quality assets go bankrupt because they were leveraged and couldn’t contain their costs when the gold market was weak (e.g. Jaguar Mining).  So unless you are gambling or an industry expert you should filter out any mining companies from consideration that have too much debt or that can’t turn a profit in this environment.

3—Finally, Ignore the Hype and Stay Disciplined

As the gold market remains weak and the stock market strengthens it becomes tempting to give up on gold.  The media has demonized gold despite the fact that it has been one of the best performing assets this century.  Banks and analysts have been paraded in front of the cameras at CNBC and Bloomberg espousing the new bull market in stocks and the end of the bull market in gold.  But very little has changed over the past three years, and in fact the bull case for gold has gotten decidedly stronger while the financial system has become more indebted and stocks continue to trade at historically high valuations.  All that has changed is the prevalent narrative and perception.  With this in mind don’t get caught up in the bubble mentality that has swept across Wall St. that is willing to pay 50-100 times earnings for social media stocks (assuming they have earnings) and 20 – 30 times earnings for consumer staple stocks.  Gold is undervalued, and under-owned.  It might take a while longer for the market to realize this, but the upward revision to the gold price is likely to be significant once the top is blown off.

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