Click here to access Part 2 of "Big Move Coming for Precious Metals"
One theme I hope to convey in my writing is flexibility, which is crucial to long-term successful investing. Being a perma-bull worked from 1982 to 2000, as did the buy-and-hold investment philosophy. However, since then a more adaptive strategy to the business cycle and investing in general has worked best, being able to sell when economic prospects deteriorate materially (2000, 2007) and being able to buy when the economy and stock market is improving (2003, 2009). If one holds to their investment philosophy and mentality without moving with the markets they are either missing out on big gains and/or suffering big losses. Flexibility has not only been vital to investors in the stock market, but also niche investing areas such as precious metals investing. While precious metals have outperformed the US stock market over that past ten years, investors in the sector have suffered tremendous volatility along the way with 2008 being the greatest example. Given global central banks continue to debase their currencies and increase money supply growth rates while deficits continue to spiral upwards, the secular bull market for precious metals is still intact. That said, investment flexibility can help precious metal investors avoid volatility and headache.
I believe there is to be a big move in precious metals over the next six months but the direction of that move is unclear. There is both a bearish and bullish case to be made and being open to both sides and knowing what to look for will help investors to be on the right side of the investing equation.
Precious Metals Beholden to the Greenback
As gold and the USD are indirectly correlated, the direction of the USD plays a key role in determining the trend in precious metal bullion and related equities. Currently, both a bearish and bullish case can be made for the greenback, which is why I feel there is both a bearish and a bullish case for precious metals over the next six months. Because the ultimate resolution of the USD’s next big move is uncertain, precious metal investors need to stay flexible in their outlook for bullion and precious metal stocks. I see two possible analogs to the present situation and both witnessed large moves in the USD and precious metals, which is why I believe a big move also lies ahead this year.
The bearish case for the greenback (and conversely bullish case for precious metals) is the analog to the 1978 crash in the dollar, which I highlighted earlier in the year (Parallels to the 1970s Suggest Parabolic Move in Gold Ahead). In 1977 the USD fell roughly 12% from point E to point F (see bottom chart) and then staged a weak oversold bounce and rallied 4-5% before falling nearly 16% from point F to the low seen in 1978 in a span of five months.
Source: Bloomberg
It’s not hard to make a bearish case for the dollar given the ever rising government deficits and a Fed Chairman bent on supporting asset prices by printing an endless supply of dollars. Fed Chairman Bernanke in his semiannual monetary policy report to Congress on July 13th showed his cards that the “Bernanke Put” is not about to go away anytime soon as another round of quantitative easing is not off the table. Below are remarks he gave to Congress earlier in the week (emphasis added):
Semiannual Monetary Policy Report to the Congress
On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.
In addition to more possible monetary stimulus, there are those in Congress willing to consider even more fiscal stimulus. Representative Barney Frank, the senior Democrat on the House Financial Services Committee, prefers to use more fiscal stimulus first before considering another round of quantitative easing, but is for more monetary stimulus if needed. Key excerpts from a Bloomberg article commenting on Barney Frank are provided below:
Frank Says Fiscal Policy Should Precede New Round of Fed Easing
A third round of quantitative easing by the Fed is “not my first choice,” Frank, a Democrat from Massachusetts, said in a Bloomberg Television interview.
Frank said critics of the Fed’s more than trillion bond purchase program “have absolutely been proven wrong” when they warned it would cause inflation.
“My first choice would be for the Congress to act in a reasonable way,” he said. “For example, let’s provide some money in the short-term to cities and towns so they can undo some of those cuts.”
“So if we needed a third round, I would be for it,” Frank said. “I would hope, however, and I think we have done enough with monetary policy, fiscal policy should come first.”
While Representative Frank is just one voice in Congress, it does show that there are high-ranking government officials that see no issue with more fiscal or monetary stimulus, and its this line of thinking that will propel the USD lower, and if foreigners begin to lose faith in US fiscal and monetary authorities, we could see a sharp decline similar to what occurred in 1978. Under such a scenario we are likely to see gold experience a parabolic move just as it did in 1978-1980 in which gold rallied more than 300%. Also of note, during this period which saw the USD rapidly decline and was associated with double-digit money supply growth rates, the S&P 500 went nowhere in real terms but in nominal terms rallied 36% from early 1978 to its early 1980 peak.
Source: Bloomberg
Given the overwhelming bearish sentiment on the USD by most investors it’s easy for them to agree with a bearish USD and bullish gold scenario. However, one can also make a strong USD case in which a possible European sovereign debt default could lead to massive deleveraging and margin calls that would be reminiscent of Bear Sterns and Lehman Brothers from 2008. While the long-term fundamentals for the U.S. and USD are quite bearish, our day of reckoning may not come for several years. However, it does appear the day of reckoning for Europe is certainly a more present threat, which is why we may see money flee the Euro and pour into the worlds most liquid currency, the US dollar.
While I can see the 1978 case for the USD and gold serving as a close bullish analog, the 2008 analog also shows close resemblance to the current situation, which is why I remain open to both a bull and bear case for precious metals. Shown below is the path of gold bullion, gold stocks (HUI), and the USD, from 2007-2008 and from 2010-2011. One of the key concerns I have is the marked underperformance of gold stocks to gold this year which is exactly what we saw in 2008. With the benefit of hindsight we now know that precious metal stocks were discounting a major USD bottom and coming bear market, and so greatly underperformed gold bullion. I shared this concern in an article last month (Echoes of 2008 Suggest Caution for Precious Metals Investors). As seen below, the current general price action in gold, gold equities, and the dollar shows remarkable similarity to 2008 and why I still believe precious metal investors should remain flexible so that they don’t get smacked by a rogue wave due to perma-bull blinders.
Source: Bloomberg
USD Snapshot
Given the USD likely holds the key for whether the next big move in precious metals is southwards or northwards, precious metal investors need to keep a close eye on the USD. The long-term trend still remains bearish since its peak in 2002 at over 120 on the USD Index. The intermediate-term picture is also bearish since the USD Index’s peak in 2010 at 88.71. From a chart formation perspective, the technical bearish break from the 2005-2011 consolidation still holds and the USD has failed now several times to rally back within the triangle. That said, the shorter term picture for the USD is bullish as seen by the rising green channel in the lower panel below. If the USD Index breaks down through its bullish short-term trend channel then the probability of the 1978 USD crash is more likely. That said, there is still major support in the low s (see green box in upper panel), and it would only be a break below the low seen in 2008 that would likely completely remove the 2008 scenario as a possibility and a sharp USD decline similar to 1978 would likely ensue.
Source: Bloomberg
Click here to access Part 2 of "Big Move Coming for Precious Metals"
