PFGBEST Perspectives
Tuesday, 12.13.11Back to newsletter
A Market Fundamentals Curve Ball
By George Cocalis, PFGBEST Sr. Market Strategist

For gold market day traders and longer-term traders, a realistic question of late is what market personality may show up in certain situations. The direction of the gold market is a puzzle within itself, especially with $40- to $60-point ranges almost the norm.

I’m going to give you an instance of one such trade that caused me more than a little blood, sweat and tears.

First, a note -- the increase in margins on gold, silver and copper futures by the CME Group has not been the reason for declines, but rather, a consequence.  This is important because many bloggers have focused on the margin increase as a reason for price dips, trying to use the explanation that “someone knew in advance that margins would be hiked” and therefore sold.  That’s bogus.

A better explanation for late summer/early fall big sell-offs in gold and silver is provided by the overarching fundamentals.

Indexed commodity funds sold commensurate levels of otherwise unrelated commodities to bring their weightings back in line. This selling tended to trip stops set by others. Moreover, it’s assumed that a number of speculators had to close out positions in order to bring their leverage down due to losses incurred elsewhere when stocks, commodities and carry trade currencies all plunged in unison.

Often the 'winners' are sold especially hard in this type of situation. This has nothing to do with fundamentals. It does make you want to keep a keen eye on charts for focus as well.

Fed announcements that portend continued policy (interest rate tweaking but no imminent money supply inflation) are negative to overvalued equities and industrial commodities. This kind of disappointment also weighs on gold's nominal price.

However, charts illustrate that even with some drubbing, gold's real price actually continues to hold up very well.


click image for larger view

One more reason to temper bearish sentiment is that, in terms of the so-called 'commodity currencies', gold remains quite strong. For instance, for South Africa's producers, the recent decline is but a barely noticeable hic-up after a huge rally.  Gold has actually continued to strengthen vs. industrial metals (the latter have been falling a lot more). This typically happens as economic confidence falters.

Gold also continues to look strong vs. crude oil.

Gold in Australian dollars remains within its recent trading range. In Canadian dollar terms gold has lost a bit more, but still has held on to more of its gains than in USD terms.

In summary, it seems the market has punished gold stocks unduly in view of the fact that profit margins depend on the real, rather than the nominal, gold price. Furthermore, this tendency to attempt to 'discount' the gold bull market has been a feature of the market since 2008. It has been continually wrong, so perhaps at some point someone will wise up. As far as we are concerned, the fundamental factors supporting the gold bull market have become stronger rather than weaker. Nevertheless, short- and medium-term corrections, even violent ones, come with the territory. One would do well to remember that the 1970s gold bull market witnessed similar volatility – at times even worse volatility – as it played out.

It is of course always possible for the fundamentals to shift, even when it is a market like gold with a finite supply in the universe. We see nothing of the sort on the horizon at present. As far as we can tell, the monetary and fiscal authorities are unlikely to change course, so we expect more money printing and more deficit spending to come down the pike in the months ahead.

And now, my tale of woe.

Consider the action of gold on Thursday, September 30, 2011. It was the last day of the month and the last day of Q3. Coming in early Friday morning, I was positioned for gold to decline to $1600 and possibly $1562; I had long option premium.

Fundamentally, as far as my trade was concerned, I needed the S&Ps to go much lower – my target was 1125 to trigger more cash margin calls in the stock market before the weekend.  Recently, up to that point, as the stock market sold off, the gold would sell off, possibly from stock traders taking those gold positions off to help pay margin calls within their stock portfolios. 

Secondly, I was looking for crude to break below my $81 target and for the dollar to resume its powerful uptrend.  Also, if the rest of the metals sector was weaker (as a whole, especially the silver market), that would even put more pressure on gold to break below the $1600 mark.

What actually occurred? The S&Ps traded down to 1121.50 which we anticipated, the crude market collapsed over $3.50 – wow, even better for our outlook! The silver market dropped over 70 cents, looking like a perfect technical setup, and the dollar rose over 70 points! What more could a bearish gold trader want, especially on a Friday?

Around 9:30 a.m. Central, gold broke to $1617, which was small support on the 60-minute chart, and it approached $1609, which was also strong support before the short-term target of about $1590.  Gold had hovered around $1625 for the previous two days, with no clear violation on the upside; all signals pointed to a hard selloff.  Indeed, I was so confident that this would occur, I was actually double checking my positions to make sure I had the correct quantity of long contracts on the December gold $1650 puts and the November gold $1625 puts as well!

The gold market traded under the $1609 number and traded as low as $1607, but to my surprise, that was it! Gold started to reverse with no news.  All other corresponding markets (dollar, crude, S&Ps, oil) still traded accordingly, which I assessed should still be bearish for the gold market.  If gold’s descent fizzled out for the moment or rallied back to $1617, the trade was still on track to retest the lows, in my opinion.

However, not only did gold reverse, it rallied above $1625 and traded to $1632, which was short-term bullish!

Lesson learned? Anymore, it is not enough for a gold trader to be right on direction. In these times and markets, there is a need to sense whether gold could react very abnormally to situations that (back in the day) used to be reliable markers of bullish or bearish moves ahead. From my trading log to you: the landscape for these markets is changing dramatically before our very eyes!