Is gold a flash in the pan?

This week Martin Weiss, publisher of the world’s largest circulation investment newsletters, asked a famous funds manager, Douglas Davenport (protégé of the legendary investment manager Sir John Templeton) the following questions:

• Is it over for gold?
• Why isn’t all this Fed money-printing driving gold through the roof?
• What should you do now? Buy? Hold? Sell?
• What’s the best strategy for grabbing future profit potential in gold in 2013?

Douglas Davenport’s answer might surprise you given his background as manager of The Wisdom Fund, a Warren Buffet-style value fund, which earned 5-Star Morningstar ratings for 10 of the 11 years that Davenport was at its helm.

But before disclosing Davenport’s advice, let’s examine what exactly has been happening to gold. Along with bonds, it has been the best-performing common asset class since the onset of the global financial crisis in late 2007.

The New York Stock Exchange quoted SPDR® Gold Shares is the largest physically backed gold exchange-traded fund (ETF) in the world.

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In the chart above, gold’s medium-term (50 day) trend line is depicted in red and its long-term (200 day) trend line is shown in green. In addition, gold’s long-term relative strength index is shown as a blue line oscillating below the main chart.

Five things stand out in this chart.

Firstly, gold has been in a ranging market since July 2011. Note that it previously ranged between 2008 and 2010 and before that between 2006 and 2007. Indeed, since gold prices took off in September 2005, the market has ranged about two-thirds of the time.

Secondly, gold advanced in three big leaps; in 2005-06, 2007-08 and between 2009 and 2011. The latter prolonged rally was in response to the US Federal Reserve’s first two rounds of Quantitative Easing (i.e. money printing) that gold bugs thought would ignite inflation.

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Note, however, that the third round of QE has not boosted gold prices. That’s because America, like Europe and Japan, still shows no signs of higher inflation. Indeed, the developed world is still gripped by deflationary forces caused by high unemployment and excess production capacity. Most investors now accept that inflation is not an immediate threat so have lost enthusiasm for using gold to speculate against the actions of the Fed.

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The third thing to note in the original chart is that gold prices, since they started booming in 2005, have only thrice exhibited a “death cross” – a point where the red medium-term price trend fell below the green long-term price-line. The first occasion was in late 2008, but the last two occasions were within the last 10 months. The poor performance of gold since it spiked in August 2011 has spooked even dedicated gold bugs.

Fourthly, the $US price of gold is now trading at the bottom of its bold red support line established in 2012. See first chart again. Right now, investors view gold as having “as much lustre as a rusty tin can,” according to Forbes magazine. That’s because the number of traders betting against gold recently reached its highest level since 1999. Gold made its worst start to the year in more than 25 years, and continues to trade around 17% below its previous peak of 19 months ago.

Finally, note that the long-term relative strength index of gold (shown as an oscillating blue line below the main graph in the first chart) has not been this low since gold took off in 2005. But it seems to have bottomed and is turning up. 

Also Colin Twiggs of Incredible charts says: “I am not yet convinced that gold is headed for a primary downtrend. We may be in a low-inflation/deflationary environment right now but central bank expansionary policies will counteract this. Watch out for bear traps. Respect of primary support around US$1,500 per ounce could present a buying opportunity”.

Sean Brodrick, a popular US resources analyst, agrees and says “it’s more than likely that precious metals are near a bottom” because:

• Central banks around the world are going to continue to pump paper money as fast as they can print it. Usually, that’s bullish for gold.

• There are great mining projects that can’t get funding now — that puts a squeeze on supply.

• The flood of selling in the SPDR Gold Trust (GLD) and other ETFs that hold physical gold seems to have ended. This tells me some hedge funds that were getting wiped out are done for now, taking some downward pressure off gold prices.

• The Chinese economy is improving, putting more money in the pockets of billions of consumers who have a cultural affinity for gold. In fact, sales of gold bars for investment purposes jumped twofold in China during its recent Spring Festival.

But Larry Edelson, another well-known market analyst, gives this warning:

There can be big disinflationary waves in commodities (such as gold), even when there’s massive money-printing going on.

Why’s that important? Because nine out of 10 investors (and analysts) think all too linearly about the markets.

They think that, if there’s money-printing happening, in any part of the developed world, it’s inflationary. And that commodity prices must therefore go up.

Not true. The markets are dynamic, complex systems. They can defy linear logic ... they can defy the fundamentals ... they can defy the news. They can also defy the authorities. That’s why (you must) think dynamically.

According to the IMF, the bulk of advanced economies in 2013 are expected to enjoy higher GDP growth, but lower inflation than in 2012. Only Australia and Norway are seen as completely bucking these trends. Stronger growth with lower inflation could undermine gold prices further.

No one knows whether gold prices will crash or escalate from here on. As long as investors continue rotating from bonds to shares in the belief that the worst of the economic crisis is over, gold will languish. But if the current share rally ends with a sharp correction there could be a rush back to gold given its safe-haven status.

Also, at some point the central banks need to exit their present strategy of forcing down interest rates by buying income securities on a grand scale (see Adam Carr’s article The dollar’s medium-term comfort zone). In the meantime the wide yield gap between bonds and shares will compress as investors dump bonds in favour of shares.

If the bond bubble bursts, central banks will be loath to add to the crisis by offloading bonds. Indeed, cash strapped governments might insist they step up bond purchases even if there is no shortage of liquidity in the wider economy. If that happens inflationary fears could resurface causing the price of gold to skyrocket.

Note that the gold price rally since 2005 (depicted by the orange price index in the next chart) has still to experience a blow-off as happened in previous gold, NASDAQ and oil price bubbles of the last 43 years.  It’s rare for booms to end with a whimper rather than a bang. Hence gold bugs argue the climax is yet to come and the present lull is the last opportunity to buy at depressed prices.

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Which brings us back to Douglas Davenport’s advice to Martin Weiss and his flock of followers. Don’t try to forecast what will happen to gold prices – instead time the gold market using a good trend-following system.

I agree. Here is the gold price chart for the ETFS Physical Gold Bullion ETF (ASX Code GOLD.AX). Applying a simple 50/200 day moving average crossover strategy shows the following results.

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As you can see, the safest course of action for investors in gold bullion ETFs at present is to be in cash. Only if the Australian price of gold shows a decisive upturn on several technical indicators will I issue a buy signal.

Unless gold’s bull-run is over, the time will come when it will rebound in response to either bond or stock fears. It’s one of the few asset classes that offers insurance against both hyper-inflation and depression. It just doesn’t like normality. Having a small portion of your portfolio in a gold ETF to safeguard against black swan events can help stabilise overall returns, especially if you conservatively trend-trade it to minimise its downside risk.

Percy Allan is chairman of Market Timing Pty Ltd. For a free three-week trial of their Weekly Update bulletin and signals for trend-trading Australian share and gold ETFs, visit www.markettiming.com.au.