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Sunday
Feb102013

Is the Gold Bull Market Over?

Before we are swamped with emails from gold bulls saying that there is no way the bull market is over, let us state that we are not saying the bull market is over right now, we are merely asking the question and discussing when it would be appropriate to call the end of gold’s run.

Nothing goes up forever. Even the most hardened gold bulls must admit that there will be a time that the yellow metal’s bull market will end, just as it did in 1980 and just like all great bull markets in financial markets. Therefore the purpose of this article is to put forward arguments as to when gold’s run could be over.

We will begin by dismissing bearish arguments that we think serve no purpose in determining when the gold bull market is over. Our personal favourite is the “gold has no intrinsic value” argument, which suggests since gold does not produce anything, pays no dividends and cannot be used for anything (except jewellery and dentistry) it is massively overvalued. This argument is so poor we will not dwell on it for too long, it can be dismissed simply by the fact that since people are prepared to pay for gold then it is worth something. The “gold has no intrinsic value” argument has been around since the beginning of time, and yet gold prices have gone up and down clearly driven by other factors, not this childish argument.

Another flawed argument is the “gold has gone up a lot in recent years, therefore it should go down”. Again, this argument is incredibly poor, potentially even more pathetic than the first, since markets are not governed by gravity nor arbitrary numbers so if something has gone up 500% then this is no reason why it couldn’t go another 500%. We are not interested in how far gold has come, we are more interested in the factors that have been driving it higher and how changes in those factors could influence future gold prices.

However there are some valid points, one of which is that equity returns are increasing and stocks outperformed gold last year. Although it is possible for equities and gold to perform at the same time, if equities are beating gold then that increases the incentive to move money from gold to the S&P 500, and such flows could dampen any potential gains in the yellow metal. A similar argument applies to rising interest rates, if US interest rates increase then that increases the cost of holding gold (which returns no interest) therefore it becomes less attractive on a relative basis. We are probably a fair way from much higher interest rates; nonetheless it is a point worth considering.

There are some cold hard facts that we must admit increase the likelihood of the gold bull market having already ended, although none of them seal its fate, they paint a bearish picture for the yellow metal. At the time of writing, gold has not made a new all-time high in 534 days, its down 4.41% in the last year and has failed three times to break resistance above $1800. Gold has certainly lost momentum, going through the worst patch in its entire bull market since the global financial crisis. It is this loss of momentum that has us concerned, we exited all our long gold positions in December and we will not be getting long again until gold breaks that crucial $1800 resistance.

In our view the most compelling argument for the end of the gold bull market is its lack of reaction to QE3. Gold prices are at pretty much the same levels they were prior to QE3 being announced. So even if one creates a scenario in which job growth in US disappoints and the Fed embarks on more easing, does this mean gold will rise? Why would gold rise dramatically on a QE4 when it hasn’t even managed to eke out gains months after QE3?

Of course on the other side of the coin, what if the Fed doesn’t ease monetary policy again and growth is satisfactory or better? Gold would be crushed under such a scenario. So on the one hand we have gold failing to rally with monetary easing and on the other we know that gold will surely fall without more monetary easing. It is hard to create a bullish view from this base. So, when does one pull the pin and call the end of the gold bull market?

For us we would say there is probably a slightly greater than 50% chance that the gold bull market is over right now. It’s 50-50, but with a gun to the head we would call it over. However one of two things would need to happen for us to believe with certainty that it is over. Firstly if gold remains in this $1550-$1800 range for another year then that would have been the longest consolidation period in the bull market by far and therefore we would have to say that the show was over due to a serious lack of momentum. However, we do not think we will reach this stage and gold’s fate will be decided before that. Our second “nail in the coffin” condition would be gold breaking support at $1550. We think that this is more likely than breaking resistance at $1800. Either way, it will not be long before we find out.

 

So how should investors react to the situation right now?

If we had any gold mining stocks, these would be the first to go. Fortunately we have avoided investing in the miners and have therefore dodged their appalling performance in recent years. However, the market is still long gold stocks and sooner or later this speculative money will lose patience and throw in the towel, making it a very vulnerable sector.

If we were long gold, we would exit the entire position right now (gold is $1675 as we write) since it makes no sense to be long gold here. If the bull market is set to continue, then there will be time to get in. We would exit all gold longs and re-establish if gold broke about $1800. Yes, that would mean missing the rally from $1675 to $1800, but we would be happy to miss the first $125 of a rally that would go hundreds of dollars higher, in return for knowing with more confidence that gold prices were indeed going higher.

We would then look to gain short exposure to gold stocks, since, as we mentioned, they are extremely vulnerable. There are also a number of option based plays that we would execute on gold itself, which one can find out more about by subscribing to SK OptionTrader to see our trading signals and model portfolio.

In conclusion, the gold bull market may not be over, but the warning signs are significant enough to take money off the table. From a risk-reward perspective we think the best position is to be square gold, looking to get long should gold break $1800, and short if it breaks $1550 or sideways trading persists. Getting outright short exposure to gold prices will probably be best achieved via short positions in gold mining stocks. To find out exactly what trades we are executing in this environment, and to view our model portfolio and to receive our premium market updates please visit www.skoptionstrading.com to subscribe.

 

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