I could write pages and pages about my thoughts on gold discussing all the finer details about what's affecting it, but I'm going to keep this post focused on the US dollar because that's ultimately what is driving gold. So then, why is it that I feel we are close to the point where gold is ready to head down in a big way? How can I even consider such an idiotic possibility you say, in the face of an ever declining dollar underpinned by 0% interest rates, massive deficit spending, and the fed read to "print money" via another round of QE? Well, first of all you have to realize that at every major long term top or bottom for any asset, the fundamentals appear to be at their best or worst respectively. That's just the way a major top or bottom gets made. It's also at this point where everyone who ever wanted to buy (sell) has already done so or is waiting to get in (out) on the next pullback (rally). Once you reach that point, there's really no other way to go but in the opposite direction...all it takes is a catalyst. I think we are in the stage of the gold bull market whereby thanks to QE and other factors that are considered dollar negative, everyone is absolutely convinced that gold will only go higher from here longer term and the only downside risk is ST in nature because gold is "overbought". I can hear those people who have been watching on the sidelines say "that's it...I'm not going to miss out on this anymore. I'm in on the next dip". Sentiment wise, this is the type of condition you see at major turning points.
I think there's little disagreement that the main reason gold has run up to present level is because of pessimism towards the dollar. It definitely can't be attributed to traditional consumption of gold for jewelry and industrial applications because annual demand for those purposes is actually lower now than it was 10 years ago! So, let's look at what the US $ and gold have done since they respectively peaked and bottomed in 2001. I want to first focus on a particular date, March 2008 because this is when the dollar traded at its lowest level to date (bear with me you'll see my point). In March 2008, the dollar (as measured by the trade weighted basket, ticker USD) had dropped about 45% from its peak. Mathematically, since gold is priced in dollars, the drop in the dollar alone justified gold to rise 90% from its low which equates to about $500....for the sake of convenience let's call this $500 figure the intrinsic value of gold. But what actually happened in March of 2008? Gold was at $1000 - 2 times this intrinsic value. Therefore, it would appear that gold was overvalued by 100% in March of 2008. Calm down gold bugs, I'm not done. Given the multi-year downtrend in the dollar that has been in place, it would be fair to assign some sort of a fear premium to this intrinsic price of gold, accounting for the possibility of future dollar weakness similar to how options have a time/volatility premium. So then, what exactly would be a reasonable premium? I'm not so sure, but a 100% premium to the intrinsic price seemed kind of rich don't you think?
Now, let's take a look at the present situation. Despite its recent slide, the dollar is still 10% higher from its lowest point in March 2008. Logically, you would expect that gold would be modestly lower or about the same from the $1000 level but instead it's higher by 35%!
Let's take a step back now. From its peak in 2001 the dollar has dropped 36% yet gold has risen about 400% from that same point! That doesn't seem justified does it? The intrinsic value of gold based upon the drop of the dollar that has taken place puts it at about $465 and here we are at $1350! Again, a premium to this intrinsic value is warranted but at $1350 the premium itself is now almost double the intrinsic price!
Now look, I realize the above analysis is simplistic and you could probably poke a few holes in it but there's no doubt to me it shows the negativity towards the dollar implied by the price of gold is far greater than at any time during this gold bull market. When you get a situation where the fundamentals for a particular asset are good for a long time, momentum and herd behavior can cause people to bid up the price regardless of what the price already implies about how good the fundamentals are. So long as these favorable fundamentals are in still intact the price keeps going higher and higher until you get a priced to perfection situation. This is what is going on with gold. Sure, the dollar has been weak for 10 years but it hasn't been as terrible as the gold price implies. The US dollar is actually slightly higher than it was 2.5 years ago yet gold is massively higher. To me there's no denying this smacks of irrational pessimism towards the dollar and therefore irrational exuberance towards gold.
In the late stages of a bull market or bubble you tend to hear any kind of justification supporting the high price. With gold you are seeing this happen with the "gold will do well in deflation or inflation" argument. What a crock of shit that is. We saw what happened to gold when there was a deflationary scare in the late 2008 (please don't tell me about how gold did well in the 1930s. Prior to the 30's the price of gold was fixed and suppressed for years and then once it was allowed to be traded freely in the early 30's it went up). The reality is that gold has big bull markets as result of secular US dollar weakness and/or run-away inflation. We haven't seen the latter during this gold bull market. Gold bugs say hyper inflation is coming but they've been saying that for a decade and instead we flirted with deflation a couple of times and nothing even close to hyper inflation.
I have a hard time believing that the price of gold over and above what's justified by dollar weakness is due to an anticipation of hyper-inflation. I realize markets can be forward looking but history shows this is typically 6-12 months into the future. We passed that deadline a long time ago with gold.
That's enough talk about fundamentals. I know there are other fundamental issues I didn't touch upon but as I said before, I could ramble on for pages and pages and so I just wanted to discuss what I felt were the main issues. Let's now talk about sentiment.... my favorite thing. You know the motto of this blog. You can analyze fundamentals to death and justify whatever fair price you want but the bottom line is when you get to the point where most people who were considering to buy have already bought or are waiting to buy on the next dip you are at the point when the market is about to make fools out of them in a big way. It's always tough to pinpoint this moment but you know you are close when dumb money retail investors are piling in while smart money insiders are rushing out or short.
