All that Glitters is Not Gold

Some say it was inevitable that we were going to see an aggressive shakeout after what appeared to be one of the most over-crowded trades of a lifetime.

We were certainly expecting a correction of some description, but the sheer magnitude and ferocity of the fall has been breathtaking. It was a classic case of retail investors responding to the gold hype in the media plus the contrarian investor's signal to start to go short, wait for the trigger and watch as the house came down. Red signals flashed when we saw the ratio of managed longs to shorts on gold at 60:1, perhaps the highest for some time, as the price action went parabolic.

A correction to the uptrend

When gold failed to close above the previous all-time high of $1913, a false breakout sent a powerful signal to traders that the buying had dried up and a rejection of higher prices had occurred. One would certainly not have expected the price to drop $389, or 20% to $1532 in 14 trading sessions, two of which recorded more than $120 in daily ranges.

There was also the expectation that central banks would step in and support prices. However, this was not to be, and fuelled further fears that traders were on their own. Margin hikes by the CME did not help either.

There are a number of factors behind the move:

• The recent strength in the USD, which broke out on the back of safe-haven flows. In the last few months, gold has been the currency of choice as traders rejected both euros and USDs, because of poor domestic fundamentals. That psychology was unwound, as traders flocked back into the perceived safety of the USD and JPY.
• The intense liquidations by margin clerks as equity prices got smashed. With gold and silver two standout performers of 2011, they were also perhaps the most vulnerable to traders raising cash to pay for the raft of equity losses - 32 out of 45 major global markets reversed into technical bear markets (a drop of 20% or more).

Fundamentals were blown out of the water, and this now remains front and centre of traders' minds. Looking ahead, gold will likely follow risk assets, and, the risk of further sell-offs in equities will see the precious metal under pressure.

Is gold's future bright?

Statistics

• The downside looks reasonably limited, with the 200-day moving average at $1529.
• According to research by Goldman Sachs, gold has been above this level since January 2009 on a closing basis (effectively 700 consecutive daily closes as of September 23), which is the second-longest run since its records began in 1967.
• The uptrend that has been in place since October 2008 is still intact at $1472, and as long as the price does not close lower, we remain positive on the metal and see it as merely a correction in a longer-term uptrend.
• It is also the eleventh year of the bull market, the longest winning streak since 1920.

Trading gold

It is clearly still a trade for the brave and those with a medium-term view could be nicely rewarded at current levels.

• The investment case still stacks up; positioning is not overly stretched, with a recent commitment of traders report showing net longs have fallen considerably.
• Physical demand is still extremely strong; India and China have started to come back into the market aggressively, and have been reported as buying coins and gold bars. Markets still have a lot to work through. According to Britain's Chancellor George Osborne, Europe has six weeks to sort itself out, so clearly markets remain nervous about who should support gold.
• Investment bank UBS recently suggested the market is not currently pricing in a worst-case scenario, with a 30% chance of severe market dislocation by year end.

Gold is up 15% for the year, and therefore is still under threat of being sold to pay for margin calls if equities continue to see sellers. However, we feel it is oversold in the short term, and given equity holdings are at extremely low levels, you could make an argument that it has made the investment case much more compelling. European issues are not getting any better, despite consistent rumours of leveraging the EFSF to ring fence-indebted nations or increasing the size of the bailout fund. At the end of the day, once the European leaders do agree on something, we will probably have to wait another six months before they actually see the light of day, and patience is one thing the market does not have. The real trigger for more cautious gold buyers will come when we see a sharp move down in risk assets, though, gold remains supported for now.

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Updated: 04/10/2011

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