In the summer I got plenty inquiries about gold from unsophisticated retail investor acquaintances (to put it very nicely). I said to them that I believed gold could have one more good run in it but then I'd be very careful after that. Well, here we are with gold having its good run. The fact that retail investors appeared to be so interested in gold and yet it did not have immediate contrarian implications suggests to me that gold is in final phase of its bull run. The final phase of any bull or bear market run tends to coincide when late to the party retail investors are stampeding in or out of it respectively. This behavior typically lasts for I'd say 4-12 months. In the final phase of a bull run, you tend to see a parabolic move in the asset and for a while, the retail investor is correct, but when the tide turned they see their paper gains lost and more. Therefore, great profits can be made actually going alongside the retail investor during the blow-off phase of a bull or bear market...you just got to get out in time. At the same time, anyone playing the role of the "intelligent" contrarian betting the other way gets ran over for being too early.
Gold is being talked about day in day out on BNN. When they ask different guests what they think about gold the response is the same every single time “gold is overbought here but I'm still bullish longer term. It needs to pullback before you should buy". This is exactly the same thing I heard when oil was at $130 in the summer of 2008. Of course, oil bulls got their correction....and more. So, even the so called "pros" on TV are convinced gold can only go up longer term. Funny how most of these same "pros" were scoffing at gold in 2001 when it made its first bull market advance. I remember quite clearly on CNBC one of these clowns saying "gold is only good for trading it's not good for a long term investment". Now after a 10 year 400% bull market with gold at $1300+ everyone on TV says they are bullish long term. lol! Thank God for these schmucks. Take a look at the long term chart in gold. Can you say parabolic?
Just prior to the bull market in gold in 2001, one of the things I remember gold bugs frequently pointing out a lot as a bullish indicator was the commitment of traders report which showed that commercial futures traders, a.k.a the smart money insiders were significantly net long gold futures. Funny how you don't hear a peep from the gold bugs about the conditions in the futures market right now. Commercial traders are presently massively net short gold futures...at a record in fact, and they have been heavily net short for the past 1.5 years. This is huge negative for gold longer term from smart money commercial traders.
The final nail in the coffin is my father. He doesn't follow markets whatsoever and just today he talked to me about how he can buy gold and silver. I asked him why. He said because he heard it being talked about in some financial program on the radio. He said gold can never go down. The last time I heard my father talking like this was with US real estate a few months before it peaked in 2005. Needless to say my father is a dumb money indicator....probably one of the dumbest! Don't tell him I said this! lol!
It's clear to me that from a fundamental and sentiment perspective the evidence is strongly supporting that it's just a matter of weeks or months before the gold bull market takes a massive dive perhaps leading to a long term bear market. But with gold still hitting fresh all time highs contrarians be warned betting against gold too early. Markets can go higher than you think possible especially if there is a blow-off/mania phase. Given that gold made fresh all time high last week, odds suggest higher prices still lie ahead before it's all over and that means more opportunities on the long side with gold stocks...you just have to be very careful at this point keeping one foot out of the door if you want to play along. I myself have cashed out last week on a nice little move on one my small cap plays aag.v which happens to be a gold exploration company.
You see, just because I'm LT bearish on gold doesn't mean I won't try to take advantage of any long opportunities in the ST. If market action suggests gold wants to go higher and do a blow-off top, then fine by be...I will try to ride it up. Just because I don't think such a move higher is sustainable in the LT doesn't mean I should stand in its way going short and then throw hissy fits and argue with tape like these idiot, loser permabears on equities do after losing money.
You know I'm against picking tops and bottoms but there are are rare times when it's warranted. Such is the case when few people are doing it, the risk/reward is so high and the reversal you're expecting would occur violently causing you to miss out on a big portion of the gains if you wait for the turn. I believe this will be the case with gold. When I feel the time is right, I intend to buy long term OTM puts on GLD starting with 5-10% of my capital willing to accept a complete loss if I’m wrong. This would allow me to be a strong holder if I'm early. And if I end up doing this play and it doesn't work out, you won't see me cry and whine about manipulation like the losers I see out there. I'll take it like a man and accept full responsibility.
Great post. Two things come to mind:
ReplyDelete1. Alan Greenspan uttered the words "irrational exuberance" in 1996...4 years before the Nasdaq peaked.
2. Hugh Hendry once said (I'm paraphrasing) that in the late 1980s the Nikkei at 20,000 was overvalued...but it had to reach 40,000 before it could hit 10,000.
I too have noticed more retail interest in gold. However, I wonder if it's still early to consider this a contrarian indicator since actual capital allocated to gold is minute and the exuberance has really only existed for a few months now.
I agree with your points...I'm just wondering about the timing.
yes, I realize there's really no limit as to how overvalued something can get which is why I always respect market action. if it suggests gold wants to go higher, by all means I'll step aside and better yet, try to join in.
ReplyDeleteAnd like i said in my post, the retail stampede in or out of an asset that occurs when it's making it's final high/low tends to last for 4-12 months. So, yes, it's conceivable that it's still early in this final phase which also means we could see further parabolic action in gold. This is why I said I think it's possible this could go on until April 2011.